Royal Bank of Canada Stock Report

Royal Bank of Canada

Royal Bank’s revenue per share (the red line) has grown at a relatively steady rate over the years, increasing at a compounded average of 4.5% per year in the period shown (But about 6% if the drop in 2010 is excluded) . Earnings per share (the blue line) increased at a higher compounded average of 13% (but 8% in the past five years) per year but has exhibited modest volatility.  Book value per share has increased very steadily at a compounded average of 9.0% per year. These increases were achieved while paying out roughly half of annual earnings in cash dividends.

Royal Bank of Canada (RY, Toronto and U.S.)
RESEARCH SUMMARY  
Report Author(s): InvestorsFriend Inc. Analyst(s)
Author(s)’ disclosure of share ownership:  The Author(s) hold shares
Based on financials from: Oct. ’19 Y.E.
Last updated: December 22, 2019
Share Price At Date of Last Update:  $                            103.47
Currency: $ Canadian
Generic Rating (This rating does not consider the circumstances of any individual investor and is therefore not specific advice for any individual): Buy rated at $103.47
Has Wonderful Economics? Yes
Has Excellent and Trustworthy Management? Yes
Likely to grow earnings per share at an attractive rate over the next decade? Yes
Positive near-term earnings outlook? Moderate growth expected
Valuation? Quite attractive
SUMMARY AND RATING:  The graph of revenues per share (red line) shows strong and relatively steady growth. The earnings per share line shows quite strong growth over the years. Note that the  lack of per share earnings growth in 2016 was due to shares issued in the acquisition of California-based City National.   The Value ratios would indicate a rating of (lower) Strong Buy. Management quality appears strong. The insider trading signal is neutral to moderately negative. Executive compensation is high but not a concern given the size of this bank. The outlook seems positive but growth has slowed and higher loan losses are a risk. RBC has strong economics and some competitive advantages in terms of its scale and established market position. It appears to be a business that can reliably predicted to continue to grow. RBC, however (like all banks) is highly leveraged and therefore there is some small risk of very major problems in certain scenarios. There are also potential risks associated with lower housing prices, recession and mark to market losses on some investments. Overall RBC is a consistent money maker but achieves this with high leverage which is managed through a finely tuned risk management system. Overall we would rate this as a Buy. at this time based on the attractive valuation but tempered by loan loss risks and lower growth.
LONG TERM VALUE CREATION: Royal Bank has created excellent value in the long term.
DESCRIPTION OF BUSINESS: Last updated, Q4, 2019. Royal Bank of Canada is the country’s largest bank with assets of $1.43 trillion, 1327 bank branches, 4600 automated teller machines and 82,801 full-time-equivalent employees. Earnings by segment are 50% from personal and commercial banking (in Canada, the U.S. and the Caribbean) , 20% from capital markets (includes equity and debt origination and distribution, and structuring and trading), 20% from wealth management (mainly Canada, the U.S., the U.K, the channel islands and Asia), 6% from insurance (In Canada and reinsurance outside Canada), and 4% from investor and treasury service. The return on equity for personal and commercial banking is reported at  a stunningly profitable 27% and was very similar to somewhat higher in (at least) the prior four years (The high ROE is presumably due to massive leverage on CMHC mortgages), 17% ROE for wealth management, 40% ROE for insurance (which seems extraordinarily high but might be explained by selling high margin insurance like life insurance on mortgages and by reinsurance which will likely occasionally have losses), 13% for investor and treasury services (down from 23% in 2018), and 11% ROE in capital markets (similar to the 13% of 2018). Based on 2017 figures Canada accounts for 61% of revenue, The U.S. accounts for 23% of revenue, International (37 countries) accounts for 17% of revenue. For 2019 (and 2018), 57% of revenue is from non-interest income (investment management fees, account service charges, foreign exchange fees and card fees, insurance, underwriting and trading) and 43% from net interest income.
ECONOMICS OF THE BUSINESS: (Updated for fiscal 2019) RBC’s economics are strong. It does however like most banks  depend on very high (even extraordinarily high) leverage. Its profit as a percent of revenue was recently 27%. However that translates into a profit on (ending) assets of only 0.88% as revenue is only 3% as large as the assets. This 0.88% return on ending assets was then leveraged up to 16.2% return on ending equity as ending common equity was only 5.4% as large as the assets (The common equity is extremely highly leveraged – which is typical for banks). The high ROE indicates that the economics of the business are very good. The economics are also strong in that the business is of a recurring nature and the customers tend to be “sticky”.
