RBC Capital Markets, 18 August 2006
Cash EPS Estimated Up 16% YoY. Royal Bank reports Q3/06 earnings on August 25. Our cash EPS estimate of $0.86 is 2¢ above the Thomson First Call mean estimate of $0.84. Our estimate reflects growth rates of 16% year over year and -1% sequentially.
Retail Bank to Shine this Quarter. Last quarter, RY posted $0.86 cash ($0.85 normalized) for ~21% growth YoY, beating consensus by 3¢. The results were heavily market-sensitive driven as trading revenue raced into record territory, only partly offset by lower-than-expected securities gains. However, the key aspect of the Q2/06 earnings was the strength across retail platforms, in Canada and in the U.S., in retail banking and wealth management. We expect it will be the retail bank’s turn to shine this quarter.
Loan Losses Expected to Edge Up 4% YoY. Our loan loss provision estimate of $140 million (0.26% of L&A) is up from $124 million (0.25%) last quarter and similar to $134 million (0.28%) a year ago. Apart from normalization in recoveries, which have been above normal in recent quarters, the estimated credit loss is otherwise uneventful. In Q2/06, impaired loans declined slightly QoQ and the reserve to impaired loan coverage ratio was fairly steady at 181%. We are looking for reserve coverage of 180% this quarter and do not anticipate any general reserve releases.
Small Dividend Hike Expected. We expect Royal Bank is on track for a dividend increase this quarter of 1¢ per share. In Q2/06, RY held its quarterly dividend at $0.36/share. We are modeling the Tier 1 capital ratio at 9.6% this quarter, versus 9.5% in Q2/06 and 9.7% a year ago.
Key Issues:
• Domestic Retail Bank Market Getting More Discipline. With both CIBC and BMO adjusting their pricing models to a more disciplined approach, we think market-leaders TD and RY will benefit. Not only should RY’s average loan spread improve, but we also expect there could be sustained market share pick-ups. We think the pricing dynamic will be most pronounced in mortgages, but the market share gains more evident in personal loans, cards and small business.
• RBC Centura Acquires Flag Financial. RBC Centura is paying $456MM cash or $25.50/share for Atlanta-based Flag Finaancial. The deal should close by end of 2006, subject to regulatory and shareholder approvals. This deal is clearly a ‘bolt-on’ (not transformational), which in itself is a relief. Also, the branch productivity of the target bank in Georgia and Atlanta specifically, is double or triple that of RBC Centura. This brings upside potential if the skills can be transferred.
• Mutual Funds. RBC is the clear leader in long-term net sales of mutual funds, improving to one-third of positive fund flows among the banks and top 10 independents since April, up from the 23% of positive flows averaged over the last twelve months. In July, preliminary estimates show RBC pulled in 31% of positive flows. CIBC, on the other hand, accounted for 17% of negative flows in May, 3% in June and an estimated 14% in July. Although domestic wealth earnings are not broken out directly, it seems patently obvious that wealth momentum and earnings were very strong in Q2/06. Wealth revenue was reported up 23% YoY, in line with 25% growth in AUM and 17% growth in AUA.
• Enron Class Action Trial Postponed. The trial date for the Enron class action suit (Newby) against RY, TD and other investment banks, has been delayed until April 9, 2007 (previously scheduled Oct 16, 2006). In our view, this allows more time for RY and TD to reach a settlement. It is also noteworthy that TD and Merrill Lynch are reportedly looking to have claims dismissed entirely on similar grounds to Barclays (dismissed from suit July 21). Overall, we see these developments as positive for RY and TD, whom each have already set aside $500-600 million in provisions. Albeit difficult to assess using rational analysis, it would be our sense that the risk of a major financial hit, such as for CIBC last year, is much lower for TD and RY. Royal Bank booked an Enron litigation provision at US$500 million in Q1/06, which while perhaps at the high end of the anticipated range, was clearly a welcome development. In our view, even in RY’s worst-case scenario, say at roughly the same size settlement as for CIBC’s Enron charge, the hit would still only be one-third the proportionate book value hit. We are not anticipating any unusual items this quarter.
Segment Review:
Domestic Banking. In Q2/06, Canadian P&C bank profit was up 16% YoY. Adjusting for a 36% YoY drop in insurance earnings (pre-tax), we calculate that personal, business and wealth earnings otherwise rose an estimated ~19%. Divisional revenue was up 6% YoY and ~7% normalized, behind only TD, which led the sector. Adjusting for RY’s weak insurance revenue, which was down 3% YoY, core retail/business/wealth revenue growth was a more appealing 8.5%, and net interest income rose a positively robust 11% YoY.
• Insurance revenue declined 3% YoY and earnings dipped 36% YoY. The insurance business line slowed last quarter partly as a result of the shorter quarter and an anticipated weak USD, but less obvious were (i) scaling down of the property & casualty catastrophe operation, and; (ii) lower U.S. annuity sales.
