Deutsche Bank Global Financial Services Investor Conference

Jun 1, 2016

I think we can get started. Tom, thank you for joining us. Just as an intro, BMO is the eighth largest bank in North America, provides personal and commercial banking services to over 8 million customers in Canada and over 2 million in the U.S. Operates a strong wealth management capital markets business in North America and select global markets, and we will touch on those businesses in the presentation. Tom joined the bank in 1992. Has held a number of senior executive positions, including Chief Risk Officer and positions within investment and corporate banking. Tom has been the bank's CFO since 2011. Before we begin, I have been asked to remind you that Tom's comments today may include forward-looking statements. Actual results can differ materially from forecast projections or conclusions in these statements. Listeners can find additional details in the public filings of BMO Financial Group. With that, Tom, why do not I start with a few questions, and certainly if there is any questions from the audience, please raise your hand. Happy to take them. Tom, the bank reported strong quarterly numbers, I believe it was last week. Maybe we could start there to give us a sense of some of that. Sure, happy to do that. Thank you for the welcome and the invitation to be here. We did report our Q2 results last week and had what we thought was a good quarter, as you said. Earnings per share were up 8% for the quarter, and that number excludes a write-down we had in our wealth management business of an investment. It was about an $80 million after-tax write-down. In the numbers that I give, because that was a one-time item, I will exclude that item, which is prominently disclosed in our disclosure documents. But earnings per share up 8%, which we felt good about, supported by good results in our operating groups. Our Canadian banking business, which is our largest single business representing about 45% of the total, had income that was up 8% year over year. Our U.S. banking business was up in Canadian dollars 27% year over year, 21% in U.S. dollars. The segment there benefited from an acquisition that we closed in Q1, and it was the acquisition of the GE Transportation Finance business. But even excluding the acquisition, we had one of the better quarters that we have had in some time. Our capital market business had a good quarter, earning about CAD 290 million, and the pre-tax, pre-provision growth was 10%. Good performance from across the divisions. The wealth management business was down a bit from last year. We had a very strong insurance earnings stream a year ago, and we had more normal insurance earnings in the current quarter. The traditional wealth part of our wealth segment was flat year-over-year at the net income line due to equity markets being down by about 11% looking at the Toronto Stock Exchange. We have been focused on doing a good job on expense management and managing our operating leverage. Operating leverage in the quarter in constant currency was 1.7%, and for the year-to-date, it is 2.4%. We feel good about those numbers. Our midterm target is to produce operating leverage of above 2%, and we are looking good on that measure for the year-to-date performance. On credit, which we will probably touch on later, loan losses were up. We have guided to losses moving up through the balance of the year, but they were still very manageable at about 23 basis points of loss. With that, we were able to comfortably earn through the higher rate of provisioning that we are seeing related to oil and gas. Overall, a good quarter, in part because of the diversification in our business. Canadian banking is about business from an income perspective, and our other three businesses, wealth, capital markets, and U.S. banking, make up the balance in relatively even parts. We find that having a diversified business mix serves us very well through time, and that it gives us a more robust income stream through different environments. That was the case in our second quarter. Tom, you mentioned credit. Oil and gas is obviously top of mind with many investors. I think the portfolio for you guys is about 2% direct exposure, 2% of total loans. Maybe you could touch on that a little bit. How do you think about cumulative loss in that portfolio? Maybe you could touch on what is driving any differences in what you are experiencing in the Canadian part of that portfolio versus the U.S. Sure. Just a few numbers related to the size of our oil and gas-related portfolio. The total portfolio is around 2% of our total loans, and that includes E&P companies, service companies that make up about 20% of the total. Or sorry, pipeline companies, which make up about 20% of the portfolio and service companies. The E&P portion is around 70% of the total. Just under half of the portfolio is investment grade rated. The dollar amount is about CAD 7.3 billion, and that is the drawn amount. Undrawn is around CAD 7.5 billion, and 60% of that is investment grade. At that size, we are very comfortable with the exposure. It is not outsized at 2% of the loan portfolio, and it is performing in line with expectations. Our consumer portfolio in the province of Alberta, which is the biggest energy-producing province in the country, is 6% of total loans. Again, not outsized at all relative to the total portfolio. As we've talked about the impact of low energy at a very high level, we've had two messages that we've been communicating. One