RISKS: See annual report for a full discussion of risks. Data breaches are a definite risk. New disruptive technologies are a possible risk. Banks always run the risk that borrowers will fail to pay their loans. This risk is enhanced by the very large leverage of most banks and of Royal Bank in particular. However, the bank has in place numerous and complex risk management strategies that are designed to prevent its risks from creating any major financial problems for the bank. Share owners must place their faith in management and its risk management abilities. RBC has operations in tax havens including the Caribbean, and (of more concern)  the Channel islands and Luxemburg. It could face risks in that area if it is found to be helping customers evade income taxes.
INSIDER TRADING / INSIDER HOLDING: Based on March 1, 2018 to December 27, 2019:  Five insiders, including the CEO, sold shares basically monthly or quarterly after exercising options. Amounts were over $7 million dollars worth in two cases and over $3 million in another case. Regular selling like that, especially on exercising options which they receive regularly,  does not give much signal regarding what the seller thinks of the stock price. Still, it has to be considered moderately negative. (in one case the selling was much heavier in September ). A new director bought shares monthly but this was required to meet minimum ownership targets. Most insiders were holding and not selling (which is positive). Overall, the insider trading signal is about neutral to moderately negative.
WARREN BUFFETT’s CRITERIA: Buffett indicates that all investments must pass four key tests: the business is  simple to understand and predict (marginal pass because the various sectors and geographies make RBC more complex and particularly because it is very hard to judge the risk of this highly leveraged business), has favorable long-term economics due to cost advantages or superior brand power (pass due to scale and established history of high ROE achievement), apparently able and trustworthy management (pass), a sensible price – below its intrinsic value (pass), Other criteria that have been attributed to Buffett include: a low  debt ratio (arguably a fail given the massive leverage although that is not unusual in banking), good recent profit history (pass – although the latest quarter was flat) little chance of permanent loss of the investors capital (pass   – although with high leverage there is some risk) a low level of maintenance type capital spending required to maintain existing operations excluding growth (pass)
MOST RECENT EARNINGS AND SALES TREND: Adjusted Earnings per share growth in the past four quarters beginning with the most recent (Q4 fiscal 2019, ended October 31) was minus 1%, 6%, 7%, and 7%. Revenue per share growth in the past four quarters beginning with the most recent (Q4, 2019) was 7%, 5%, 15% and 8%. In 2019 overall, the earnings per share growth was 5% and revenue per share growth was 9%. In 2018 overall, the earnings per share growth was 13% (possibly boosted by the Trump tax cuts) and revenue per share growth was 6%. In 2017 overall, the earnings per share growth was 12% and revenue per share growth was 6%. Overall, the recent earnings trend has been good (although the latest quarter showed a small decline) although lower than 2018 while revenue per share growth was higher than 2019. very strong and the revenue per share trend is also reasonably strong.
 INDUSTRY SPECIFIC STATISTICS: (At end of fiscal 2019) Provision for Credit Loss was at 0.31% (a sharp increase from 2018 at 0.23%), and Gross Impaired Loans 0.46% (an increase versus 2018 at 0.37%.) Net Interest Margin 1.61% (2018 was 1.64%) on average earning assets. The CET 1 common equity (minus goodwill and equivalent) ratio was 12.1% (2018 was 11.5%) of risk-weighted assets or 8.3 times leverage. The Tier 1 Capital ratio to risk-weighted assets was 13.2% (2018 was  12.8%). The leverage ratio which is Tier 1 capital divided by total assets including some off balance sheet assets was 4.3% or 23 times. Balance sheet common equity was 5.45% of assets or 18.3 times leverage. The fact that the risk-weighted asset several is far lower than the non-weighted leverage indicates that much of its assets (like government securities and CMHC insured mortgage loans  are extremely low or zero risk).
Earnings Growth Scenario and Justifiable P/E: With a dividend yield of 4.1%, it does not take much growth at all to justify the P/E ratio of 11.8. That is, the stock is pricing in only modest growth.
