28 August 2009

RBC Q3 2009 Earnings

Scotia Capital, 28 August 2009

Earnings Estimate and Target Price

• We are increasing our 2009 and 2010 earnings estimate to $4.40 per share and $4.80 per share from $4.15 per share and $4.65 per share, respectively due to strength in its core earnings particularly in Capital Markets.

• We are increasing our 12-month share price target to $75 from $65, representing 17.0x our 2009 earnings estimate and 15.6 x our 2010 earnings estimate.

Third Quarter Results

• Canadian Banking earnings declined 5% to $671 million from a year earlier. Retail NIM declined 24 bp year over year and 7 bp sequentially to 2.71%. Insurance earnings were $167 million, an increase of 22%. Wealth Management earnings moderated declining 11% to $179 million but rebounded 30% sequentially. RBC Capital Markets increased 50% to $622 million (excluding writedowns) due to very strong trading revenue. International Banking recorded a loss of $43 million.

Canadian Banking Earnings Decline 5%

• Canadian Banking earnings declined 5% to $671 million from $710 million a year earlier due to a decline in retail net interest margin and higher loan loss provisions.

• Revenues in the Canadian Banking segment increased 1.6%, with non-interest expenses declining 1.4% from a year earlier, resulting in positive operating leverage of 3.0%.

• Loan loss provisions (LLPs) declined 3% to $340 million from $351 million in the previous quarter.

Canadian Retail NIM Declines 24 basis points

• Retail NIM declined 24 bp year over year (YOY) and 7 bp sequentially to 2.71%.


• Insurance earnings were strong at $167 million versus $113 million in the previous quarter and $137 million a year earlier.

Wealth Management Earnings Decline 11%, Rebound Sequentially

• Wealth Management cash earnings declined 11% to $179 million from $201 million a year earlier due to large declines in AUM, but improved 29% sequentially from $139 million.

• Revenues were flat year over year with operating expenses increasing 2.5% for negative operating leverage of 2.5%.

• U.S. Wealth Management revenue improved 18%, with Canadian Wealth Management declining 15%, and Global Asset Management declining 13%.

• Mutual fund revenue declined 19% from a year earlier to $335 million. Mutual Fund assets (IFIC) declined 6.4% from a year earlier to $101.6 billion including PH&N.

International Banking Remains in Loss Position, LLPs Improve QOQ

• International Banking recorded a loss of $43 million versus a loss of $97 million in the previous quarter and net income of $37 million a year earlier. The loss position was driven by the continued high level of LLPs although down from the previous quarter. LLPs were $230 million in the quarter, down 20% from Q2 level of $289 million but up significantly from $137 million a year earlier. LLPs remained at an extremely high level of 2.80% of loans and are expected to remain high throughout the remainder of 2009 and into 2010.

• Net interest margin increased 16 bp from a year earlier, and 21 bp sequentially to 3.88%.

RBC Capital Markets Earnings Very Strong

• RBC Capital Markets earnings increased 50% (excluding writedowns) to $622 million, up from $415 million a year earlier due to very strong trading revenue.

Underlying Trading Revenue Very Strong at $1.5 Billion

• Trading revenue remains high at $1,476 million (excluding writedowns) versus $1,414 million in the previous quarter and $717 million a year earlier. The high trading revenue we believe is being driven by structural factors (U.K. and U.S. platforms) as well as cyclical.

• Trading revenue was extremely high in all products: interest rate, credit and equities, and foreign exchange.

Capital Markets Revenue

• Capital markets revenue was $636 million versus $568 million in the previous quarter and $588 million a year earlier.

• Securities brokerage commissions declined 2% to $337 million from $345 million a year earlier, with underwriting and other advisory fees at $299 million, increasing by 23%.

Security Losses Negligible

• AFS security loss was $57 million or $0.03 per share versus a loss of $0.03 per share in the previous quarter and nil per share a year earlier.

• Unrealized security surplus was a deficit of $629 million versus a deficit of $1,786 million in the previous quarter.

Securitization Net Income Declines

• Securitization net income impact declined to $47 million or $0.02 per share versus $354 million or $0.16 per share in the previous quarter.

Loan Loss Provisions Stabilize

• Specific loan loss provisions (LLPs) were $709 million or 0.99% of loans versus $751 million or 1.07% of loans in the previous quarter and $334 million or 0.47% of loans a year earlier. The bank recorded a $61 million general provision ($40 million or $0.03 per share) relating to U.S. banking. Total loan loss provisions were $770 million or 1.07% of loans.

• LLPs in Canadian Banking declined 3% sequentially to $340 million from $351 million. Credit card loss ratio increased to 4.67% from 4.37% in the previous quarter but remains substantially below CM at the 7.44% level. Specific LLPs in International Banking declined 20% QOQ to $230 million or 2.80% of loans from $289 million or 3.08% of loans.

• Our 2009 and 2010 LLP estimates are unchanged at $2,800 million or 0.99% of loans and $2,600 million or 0.88% of loans, respectively.

Loan Formations Decline

• Gross impaired loan formations declined to $1,229 million from $1,800 million in the previous quarter but increased from $753 million a year earlier. Gross impaired loans declined 1% quarter over quarter (QOQ) to $4,158 million or 1.46% of loans versus $4,217 million or 1.46% of loans in the previous quarter.

• Net impaired loan formations declined to $600 million from $1,467 million in the previous quarter. Net impaired loans declined to $1,246 million or 0.44% of loans from $1,341 million or 0.46% of loans.

Tier 1 Ratio Very Strong at 12.9%

• Tier 1 capital was very strong at 12.9% versus 11.4% in the previous quarter and 9.5% a year earlier due partially to a 9% sequential decline in risk-weighted assets mainly from currency impact.

