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RBC Financial Group research and analysis

Contributed by eResearch

By Bob Weir

RBC Financial Group (RY) reported Q4/11 EPS cash net income of $1.09, up 20% Y/Y. This excludes the U.S. personal and commercial bank which is part of discontinued operations as RY recently reached an agreement to sell the U.S. bank to PNC Financial (see discussion below). Earnings were $0.08 below our estimate and about $0.11 above that of consensus. Overall, it was an acceptable quarter as trading revenues continued to be very volatile, declining over 60% Y/Y. Fixed income trading remained under pressure, down over 80% Y/Y. The Tier 1 capital ratio increased in the quarter to 13.3% from 13.2% last quarter. Adjusted ROE was 17.2%, up from 17.1% last quarter.

Domestic banking earnings in the quarter were very solid, increasing 18% Y/Y. Wealth Management had a good quarter with net income up 11% Y/Y. Capital Markets reported very weak results as net income declined 25% Y/Y driven by much lower trading revenues and weaker underwriting and advisory fees. RY’s Provision for Credit Loss (PCL) was down 17% Y/Y and about 10% lower than we expected.

For fiscal 2011, RY reported cash EPS was $3.19, down from $3.46 in fiscal 2010. Adjusted cash EPS, which excludes non-operating items, was $4.37, up 18% from $3.70 in fiscal 2010. Adjusted ROE for all of fiscal 2011 was 17.6%, up from 15.9% in fiscal 2010. Canadian Retail net income (53% of total bank) was solid with a 15% Y/Y gain driven by strong loan growth and lower PCL. Wealth Management net income (12% of total bank) increased 21% Y/Y. The Wholesale Bank’s adjusted net income (24% of total bank) declined 4% Y/Y due largely to weaker trading revenues. For fiscal 2011, PCL declined 20% Y/Y to $1.0 billion from $1.2 billion. GIL was lower at $2.4 billion in fiscal 2011, down 11% Y/Y. The dividend per share was increased by 8% to $2.16 from $2.00.

For fiscal 2012, we have lowered our EPS estimate to $4.80 from $4.95. Our preliminary estimate for 2013 is $5.30. Our forecast is predicated on only a modest improvement in capital markets. Further dividend increases are a possibility in fiscal 2012 based on payout ratios of 45% and 41% on our 2012 and 2013 EPS estimates respectively. The 2012 payout ratio is slightly below the mid-point of management’s targeted payout range of 40%-50%.

Although disappointed with RY’s recent quarterly earnings, particularly Capital Markets, we continue to recommend it as a BUY. The Capital Markets’ model continues to be a struggle amid difficult market conditions particularly in Europe, but we applaud the sale of the U.S. personal & Commercial bank. The sale of the latter will place RY on a very solid capital base footing that, in our view, will allow the Bank to build on its strengths and position it as one of the top banks globally. Capital Markets is expected to improve modestly over the next 12 months as management realigns its business platform. Management also appears intent on expanding its Wealth Management business which is a strategy that we highly endorse. We expect more selective acquisitions in Wealth Management and Capital Markets.

Conclusion: BUY – 12-Month Target Lowered to $62.00

Valuation

We have lowered our share price target to $62.00 from $63.00 which is consistent with the lower earnings outlook for fiscal 2012. Our share price target implies a 12.8x multiple on our 2012 EPS forecast which is a small premium to the Canadian bank average.

IFRS Impact Update

Management gave an update on the IFRS accounting changes that will impact Q1/12 reporting on both the Bank’s Balance Sheet and Income Statement.

Shareholders’ Equity

- Negative by $3.5 billion comprised largely of $1.3 employee pensions (cumulative actuarial gains/losses recognized in opening balances), $1.2 billion of goodwill. Phase in over 5 quarters offset by expected retained earnings over the period.

Income Statement

- Reduced expenses by $315mm or 1%.

Tier 1 Capital (Basel II)

- Minimal due to phase in period.

Credit Exposure to Europe & PIIGS

RY updated its credit exposure to Europe as well as the PIIGS countries is outlined below:

- Total credit exposure to Europe (largely investment grade) was $43.3 billion which includes loans, derivatives, counterparty risks and securities. Of the total, $26.4 billion was France, Germany and the U.K.

