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Competition for Capital:

I’m not the brightest investor on the street, but I know enough that something isn’t quite right when I’ve fielded two dozen questions in recent days about the investing prospects of the Bank of Montreal (BMO) from peers who are intently focused on the stunning 9%+ dividend yield of its common shares.

I first want to lay out in this post the cost of capital that banks have currently experienced when going to the market for equity to shore up their balance sheets.

For investors who might be asking, “What’s this tier 1 capital ratio everyone is talking about?” it’s a basic measure of a banks overall financial strength and health. This ratio measures a bank’s core equity capital to its risk-weighted assets. Risk-weighted assets are a group of assets held by the bank that are weighted for credit risk using a formula provided by industry regulators. Essentially – what reserves does a bank have on hand to cover losses on any assets that it holds?

There’s been a significant move recently in Canada for financial companies (banks & insurers) to raise equity in order to place them over the minimum regulated threshold with the banks as a peer group seeking to bump their tier 1 capital ratio to ~10%.

Royal Bank (RY) announced on December 8th that it intended to issue $2.0B in common equity with the option of fully exercising a total of $2.3B. The pricing of the common shares was set at $35.25 per share and would increase their tier 1 capital ratio to 9.9-10.1%. The equity priced at $35.25 was approximately issued at 1.75x book value and sold at a 6% discount to the previous market price. This puts the issue into a valuation perspective for what it costs to raise this equity.

Canadian insurer Great-West Life (GWO) announced on December 9th that it intended to issue $1.0B in common equity. The pricing of the common shares was set at $20.75 per share. At this price the equity issue was done at approximately 1.9x book value and sold for a 7% discount to the previous market price.

Bank of Montreal (BMO) announced on December 15th that it intended to issue $1.0B in common equity with the option of fully exercising a total of $1.1B. The pricing of the common shares was set at $30.00 per share and would increase their tier 1 capital ratio to 10.4%. At this price the equity issue was done at approximately book value when you account for dilution and sold for a 8% discount to the previous market price.

So let’s compare: 1.75x book value & a 6% market discount for RY versus 1.0x book value & a 8% discount for BMO.

That might not appear to be a huge difference to the average retail investor, but consider that on October 31st, 2008 when BMO reported quarterly earnings their tier 1 capital ratio was 9.77%. To raise equity at such a discount for such a small move in their capital ratio makes me suspicious for a number of reasons.

Something is not right here and I hate to be the perpetual downer when it comes to BMO, but investors need to put this into perspective regardless of the attractive yield of the common dividend.

Here’s another perspective:

On December 16th the common equity of BMO trading on the TSX closed at a yield of 9.23%. The highest yielding preferred issue (BMO.PR.K) closed at a YTW (yield to worst) of 8.09%.

That’s a -114 basis point spread between common & preferred equity!

Essentially the market is giving no respect to the preference of the preferreds in the capital hierarchy. The common equity is essentially spitting in the face of the preferreds when water always travels downhill.

If I conduct the same quick analysis with perpetual preferreds for the other four major banks you find the following information:

RY: closed +178 bps above common
TD: closed +137 bps above common
BNS: closed +120 bps above common
CM: closed +141 bps above common

That’s nearly a 235 basis point spread between the lowest positive spread of the BNS preferreds and the negative spread of the BMO preferreds.

My current concern with BMO is that this equity raise makes no logical sense from a valuation perspective and unless they anticipate their tier 1 capital ratio being hammered down in the foreseeable future this almost appears as desperate in comparison to their peers.

If I can borrow a quote from Scott in a recent conversation we had about this equity issue:

I mean really, who does a share issuance at book value? To me, this is like saying we are only interested in diluting your stake in the break-up value of the business. The operating business has no value, so we aren’t going to charge you for it. Well, if the operating business has no value, then that means that past earnings are just a myth under the current reality.”

When I evaluate management I focus not only on what they’re saying, but what they’re doing. In my opinion actions speak louder than words in the world of business. A CEO or president can publicly state intentions as clearly and inspiring as they want; but they have to follow through on those words with tangible actions.

What can investors take from this? Do your own due diligence before blindly jumping into the market despite the attractive yield and market sentiment over the safety of a Canadian banks dividend.

Over the past year I’ve commented privately with peers at the astounding discount that Royal Bank can raise equity at (via common or preferred shares) versus their Canadian competition. When you can raise common equity at 1.75x book value or preferred equity at 50 bps lower than similar preferreds from competitors with no shortage of demand in sight from the market you have one thing: a sustainable competitive advantage.

Not many investors would realize this at first or second glance, but one thing we’ve all realized during this market turmoil is that equity comes at a premium. When a company is able to issue equity at a considerable discount to its peers it stands to take advantage over the long-term in a significant way.

In my opinion, after studying their issues over the past 18 months, RY is likely conducting business at a significant advantage to their peers. They’ve been able to tap the equity markets for capital at a substantial discount to their competition and are in turn likely charging a premium rate for the equity they issue back to customers in business loans, personal lines of credit or mortgages.

When you can generate this type of spread in pricing during an environment as difficult as this a competitive advantage becomes quite clear.

Disclosure: I own shares in RY and indirectly in GWO through PWF

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{ 7 comments… add one }
  • T. December 22, 2008, 8:34 pm

    Safe to say, your next acquisition will be RY?

    What are your thoughts on BNS’ prospects as it looks very well that it’ll follow the same path as RY in diluting equity to shore up their reserves.

  • Nurseb911 December 23, 2008, 8:43 pm

    Thanks for the comment T.

    I currently hold RY as one of my core CDN banking stocks (RY, TD & BNS) but I will be looking to add to my position in the future when I have the resources to do so.

    I have expected BNS to raise equity to boost their tier 1 ratio, but their style is more conservative so if they feel an equity issue would be too expensive in this current market environment they may look to sit tight for the time being as I do consider them a more conservative bank with their diversification of operations.

  • Anonymous January 3, 2009, 2:35 am

    Sorry for the ignorant question, but can you explain your comments on the negative spread between common and preferred yields? What is the significance of this?

  • Nurseb911 January 3, 2009, 10:13 am

    Preferred shares are in the hierarchy of equity and stand above common shares with respect to dividends and stake in the business. It's kind of like Bonds being King, Pref's being Queen & Commons being the Jester.

    Yields on pref's should routinely be higher than commons because of this priority. Dividends must be paid out to pref shares before common shares.

    When you have a negative yield (common yield higher than pref yield) its akin to the Jester sitting in the Queen's throne telling her what she should do.

  • Anonymous January 4, 2009, 8:44 pm

    The recent share offering was for common equity. You should check the share price and yield history of BMO common versus preferred shares. Preferred shares yield less but of course have relatively greater security.

  • Nurseb911 January 4, 2009, 9:26 pm

    Anon – The average yield for BMO common over the past 20 years has been 4.13% which is well below that of their preferred issues over the same time period.

    Preferreds have very little upside potential with respect to capital gains if bought at issue and therefore offer a higher yield as an incentive for investors to commit equity to a company over a period of time. The point I am making is that the common equity issued by BMO is very expensive in relation to an industry leader and that the behaviour of the commons indicate suspicious activity.

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