Morgan Stanley Financials Conference

Jun 13, 2012

It's my pleasure today to welcome BMO Financial Group. BMO is Canada's oldest bank and serves more than 10 million customers, and BMO is focused on delivering a great customer experience and is known for strong credit management. BMO operates 924 branches in Canada and 672 branches in the U.S. Here to present for BMO today is Tom Flynn. Tom has been with BMO since 1992 and has held a variety of senior management positions. He's been in his current role of Executive Vice President and Chief Financial Officer since March of 2011. Tom has served as Chief Risk Officer prior to his current role. Tom, on behalf of everyone here today, I'd like to thank you for your participation in this event, and I'll open it up to you to make some opening remarks before we join the fireside chat. Thank you. Thank you, Cheryl. It's good to be here in New York. Good morning, everyone. I'll be fairly brief, but I'll make some comments related to priorities at the bank and our recent financial results. I'll take five or six minutes doing that. Bank of Montreal is a North American universal bank serving over 12 million customers. We're the eighth-largest bank in North America by assets and number nine by market cap. In the first half of this fiscal year, approximately 70% of our revenues were generated in Canada and other countries, and the balance in the U.S. We have a strong capital base. Our Basel II Tier 1 ratio was 12% at the end of Q2. Our retail banking business operates in Canada and the U.S. Midwest, with nearly 1,600 branches, over 920 in Canada and over 660 in the U.S. Retail banking is the largest contributor to total bank income. Within this segment, commercial banking is a strength. We rank second in Canada with approximately a 20% share, and in personal banking, we have an 11% share. In the U.S., we have strong deposit share positions, number one in Wisconsin, number two in Chicago, and number three across our Midwest markets. Our U.S. commercial business is also strong, and we're well-positioned for a business-led recovery relative to peers. Our private client group manages and administers total assets of approximately CAD 440 billion. This business provides a broad offering of wealth management and insurance to a full range of client segments, from mainstream to ultra-high net worth and institutions. Over 75% of the bank's operating group revenues and adjusted income comes from these retail businesses. Our fourth business group, BMO Capital Markets, provides a full range of products and services to corporate, institutional, and government clients. We operate mainly in Canada and the U.S. as a bulge bracket firm in Canada and with a mid-market focus in the U.S. We were recently named Best Investment Bank in Canada for the second time and Best Metals and Mining Investment Bank for the third year in a row by Global Finance Magazine. I'll now touch on a few key priorities that we're focused on. First, execution of our North American growth strategy is progressing well, and we're pleased with the benefits from our acquisition of Marshall & Ilsley, completed about a year ago. The transaction was opportunistic and significantly strengthened our U.S. banking platform. We've taken the best from both organizations in terms of people, processes, and products to significantly increase the competitiveness and profitability of our U.S. banking business. Integration is on track, and we continue to expect that the more than CAD 300 million in cost synergies that we've talked about will be fully reflected in our run rate results by the end of next year. Second, each of our businesses operate under a single vision, which is to be the bank that defines great customer experience. The consistent focus we have on customers and their success is underpinned by a strong, consistent brand and is grounded in a belief in relationship banking. The importance we place on giving our customers increased confidence has helped us carve out a distinctive position in the marketplace. Lastly, we're focused on improving our productivity. We're simplifying structures and process to become a more efficient bank. Our effort here is well-organized and focused on a number of work streams. I'll wrap up with a few quick comments related to our Q2 numbers, which we thought were good. Second quarter net income was CAD 1 billion 28 million. Adjusted net income was CAD 982 million, up 28% from a year ago. EPS was up 15% to CAD 1.44 per share. Looking at the operating groups, Personal and Commercial Bank in Canada, net income of CAD 446 million was up 8% year-over-year, with operating leverage of 2.3% as expenses were well managed. Personal and Commercial Banking US adjusted earnings of CAD 137 million more than doubled from a year ago. We remain focused on completing the integration of M&I and building on our leadership position in commercial banking in the U.S. Midwest. Our private client group had its best quarters in two years with adjusted net income of CAD 150 million. We had good performance across our wealth businesses and from our insurance business in Canada. Lastly, Capital Markets delivered good earnings in the quarter of CAD 225 million, which was in line with the level of a year ago and up about 10% from