is we expect loan losses to go up because there is an economic cycle playing out in the energy-producing regions. Second point is we don't think they'll go up in a way that will be dramatic or high impact for the bank. That's simply because the portfolio isn't that large in the overall mix of the business. For the year, we've guided to loan losses in the range of 20-25 basis points of loans. That's up from around 20 last year. The increase would represent expected higher losses from oil and gas. Year-to-date, our performance has been better than that guidance. In Q2, we were 23 basis points of loss versus the 25-28 guidance. Looking forward, we've really reiterated the guidance expecting loss over the next two, three, four quarters in the 25-30 bip zone. The better performance this quarter, I would attribute really just to some normal variation around a broader trend, as opposed to reading anything more significant into it. Loan losses in any quarter can be a little better or a little worse than you think they're going to be. Fortunately for us, they were a little better. Ordinary thing when you go through a downturn. Secondly, the business is big and diversified, and given the size of the portfolio, our expectation is that we will earn through the higher losses. Are you seeing any differences between exposures in Canada versus the U.S.? The structure of the lending is a little different in the two countries. This is a general statement, so there's truth in it, but you don't want to take it too far at the same time. On average, based on what we see in our portfolios, the companies in the U.S. are somewhat more highly levered, and so have sort of more financial risk in their capital structures. But our position tends to be a senior position. We don't think the net risk profile for us is really higher in the U.S. versus Canada, although the leverage tends to be higher. Then in Canada, somewhat more of the bank credit is pari passu with bond creditors, whereas in the U.S. you've got sort of more of a hierarchy in the capital structure. Net-net, when we do stress testing within a margin of error, the losses tend to emerge in the stress work we've done relatively in proportion to the size of the portfolio split between Canada and the U.S. Can you touch on contagion? Are you seeing oil and gas contagion across other exposures, and what are your expectations? What are your concerns going forward? Yeah. We're not seeing any contagion at all, I would say. Early on when energy turned lower, we asked ourselves that question. We wondered if that might be the case. But to date, we haven't seen any contagion. We're not expecting to see any. The big reason for that is the rest of the country is doing fine, and that's true of the Canadian economy, and it's true of the U.S. economy as well. Interest rates are low. We expect Canadian GDP growth this year of around 1.5%, around 2% next year. U.S. number's a little bit higher. Low energy prices are stimulative to the economy outside of the producing region. The economic environment is sort of just fine, and that's helping. At a sort of human behavior level, although there are some difficult times in the energy-producing regions as people work through the impact of the low energy prices, people outside of those regions recognize that the economy is different. Structurally, the economy in Ontario or British Columbia would be very different than the economy in Alberta. I think the consumers in the country recognize that they're not subject to the same pressures that exist in the energy-producing regions. How about this. If there's any questions in the audience, please raise your hand. I'm happy to take them. Moving to real estate, there's been a lot of talk about the housing market in Canada being a bit overheated, perhaps. What's your view of the market, and how does the bank manage its risk to real estate in Canada? The market has done very well. I would say better than our expectations in the big cities. The larger cities of Toronto, Vancouver, and to a lesser degree, Montreal, have had markets that are pretty active and robust. Outside of those big centers, the market is more stable. In the bigger cities, you've got some unique factors that are contributing to strong performance, and they vary by city. But in the city of Toronto, the city grows every year. There's significant migration into the city. There's a green belt around the perimeter of the city as part of the city's urban plan. Real estate is valuable within the city, and we've had some vertical development as a result of the growth and the green belt. The market feels like it's in a solid place. We see the market pretty much in supply-demand balance, given the inflow that comes into the city. Affordability is fine, although house prices are up and consumer leverage is up in Canada, given that interest rates are low. In the Vancouver market, there's a large element of the market that is driven by some foreign inflow of capital, and the market is more expensive relative to income than it is in Toronto or other parts of the country. That's been the case for some time. I'd say we're not expecting the foreign capital that is flowing in to stop. If it did, we would expect the market to be down by some amount. To protect ourself against the risk of the market there moving down, we do, when we underwrite mortgages, require a higher percentage down payment for more expensive properties to cover the risk in that market. Then just more generally, I'd say, overall, we're