VALUE RATIOS: Analysed at Canadian $103.47 (U.S. $79.07). The price to book value ratio is neutral to perhaps moderately unattractive at 1.9  and at 2.3 excluding goodwill and the equivalent (although these ratios can definitely be MORE THAN  justified if the ROE remains near current levels). The trailing P/E ratio seems very attractive at  11.8. The dividend yield is very attractive at 4.1% and amounts to a payout  of 48% of earnings. The Return on equity is very high at 16.6%. Earnings per share have grown at a compounded average of 7.8% in the past five years and revenue per share has grown at a compounded average of 6.3% per year. This is good growth considering that half of earnings are paid out as dividends. We calculate the intrinsic value to be $110 per share if earnings can be expected to grow at 4% per year and the P/E rises to 12 and $150 if earnings per share grow at 8% per year for five years and the P/E rises to 14. These intrinsic value calculations use a required return of 7.0% reflecting today’s low interest rates. These value ratios would support a rating of (lower) Strong Buy.
SUPPORTING RESEARCH AND ANALYSIS  
Symbol and Exchange: Royal Bank of Canada
Currency: $ Canadian
Contact: invesrel@rbc.com
Web-site: www.rbc.com/investorrelations
INCOME AND PRICE / EARNINGS RATIO ANALYSIS  
Latest four quarters annual sales $ millions: $46,002.0
Latest four quarters annual earnings $ millions: $12,591.0
P/E ratio based on latest four quarters earnings: 11.8
Latest four quarters annual earnings, adjusted, $ millions: $12,591.0
BASIS OR SOURCE OF ADJUSTED EARNINGS: We have not made any adjustments except for a gain on a sale in 2017 AND 2016. RBC does not appear to have provided an overall adjusted earnings figure. Also there are a number of pluses and minuses that could be considered each year but RBC’s earnings are also inherently subject to the estimation of bad loans and it might be misleading to present an adjusted earnings figure.
Quality of Earnings Measurement and Persistence: Earnings measurement is probably of reasonably high quality but there are certainly some estimates involved such as for loan losses. There is a modest amount of amortization of purchased intangibles that are not a “real” expense. Some mark to market changes in asset values flow to the net income.
P/E ratio based on latest four quarters earnings, adjusted 11.8
Latest fiscal year annual earnings: $12,591.0
P/E ratio based on latest fiscal year earnings: 11.8
Fiscal earnings adjusted: $12,591.0
P/E ratio for fiscal earnings adjusted: 11.8
Latest four quarters profit as percent of sales 27.4%
Dividend Yield: 4.1%
Price / Sales Ratio 3.24
BALANCE SHEET ITEMS  
Price to (diluted) book value ratio: 1.91
Balance Sheet: (Updated Q4, 2018) The composition of assets is as follows: 43% of assets are loans (of which 69% are categorized as retail and 31% as wholesale), 22% assets purchased under reverse repurchase agreements and securities borrowed (essentially short term secured lending), 17% securities – which would mostly pay cash yield or interest (58% of which are held for trading and 42% are held for investment), 7% derivatives (which appear to be mainly for risk management purposes), 6% “other” –  which is mostly financial receivables and 5% cash and deposits with other banks, and just 1% goodwill. Liabilities consist of 63% deposits (of which 32% are personal, 64% are business and government and 4% are from other banks), 7% derivatives, 15.5% obligations for assets sold under repurchase agreements (essentially short-term borrowing or perhaps equivalent to a very short-term deposit where the “depositor” has security), 2.4% obligations related to securities sold short, 6% “other” – which is mostly financial payables of various kinds, 5.5% common equity, 0.7% subordinated debt  and 0.5% preferred shares. In general the balance sheet shows some complexity in that loans are only 43% of assets (65% if assets purchased under repurchase agreements are treated as loans). Common equity at about 5.5% is very highly leveraged which is typical of banks.
Quality of Net Assets (Book Equity Value) Measurement: It is difficult to judge the reliability of the net book value. Not all assets are marked to market and the leverage is so high that a small error in asset values could wipe out a large chunk of equity. On the other hand most of the assets are very liquid and a significant portion are marked to market.
Number of Diluted common shares in millions:                              1,438.3
Controlling Shareholder: No one is allowed to own more than 10% of the shares.
