On November 25th Bank of Montreal (TSE: BMO) reported their Q4 results and the numbers weren’t all that bad, on the surface anyway. They reported EPS of $1.18, slightly ahead of analyst expectations and ahead of last year’s earnings. Revenue was also ahead of expectations, the tier 1 capital ratio was a solid 9.77% and there was no sign of a big write-down. So, low and behold, everything looks pretty good… could this possibly be the bottom?

Well, not so fast. First of all, BMO’s positive earnings surprise was driven primarily by one-time items that are likely not sustainable. One-time items included: a very low effective income tax rate for the quarter, gains in trading revenue, and a higher than normal net interest margin. In addition, BMO avoided taking a $123 million loss to its bottom line because of a recent accounting rule change – the rule change allowed BMO to reclassify $2.0 billion of assets and make them exempt from the mark to market rule. Regardless, that’s not what’s important here. What is important is what the future holds – that’s what will drive the stock price.

Credit markets haven’t improved one bit and BMO’s exposure to the US will certainly result is further losses in the loan books. Loan loss provisions grew to $465 million this quarter, up 360% year-over-year and well ahead of expectations. That brings the year’s total provisions for bad loans to $1.33 billion vs. $353 million for 2007. After what’s happened this year in the markets, bad loans (particularly US loans) will plague banks for years to come. Further losses will continue to eat away at the bank’s capital and put pressure on the tier 1 ratio [the ratio of a bank’s tier 1 capital (equity, retained earnings and cash) to its risk weighted assets (loans adjusted for credit risk)].

BMO’s tier 1 ratio currently stands at a healthy 9.77%. Regulations stipulate that banks must maintain capital levels such that the tier 1 ratio stays above 8%. If the ratio drops below 8%, the bank must replenish its tier 1 capital by issuing common stock or preferred shares. However, given current market conditions, there’s speculation that this threshold level may be raised. Accordingly, Canadian banks have been aiming to keep these ratios above 9%. With earnings deteriorating and more write-downs always a possibility, the current 9.77% ratio could be at risk.

On to the sacred dividend – the bread and butter for any Canadian bank stock. Is it safe? I’ll wager a guess and say no, it’s not. In Tuesday’s earning’s release, the company announced they would be freezing the dividend at $0.70 per share and will not be increasing it until the market calms down, which could be for quite a while. Understandable, but there go most of the dividend based investors who hope for steady dividend growth that’s typical for a Canadian bank. But that’s not where the story ends. When specifically asked on the conference call whether BMO would cut their dividend to preserve their capital, the CEO suggested that it was more important to maintain high levels of capital. Not once would he say that he intends to maintain the dividend, even when asked directly. This may not sound like much, but when every other bank firmly states there’s no chance they’ll be cutting their dividend, it makes BMO really stand out as a risk.

This is particularly troublesome when you consider the quarter wasn’t so bad. The bank did earn almost $600 million this quarter alone. Compare that to CIBC who will have negative earnings this year after all the write-downs they’ve taken, and they continue to insist the dividend is not at risk of being cut. So what on Earth is BMO so worried about? Are there big write-downs coming? Further losses on the horizon? Whatever it is, it sure won’t be good for the bank’s tier 1 ratio, which if it becomes too low will require the bank to issue new equity or preferred shares. BMO, and every other Canadian bank, has already issued preferred shares this year and the market for preferreds is completely saturated. Issuing equity with the stock at these levels would likely be the last thing management would want to do. Not only would it depress the stock price further, but the demand for such stock could be falling given TD and CIBC have already issued billions this year. Plus, issuing new shares makes maintaining the dividend more expensive due to the larger share count. The only way left to preserve tier 1 capital is to somehow preserve earnings, i.e. cut the dividend.

One other indication that suggests the dividend may not be sustainable is the current dividend yield. Currently that yield exceeds 8%. Only Citigroup and Bank of America have higher yields, and the dividend at both of those banks is anything but safe. At 8%, BMO’s dividend yield is far higher than it has been in recent memory – I was only able to get dividend history going back to 1993 (see chart below). When yields spike to historically high levels, it’s the market’s way of telling you the dividend isn’t sustainable. I don’t think we’ll see that 8% yield last, and there are only two ways for that percentage to come down: either the stock price begins to rise (significantly), or dividends are cut. Personally, I think the latter is more likely.For a more complete dividend analysis, I’d suggest reading my colleague’s recent BMO article.

The other tidbit that should set off some alarm bells was the fact that the company has decided against publishing annual performance targets – a practice the company has been following for years. Not a good sign.

What’s The Chart Saying?
BMO had previously traded within a well defined trend channel roughly 33% wide (see chart below). On November 20th, the stock broke this trend channel. Projecting this channel lower suggests the stock could hit ~$29 in the near term.

In addition, from the recent series of lower lows and lower highs, a declining trend is beginning to emerge. A $39 to $40 stock price now looks to be a formidable resistance level.

Conclusion
For Canadian banks, dividends are very sacred. They really are the major reason why retail investors flock to these stocks. The fact that most investors feel this dividend is safe could also play a major role in why Canadian banks trade at a premium to their US counterparts. Some may feel the market is already pricing in a dividend cut for BMO, but on a price-to-book value basis, BMO is trading roughly inline with the other banks. Unless the market is expecting all other Canadian banks to cut dividends, a cut at BMO would most certainly send the stock lower.

Ownership Disclosure: I do not currently own shares of Bank of Montreal.

Disclaimer: Any information contained in the above article represents my opinions only, and should not be construed as personalized investment advice. I cannot assess, verify or guarantee the suitability of any particular investment to any particular situation and the reader of the article bears complete responsibility for its own investment research and should seek the advice of a qualified investment professional that provides individualized advice prior to making any investment decisions. All opinions expressed and information and data provided therein are subject to change without notice.