very comfortable with our Canadian mortgage portfolio. Around 60% of the total portfolio is insured. The insurance is backed by the federal government, so we don't have counterparty exposure with that insurance. The loan-to-value on the uninsured part of the portfolio is 57%. We've got significant equity balance beneath our uninsured mortgage position, which makes us feel good. You spoke a little bit about the factors affecting the economy in Canada. Maybe you can elaborate on that a little bit. Give us a sense of where BMO is seeing the state of the economy in Canada, and with 25% or so of your business in the U.S., what are you seeing in the U.S. economy, and maybe do that on a relative basis? Sure. Overall in Canada, we're expecting growth in the range of 1.5% for the current year, moving up to about 2% next. That contrasts with pushing 2% for the U.S. in the current year and pushing 2.5% for the U.S. next year. So growth in Canada is slightly lower without reflecting a drag on growth coming from the oil-producing regions. The province of Alberta, which again, is the big producing region, represents about 18% of the Canadian economy, and so there's a contraction going on. To us, as a general statement outside of that area, the two economies feel pretty similar. We see a stable and solid base to business confidence and consumer confidence in both countries. We're living with an economy that's growing. It's kind of new normal growth, and that's what we expect, and we think that's what people are coming to expect. So 2% growth to us isn't a bad thing and a sub-potential kind of performance. It more reflects our broader expectation around economic growth rates being somewhat lower than they were pre-crisis. Importantly, again, we think confidence is pretty good in both countries. The Canadian dollar has depreciated meaningfully over the last couple of years. That's helped the export part of our economy, and it takes time for that to fully develop. So our hope and expectation is that there will be more upside in the export market coming from the lower Canadian dollar. Interest rates are a little lower in Canada, which relates to the dollar move and is also helpful for consumers. How do you compare the relative opportunities for BMO in the U.S. versus Canada? Maybe you could talk about where you see the profitable organic growth opportunities for BMO on a relative basis. Sure. I guess a few things in that regard. We do think we have a good mix of business from a growth perspective for the opportunities that exist in the environment. First point would be true for both the Canadian business and the U.S. business, and it is that we're stronger in commercial lending than personal banking or personal lending in both countries. In Canada, our commercial lending share is approaching 20%, and it's number two in the market. In the U.S., we have very strong growth and very good performance in the Midwest part of the market, and our commercial business is larger than our personal. We think given consumer leverage in both countries, we're likely to have better growth in commercial lending over the next one, three, five years than we are in personal lending. Our recent numbers bear that out. In the last quarter, our Canadian commercial growth was 10%, and our U.S. commercial growth was 13%. We feel good about performance there. In the U.S. business, we do see upside in our personal lending business. The aggregate portfolio there hasn't grown in the last few years, in part because we have been reducing the higher-risk parts of an acquired portfolio. We're expecting that portfolio to turn to growth with the mortgage and home equity portfolio later this year. We're expecting upside there, and we hope to get it. As well in the U.S., we've had one Fed rate increase. Looks like we're going to get another in the summer, at least that would be our read, and maybe more. We have a nice interest rate sensitivity in the U.S. business. A 100-basis-point increase in U.S. rates is around $150 million, $160 million of revenue to us, and about $100 million of that is off of the short end of the curve. We've had some benefit from that in our results year to date from the one move that we've had, and we hope that we have more. Just a couple more points. In our capital market business, we have what we describe as a bulge bracket Canadian firm. We're active in all parts of the capital market business. We have strong share positions, typically in the top three. In the U.S., we're focused on the midcap part of the market, and we've invested in that platform over the last five years or so by adding talented people to the platform. We think that we've got an ability to drive more revenue off of the expense base that we've built, and we see traction in that business. We're expecting to grow the revenues in the U.S. capital markets and to have good operating leverage as a result, because we're basically paying market comp, which you need to do in order to retain people, and driving below market revenue per producer. We're expecting outsized growth from the U.S. capital market business, just from the investments that we've made continue to run. Joe Ouellette, who heads up our wealth business, would give me a kick if I didn't mention wealth. Two things on wealth. Number one, we've had very good growth over a long period of time. Over the last five years or so, we've had double-digit income growth, aided by acquisitions, but also organically. The business has been well managed. The numbers in the