Citigroup US Financial Services Conference

Mar 6, 2013

Slides

Thank you for that introduction. It's good to be here in Boston. I'll make a brief presentation, 10 minutes at most, and then I'm happy to take questions. Before I begin, please note the caution regarding forward-looking statements on slide 2. You'll find additional details in our public filings. BMO Financial Group is a diversified North American universal bank. We provide a broad range of retail banking, investment banking, and wealth management products and services to more than 12 million customers. BMO is the second largest Canadian bank as measured by the number of retail branches in Canada and the U.S. We're the eighth largest bank in North America by assets and the ninth largest by market cap. In fiscal 2012, approximately two-thirds of our revenues were generated in Canada and the other third in the U.S. Our footprint is centered in the U.S. Midwest states, Illinois, Indiana, Wisconsin, Minnesota, Missouri, and Kansas, and the two largest Canadian provinces, Ontario and Quebec. This contiguous market has a combined population of more than 74 million and generates GDP of over CAD 3 trillion. BMO is well-diversified with a retail-focused business mix. We have strong retail businesses in Canada and the U.S. Midwest, with over CAD 200 billion of customer deposits and approximately 1,600 branches, 930 in Canada and 630 in the U.S. Retail banking is the largest contributor to total bank income, and within this segment, commercial banking is a proven strength across our North American platform. We rank second in commercial lending share in Canada at 20%. In the U.S., we have strong deposit share positions, number 2 in Greater Chicago and number 2 in Milwaukee. Our commercial business is also strong, positioning us well in an environment of business expansion. We're solidifying our position as a leading Midwest commercial bank through a combination of local access, sector and product expertise, and excellent treasury management services. Segments of focus include corporate finance, diversified industries, financial institutions, food and consumer, auto dealership, equipment finance, healthcare, agricultural, and commercial real estate. We have top 3 commercial lending share positions in Wisconsin, Chicago, and Minneapolis. Our Private Client Group manages and administers total assets of $479 billion. This business provides a broad range of wealth management and insurance offerings, including full service and direct brokerage, mutual funds, institutional asset management, private banking, and ultra-high net worth family offices. During the first quarter, we completed the acquisition of a Hong Kong and Singapore-based private bank and are now operating as BMO Private Bank Asia, providing our investment expertise and service to high net worth clients. This transaction is another element of our overall Asian wealth strategy, creating an integrated platform that bridges our North American and Asian markets. China represents a growth opportunity for BMO outside of North America, and we're one of only three North American banks with local incorporation through our subsidiary bank, Bank of Montreal China Co Limited. Importantly, we've established very good working partnerships in China over time, including a 28% interest in Shanghai-based Fullgoal Fund Management Co, one of China's leading fund management companies, Hong Kong-based Lloyd George Management, a boutique asset manager we acquired in 2011, and a 19.9% interest in COFCO Trust Co, a subsidiary of COFCO Group, one of China's largest state-owned enterprises. BMO Capital Markets is our fourth business segment. We provide a full range of products and services to corporate, institutional, and government clients. We operate in Canada as a bulge bracket firm with a mid-cap focus in the U.S. We have a full offering of investment and corporate banking services, including equity and debt underwriting, M&A, and trading products with leading equity research. In sum, we have a diversified business mix with personal, commercial, and wealth businesses representing more than 75% of adjusted group operating revenue. I'd now like to touch on BMO's risk philosophy, practices, and performance. Our objective is to have a leadership position in integrated risk management consistent with our strong credit history. In this regard, we developed a statement of our vision, strategy, and priorities for the risk group similar to the way we do it for our operating business groups. Our approach is to provide appropriate and independent oversight while working with all of our businesses to generate sustainable shareholder returns within our risk appetite. BMO's strategic priorities include ensuring that our strength and risk management underpins everything we do for our customers, and our performance relative to peers remains strong over time. Moving now to a few comments on strategy and areas of focus. Our brand strategy places the customer front and center. We'll drive revenue growth by achieving industry-leading customer loyalty and delivering on our brand promise, Making Money Make Sense. We also have an ongoing initiative to improve productivity. We are targeting efficiencies in both parts of the equation, revenue and expense, and we're making good progress. In fiscal 2012, expenses increased a modest 2% after adjusting for acquisitions and the stronger USD. This was a result of good cost management and continued investment in our businesses, including investing in technology and