Big banks—the rich will get richer

Royal Bank of Canada is Canada’s largest financial institution and the 24th largest bank in the world based on total assets. The bank serves 16 million clients in 36 different countries. So what does Canada’s fifth-largest bank (59th in the world by assets) think of the Royal’s performance?

Royal Bank, Canada’s largest bank, presents a positive outlook for its fiscal 2019.

The results from the fiscal 2018 fourth quarter at Royal Bank of Canada (TSX—RY; NYSE—RY) give investment bank CIBC World Markets the impression that the Royal is being proactively managed for through-the-cycle performance.

Analysts Robert Sedran, Christopher Bailey and Marco Giurleo noted there were several items that seemed unusually good this quarter, insurance revenues and taxes among them. However, the bank also took the opportunity to build reserves through Stage 1-2 provisions and to keep expenses a little higher—both areas that the analysts say may prove to be helpful when the inevitable downturn comes. They say: “Even after normalizing for some of those unusual positives, we still get a result that was strong on many fronts, and with an almost uniformly positive outlook described on the conference call for fiscal 2019.”

Messrs. Sedran, Bailey and Giurleo give the stock a “neutral” rating and $110 target share price.

Strong Q4 sets stage for better 2019

The analysts note: “Variance analysis is normally our go-to activity on earnings days since it helps us figure out what needs to happen to estimates. In this case, and as noted above, we think the bank took advantage of a strong quarter to set itself up for a better year to come (as on loan losses and expenses, for example), which means we should not get too carried away with any individual variances. That view combined with the outlook articulated on the conference call that suggested management is comfortable with assumptions that earnings will be at or above target range (i.e. seven per cent plus EPS growth) takes our above-consensus estimates modestly higher.

“For fiscal 2019E EPS, we are now at $9.25 (was $9.17). For F2020E, we are now at $9.83 (was $9.72).

Stronger balance sheet brings flexibility

“The balance sheet also made news on earnings day with the CET1 [Common Equity Tier 1] ratio bouncing higher to 11.5 per cent from 11.1 per cent last quarter, helped by some model refinements in calculating risk-weighted assets. This is the highest this bank has been on this measure and for those not impressed by 40 basis points, this equates to an additional $2 billion ready for deployment or return. We expect a little of both, which shows the flexibility that a strong balance sheet brings.

“Our investment thesis is based, in part, on a diversified business mix that yielded strong results in the fourth quarter of fiscal 2018. Canadian Banking grew earnings eight per cent year-over-year, while Wealth, Capital Markets, and Insurance all produced double digit growth. A growing US exposure should also be viewed favourably, which the bank gets from its Capital Markets and Wealth Management (City National) businesses. The capital position remains in surplus and we see modest ongoing buybacks throughout our forecast horizon. Valuation, however, remains unfavourable.

Net insurance revenue highest ever

“Net insurance revenue came in at $545 million (the highest it has been), up 15 per cent year-over-year, which led to a 20 per cent year-over-year increase in insurance earnings to $318 million in the fourth quarter of fiscal 2018. The strong top-line growth reflected the positive impact of contract renegotiations in the bank’s life retrocession [a type of insurance wherein a reinsurance company takes on part of the risk assumed by another reinsurance company] business, as well as higher favourable investment-related experience.

“Looking ahead, management is calling for another three- to five-per-cent mortgage growth in fiscal 2019 . . . , as well as four to eight basis points of margin expansion. Management indicated that the margin expectations are a reflection of past rate hikes flowing through to mortgages that re-price through the year and not as dependent on future rate hikes. As a result, we anticipate solid top-line momentum to continue in fiscal 2019 (was 10 per cent year-over-year in 2018), which should provide enough leeway for the bank to generate its targeted two to three per cent operating leverage. Bottom line, we expect another strong year for Canadian personal and commercial banking in 2019.”

This is an edited version of an article that was originally published for subscribers in the January 4, 2019, issue of Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada.

Investor’s Digest of Canada, MPL Communications Inc.
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