Bank of Montreal is Canada’s fourth-largest bank by market
capitalization, with 920 domestic branches and 685 branches in
the US. Canadian retail banking is expected to contribute
approximately 45% of 2012 earnings, US retail banking 15%,
wholesale banking 25%, and wealth management 15%.
We have a Sector Perform, Average Risk rating on Bank of
Montreal shares, as we believe the market now better appreciates
the positives from the acquisition of M&I (i.e., greater expected
cost synergies than originally targeted and the potential for credit
recoveries), as evidenced by the stock trading close to TD and
Scotiabank on a 2012 P/E basis (and higher than CIBC and
National Bank), and the stock having been the best performing Canadian bank stock so far in 2011. We continue to believe
that the M&I transaction will turn out to be more beneficial than management originally suggested, although we believe that
the market is now ‘on board’. 1) The expense synergies of a minimum $300 million (up from the originally estimated $250
million) could be higher still as they do not appear high in the context of M&I’s expenses (nearly 18% of 2010 non-interest
expenses), especially when considering that 2010 expenses included an elevated level of credit-related costs. 2) The expected
future loss estimates appear high, taking total cumulative incurred and expected loan losses to 21% of the loan book. Should
ultimate losses be lower, it could lead to recoveries which would boost future earnings. In the fourth quarter of 2011, there
was a net
.17 positive EPS effect from acquired loans. 3) Management’s targets for the transaction do not take revenue synergies into account for reasons we understand but will likely prove conservative, in our view, over the medium term.
Revenue growth in Canadian retail banking is at the low end of the peer group, and organic revenue growth remains low inthe US. Capital ratios are average relative to peers. The bank is getting closer, in our view, to increasing its common share
dividend (we expect an increase in the first half of 2012), although the bank has less room for dividend increases than peers
given an industry-highest payout ratio of 47% based on our 2012 earnings estimates, which compares to the bank’s last stated
target payout range of 45–55% and is above the expected payout range of 37–45% for the bank’s peers.
Our 12-month price target of $69 is based on a P/E multiple of 10.5x our 2013 EPS estimate and adding approximately
.50
per share to reflect our estimate of excess capital in 12 months. The 10.5x target P/E multiple that we are using is near the
lower end of the target range of 10.0–12.0 for the big banks that we cover, reflecting lower retail revenue growth. The 10-
year average P/E for the bank group is 10.5–12.5x. Our 12-month price target is equivalent to 1.8x Q4/12E P/BV and 2.2x
Q4/12E P/TBV.
Risks to our price target include the health of the overall economy, sustained deterioration in the capital markets
environment, the US housing market, and a greater than anticipated effect from off-balance sheet commitments. Additional
risks include regulatory and political risk including the tax rate, integration and execution risks with the M&I acquisition,
litigation risk, and declining domestic market share.