• Risk-weighted assets declined 4% year over year to $243.0 billion. Market-at-risk assets were flat YOY and declined 12% QOQ to $17.6 billion.

• The common equity to risk-weighted assets (CE/RWA) ratio was 12.7% versus 11.2% in the previous quarter and 10.4% a year earlier.

Additional Disclosure on High-Risk Assets

• The bank provided additional disclosure on its exposure to U.S. sub-prime CDOs of ABS, RMBS, and U.S. insurance and pension solutions. The notional and fair value exposures to these areas as well as writedowns are detailed in Exhibit 2. We believe that RY has a good handle on exposure and that cumulative and potential writedowns are manageable.
Financial Post, Jonathan Ratner, 27 August 2009

The relative strength of Royal Bank’s third quarter results should be repeatable in future quarters, according to Dundee Securities analyst John Aiken, who upgraded the stock to Neutral from Sell and boosted his price target from $40 to $54.

He told clients to expect the bank’s absolute and relative valuation multiples to increase coming out of the quarter, but continues to believe absolute valuations for the banks as a whole are too high. As a result, the analyst finds it difficult to rate any banks a Buy, although he is tempted to for some, like Royal, on a relative basis.

Mr. Aiken remains concerned about how rising unemployment in Canada and the United States will impact retail and corporate credit quality in the next year.

He does have one major complaint against Royal – the level of trading revenues, which came in at $1.6-billion for the quarter, or roughly 21% of all revenue.

“We continue to believe that Royal’s earnings quality is dampened by the significant level of revenues generated by its trading activities,” the analyst wrote. “However, RY’s trading revenues continue to be frustratingly less volatile than its peers, despite their absolute size.”

Mr. Aiken thinks the market will look beyond this and focus on the bank’s comment regarding the “decline in the pace of credit deterioration” in its U.S. portfolios.

While corporate loan quality improved marginally in the quarter, he noted that retail credit continues to deteriorate and will continue to be impacted by unemployment levels. However, the analyst pointed out that Royal’s balance sheet strength provides a significant cushion.
The Globe and Mail, Tara Perkins, 27 August 2009

Canadian banks, bolstered by surprisingly strong demand for housing and robust trading businesses, are breaking profit records in the midst of a recession.

Royal Bank of Canada, National Bank of Canada and Toronto-Dominion Bank all reported earnings that topped analysts' expectations yesterday.

The first two actually managed to churn out higher profits than ever before despite the economic gloom.

“At the beginning of 2009 I would have found it hard to believe that by the third quarter I'd be talking about year-over-year increases in our earnings per share, even after issuing shares last year,” said Toronto-Dominion Bank chief executive officer Ed Clark. “But it certainly looks like we're going to be there.”

Serious questions remain about the sustainability of the banks' trading revenues, and the damage that rising unemployment levels will inflict on loans such as credit cards and corporate lines of credit.

But this quarter's earnings are the clearest evidence to date that the big banks are not only weathering the downturn but, in many ways, prospering without the aid of government equity and other forms of support that banks in other countries are receiving.One of the reasons for the sector's stellar performance is the surprising strength of the Canadian resale housing market.

It has been helping to keep both the economy and bank profits aloft, Mr. Clark suggested yesterday.

Mortgages are the largest component of the banks' personal and commercial loan portfolios.

TD held $52.1-billion of Canadian mortgages in the latest quarter and $53.5-billion in home equity lines of credit, up from $44.8-billion and $49.1-billion, respectively, in the prior quarter.

“The Canadian economy's come through I would say an almost surprisingly robust spring mortgage season across the country,” said David McKay, the head of Royal Bank's Canadian lending business. “I think as long as unemployment trends stabilize, and Canadians get back to work, you should see relatively strong growth.”

That's allowing the banks to wean themselves off the programs that the government did roll out.

At the height of the crisis last fall, Ottawa introduced a new program to buy mortgages from the banks in order to lower their funding costs and allow them to make more loans. That program is scheduled to end next month, and markets have improved to the point that Royal Bank, for one, had much less need for it in the latest quarter, said chief financial officer Janice Fukakusa.

The bank sold $18.3-billion worth of residential mortgages to that program and the Canada Mortgage Bond program in the first three quarters of the fiscal year, but only $2.3-billion of those were sold in the latest quarter.

The improved funding conditions should help further support bank profit margins in the coming quarters.

One area where the banks' earnings are potentially more precarious is trading revenues, which were a key profit driver for each of the three that reported yesterday. National Bank pulled in trading revenue of $164-million, well above its six-quarter average of $120-million, noted Credit Suisse analyst Jim Bantis. Royal Bank's trading revenues amounted to $1.6-billion, or nearly 21 per cent of its overall revenue, noted Dundee Securities analyst John Aiken.

The trading revenues stem partially from the high degree of volatility in the markets, and many analysts question whether the banks can maintain those levels. Mr. Clark himself suggested it's unlikely, telling investors to expect earnings from TD Securities, the bank's capital markets business, to be lower in the future.

Royal Bank CEO Gordon Nixon said that capital markets businesses tend to be the first to rebound coming out of a recession. Profits from wealth management and basic banking will take more time to improve to the same degree, he suggested.

However, both he and executives at TD also noted that with markets stabilizing, more financial institutions, particularly U.S. banks, are resuming their trading operations or kicking them up a notch, creating competition that could take some of the wind out of the Canadian banks' sails.

Mr. Nixon pointed out that Royal Bank earned $1-billion even without its investment banking and capital markets activities. “So I wouldn't characterize us as the Goldman Sachs of the north,” he said, referring to the U.S. bank that has long thrived off of trading activity.