Tuesday, March 20, 2007

RBC's Target Price Increased by TD Newcrest

TD Newcrest, 20 March 2007


We have come away from recent RY management meetings even more convinced with the bank’s impressive potential. We believe the bank’s April 25th investor day, which will focus on the domestic wealth and banking divisions, will demonstrate the momentum these divisions are enjoying, and result in the market placing a higher valuation on the stock.


We are increasing our valuation multiples slightly on the stock, resulting in our target price increasing to $67 from $64. We reiterate our Action List Buy recommendation.


On April 25th, RY will be hosting an investor day, showcasing its domestic banking and wealth operations. At the event, the company will be providing new disclosure, as beginning Q2/07, the bank will segment its global wealth operations into a new division.

We believe the market will be most impressed by the scale and growth of RY’s wealth operations. As seen in Exhibit 1, we estimate (note that numerous assumptions were applied) RY’s wealth operations generated $1.25 billion in revenues last quarter and $346 million in profitability. We believe the market will be pleasantly surprised that this operation generates roughly one-quarter of the bank’s total earnings (versus 18% for the rest of the group).

Perhaps the bank’s most impressive growth story is the domestic mutual fund operation, which grew its assets under management by 21.4% in the last 12 months, versus an average for the industry of 14.7% and 12.1% for the other 5 domestic banks. We believe growth will continue for this operation for the following reasons:

• 95% of funds are generating either 1st or 2nd quartile performance
• A distribution commission of 115bps is paid, roughly 15% above average
• Management fees on 95% of funds are below average

In our opinion, the combination of the above three points makes not selling RY funds difficult for third parties, which have become an important source of growth. Management informs that 25-30% of net sales are generated by external channels, which are supported by 25 wholesalers and a dedicated service support model. Internal distribution is also impressive, as the bank now fields roughly 1,100 in-branch financial planners, 500 out-of-branch investment and retirement professionals, and over 1,300 RBC DS full service financial advisors. Looking forward, the bank intends on furthering product development (particularly in the international category), taking advantage of in-branch technology that allows consolidation of client portfolios, reducing fees, targeting wealth transfer client needs and maintaining above average performance. On the fee front, management quite simply stated their intent is to be disruptive, leveraging their #2 in assets scale advantage and placing pressure on the competition.

We also believe that investors will be pleased with the growth experienced at Dain Rauscher, opportunities to put the Canadian and US broker dealers on a common platform, and the potential to grow outside of Canada in areas such as private banking.

In Domestic Banking, the prospects remain very bright, and of note, management stated that, unlike the US market, the Canadian mortgage market remains buoyant, and margins are the healthiest levels they’ve been at over the last 3-5 years. Simply put, management stated that Canada’s mortgage market was the least of their concerns, as unemployment is low, housing prices are stable and debt to value ratios are very reasonable (certainly as it relates to the US averages).

Other Domestic Banking points of interest include:

• Revised compensation has been well received by employees, who are taking a much greater sales emphasis (we understand the RY branch managers and others received relatively significant bonus compensation in 2006).
• The growth of the bank and competitive pay packages has allowed the bank to successfully recruit many individuals from other financial institutions. The bank remains in aggressive hiring mode, particularly in the West.
• Management regards branch banking with a much greater 'retailing' perspective; future branches will come in various sizes with a clear sales emphasis.
• Technology is being leveraged in a real way towards expanding existing client relationships
• As the bank grows, operating leverage is a clear scale benefit
• To try to offset deposit market share losses, the bank will soon offer an on-line, high interest rate savings account with an introductory 4% rate. Management estimates that over 180m RY clients presently hold accounts at ING, and they want them back.
• A 'disproportionate' amount of RY clients do their discount brokerage at TD Waterhouse, and improving service in this area will be of increased focus in the future.


RY’s momentum in domestic banking and wealth has been spectacular. Consider that most of the assets put on last quarter didn’t fully impact revenues, and then consider the long-term, recurring nature of most of the businesses that RY operates in, and we believe it is fairly easy to model industry-leading earnings growth for the foreseeable future.

Justification of Target Price

Our $67.00 target is a product of adding 50% of the $65.17 value derived from our 2007 P/E valuation of 15.9 times to 50% of the $68.54 value derived from our 2007 price-to-book valuation of 3.56 times.

Key Risks to Target Price

We believe the key risks are: 1) unfavorable interest rate movements; 2) a downturn in the credit cycle; and 3) additional US acquisitions at premium valuations.

Investment Conclusion

RY is enjoying phenomenal revenue momentum that we believe is translating into sustainable earnings outperformance. We believe new disclosure will highlight the strength and growth of the bank’s global wealth management operations, which will act as a valuation catalyst. We rate the stock an Action List Buy.