development initiatives that support lowering the cost of generating each dollar of revenue. In the first quarter, adjusted operating leverage improved for the bank and for all business groups quarter-over-quarter, excluding costs related to employees eligible to retire booked in Q1 of each year. As I've talked about, we are focused on leveraging our expanded North American platform to drive business. At the same time, we have made selective investments internationally to advance our business and expand our reach. Our focus is paying off with 2012 a year of progress for BMO. We delivered record financial performance with over CAD 15 billion in revenue and earnings of CAD 4 billion. We successfully completed the conversion of our U.S. banking system and advanced our strategic agenda. Each of our businesses is well-positioned to build on this momentum and success in 2013. BMO also had a strong start to the fiscal year. First quarter adjusted net income was CAD 1.041 billion. This marked the third consecutive quarter with adjusted earnings over a billion, and both reported and adjusted income have been in the billion-dollar range for five consecutive quarters. Adjusted results adjust for acquisition-related items like integration costs and loan accounting on the acquired loan portfolio, as well as certain other non-core items. In Q1, adjusting items were similar in character to prior quarters and netted to just $7 million. Q1 EPS was up 7% year-over-year to $1.52, and return on equity was approximately 15%. Effective Q1 2013, regulatory capital ratio requirements for Canadian banks are calculated on a Basel III basis. Our capital position is strong, with a common equity tier one ratio of 9.4% at the end of January on an all-in Basel III basis, and 12.4% on a B3 transitional basis. Last week, we announced a dividend increase of 3% to CAD 0.74 per share or CAD 2.96 annually. BMO's dividend yield is approximately 4.6%. The return of capital to shareholders was supported by our capital strength and the success of our business strategies. Looking briefly at operating group results for Q1, P&C Canada adjusted net income was CAD 461 million, up 4%. There was strong loan growth for the third consecutive quarter, with both commercial and personal lending up more than 9%. Personal and commercial U.S. had a very good quarter with adjusted net income of US $197 million, up 13% year-over-year. We are seeing continued good growth trends in core C&I loans. Volumes were up 18% from a year ago, and our pipeline remains strong. BMO Capital Markets had a strong quarter with net income of $310 million. Results reflect good execution in an improved environment and the benefit of a diversified business mix. Strong revenue in Q1 was driven by M&A activity, debt underwriting, and trading revenues. Private Client Group produced adjusted net income of $169 million, similar to Q4. Traditional wealth was up 36% year-over-year, excluding a gain on a strategic investment recorded last year, and insurance results bounced back nicely. To wrap up, we had a strong first quarter with good operating group performance and momentum across our businesses. Against the backdrop of slower consumer growth, we are well-positioned with other avenues of growth. Our strong commercial banking business, north and south of the border, positions us well in a business-led recovery. We have upside from an expanded and upgraded U.S. platform. This is true of our U.S. banking business, but also in capital markets and our wealth group. We expect to drive performance and shareholder value through our focus and efforts around efficiency across the bank, while delivering exceptional customer experience to help drive revenues. Lastly, as mentioned earlier, our capital position is strong. With that, I would be happy to take your questions. Okay. I will start. Okay. In terms of your U.S. business, you guys reported some pretty strong commercial lending results in the first quarter. You noted that your commercial real estate pipeline in the U.S. is pretty strong. As a Canadian owner of a U.S. regional bank, how do you see 2013 in terms of, number one, growth versus peers, and number two, how much NIM you're willing to give up in order to produce that growth? The focus there is on the U.S. business? That's right. A few comments on the U.S. business. We thought we had a very good quarter in the first quarter with good growth both year-over-year and quarter-over-quarter. The quarter was really driven by strong growth in our C&I portfolio, which was up to 18% year-over-year and up 7% quarter-over-quarter. So exceptionally strong performance, I would say, quarter-over-quarter. As I said in my remarks, and we said on our Q1 call, the pipeline remains strong on the commercial side. The performance there reflects in part the strong capability in commercial lending that Harris Bank had, and M&I, the bank that we acquired about a year and a half ago, had. Combined, we've got just a very good capability in our footprint in the commercial space, and we've been investing in the brand as well. We have a good capability that is paying off for us in the marketplace. Total loan growth for us in the portfolio was positive quarter-over-quarter in Q1. That is the first quarter of total positive loan growth that we have had in the business since we closed the acquisition of M&I. Since closing, we have been working down parts of the portfolio that were higher risk, and we wanted to right size. We were pleased this quarter to see the crossover point driven by the C&I