current quarter, as we talked about earlier, were softer. That reflects equity markets. But through time, we do expect to continue to have good growth in wealth, and it does represent almost 20% of our group income. It is a large part of the bank, and we do think a somewhat underappreciated contributor to the bank results. You started to talk about this a little bit, maybe elaborate. When you think about Harris Bank, what in your mind is going well with Harris Bank, and what are the areas that you think the bank can improve? Sure. So Harris Bank, which we have now branded BMO Harris Bank, we acquired in the early 1980s. It was a Chicago bank. Then in 2011, we closed the acquisition of M&I Bank, which was headquartered in Milwaukee, and that basically doubled the size of our U.S. banking business, gave us an operation with about 600 branches in the upper Midwest and a number 4 position in the market overall in the upper Midwest states that we compete in. To date, we have been very happy with the commercial business. I talked about that a little bit earlier. We have averaged about 15% year-over-year loan growth for 2 and a half years. So very strong performance with that coming from the fact that both Harris and M&I had strong legacy commercial banking businesses. Together, we have got a real powerful competitor in the market, and we have had great management of the business, and we have deployed best practice. So we feel really good about the commercial growth that we have had, and we are expecting it to continue, although with growth more like 10%, just given the fact that the denominator is that much bigger. On the personal side of the business, I touched on this as well. We have been running down some higher-risk parts of the portfolio for a period of time. The U.S. consumer has been deleveraging, and so we have not seen that portfolio growing yet. We very much want it to turn to growth mode, and we are expecting that to occur in the second half of the year. We do see meaningful ability to grow that part of the business. And as one set of numbers related to that, in the Chicago market, we have an 11% or 12% deposit share, so very strong deposit share in the market. Our mortgage share is in the order of 3%. We are significantly underrepresented in the mortgage product, and we are putting more energy into growing that part of the business. The last point would be around deposits. We have had good growth in the deposit part of the business, and we expect that to continue, and profit potential of that part of the business will increase nicely, as we talked about earlier, if and when we get another move from the Fed. When we think about acquisitions, I guess the last acquisition that the bank made was in the U.S., predominantly a U.S. business in the BMO Transportation Finance acquisition. Can you talk about why that acquisition made sense from the bank's perspective and how it was approached? Sure. We acquired the GE Transportation Finance business in a transaction that closed in December of last year. Transaction size was about CAD 10 billion in loan balances. It was a good fit for our business for a few reasons. Number one, as we have talked about, we have a strength in commercial banking in Canada and the U.S., and the transportation finance business is a commercial banking business, and so it fits nicely with our strength. Second point is that it is a leading business. They are a leader in their segment of the market. They have about a 20% share of the transportation finance market in the U.S. We were happy to buy a business that had that kind of strong position, continue to do so. We have had great success at keeping the management team and the customer base, and the integration is going well. Acquiring a leading business is not something you get the chance to do all that often, and we did have that opportunity with this acquisition. The last point would be that it was a nice transaction from a financial perspective in that we had some excess liquidity in our U.S. bank and some excess capital, and we were able to bring these assets on board, which improved the profitability of the entity in a nice way. Before the transportation finance acquisition, F&C was the largest acquisition for BMO, and that was a few years back. Can you talk about what the bank's overall approach is to acquisitions when you think, and also touch on when you think about M&I, which is six or so years ago. Is building BMO Harris further through acquisition something that you guys think about or actively pursue? Yeah. A few things. The first point would be that we did just close the acquisition of the transportation finance business. Closed in Q1, reduced our capital ratio by 60 basis points. The immediate focus at the bank is on integrating that acquisition, and the integration is going well. And building the capital ratio back up somewhat, although we're in a good position at a 10% CET1 ratio. Then, beyond that, the focus for acquisitions would be in our wealth management business where, as you said, we have been active acquiring F&C Asset Management about two and a half years ago. In wealth management, we like the asset management business, which is a large business for us now, and also private banking, which is also one of our larger wealth management businesses. On the U.S. bank side, we do think the acquisition of M&I gave us critical mass in the Midwest states that we compete in. It doubled the size of our U.S. banking business, and with that gave us, we think, a platform that