the prior quarter. To close, we feel good about the financial performance of our businesses and how we're positioned looking ahead. With that, I'd be happy to take your questions. Great. Before we get started here, I'd like to remind listeners that Tom's comments may include forward-looking statements and that listeners should consult BMO's disclosures on its website for further details and the caution regarding forward-looking statements. Tom, I thought we'd start off talking about the Canadian personal and commercial business. Obviously, a lot of debate surrounding consumer leverage and the state of the Canadian housing market. Maybe you could lay out the macro thoughts in terms of if we're looking for some sort of correction in housing and how that plays through into lower growth that we're expecting in the consumer lending segments over the next several quarters. Sure. It's our view on the personal business and the housing market is that growth is likely to slow. We think that's a good thing because Canadian consumer leverage has increased significantly. As we look at the business, we're managing our risk in what we think is a prudent way across our portfolios. We don't expect that we're going to have a significant correction in the housing market, and we think that the issues in the market now will manifest themselves through lower growth. Looking at the performance of our bank and the other banks over the last few quarters, you are starting to see loan growth slow. We're running mid-single digits, and we think that rate of growth will continue over the next few quarters. We're managing our business based on that kind of an expectation. The other thing that's impacting the business is lower rates, and lower rates put some pressure on net interest margins. So that's another factor that has caused us, in part, to focus on productivity and looking to drive the bottom line through a sharper focus on managing productivity. We do stress testing of different results, and I know talking about stress testing is topical. I won't go into the details of the different scenarios that we run, but the structure of the Canadian housing market provides a very significant cushion to the banks from a risk perspective. The banks don't take mortgage risk above an 80% loan-to-value, and we don't take home equity risk above an 80% loan-to-value. Where we write mortgages above an 80% loan-to-value, 100% of the mortgage that we do is insured. You need a very significant correction in the market in order to produce a significant impact on earnings. Based on all the stress testing that we have run, we're very comfortable with our portfolios. Great. BMO did exit the broker channel for mortgage a few years back and have been focused on the branch channel originations. One of your great successes has been the 25-year amortization, simple mortgage. Can you talk about where you're seeing the growth coming within the channel, albeit in a more normalized, I would say, growth in general, but what your competitive advantage is and how you've been able to take some share, given the new product focus. Sure. We exited the broker channel about four years ago and did that mainly because we wanted to focus our employee efforts and our balance sheet on our core customers who we think we will have the opportunity to do more business with. Our experience was that it was hard to cross-sell people who we wrote mortgages for through the broker channel. We are focused on maximizing wallet and our core customer, and that is why we moved in that direction. We did have a mortgage offer earlier this year that featured a 25-year amortization, and that is a shorter amortization than the average in the market, which would be around 30 years, and a relatively low rate. The product was structured so that customers were basically signing up for a shorter amortization, a relatively low rate, but a lesser ability to opt into different products through time. The retention level in the product will be above average. We did very well with that product. Our pipelines are stronger than they have been for some time, and we think it is a good product for our customers and the market, because although the rate is relatively low, the payments per dollar of mortgage are actually higher because the impact of a shorter amortization period is larger in the determination of the payment than the low rate. It helps our customers pay off their mortgage more quickly, which is good for them, and it also does not put upward pressure on the housing market because the payment associated with that house purchase is higher. It is a good product for the market, good product for our customers, and a good product for us in terms of generating interest in our bank and our offers, and attracting good customers. Okay. Maybe to round out the consumer lending, we will spend a little bit of time on credit card. Obviously, a strong MasterCard issuer. There has been obviously an acquisition in this space in your peer group and another peer that is pulling back on the credit card lending. Can you talk about the dynamics you are seeing in the marketplace within the credit card product? Sure. We are a MasterCard issuer in Canada, and historically, Canadian banks were only able to issue either a MasterCard