growth. Our hope would be that we would continue to show loan growth over the balance of the year. We do have NIM pressure, and we are not alone in that. U.S. regionals generally experience some NIM pressure, mainly driven by the impact of low rates, although pricing is competitive on the loan side as well. In Q1, our NIM was down 9 basis points quarter-over-quarter, and that was more than we thought it would be down heading into the quarter. A few things contributed to that, including the strong loan growth. Over the balance of the year, we do think that the NIM will trend down through time but at a lower rate than we saw in the first quarter and more like in the order of around 5 basis points a quarter as a number to think about. There will be movement around that number. That is sort of the picture on the NIM and the loan growth side. We had good non-interest revenue performance in the quarter that was generated from good fees on the commercial lending side that went with the loan growth volume. We have also been in the practice of selling the majority of our originated mortgages. We are selling over two-thirds of our originated U.S. mortgages, and so we are generating fee income off of that activity. Against the backdrop of a net interest number that is going to be hard to grow given the NIM compression, we are focused on generating non-interest revenue where we can. Revenue growth in total will have some challenges around it in the U.S., but we are focused on moving the business where we can. Sure. Let us talk a little bit about your U.S. business in the context of the overall group. Obviously, the U.S. is on a recovery path. Most of your competitors are preparing for expansion, for more lending growth, et cetera. For you right now, the U.S. contributes around 20% of group net profit. What would you like that percentage to be 5 years from now? Are you happy with 20%? Would you want to have more exposure to the U.S. given the relative growth differential between Canada and the U.S. going forward? Yeah. The U.S. retail banking business and wealth business are generating a little over 20% of group income, and capital markets is on top of that. In the first quarter, our U.S. capital market business generated about $88 million of income, which was a very good quarter for it. So in total, this quarter we were a little above 25% of the income across the three business groups. The way I would think about your question is that through time given our outlook for the two economies we do expect the U.S. business to show stronger growth than the Canadian business given the investments that we've made in the platform over the last few years, and also slightly higher economic growth in the U.S. than in Canada. In Canada, this year we're calling for sort of 1.5%-1.8% growth. In the U.S., 2% plus a bit. Our footprint is growing basically in line with the national average in the U.S. So we expect we'll have a positive growth delta organically coming from the U.S. It's clearly a larger market for us to grow into. From an acquisition perspective what we've been saying is that having completed a large acquisition about a year and a half ago and completed the integration of it, we're now focused on making sure we get the payoff from those investments. We're not expecting to do another acquisition of any size in the U.S. anytime soon. That reflects the confidence we've got in growing the business organically and again, taking advantage of the investments that we've made. In terms of synergies from your M&I acquisition, you have upped the guidance up to around $400 million with around 90% of that being phased in by the end of this year. Is there scope for additional synergies maybe for 2014 onwards? It's a great question. We have moved our synergy target up quite meaningfully, as you know. When we announced the transaction, we said that we thought synergies would be approximately CAD 250 million, and that was based on the initial work that we did pre-transaction. We've increased that number really quite significantly to go from the 250 to 400. We're now at the point where about 75% of the synergies have been realized, expect to move up into the 90s by the end of the year. There will be a trickle after this year as we move from in the 90s to 100, but they won't be significant. I think beyond the CAD 400 million number that we've talked about, the synergies will be more like just benefits from the transaction. Our hope would be that with the stronger platform and the approach we took to integration, which was really to take the best from both organizations, people, products, and processes, that we'll have a much more competitive bank and that we will take share and we'll realize higher growth than we otherwise would. We see upside from that, benefits from that, but I wouldn't call them synergies. I see. Okay. Moving more towards Canada. In a slowing domestic consumer market, in my eyes, you're actually one of the more uniquely positioned Canadian banks because you have the largest market share in business lending, according to the data that we have access to. The number 2 player is not very much far away from you, but you are still the top dog right now in terms of share. Yet, you have chosen to expand your mortgage book by offering very low, almost rock-bottom mortgage products such as a 5-year fixed or even a 10-year fixed. What is driving you to expand in an area that is slowing rather than building on your strengths in terms of business lending, something that is looking up in my view? I guess