Friday, March 04, 2011

RBC Q1 2011 Earnings

TD Securities, 4 March 2011

Investment Thesis. After a series of muddled quarters, Royal came through with a solid well rounded result. To us, this quarter is a truer reflection of what we believe to be the underlying earnings power of the platform. With better evidence in hand, we increased our operating outlook coming out of the quarter.

We continue to view Royal as a solid banking franchise and we expect the broader sentiment around the stock to improve. We look for earnings power to continue to develop favourably through the year and into 2012. On our revised outlook and Target Price we see reasonable upside from yesterday’s close. However, with the name now up over 12% over the past couple of weeks, the likely returns are not quite as generous. We see roughly 15% Total Return over the coming 12-months. We reiterate our Buy rating.

Reaction to Q1/11 Results. The market responded very positively to a solid report that appears to have comfortably exceeded even raised expectations heading into yesterday. In a strong day for Canadian bank stocks, Royal was up roughly 5.25%.

Investors seemed to be impressed with the surprisingly good strength across much of the bank’s businesses, particularly the Domestic P&C franchise which delivered good volumes, improved margins, lower PCLs and better credit expense control after an up-tick in Q4.

Capital Markets had a very strong quarter, ahead of our estimates and one of the better quarters over the past few years (although off peak levels). This was used to somewhat discount the strength of the quarter, and management did suggest the result was at the high-end of the likely range for the year. We continue to view the Wholesale business as a C$400-C$500 million per quarter (with some growth) contribution.

The biggest surprise came in U.S./International. To us, the C$157 million loss in Q4 represented a material understatement of the earnings power. In our last note, we considered the significant potential for the segment to recover and contribute meaningfully. That happened much more quickly than anticipated as the segment moved to a small profit (adjusting for non-core items) on the quarter. However, we would not sound the all clear at this point, but we have greater comfort that the segment will shift from a material drag to steady contributor by late 2011 and early 2012.

There was some resistance to extrapolating the measure of one quarter. However, we believe the past few quarters were the anomaly and taking what we feel is a reasonably conservative outlook, we remain comfortable with the earnings power of the platform.

In terms of dividends, we continue to expect the bank to raise its dividend in Q3/11. We expect the bank to raise the dividend by C$0.03 per share to C$0.53 (up from our previous estimate of C$0.52) or by 6%, reflecting an expected payout ratio of 43.8% versus the bank’s stated target range of 40-50%.

Valuation. The stock has recovered gradually over the past few months, capped with yesterday’s strong upward move. With what we expect will be a healthy round of upward revisions to estimates, earnings have caught back up with the share price. At these levels, we view valuations as only modestly attractive, with the name trading at 12.1x our revised forward earnings or 2.4x Q1/11 reported book value.

Outlook We had previously assumed that the bank would generate better earnings through the back half of 2011 as the U.S. drag subsided and the businesses enjoyed core growth. The drag reversed more quickly than we anticipated and the core businesses are performing better than we had modeled. As a result, our estimates are up for both 2011 and 2012 to C$4.80 from C$4.25 and to C$5.25 from C$4.75 respectively. Our model still assumes the U.S. sees losses over the balance of the year, and we believe the contribution from Wholesale will be lower. However, the outlook still suggests to us a reasonable run-rate on the order of C$1.25+/- per quarter in H2/11.