• The domestic retail division’s loan loss edged up to $168 million or 0.42% of average loans and acceptances in Q2/06, right in line with write-offs. This will look high relative to the competitors, but is not necessarily a bad result. Instead, it likely reflects loan mix, which now includes a higher proportion of higher-loss ratio credit card balances. The incremental revenue offset, however, at an estimated 2-3x the comparable loan spread, is presumably more than adequate under most all credit scenarios.
U.S. P&C. U.S. & International P&B bank net income increased in Q2/06 by 39% in USD, and 29% YoY in CAD after the F/X impact. Revenue in this division was up 16% in local currency to generate 8% in CAD (effectively higher than for the RY’s domestic retail operation). Progress at RBC Centura is well ahead of expectations, in our view, exemplified by last quarter’s personal chequing account growth of 24% QoQ, commercial account growth of 21% and new HELOC and Visa product introductions that could keep the momentum intact.
Capital Markets. In Q2/06, wholesale earnings were up 47% YoY to $433 million and 38% of RY’s total earnings (2005 contribution was 17%). Revenue grew 30% YoY reflecting record trading revenue of $586MM. RBC Dain Rauscher registered a 38% YoY lift in assets under management. RBC Capital Markets was ranked an impressive #4 in U.S. IPOs in calendar Q1/06 by both number of IPOs and dollar value. RBC provided some new wholesale related slides and disclosures in its post-Q2 investor package: (i) trading still represented only 10% of total revenue (low end of the range since 2003); (ii) trading volatility, at 14% standard deviation to the mean, is half the peer average of 29%; (iii) RY and its Canadian peers are below global banks on a risk / return basis (daily trading revenue versus 1-day VaR) and resisting internal pressure to match, and; (iv) business loans, at 13% of total, are still below 16% average.
Valuation
Our $55 price target is set at 14x our 2007 cash EPS estimate of $3.94. Our premium target P/E is based on high-quality EPS revisions potential, best-in-class ROE and excellent credit performance. Our price target is indicated at ~3.0x our projected book value of $18.20 (as at Jul 31/07). RY continues to face some execution risk in its US operation as it undertakes ambitious cost savings and operating leverage programs. An over-sized Enron provision could pose a short-term risk to price performance, though we expect this risk is fairly well contained with the Q4/05 litigation reserve of US$500 million (pre-tax).
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Cash EPS Estimated Up 16% YoY. Royal Bank reports Q3/06 earnings on August 25. Our cash EPS estimate of $0.86 is 2¢ above the Thomson First Call mean estimate of $0.84. Our estimate reflects growth rates of 16% year over year and -1% sequentially.
Retail Bank to Shine this Quarter. Last quarter, RY posted $0.86 cash ($0.85 normalized) for ~21% growth YoY, beating consensus by 3¢. The results were heavily market-sensitive driven as trading revenue raced into record territory, only partly offset by lower-than-expected securities gains. However, the key aspect of the Q2/06 earnings was the strength across retail platforms, in Canada and in the U.S., in retail banking and wealth management. We expect it will be the retail bank’s turn to shine this quarter.
Loan Losses Expected to Edge Up 4% YoY. Our loan loss provision estimate of $140 million (0.26% of L&A) is up from $124 million (0.25%) last quarter and similar to $134 million (0.28%) a year ago. Apart from normalization in recoveries, which have been above normal in recent quarters, the estimated credit loss is otherwise uneventful. In Q2/06, impaired loans declined slightly QoQ and the reserve to impaired loan coverage ratio was fairly steady at 181%. We are looking for reserve coverage of 180% this quarter and do not anticipate any general reserve releases.
Small Dividend Hike Expected. We expect Royal Bank is on track for a dividend increase this quarter of 1¢ per share. In Q2/06, RY held its quarterly dividend at $0.36/share. We are modeling the Tier 1 capital ratio at 9.6% this quarter, versus 9.5% in Q2/06 and 9.7% a year ago.
Key Issues:
• Domestic Retail Bank Market Getting More Discipline. With both CIBC and BMO adjusting their pricing models to a more disciplined approach, we think market-leaders TD and RY will benefit. Not only should RY’s average loan spread improve, but we also expect there could be sustained market share pick-ups. We think the pricing dynamic will be most pronounced in mortgages, but the market share gains more evident in personal loans, cards and small business.
• RBC Centura Acquires Flag Financial. RBC Centura is paying $456MM cash or $25.50/share for Atlanta-based Flag Finaancial. The deal should close by end of 2006, subject to regulatory and shareholder approvals. This deal is clearly a ‘bolt-on’ (not transformational), which in itself is a relief. Also, the branch productivity of the target bank in Georgia and Atlanta specifically, is double or triple that of RBC Centura. This brings upside potential if the skills can be transferred.