or a Visa product, and those rules have recently changed. Most of the banks are very dominant in one or the other card. We are the number 2 MasterCard-issuing bank in the country. Our portfolio, I think, is about CAD 6 billion in size, slightly underweight as a product for us relative to our peers. What we have seen there is balance growth has slowed, so we have not pulled back significantly from a risk perspective over the last little while. Our credit performance has been trending over the last few years in a positive direction as unemployment has come down, and we are comfortable with the risk profile. Our loss rates would be comfortably below the loss rates in the industry overall, and that would be consistent with our overall credit performance, which is better than the industry average overall. The business is relatively stable. Growth is down a bit. Again, not a bad thing given the state of consumer leverage. There was one transaction that you referred to in the market, and a non-Canadian player exited the market. We do not see that as having a really significant impact on the overall competitive dynamics in the marketplace. Great. Maybe we will turn our focus a little bit to commercial lending, which clearly has been an area of focus for all of the Canadian banks as the growth dynamics within the commercial segment are accelerating versus the deceleration on the consumer lending side. Obviously BMO has historically been a very strong player in the commercial market. Maybe we can talk a little bit about your competitive advantage there and how you are managing through an increased competition in the commercial lending space in particular. Sure. Commercial lending is a strength of our bank, and we think it is something that positions us well for this environment. Our share position in commercial banking, both Canada and U.S., is bigger than in personal banking, and we think we have got good offers. In Canada, in commercial banking, we are number 2 in the market. We have a 20% share, give or take, and we have had that strong position for years, and it is based on a business model that focuses on relationship coverage, looking to provide our customers with a full suite of products, including lending deposit products and treasury management products where we have been investing in our technology and good industry expertise. We think that that kind of a model sets us up well. We're integrated in that we've got frontline people who know the clients, know industries, and we've also got that supported with a risk group that is experienced and does a good job for us. In the U.S., we've also got, we think, a very good business in both our Harris Bank and M&I had strong core commercial and industrial lending businesses. Together in our Midwest footprint, we've got, we think, a great capability, and we've put together the two businesses. We've got industry focus. We're focused as well in the U.S. on our treasury management product, which is a good business in that it generates deposits and also fees. Our technology is good, and we're starting to see good growth coming out of the combined U.S. commercial business. In the last quarter, our loan growth in the core C&I portfolio was 16% on an annualized basis. The growth in the overall commercial portfolio was lower because we do have a portion of the portfolio that's in runoff, and that's about CAD 3.3 billion coming from mainly the legacy M&I commercial real estate portfolio. But if you look at the core part of, or what we would call the core part of the C&I book, the trends are very encouraging. We've had three quarters of growth and a good 16% growth in the last quarter. Our hope, and the hope of some of our competitors, is that with the economy continuing to grow and hopefully Europe settling down and confidence increasing, we'll start to see growth in the commercial segment that is in the higher single-digit level on a sustained basis. Great. I think a couple of the initiatives that you've highlighted today and before have been building out the deposit side and the treasury management side of commercial banking, particularly in Canada. Can you give some more color around just how that's progressing? Sure. In Canada, we have the 20% share in the commercial market. We're very proud of that, and we've built that business. Our deposit share on the commercial side is significantly lower than that, and the deposit share numbers are harder to define because the industry data is not as good, but we would be below 15% from a deposit share perspective. We've focused on encouraging our relationship management people to put energy into the deposit product and treasury management products. We've been doing that for over a year, and we're seeing good growth. In the last few quarters, we've had growth that's in the double-digit range, low double digits, sort of 10%, 11% growth in our deposit business. What we're trying to do in part is just change the culture of the organization in our commercial business. And because we've had a strong lending share and we've got a good capability, that's been the higher profile, sort of sexier part of the business. And we're promoting with people the value of deposits and the treasury management business and encouraging them to focus there