the way I would answer that question is we're looking to get growth on both sides. We do think that the market opportunity will be larger on the commercial side given the leverage that exists with the Canadian consumer and having a business-led recovery. We run our personal business separate from our commercial business. Putting energy into one side of that business doesn't really detract from our ability to look to grow the other side. We do think that our business mix is very well-suited to the current environment from a growth perspective because we are overweight commercial lending, in both Canada and the U.S., and we think commercial lending will be higher, from a growth perspective, than personal. We've also got upside from our U.S. businesses, having invested them over the last few years, and we think there's natural operating leverage there. Plus the U.S. economy we think will grow more rapidly than the Canadian economy and will be a beneficiary of that to a greater extent than some of the Canadian banks that aren't as big in the U.S. Their capital position is strong. We feel good about our mix as it lines up against the current environment. On the mortgage product, we have promoted a mortgage product that we think is a good product for our customers. The product offers customers a fixed rate for generally five years, and a 25-year amortization period for the principal repayment. We think it makes sense for our customers to lock in a mortgage rate at the current time because rates are low, and also to pay off their mortgage more quickly. The product that we've promoted, we think lines up well with market demand, but also with good financial planning from an individual customer perspective. Living our brand of Making Money Make Sense, we think it's a good product. The product has been very successful. We had a campaign around it about a year ago. This week we've just relaunched the campaign for the sort of spring house sale season. We've had very good success at cross-selling customers and also bringing in new business. In the campaign that we had about a year ago, 40% of the business that we did came from customers who were new to our bank, and that was a great customer acquisition strategy. The spreads on the product are in line with the average spread on our overall mortgage product. That's in part because we're doing the business at the advertised rate versus having a higher rate that you might discount off of to do business. The spreads are reasonable. We've had very good success at cross-selling new customers other products. On average, we've cross-sold 1.9 products to the new customers who have come to the bank with that product. From our perspective, we've got spreads in line with the portfolio. We're attracting new customers. We're cross-selling them other products. We're gaining share. Our share in mortgages is relatively low. It's around 11%, about half of our share in commercial lending. Although growth is likely to slow in the mortgage market, we think it should from a market health perspective. Our share is relatively low in that segment, so having growth makes sense in our overall mix. In terms of your other residential exposures, you do have a fair amount of home equity lines of credit. I believe you are the second most exposed bank as a percentage of the total loan book at around 15% of your domestic loan book is HELOCs. It's not materially larger than most of the other banks, which are around 9%-10%, and it's below one of your competitors who is around 20%. Yet that is the one product that could potentially keel over if the consumer slows down. It's a product that introduces almost nonlinear risks, if you will. You just need a little bit of negativity in the economy, either from the construction sector and employment, GDP slowing down overall in order for the infection to start spreading. Do you think this is something that is this risk overblown? Are people worried too much about it? What are you doing to sort of mitigate the risk around your HELOC exposure overall? We have been active in that market, as have the other banks, as you've said. The short answer to your question is that we're mindful of the risk, managing the risk, but not unduly concerned about the risk. We had U.S. Bank through the U.S. downturn. That bank had a home equity portfolio and a mortgage portfolio and an indirect auto portfolio. We've seen what can happen to home equity portfolios through a significant housing correction. Clearly there is risk, and the risk can be very sensitive to employment and housing markets. But there's one, I think, very material structural difference between the way the business is done in Canada and the way it's done in the U.S., and that difference relates to the loan-to-value that we'll lend at. We don't have home equity exposure above an 80% loan-to-value ratio. In the U.S., it was common to have meaningful exposure above an 80% loan-to-value ratio. That is a huge cushion that exists in the Canadian marketplace relative to the U.S. marketplace, and I think materially lowers the risk profile of the product in Canada compared to the risk profile that existed in the U.S. Is the LTV of less than 80%, is that applicable to both first and second lien, so the entire HELOC book or just on the first lien? The entire book. The entire book. The entire book, yeah. On the question of first and second lien, I think losses were highest in the U.S., obviously with high loan-to-value HELOC products, and also when a bank was in a second position behind another bank