• Mutual Funds. RBC is the clear leader in long-term net sales of mutual funds, improving to one-third of positive fund flows among the banks and top 10 independents since April, up from the 23% of positive flows averaged over the last twelve months. In July, preliminary estimates show RBC pulled in 31% of positive flows. CIBC, on the other hand, accounted for 17% of negative flows in May, 3% in June and an estimated 14% in July. Although domestic wealth earnings are not broken out directly, it seems patently obvious that wealth momentum and earnings were very strong in Q2/06. Wealth revenue was reported up 23% YoY, in line with 25% growth in AUM and 17% growth in AUA.
• Enron Class Action Trial Postponed. The trial date for the Enron class action suit (Newby) against RY, TD and other investment banks, has been delayed until April 9, 2007 (previously scheduled Oct 16, 2006). In our view, this allows more time for RY and TD to reach a settlement. It is also noteworthy that TD and Merrill Lynch are reportedly looking to have claims dismissed entirely on similar grounds to Barclays (dismissed from suit July 21). Overall, we see these developments as positive for RY and TD, whom each have already set aside $500-600 million in provisions. Albeit difficult to assess using rational analysis, it would be our sense that the risk of a major financial hit, such as for CIBC last year, is much lower for TD and RY. Royal Bank booked an Enron litigation provision at US$500 million in Q1/06, which while perhaps at the high end of the anticipated range, was clearly a welcome development. In our view, even in RY’s worst-case scenario, say at roughly the same size settlement as for CIBC’s Enron charge, the hit would still only be one-third the proportionate book value hit. We are not anticipating any unusual items this quarter.
Segment Review:
Domestic Banking. In Q2/06, Canadian P&C bank profit was up 16% YoY. Adjusting for a 36% YoY drop in insurance earnings (pre-tax), we calculate that personal, business and wealth earnings otherwise rose an estimated ~19%. Divisional revenue was up 6% YoY and ~7% normalized, behind only TD, which led the sector. Adjusting for RY’s weak insurance revenue, which was down 3% YoY, core retail/business/wealth revenue growth was a more appealing 8.5%, and net interest income rose a positively robust 11% YoY.
• Insurance revenue declined 3% YoY and earnings dipped 36% YoY. The insurance business line slowed last quarter partly as a result of the shorter quarter and an anticipated weak USD, but less obvious were (i) scaling down of the property & casualty catastrophe operation, and; (ii) lower U.S. annuity sales.
• The domestic retail division’s loan loss edged up to $168 million or 0.42% of average loans and acceptances in Q2/06, right in line with write-offs. This will look high relative to the competitors, but is not necessarily a bad result. Instead, it likely reflects loan mix, which now includes a higher proportion of higher-loss ratio credit card balances. The incremental revenue offset, however, at an estimated 2-3x the comparable loan spread, is presumably more than adequate under most all credit scenarios.
U.S. P&C. U.S. & International P&B bank net income increased in Q2/06 by 39% in USD, and 29% YoY in CAD after the F/X impact. Revenue in this division was up 16% in local currency to generate 8% in CAD (effectively higher than for the RY’s domestic retail operation). Progress at RBC Centura is well ahead of expectations, in our view, exemplified by last quarter’s personal chequing account growth of 24% QoQ, commercial account growth of 21% and new HELOC and Visa product introductions that could keep the momentum intact.
Capital Markets. In Q2/06, wholesale earnings were up 47% YoY to $433 million and 38% of RY’s total earnings (2005 contribution was 17%). Revenue grew 30% YoY reflecting record trading revenue of $586MM. RBC Dain Rauscher registered a 38% YoY lift in assets under management. RBC Capital Markets was ranked an impressive #4 in U.S. IPOs in calendar Q1/06 by both number of IPOs and dollar value. RBC provided some new wholesale related slides and disclosures in its post-Q2 investor package: (i) trading still represented only 10% of total revenue (low end of the range since 2003); (ii) trading volatility, at 14% standard deviation to the mean, is half the peer average of 29%; (iii) RY and its Canadian peers are below global banks on a risk / return basis (daily trading revenue versus 1-day VaR) and resisting internal pressure to match, and; (iv) business loans, at 13% of total, are still below 16% average.
Valuation
Our $55 price target is set at 14x our 2007 cash EPS estimate of $3.94. Our premium target P/E is based on high-quality EPS revisions potential, best-in-class ROE and excellent credit performance. Our price target is indicated at ~3.0x our projected book value of $18.20 (as at Jul 31/07). RY continues to face some execution risk in its US operation as it undertakes ambitious cost savings and operating leverage programs. An over-sized Enron provision could pose a short-term risk to price performance, though we expect this risk is fairly well contained with the Q4/05 litigation reserve of US$500 million (pre-tax).
