Royal Bank of Canada (NYSE: RY) following fiscal 4Q 20 results, which showed strength in capital markets and wealth management segments offsetting weakness in the lending business due to low interest rates. We expect improvement in North American economies, but with still low interest rates keeping pressure on net interest margins. Management is projecting Canadian GDP growth of 4%-5% in 2021, versus a decline of 5% in 2020.
We like several aspects of RBC’s franchise, including its leading positions in personal/commercial banking, capital markets, and wealth management. The company also has a strong record of organic growth and well-timed acquisitions. Aside from the recent coronavirus downturn, the Canadian economy has benefited from strength in the housing market, with continued positive business sentiment and low unemployment, although business investment and consumer spending has weakened a bit.
While other Canadian banks have exposure to U.S. financial markets, RBC has focused on the highest-margin areas of wealth management rather than on traditional banking. Canada still accounts for most of the company’s loans and net income, and generates about 62% of revenue. The U.S. generates 21% and other international 17%. We believe that expansion and diversification outside Canada will remain a primary growth driver for RBC. Other growth initiatives include the addition of commercial bankers (which has boosted business lending), and financial advisers (which has helped to grow fee-based assets).
The company scores well relative to peers on earnings growth, ROE and ROA, efficiency levels, and regulatory capital ratios, which we believe should result in a premium P/E valuation. Our 12-month target price of $92 (raised from $89) implies a multiple of 13-times our FY21 earnings estimate, and potential upside of 15%, including the 4% dividend yield.
The company is based in Canada and reports results in Canadian dollars. On December 2, RBC reported adjusted EPS for fiscal 4Q20 (ended October 31) of C$2.27 (US$1.77), up from C$2.22 (US$1.69) a year earlier. Revenues declined 2% to C$11.1 billion, hurt by lower net interest income and insurance premiums. Adjusted revenue, net of insurance fair value change, was down 1%. Noninte rest expense was down 4%, reflecting lower discretionary and compensation expense, with the adjusted efficiency ratio moving up to 53.5% from 51.6% the prior year. Net income came to C$3.2 billion, down 8%. For all of FY20, revenues were up 2.2%, to C$47.2 billion (US$35.4 billion), while EPS declined 11% to C$7.94 (US$5.96).
EARNINGS & GROWTH ANALYSIS
RBC has five major reporting segments: Personal & CommercialBanking (46% of net income in FY20), Wealth Management (17%), Insurance (8%), Investor & Treasury Services (3%), and Capital Markets (26%). We detail fiscal 4Q20 results by segment below.
In Personal & Commercial Banking, net income was down 7% from the prior year, to C$1.50 billion, as a 4% drop in revenues, due mainly to the effect of lower interest rates, was further hurt by 3% higher expenses attributed to digital investments and COVID-related costs.
In Wealth Management, net income was down 25% to C$546 million, as a 4% drop in revenues was further hurt by 2% higher expenses and greater credit loss provisions. In Insurance, net income declined 10%, to C$254 million, hurt by lower realized investment gains.
Investor & Treasury Services net income was up 102% to C$91 million, as an 8% decline in revenues was more than offset by a 20% drop in expenses due to the absence of severance and other costs related to a repositioning of the business.
Capital Markets net income advanced 44% to C$949 million, aided by higher debt and equity originations, and higher client activity for fixed-income and equity trading.
The company has provided medium-term financial objectives calling for better than 7% EPS growth (in Canadian currency), at least a 16% return on equity, and a payout ratio of 40%-50%. At the segment level, management intends to have a Canadian banking efficiency ratio of less than 40% by 2021 (43.2% in FY20), a non-U.S. wealth management efficiency ratio of less than 65% by 2021 (66.5% in FY20), and U.S. wealth management pretax income of US$1.3-$1.45 billion by 2020 (US$887 million in FY20).
In FY21, we expect revenue growth of 4%, up from the 2% achieved in FY20, aided by an improving economy following FY20 weakness caused by the coronavirus, but continued pressure on the lending business to the low interest rates. Loss provisions more than doubled in FY20 as the company prepared for higher credit losses related to the pandemic, with particular pressure on oil & gas and retail credit exposure. But by 4Q the provision was back to the prior year’s trend, and we look for provisions to drop sharply in FY21. Given continued revenue headwinds from lower interest rates, management is looking to slow expense growth by leveraging the company’s scale while also growing its client base and deepening existing client relationships. We would expect the sharply higher trading revenues and underwriting activity seen in FY20 to subside in FY21.
On the expected reduced capital markets activity, we are lowering our FY21 estimate to C$9.00 from C$10.14, while initiating a FY22 forecast of C$9.33. Using a 0.78 U.S. dollar/Canadian dollar exchange rate, our FY21 U.S. dollar estimate is now US$7.02, down from $7.51, while our FY22 forecast equates to US$7.28.
FINANCIAL STRENGTH & DIVIDEND
RBC had an adjusted 16.3% return on equity in 4Q20. Adjusted
ROE has been running 16 -17% in most recent quarters. The company also scored above average in efficiency, with an adjusted 53.5% efficiency ratio in 4Q20.
At October 31, 2020, RBC’s Basel III tier 1 common equity capital ratio was 12.5%, up from 12.1% a year earlier. anagement has a target ratio of 10.5%.
RBC paid US$3.22 in dividends in FY20. It announced an increase in the quarterly payout to C$1.08 from C$1.05 beginning in 2Q19. The shares yield about 4.0%.
MANAGEMENT & RISKS
David McKay became CEO in April 2014, replacing Gordon Nixon, a 13-year company veteran. Mr. McKay began his career at the company in 1988 and has risen through the ranks. In 2012, he was named ‘Retail Banker of the Year’ by Retail Bank International. Rod Bolger is the company’s CFO.
Investors in Royal Bank of Canada face risks, including the company’s high exposure to the energy sector. In Canada, only the Bank of Nova Scotia has a higher proportion of energy sector loans. The company’s high energy industry exposure also creates ancillary risks for its wealth management business. However, we also note strong revenue diversification, including a substantial presence in U.S. wealth management and capital markets.
The Royal Bank of Canada is one of Canada’s largest banks. It is also one of the largest banks in the world, with a market capitalization of $117 billion. The company has 83,800 employees and more than 1,300 banking branches in 37 countries.
In valuing RBC, we look at several Canadian peers, including Bank of Montreal, CIBC, and Toronto Dominion. We would expect a higher P/E ratio for RY based on these better metrics.
On December 14, BUY-rated RY closed at $82.17, down $1.14.