Monday, April 20, 2009

RBC's US$850M Goodwill Impairment Charge

Scotia Capital, 20 April 2009

• RY announced that it expects to record a US$850 million ($1,020 million or $0.72 per share) goodwill impairment charge on its U.S. & International Banking segment in the second quarter ending April 30, 2009.

• The impairment charge the bank indicated was a result of the prolonged economic difficulties in the U.S., in particular the deterioration of the U.S. housing market, and the decline in market value of U.S. banks.

• The writedown represents 22% of the $4.6 billion in goodwill attributed to the U.S. & International Banking segment. The net goodwill after the writedown is now $3.6 billion.

• Total goodwill at RY is $10 billion before the writedown, comprised of $1.9 billion in Canadian Banking, $2.2 billion in Wealth Management, $1.0 billion in Capital Markets, and $4.6 billion in US & International (Q4/08).

• RY's book value is expected to be reduced by a modest 3.3% with no impact on Tier 1 and total capital ratios.

• In terms of valuation and share price, we expect minimal impact. The bank's International business unit has contributed very little to earnings over the past several years and actually recorded a loss in Q1/09. Thus, the valuation of this unit is already reflected in the earnings and P/E of the bank.

• RY's announcement is likely to focus the market on TD's $16.7 billion in goodwill (TD USA $11.9 billion as at Q4/08) and total $20 billion in goodwill and intangibles. Thus, we expect a similar 22% writedown on goodwill from U.S. retail would result in $3 per share charge.


• Our quarterly operating earnings estimate remains unchanged at $1.00 per share, with reported earnings for Q2/09 expected to be $0.28 per share. Our 2009 and 2010 operating earnings estimates remain unchanged at $4.25 per share and $4.65 per share. Our target price is unchanged at $48 per share representing 11.3x our 2009 earnings estimate.

• RY - 1-Sector Outperform, TD - 3-Sector Underperform.
TD Securities, 20 April 2009


Thursday (04/16) after market close, RY pre-announced a Q2/09E goodwill impairment charge of US$850 million (pre and post tax) related to its International Banking business.


Slightly Negative. The write-down itself is largely a non-issue. However, we think it speaks to our standing concerns around the bank's medium-term growth prospects in U.S./International banking. While still a solid platform, the stock appears to be relatively fully valued with little room for disappointment in our view.


Non cash charge is not the issue. The US$850 million charge (pre and post tax) has no impact on our estimate of core earnings nor on regulatory capital levels or our preferred metric TCE:RWA (tangible common equity: risk weighted assets). In that sense, a goodwill write-down is a non-issue.

Concerns around future growth are. Goodwill impairment tests are forward looking in that they consider the present value of future profits. While the analysis requires substantial guesswork, the move suggests that in the eyes of management the earnings base and/or future growth of the business has diminished relative to prior views. To us, this speaks clearly to our standing concerns around the bank's medium-term growth prospects which we believe will become increasingly reliant upon U.S./International banking.

Who shall follow next? The obvious candidates for concern in our view are TD (Q1/09 goodwill of C$16,662 million) and BMO (Q1/09 goodwill of C$1,706 million) both of which have fair amounts of goodwill on their books associated with their U.S. retail banking strategies. However, despite recent challenges, both platforms are generating profits (material profits in the case of TD) as per Exhibit 1. Both banks conduct regular reviews for goodwill impairment and neither bank have suggested any concerns at this point. In both cases our operating estimates, outlook and investment case reflects on-going challenges in the U.S. retail banking market.

Stock looking increasingly fully valued. Yesterday's announcement is not terribly significant in our opinion. We continue to view RY as a solid platform which is also benefitting from opportunities in its trading businesses. However, we remain concerned about the overall shift in business mix (in favor of trading/wholesale), medium-term growth strategies and the bank's credit exposures and thin reserve levels heading into the current downturn. This all against a relative premium valuation with the stock trading at 2.0x reported book after this charge (3.2x tangible book). From here we see relatively modest returns and little room for error/disappointment.

During Q1/09, RY had begun a two-stage goodwill impairment test of their International Banking operations. Yesterday after market close, RY announced the testing has been completed and determined a goodwill charge of US$850 million was warranted for their International banking business. The bank cited challenging economic conditions with particular emphasis on the declines in the U.S. housing and operating landscape as reasons for the charge.

As of Q1/09, RY had C$9,948 million in goodwill which will be reduced by approximately C$1,037 million (assuming f/x of $1.22) to C$8,911 million to reflect the charge.

Our Q2/09E core cash FD-EPS for RY is C$0.90, and the non-cash goodwill charge is worth approximately C$0.74 per share.


We have made no changes to our estimates.

Justification of Target Price

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

In our view, the goodwill charge speaks to our standing concerns around the bank's medium-term growth prospects in U.S./International banking.