has scale in our markets and is able to compete effectively. Other things that we would do in U.S. banking would be smaller in size and sort of tuck-in type acquisitions that would complement the existing business that we've got. But as I said, the immediate focus, given that we've just closed the transaction, is on getting the integration done, doing a good job of it, and taking the capital ratio off of it. Digital banking is obviously a big topic across the sector, across geographies. What does digital banking mean to BMO? Well, I think it means that you need to move with the times and to be relevant to your customers in different ways. We are doing that. We have a great set of mobile apps for our personal banking business. We have invested in those over time. We have very good online banking capabilities. We have a check image capture capability in our U.S. business. We have a biometric credit card, and we were the first bank to introduce that. Sounds a little bit scary almost, but biometric card means that the card will work with fingerprints and facial recognition technology, and that is mainly for online purchases. So I would say we are investing significantly in mobile-related things and also new format branches, which are smaller and lighter touch, in order to keep a strong position with our business and to do business in the way that our customers want to do business. Under the surface, we have also been working very hard over the last few years to redo the technological infrastructure that underpins our client-facing apps. We have rewired a lot of our infrastructure and aggregated our data so that we are better able to introduce new capabilities through time because new applications, in essence, need to touch fewer parts of the existing system to become operative. We have got the client data more aggregated. So we have done a good job, we think, sort of increasing the efficiency and the capability of the underlying infrastructure in addition to doing things on the customer side. As you think about the remainder of this year and your outlook for 2017, what are your biggest concerns for the bank's performance? I would say the biggest concern is just a curve ball and some sort of environmental development that we do not anticipate that would cause meaningful dislocation in the market. Our ability to predict that I think is better than the ability anyone in the room here would have. Away from that kind of unanticipated event, we have confidence in our ability to continue to grow the business. We have talked about that. Each of our operating groups are working hard on growing their revenues, growing their customer base, and driving positive operating leverage. We expect to be able to move the bank forward given that focus, and also given the things we are doing on the technology side. All of that said, higher rates would be nice, and so we will take higher rates any day we can get them. Our hope is that we do get them. Significantly lower for significantly longer would go in the opposite direction for us. Any Go ahead. You have a question. Hi. Could you please discuss the improvement in the credit quality in the Canadian residential mortgage book? Specifically, I know it's been historically been a very low loss level, but I'm talking about the impaired loans were down pretty dramatically sequentially and year-over-year, as well as kind of their early stage delinquencies, which may be a little bit counterintuitive to the employment picture. Yeah. So there are a couple of things going on there. The first is that in the overall portfolio, we're seeing, I'd say, mild positive migration outside of the energy-producing regions and negative migration in the energy-producing regions. But the province of Alberta is only 18% of GDP, so most of the country has positive migration, and that's contributing to the positive trend that you see in the disclosure. There can be a funny issue related to the day that the month end falls on. This is a purely technical thing, but when the month end falls on a weekend, you process fewer payments and you can have a bit of a uptick in your early-stage delinquencies because of that. So the early-stage numbers can be a little variable just based on that quirk. And I think that hurt us a bit last quarter and contributed to some of the quarter-over-quarter improvement that you've seen. But bigger picture, the trends outside of the producing region are mildly positive. The employment picture is stable, so consistent with that. And the delinquency levels in the producing region are pretty much playing out as we thought they would, and we expected an uptick. We're seeing the uptick, but net, the overall quality remains high and the loss rate low. Any other questions? I think we're just about out of time. So any closing remarks you'd like to make? Maybe just briefly, I'll just reiterate the comments around the mix of business that we've got. And we do think we have a good mix of business for the opportunities in the environment, being overweight commercial banking, given the expectation that it will have higher growth in Canada and the U.S. over the next period of time. Wealth is a large business for us. We think it's somewhat underappreciated business because it's only 20%, but it's still 20%. It's had good growth, and we expect that to continue. And we are investing on the technology side and expect to continue to do that while driving positive operating leverage. So thank you all very much for your time. Thanks, Tom. Appreciate it.