Friday, February 22, 2008

RBC to Acquire Phillips, Hager & North

Scotia Capital, 22 February 2008

RY to Acquire Phillips, Hager & North

• Royal Bank (RY) announced its intention to acquire Phillips, Hager & North Investment Management (PH&N). PH&N shareholders will receive 27 million RY shares with a value of approximately $1.4 billion with a portion deferred for three years. The purchase price will be adjusted if PH&N's client outflows exceed a certain threshold prior to closing. The price seems to be reasonable at 2.0% of mutual fund AUM. The impact to RBC's earnings in the near term is not material. The transaction is expected to close April 30, 2008.

PH&N Description

• PH&N was founded in Vancouver in 1964. The firm employs approximately 300 people and has offices in Vancouver, Victoria, Calgary, Toronto and Montreal. PH&N has approximately $69.2 billion in assets under management (AUM) including mutual fund assets of $19.5 billion.

Transaction Valuation - Very Reasonable Price

• PH&N has approximately $69.2 billion in assets under management, 81% of AUM is institutional and 19% is private discretionary and non-discretionary clients. If we applied a 1.5% value to the $56.1 billion in institutional AUM, the $13.1 billion in private client assets would be valued at 4%.

• If we sliced PH&N AUM into mutual fund (Exhibit 3) at $19.5 billion and non-mutual fund or institutional at $49.7 billion and applied a 1.5% value to institutional assets, the mutual fund assets would be valued at 3.2% of AUM. Mutual fund companies such as Mackenzie and Trimark were acquired for approximately 10% of AUM, significantly higher than the implied value for PH&N mutual fund assets at 3.2%. However one could argue that PH&N has considerably less channel penetration and not as strong a brand as Mackenzie and Trimark, reflecting the lower valuation.

• We view this transaction as positive in terms of deployment of capital in a high growth, high P/E multiple business. Strategically, this places RY in a dominant position in wealth management in Canada and on a niche basis globally. In terms of risk, execution and operational risks are there but no different than any other acquisition.

First Quarter Earnings

• RY is scheduled to report Q1/08 earnings on February 29, 2008. We are expecting earnings of $1.00 per share and an 8% dividend increase. There is a conference call scheduled for 1:30 pm (EST), the same day.


• Our 2008 and 2009 earnings estimates are $4.50 per share and $5.20 per share. Our 12-month target price remains unchanged at $75 representing 16.6x our 2008 earnings estimate and 14.4x our 2009 earnings estimate.

• RY - 1-Sector Outperform
The Globe and Mail, Tara Perkins & Shirley Won, 21 Feb 2008

Royal Bank of Canada [RY-T] has won one of the country's last remaining independent money managers with a $1.36-billion takeover bid for Phillips Hager & North Investment Management Ltd. The deal would deliver an asset manager that's been prized for its independence and cheap fees into the hands of the country's biggest bank.

PH&N will give the bank a top-five position in the Canadian institutional market for pension plans, where it currently has no presence, said George Lewis, the head of RBC's wealth management business and CEO of RBC Asset Management. The deal gives it the opportunity to grab the number one share of the Canadian mutual fund business, Mr. Lewis added. “Combined, we'll only be $3-billion short of the number one [mutual fund] player.”

Vancouver-based PH&N, which has roughly $69-billion under management and is owned by its employees, is one of the most desired wealth management businesses in Canada.

“We've had a number of approaches each year, and frankly, over 44 years [in business] we've been a coveted organization, and we have always rebuffed any approach,” PH&N president John Montalbano said in an interview Thursday.

What changed the firm's mind was a strategic review that identified a number of needs its clients would have over the next three to five years.

“The business is becoming a lot more complex in the sense of customization of investment strategies, broader diversification options with global fixed income and equities, alternative investments that have low correlations to traditional equity and bond portfolios, and also emerging market exposure as well as foreign exchange management,” Mr. Montalbano said.

While the company had identified areas in which it needed to gain traction, it hadn't gone looking for a partner.

“When we went into this, our firm was not for sale nor was it shopped around,” Mr. Montalbano said.

But when Mr. Lewis approached PH&N with a very detailed offer a few months ago, “it was incredible timing” because PH&N had recently completed its strategic overview, Mr. Montalbano said.

That said, out of its long line of suitors, PH&N only had eyes for RBC for some time.

“You can actually say that this took place a number of years ago,” Mr. Montalbano said. “The two organizations know each other exceptionally well.”

In an interview from Vancouver, Mr. Lewis added: “From our perspective, while we respect all of our competitors, there was only one asset management firm that we wanted to join forces with in Canada, and that is Phillips Hager & North.” David O'Leary, manager of fund analysis at Morningstar Canada, was surprised by RBC's move, but said it was “getting a great lineup of funds and managers.”

The two firms almost seemed to be getting ready for a merger by doing business in each other's domains last year, Mr. O'Leary added.

PH&N, which has over $19-billion in mutual fund assets, launched a new series of no-load funds last summer that were aimed at financial advisers by offering them a 0.5-per-cent annual trailer fee for the first time in its history. And RBC launched its D series of low-fee funds that do-it-yourself investors could buy through its discount brokerage arm.

A little over a year ago, RBC carved out a new wealth management segment and one of its major focuses was boosting the bank's standing in the Canadian wealth and asset management markets.

With strong recurring revenue and free cash flow, no credit risk and no trading risk, “these businesses are very solid and ones that we want to own more of at RBC,” Mr. Lewis said Thursday.

RBC plans to keep all of PH&N's 300 employees as well as its Vancouver office. The bank is offering 27 million RBC shares, with a portion of that deferred until three years after closing.

Mr. Montalbano suggested the deal has significant employee support, saying the majority of PH&N's senior talent have signed five-year non-compete agreements, and there is no break fee attached to the deal.

Dan Richards, president of financial services consulting firm Strategic Imperatives, said PH&N is a “terrific franchise particularly in Western Canada where they are a household name, particularly among the more affluent sector of the market.

“They really stand out as the market leaders in terms of a focus on low fees and reputation as having a customer-first orientation in the retail space,” Mr. Richards said.

They could lose disaffected mutual fund clients, he conceded. “There is always a risk when there is a change, particularly when you have a powerful franchise like PH&N … but it's a very manageable risk.”

Mr. Montalbano, who will become CEO of RBC's asset management business in Canada after the deal closes, said “change is always unsettling,” but added that he believes clients will greet the news positively when they see why the deal is right for them.

The transaction requires approval from regulators and is expected to close around the end of April. While it's strategically important to RBC's future, it is not expected to have a significant impact on its earnings in the near term.

The acquisition is the latest move by a bank to expand its mutual fund assets. The last time that RBC made an acquisition with significant fund assets was the purchase of Royal Trust in 1993.

Bank of Nova Scotia expanded its reach into the mutual fund arena last year by acquiring an 18-per-cent stake in Dundee Wealth Management Inc., which owns Dynamic Mutual Funds.

National Bank bought no-load fund company Altamira Investment Services Inc. in 2002. Bank of Montreal bought Guardian Group of Funds in 2001.