and seeing a good pickup. And part of the theory behind this is that it's easier to do more business with existing customers than to win new customers. And with a loan share that is significantly higher than our deposit share, we think that if we focus on it, there will be a good opportunity for us to grow the business. Right. And then clearly, expense management has been very topical this year as well as sort of the consumer lending sort of slows down to a more normalized rate. And we certainly saw good improvement on the operating leverage front in the second quarter. Maybe you can talk a little bit about specific areas you're looking to manage down costs and sort of weighing that off against investment spend to grow the business as well. Sure. So I think a natural reaction in the current environment, given lower growth and low rates and higher capital and liquidity requirements, is to focus on productivity. We're doing that in an organized way in the bank across the organization, and we've got a team of people focused on that. We saw good results in our P&C Canada business in the last quarter with operating leverage of 2.3%, which was a great number in our view. We haven't suggested to people that we'll keep up at that rate through the balance of the year, but we are very focused on generating positive operating leverage in the business through the year. And in our program, we're focused on a few themes. One of them is to look at what we call our core processes, and to go through those processes and to define them, introduce better lean methodologies so that we're doing things as efficiently as possible and in a lean fashion. Right. Introduce more technology, and in places looking at offshoring. An example of that is our mortgage processing in Canada. We've got about a CAD 65 billion Canadian mortgage portfolio. It's our biggest single product. We're working now on redesigning the entire process for the underwriting and servicing of mortgages and changing the model in significant ways that we think will free up meaningful time for people in the branches, reduce our cycle time to respond to customers significantly so that we're improving the customer experience, and lower our cost because we're designing things in a better lean fashion. Right. That's a little color around one of the processes that we're focused on. We've talked about this as work that will go on for a few years. We're managing expenses in the current environment, squeezing expenses down in places. But as we look to invest in more technology and lean methodologies in our core processes, you're into the basic functioning of the bank's operations. That's a big job that just takes time. We've talked about this as an effort that will go on for a few years as we work through the organization. We're not expecting a fundamental change in the outlook, so we think the relevance of this effort will continue for the next several years. We're focused on it and committed to it. Okay, great. Maybe just one last question on the Canadian P&C side. Obviously, net interest margins have been under pressure given the low rate environment and the competitive dynamics, particularly on the lending side. Can you talk about some of the tools that you're using to help mitigate some of the pressure, and areas that you've been able to grow successfully? Sure. Banks in Canada, as you would know, are experiencing pressure that is similar to pressure in the U.S. The biggest source of the pressure is low rates. Competitive pressure contributes to it, but rates are the larger factor. Looking ahead, we expect some continued downward pressure on net interest margin. We do not think it will be significant quarter-over-quarter. But 2, 3, maybe 4 basis points of pressure absent action is something that we think is likely to occur, and there will be movement around that. In terms of things we are doing to focus on the issue, one is back to growing our deposit business and the commercial business. That is profitable business, an additive to both our net interest income and our net interest margin. We think will generate disproportionately strong growth in that part of the market. We do think that the Bank of Canada is likely to raise rates in the first half of next year. We have pushed our expectation out there from a timing perspective. When that begins to happen, it will be positive from a margin perspective. We are hopeful that we will pick up something there. Then I guess lastly, I would say that the industry is mindful of the impact that low rates has on margin, and it is a highly competitive industry. But the price competition element is one that I would say has cooled over the last 6 months compared to where we would have been about a year ago. Right. Okay. Maybe we will move along to the U.S. Personal and Commercial Bank. We talked about it a little bit, the growth that you are seeing in the C&I portfolio, ex the runoff in commercial real estate. Maybe you can give us a little bit of an update on the M&I integration, and sort of next major milestones to come. Sure. We closed our acquisition about 11 months ago. This was a large acquisition for us, $4.1 billion, roughly double the size of our U.S. retail bank. It was a really good fit in terms of the geography and the core