Friday, February 27, 2009

RBC Q1 2009 Earnings

TD Securities, 27 February 2009

The bank reported core cash FD-EPS of C$1.15 v TD Newcrest of C$0.90 and Consensus of C$0.94.


Positive. Helped by substantial trading revenues the bank managed to earn through significant write-downs and higher credit costs. That said, we remain mindful of the ongoing business mix shift, challenges in the medium-term growth strategy and some near-term credit pressures and exposures. As such, it is still not our favorite name in the group, but the stock has lagged in a weak tape and the quarter lifts some immediate concerns.


Credit costs running a bit hot. Credit costs came in comfortably above consensus. The bank feels it is well reserved and contends that it is well secured on a large portion of its impaired loans. Difficult for us to dispute these claims, and the trends are not shocking. However, the issue is likely to remain front and center in coming quarters and at face value the bank appears to have less ''padding" than some peers should the downturn worsen.

Exposures yield losses. We have previously noted the breadth of the bank's risks/exposures and in Q1 the result was surprisingly large write-downs (C$1.3 billion pretax). They were tolerable in the context of stronger overall earnings and management remains comfortable with the ongoing exposure. However, they are a reminder of the risks in the context of a weaker market.

Trading: Cyclical or Structural. The bank continues to invest in the build out of its capital markets and trading operations helping the bank to gain share from weakened competitors. Sustainable earnings are thus likely to be higher going forward, but we doubt they are 2-3x higher (as they were this quarter) on a sustainable basis.

Business mix concerns appear valid. Following on the above, Royal is increasing its Wholesale mix relative to its Retail operations. Thus far the shift has been helpful, but to us it carries negative implications for relative valuation and earnings volatility over the medium-term.

Supporting a return of the relative premium? Our standing contention with the stock has been its relative valuation in the context of the medium-term strategic and operating outlook and potential near-term risks. The stock has recently given up much of its premium as industry multiples have compressed. The stock looks attractive to us on an absolute basis (as does the industry), but we remain skeptical of the prospects for it to return to a material relative premium.

Conference Call Highlights

• Business Mix. The bank continues to target a business mix of 20-30% wholesale versus 70-80% retail, although it has been much higher in recent quarters and that would still put it comfortably ahead of retail focused players.

• Acquisitions. Management is very reticent about making acquisitions in this environment given uncertainty around 1) balance sheet quality and 2) regulatory uncertainty.

• Write-downs/Charges. The bank has significantly reduced its exposure to some areas that drove writedowns this quarter which should reduce future charges even in weak markets (our best guess remains a few hundred million in any given quarter). Further, management argued that mark-to-market (MTM) understates the value they are ultimately likely to realize.

Segment Highlights (growth rates are year-over-year unless otherwise stated)

• Domestic P&C. Results here were decent with Net Income -1.9% (adjusted) on good volume growth and expense control against ongoing margin pressure (-27bp) and rising credit costs.

• International. The segment continues to struggle under the weight of the bank’s U.S. P&C credit portfolio which continues to suffer material credit expense.

• Wealth. Consistent with a challenging market, the segment saw Net Income down over 30%; including the addition of recent acquisitions.

• Wholesale. The trading business produced another significantly outsized quarter with trading revenues (adjusted) on the order of C$1.442 billion compared to recent ranges of C$600-700 million. We believe that the bank has materially improved its trading platform, but do not believe it can produce over twice the revenue on a run-rate basis.

Operating Outlook. Outsized trading activity can readily account for the outperformance of adjusted earnings this quarter. Therefore, we are leaving our quarterly path unchanged through year-end which continues to reflect our outlook for a moderating environment and rising credit costs.

Segment Outlook. Domestic P&C continues to moderate inline with industry trends and should show modest trends through year-end. We assume Wholesale will perform at elevated levels, but below Q1/09's outstanding performance. International is likely to continue to struggle for the foreseeable future, while Wealth will remain largely market dependent.

Credit Outlook. Costs were lifted by an exposure from the bank's prime brokerage business (approximately C$100 million). Core Specific PCLs were not materially off our above consensus estimates and we expect credit expense to remain elevated through 2009. Reserves look light, but management maintains that many of their impaired loans remain well secured and have minimal expected loss.

Capital Outlook. The bank came out of the quarter with improved metrics, helped by some reduction in RWA. We expect the ratios to improve modestly over the coming quarters, barring additional potential writedowns (we assume they are unlikely to be materially more than a few hundred million in a weak market environment).

Our Target Price reflects a discount to our estimate of equity fair value 12 months forward (based on our views regarding sustainable ROE, growth and cost of equity), implying a P/BV of 1.75x.

Key Risks to Target Price

1) Increased competition and tighter margins in the U.S. banking environment, 2) integration challenges associated with recent acquisitions and 3) adverse changes in the credit markets, interest rates, economic growth or the competitive landscape.

Investment Conclusion

We remain mindful of the ongoing business mix shift, challenges in the medium-term growth strategy and some near-term credit pressures and exposures. As such, it is still not our favorite name in the group, but the stock has lagged in a weak tape and the quarter lifts some immediate concerns.
Financial Post, David Pett, 27 February 2009

RBC's first quarter earnings have received solid enough reviews from the Street, but Canada's largest financial institution can be added to the list of banks who might be headed for trouble due to credit quality problems.

With its first quarter results, John Aiken, an analyst at Dundee Securities, said Royal Bank was able to address market concerns about its capital levels, but while that should generate some support for the stock near term, he says "the underlying concern remains credit quality.

"We are not optimistic that this situation will remain static and, as with TD, we believe that the first quarter earnings will represent a high water mark," said Mr. Aiken in a note to clients. "Consequently, we would recommend that investors sell into the rally we anticipate over the next week."

Longer term, Mr. Aiken remains "neutral" on the stock and maintains his $35 price target.

UBS analyst Peter Rozenberg remains more bullish on Royal Bank's prospects and called first quarter profits "striking" when compared to global bank peers. Still, he acknowledged that provisions of credit losses are likely to increase further given the negative economic outlook. He cut his price target from $44 to $42 but maintained his "buy" rating.