Market Equity Capitalization (Value) $ millions: $148,816.5
Percentage of assets supported by common equity: (remainder is debt or other liabilities) 5.4%
Interest-bearing debt as a percentage of common equity 13%
Current assets / current liabilities: not revealed
Liquidity and capital structure: With common equity of only 5.5% of the asset level, the capital structure appears to be weak in that regard. But this is apparently typical for large banks. And, the assets are considered to be highly liquid and safe and credit rating agencies rate the debt at. On a risk-weighted basis and by bank standards it balance sheet is considered strong. As of late 2018, Standard and Poors rates the legacy long-term debt at AA minus and stable but only A for new long-term debt subject to bail-in legislation.
RETURN ON EQUITY AND ON MARKET VALUE  
Latest four quarters adjusted (if applicable) net income return on average equity: 16.6%
Latest fiscal year adjusted (if applicable) net income return on average equity: 16.6%
Adjusted (if applicable) latest four quarters return on market capitalization: 8.5%
GROWTH RATIOS, OUTLOOK and CALCULATED INTRINSIC VALUE PER SHARE  
5 years compounded growth in sales/share 6.3%
Volatility of sales growth per share:  strong, steady growth
5 Years compounded growth in earnings/share 7.8%
5 years compounded growth in adjusted earnings per share 7.8%
Volatility of earnings growth:  moderately volatile
Projected current year earnings $millions: not available
Management projected price to earnings ratio: not available
Over the last ten years, has this been a truly excellent company exhibiting strong and steady growth in revenues per share and in earnings per share? Yes
Expected growth in EPS based on adjusted fiscal Return on equity times percent of earnings retained: 8.7%
More conservative estimate of compounded growth in earnings per share over the forecast period: 4.0%
More optimistic estimate of compounded growth in earnings per share over the forecast period: 8.0%
OUTLOOK FOR BUSINESS: The bank anticipates low GDP growth in Canada, the U.S. and Europe in 2020. Therefore it appears to be signaling modest growth in 2020 – (and we suspect that higher loan losses could push earnings growth even lower or negative). Still, the bank’s goal is a minimum of 7% annual earnings per share growth over the next three to five years and a 16% ROE. Based on the forward P/E ratio, analysts appear to be forecasting 10% earnings per share growth in 2020 but such forecasts tend to optimistic. There are possible headwinds in terms of mark to market losses on investments and loan losses on non-CHMC mortgages if home prices fall very much. If the Canadian dollar rises, that would be negative for earnings growth.  The reinsurance business can occasionally lead to material losses. The North American economy may slow. Loan losses recently rose somewhat and this is a risk. But in general, the outlook remains reasonably good. Technology is allowing for big cost reductions as transactions become more and more digital and self-serve.
LONG TERM PREDICTABILITY: Royal Bank of Canada has been growing its assets and earnings per share for decades. It seems reasonable to assume that it can continue to grow with the economy. But it is possible though that newer technologies will disrupt banking leading to lower profits.
Estimated present value per share: We calculate  $110 if adjusted earnings per share grow for 5 years at the more conservative rate of 4% and the shares can then be sold at an unchanged P/E of 12 and $150 if adjusted earnings per share grow at the more optimistic rate of 8% for 5 years and the shares can then be sold at a HIGHER P/E of 14. Both estimates use a 7.0% required rate of return.
ADDITIONAL COMMENTS  
INDUSTRY ATTRACTIVENESS: (These comments reflect the industry and the company’s particular incumbent position within that industry segment.) Michael Porter of Harvard argues that an attractive industry is one where firms are somewhat protected from competition based on the following four tests. Barriers to entry (Marginal pass, there are certainly barriers to achieving a large scale in banking since it is difficult to acquire customers but new entrants are emerging). No issues with powerful suppliers (pass). No issues with dependence on powerful customers (pass), No potential for substitute products (pass) No tendency to compete ruinously on price (marginal pass – they may compete aggressively on some products but there are some parts of the business where there appears to be little price competition such as credit card rates and exchange rate fees.). Overall this industry appears to be attractive for an established large incumbent.
COMPETITIVE ADVANTAGE: Size and scale are advantages. Customers find it inconvenient to switch banks and therefore having an established large market share is an advantage. They indicate that there are significant barriers to entry in the reinsurance part of their business.
COMPETITIVE POSITION: (2019) Royal Bank is the largest Bank in Canada. In personal and commercial banking it is number 1 or 2 in all key product categories. It is the largest wealth manager and mutual fund issuer in Canada  and in the top ten largest brokers in the U.S. It’s the largest investment bank in Canada. It’s the 10th largest investment bank globally and in the Americas. They have 7 million credit card accounts and a 23% market share of Canada’s credit card purchase volume.