business that M&I had. Both the geography and the approach to the business was highly complementary to our Harris business. Our hope through the downturn was that we would have a chance to materially grow our retail banking business towards the end of the downturn. M&I was always a bank that we thought would fit well with ours. We are very pleased with how that played out. Performance to date on almost all measures is ahead of the business case that we had at the time we did the transaction. The businesses have come together from a frontline perspective, so we fully integrated the management teams in all of our business groups very shortly after closing. We're working on integrating our corporate functions and on doing our systems conversion. The timing for that is that we're looking to complete the major part of the systems conversion in the fall of this year. Work there is on track, and we feel good about how it's progressing. The synergy number that we've talked about is synergies of in excess of CAD 300 million. We're running ahead of schedule on that, with current run rate being comfortably above CAD 100 million. You see that if you look at our combined U.S. expense base compared to the sum of the expense base M&I had and we had pre-transaction. Right. There's a significant drop-off between those two numbers, and the synergies will ramp up into next year from the current level once the benefits of the system conversion come through. The credit performance has been good relative to our initial expectations. So we took a large credit mark on closing and talked about that at the time that we announced the deal. In the three quarters that we've had since closing, credit performance has been better than anticipated by the mark, and we've had meaningful income coming from, in effect, the excess of credit mark over the losses that we've had, and we continue to be very comfortable. So overall, we're very pleased. The businesses have come together well. People are united around the combined bank. We're ahead of schedule, and we're very confident that the combined business will be bigger, stronger, and more competitive. Great. Why don't I pause for a moment and see if there's any questions from the audience? No? Fair enough. Hi. I just wanted to get an understanding of what's driving the expectation for higher rates that you're looking for next year. What's the base case assumptions that you have feeding into the view that Canada will raise rates early next year? Yeah. Well, I did sort of preface my comment there by saying that we had pushed out our expectation, and the base case is GDP growth of sort of 2.5%-3%. There's an assumption that Europe settles down, confidence comes back, and growth resumes with a little more conviction. In statements from the Bank of Canada over the last six months, they were becoming a little less dovish in their statements maybe three, four months ago based on the economy doing reasonably well and growth expectations being okay, and also a belief that there's a lot of monetary stimulus in the system, and we just don't need it anymore. Pulling some of that back will create powder in case there's a downturn later in the road. It would be helpful to have rates somewhat higher from a housing market perspective. The last few statements from the bank have reflected the reality that uncertainty is higher given Europe, and with that, we've pushed out our expectations related to the potential for a hike. But we still think in the first half of next year we'll have one. The big two things are we think growth will continue and pick up a little, and rates are already very low, and monetary policy is very accommodative. Giving a bit of that back as the economy recovers is what we think will happen and seems to be consistent with the reading of the tea leaves off of the statements from the Bank of Canada. Demand from China for resources is also part of your The question was, is demand from China for resources part of that? I would say it factors into the mix. Chinese growth has slowed, but we do think that the fundamental trends of there being a good base for demand in commodities will continue. All right. Thank you. Could you give a little more color on the C&I loan growth, the core loan growth? I think you said it was around 16% or 17%. Which industries or types of companies are increasing borrowing? Sure. The 16% number is the annualized growth number for the last quarter coming from the core portfolio in the U.S. It's fairly broad-based, so we're seeing some good trends in the core manufacturing part of the portfolio, some good trends in our auto dealership finance business, and good trends in the financial services part of the portfolio. So we feel good about that. It's not one sector in particular. It also reflects, I think, just good focus in our business, and we went through an exercise of combining people from the two legacy organizations. We do think we've got very strong leadership in place, and we're focused outwardly now and marketing to new customers and to the customers that we've got. That greater energy and stronger capability being applied to the market is contributing to the strong growth rate. Great. Well, thank you, Tom, and please join me in thanking Tom for the presentation today.