who was first. In Canada, virtually all of our product is either first in itself or part of a package, a business that we are doing with our customers. So there is very little that would be in a second position structurally behind another institution. That is another mitigant to the market. So overall, I would say we are mindful of the risks. We think we have underwritten the business in a prudent way. We are not unduly concerned. Sure. I asked this question of Janice right before you as well. Very curious to hear your thinking. What will cause Toronto real estate prices to follow those of more western cities such as Vancouver? Well, I used to be in the risk group, as you mentioned. I have been asking that question for probably at least three years. I would say there is a reasonable degree of comfort around the Toronto housing market. One of the important drivers of that comfort relates to the net inflow of population into the market. Canada is a country that has net migration in, and Toronto receives a very disproportionate amount of that migration into the city. The economy is doing well generally and attracts people from the surrounding region. So there is a net inflow of population that provides a natural base of support to the housing market. Second point would be that the new supply that is coming on stream is generally not being built on spec. In the U.S. at the peak, there was a meaningful component of the new construction market that was built on the expectation that the product would sell as opposed to having it sold before the shovels went into the ground. In Canada, it is more a practice, particularly in the condo market, to have pre-sales above a prescribed level before the construction begins, which also helps with just maintaining supply and demand in the marketplace. Last point, I guess, would be that affordability remains reasonable, and that is obviously helped in a very significant way by the current rate environment. But our expectation is that rates will remain low for some time. With that, we do not see a big shock to the capacity to pay that individuals have for mortgages. All that to say is prices are up almost by definition, there therefore must be some incremental downside. But we think the market is pretty much in balance at the present time. And for that to change, I think you would need some combination of a significant downturn in the economy, a spike up in unemployment, and potentially an increase in rates. And it is clearly possible that we will have another recession. We will have another recession at some point. It does not feel imminent. But based on all the stress testing that we have done under fairly extreme assumption scenarios, the losses would be very manageable coming from the mortgage business. Okay. Well, thank you. Can we open the floor for questions? I would just be curious to hear how you are thinking about your Capital Markets business, capital allocation within that. Are there certain businesses where you are going to keep pushing for market share and hope the returns follow? What is your thinking on that? Sure. For those listening, the question was how do we feel about our Capital Markets business and capital allocation within the business. I would say we feel very good about the business. We have had two quarters in a row with income above $300 million. That is well above the run rate that we had over the preceding four quarters. And it feels to us like the capital market environment is improved, and that is partly a function of confidence slowly crawling its way back and having an uptick in corporate M&A as a result of management teams feeling more confident. And it is also helped by a stronger equity market. So heading into the new year, we feel good about the business in general and the outlook for the year, and we have had two good quarters given that kind of a backdrop. In terms of share, in the Canadian market, we view ourselves as kind of a Canadian bulge bracket player. We've got very good capabilities across the product suite and fight it out for market share every day with our competitors and feel good about our capacity to compete. In the U.S., over the last three or four years, we've invested in upgrading talent and strengthening the alignment between the different parts of our business. We are hoping to see this year a good payoff from that investment, given that the teams have been together for a while now, they've gelled, and we've got a better environment. As I mentioned earlier, in the first quarter, we had strong profitability from our U.S. capital market business, $88 million of net income. There was a tax reserve release included in that. The operating earnings would have been lower, but it was still a very good quarter. The upside that we see from the capital markets, we hope will come from continued good performance in the U.S., where the focus is very much on the midcap sector, and we're not trying to compete with bulge bracket firms. Taking advantage of some opportunities that result from having a relatively strong balance sheet. Trade finance has been an area of focus for us over the last two years. We've seen good gains in share in that business and very good returns, and we're hopeful that will continue. From an overall mix perspective and a capital allocation perspective, we're happy with the portion of the total business that capital markets represents at the current time. Not looking to make any big changes from an allocation perspective, and the return on capital has been good. Our return last