RECENT EVENTS: The dividend was increased by a further 8% in 2019. 10 million common shares were repurchased but this was only 0.7% of the outstanding and barely exceeded new share issuances through stock option exercise.  In December 2019, sold a significant portion of its remaining Caribbean banking operations. It sold its eastern Caribbean operations.  In May 2017 sold Caribbean trust, custody and fund administration business. (We view this as positive getting rid a  business likely involved in tax err “avoidance”). In November 2016 sold its share of U.S. operations of Moneris for a gain of $212 million. On July 1, 2016 sold its home and auto “manufacturing” business for an after-tax gain of  $235 million with a 15 year agreement to distribute (sell to clients) the insurance.  In November 2015 made a U.S. $5.5 billion acquisition of a California wealth manager, City National Bank paying U.S. $2.6 billion in cash the rest in shares. Disposed of a couple of small foreign banking subsidiaries for modest losses in July and August 2015. Earlier sold some its Caribbean Wealth management business.
ACCOUNTING AND DISCLOSURE ISSUES: The disclosure of large banks is voluminous. But we are always left with some questions. They speak of trading revenues but it is often impossible to know if they refer to proprietary trading for their own account or merely collecting fees on customer trading activity, which is a vastly different thing. Net income is reported in a legal but misleading way. They fail to prominently show and focus the lower net income to common after deducting preferred share dividends and non-controlling interest. Accounting rules require gains on asset sales to be counted as revenue, which distorts the figure. Earnings are impacted by mark-to market changes in some assets and liabilities. Currency changes affect earnings. The net income for 2013 as reported in 2015 is different than what was reported in 2013. There appeared to other such revisions of history as well. No doubt, all legal but nevertheless somewhat disturbing.
COMMON SHARE STRUCTURE USED: Normal, one vote per share.
MANAGEMENT QUALITY: Overall, the quality appears to be high. Listening to the CEO speak, he seemed to be a very able individual. He is very much focused on applying new technology to banking. Management indicates they are focused on Total Shareholder Return through performance over a 3 to 5 year period. This could be dangerous in that it could cause a focus on the share price rather than long-term earnings or could lead to excessive leverage in order to attempt to boost earnings. We do not have a strong opinion about management. We are somewhat concerned about why they were ever involved in Caribbean wealth management or (of more concern) operations in the Channel Islands and Luxemburg, which are known as tax havens.
Capital Allocation Skills: Given the high ROEs in all of the various divisions of the Bank, capital allocation skills appear to be strong based on past results.
EXECUTIVE COMPENSATION: Updated in December 2018.  Compensation is generous with the top five officers earning total compensation of  $5 million to $13 million. Given the size of the bank and its earnings, this is not a concern.
BOARD OF DIRECTORS: Warren Buffett has suggested that ideal Board members be owner-oriented, business-savvy, interested and financially independent. The Board members at RBC are well qualified. Most are independently relatively wealthy and hold more shares than the minimum target of $750k. A number of the members are quite recent and none have been in place since before 2005 and the average tenure is only about 5 years. We’d like to see a bit more continuity that that.
Basis and Limitations of Analysis: The following applies to all the companies rated. Conclusions are based largely on achieved earnings, balance sheet strength, achieved earnings per share growth trend and industry attractiveness. We undertake a relatively detailed  analysis of the published financial statements including growth per share trends and our general view of the industry attractiveness and the company’s growth prospects. Despite this diligence our analysis is subject to limitations including the following examples. We have not met with management or discussed the long term earnings growth prospects with management. We have not reviewed all press releases. We typically have no special expertise or knowledge of the industry.
DISCLAIMER: All stock ratings presented are “generic” in nature and do not take into account the unique circumstances and risk tolerance and risk capacity of any individual. The information presented is not a recommendation for any individual to buy or sell any security. The authors are not registered investment advisors and the information presented is not to be considered investment advice to any individual. The reader should consult a registered investment advisor or registered dealer prior to making any investment decision. For ease of writing style the newsletter and articles are often written in the first person. But, legally speaking, all information and opinions are provided by InvestorsFriend Inc. and not by the authors as individuals. The author(s) of this report may have a position, as disclosed in each report. The authors’ positions may subsequently change without notice.
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