year was about 19%, and in Q1 was 21%. Could you provide more color as to your stress test scenarios that you used? I'll provide more color. We do a variety of stress tests, as you would expect, and do some stress tests individually as an institution where we look at different scenarios and then our regulator has the industry run through different scenarios. We've run scenarios where the market is down for housing by 40% and by greater amounts in the large markets in the country. Unemployment is double digit and interest rates are up. So what I would describe as pretty extreme downturn scenarios. In those scenarios, as you would expect, the losses that are modeled go up, they go up meaningfully. But they don't take away from the profitability in the Canadian retail business. I come back to the point about the structure of the market, and I think people in the room know this, but when you don't have exposure above an 80% LTV position in either home equity or the mortgage product, you really have a different risk profile were you to head into a downturn. That shows up in the stress testing results that we run. Just talked about economies of scale in your U.S. business. You were asked about whether you had more ambitions there. But do you get economies of scale from the U.S. business being part of the group? Or do you need some other national franchises in the U.S. to really make U.S. regional banking work? That's what you are in the U.S. All the regional banks that are really good in the U.S. seem to have some other national franchises, something special in them, not just deposits and C&I. I'll answer that question in a few ways. Firstly, on whether we get economies of scale across the broader group. The answer is that we do, and as part of our focus on productivity, we're working to increase the extent to which that is true. The phrase that we use internally is that we want to leverage our platforms north-south, and that's a reference to getting activities on common platforms in the Canadian business north and the U.S. business south. Our technology and operations group, I would say, is very focused on this, has been focused on it for over a year, and there's a constant challenge to try to leverage platforms in that kind of a way. Isn't always easy because you do have differences in products between different jurisdictions, and clearly it can be hard to put different products on the same platform. But we are making good progress. As example, we run our call center business and support centers on a north-south basis with one management team. Our computer backup systems are on a common platform with the redundancy built in into a location in Toronto. Our senior management teams across the business groups and the functions are common management teams across the different parts of the business. There are also customer benefits that flow from being active in both Canada and the U.S. So for example, our Capital Markets business is absolutely more relevant to our Canadian clients, both investing and corporate, because we have got a window onto the U.S. We can raise debt and equity in the U.S., we have got perspectives on M&A in the U.S., and we have got research coverage on a large number of U.S. stocks, and that is helpful for our Canadian investors. And vice versa to a degree, but more so for the Canadians. We are focused on it as a theme and see benefits and are going to continue to work it. On the point related to national businesses, we do not have at the current time what I would call a national asset gathering business. We do not have plans to create that right now. We feel good about the ability to grow the business. We have got see leverage in that and legs in that, and are focused on that right now, and are not in the process of ramping up a national asset origination type of a business. Any more questions? I have one more question for you. Your interest rate sensitivity, as reported by yourselves, has gone up over the past few quarters. I think you now would benefit by CAD 50 million-CAD 60 million in earnings from a 100 basis point increase, while just a few quarters ago, the impact would have been negative. So this is quite a significant change in how you have positioned your balance sheet. This is obviously, or most likely due to your view on interest rates going up over the short to medium term. What if that does not happen? What is the risk to your potential P&L and balance sheet if rates do not rise? Right. We have changed the positioning directionally in the way that you've described. The change is based on a view that given where rates are, they're more likely to go up than to go down. I'd say we have more upside sensitivity to increases than downside exposure to decreases, so the exposure isn't symmetrical. I think the real answer to your question, though, is that if rates stay low, then there will be, for a while longer, a continuation of the pressure that we and other banks have seen on margin. That comes from basically reinvesting assets that are maturing at old higher rates into a lower rate environment. We're not fully through the cycle of reinvesting in a low-rate environment, given the duration that we've got on our equity and our deposit investments, and that would continue a little bit further if rates were to stay low. That said, we're, we think, well through the halfway point of repricing into a lower market. Okay, great. Well, Tom, thank you so much for your time and for your insights. We'll be back in 5 minutes, and we'll be meeting CIBC's CFO. Okay.