- Total exposure to PIIGS is $1.4 billion. Spain - $701 mm, Ireland - $456 mm, Italy - $241 mm, Portugal - $28 mm, Greece - $13 mm. Other Quarterly Highlights

- Reported a net operating income of $1.6 billion for the quarter, flat sequentially (excluding the $1.7 billion loss related to the sale of the U.S. banking operation last quarter) and up 19% Y/Y. Revenue from continuing operations was flat Y/Y while non-interest expenses increased 1% Y/Y for negative operating leverage of 1%. Expenses included higher pension costs and acquisitions.

- Canadian Personal and Business Banking (P&B) reported net income of $904 million, up 18% Y/Y and 6% sequentially. Interest margins decreased 2 bps on a Y/Y basis and 1 bp sequentially. Management indicated that decrease was largely driven by competitive pressures. Revenue increased by 6% Y/Y while expenses increased by 4% Y/Y. The higher expenses reflected higher pension expense as well as increased costs related to business expansion. Volume growth remained good, up 7% Y/Y. Domestic PCL was reported at $222 million, down 23% Y/Y and 13% sequentially. ROE for this group was 31%, down slightly Y/Y.

- Wealth Management reported cash net income of $207 million, up 11% Y/Y and 5% sequentially. Fee-based revenue was up 18% Y/Y driven by a 17% increase in client assets under management which included the BlueBay acquisition. Mutual fund revenue increased 24% Y/Y. Canadian revenue was up 7% Y/Y driven by higher average fee-based client assets. U.S. and International Wealth Management revenue decreased by 10% Y/Y, however, on a constant currency basis, revenue was down only 7% Y/Y. Global Asset Management revenue increased 41% Y/Y and included BlueBay. RY reported total AUM of $316 billion. The adjusted ROE was 13%.

- Insurance cash net income was reported at $196 million, up 58% Y/Y and 38% sequentially. Earnings were driven by strong volume growth across all sectors as well as $26 million relating to the timing of a U.K. annuity reinsurance earnings and lower auto claims experience. The adjusted ROE was about 38%

- International Banking reported net income of $12 million, up from a loss last year of $7 million but well down from $31 million last quarter. Total revenue was flat Y/Y due to lower loan volumes. RBC Dexia IS reported revenues up 9% Y/Y reflecting higher average fee-based client assets and wider spreads. PCL decreased 33% Y/Y to $31 million due to lower losses in the Caribbean portfolio.

- RBC Capital Markets reported another poor quarter with cash net income of $278 million, down 25% Y/Y and flat sequentially. Trading revenue, adjusted to exclude the MBIA gains and other small items, was lower by 60% Y/Y and 35% sequentially. Lower trading revenue resulted from lower fixed income trading (largely U.S. & Europe), lower client volumes, and reduced market liquidity. Fixed income trading was $70 million in the quarter, down from $414 million last year and flat sequentially. Underwriting and advisory fees were down 17% Y/Y and 23% sequentially. PCL was $4 million versus a net recovery of $22 million in the same quarter last year and a loss of $8 million last quarter. The ROE was 11% versus 17% in the same period last year.

- PCL was reported at $235 million, down 17% Y/Y and 15% sequentially. Overall, PCL came in almost 10% below our expectations. PCL, as a percent of average loans, decreased to 31 bps from 38 bps last quarter and was lower than the 40 bps reported in the same period last year. PCL in Canada decreased marginally due to lower commercial provisions. International banking PCL decreased driven by lower losses in the Caribbean. Capital Markets reported PCL of $4 million compared to $8 million last quarter. For fiscal 2012 and 2013, we are maintaining our PCL estimates at $1.0 billion for each year which would represent a small increase from 2011.

- Gross Impaired Loans in the quarter amounted to $2.4 billion which was down 11% Y/Y but flat sequentially. Overall, this level was about in line with our expectations. New impaired loan formations in the quarter decreased by 20% to $411 million from $511 million last quarter. We continue to expect GIL to remain elevated for some time and have maintained our fiscal 2012 and 2013 targets at $2.4 billion.

Basel III Capital Rules – RY Meets New Standards

Under the current Basel II capital rules, RY’s Tangible Common Ratio is 10.6% and its Tier 1 Capital Ratio is 13.3%. Management estimates that the Tier 1 Common Equity Ratio under Basel III (2019 rules) currently meets the 7.0% minimum required by 2019.

Recent Events

On June 20, 2011, RY announced the sale of its U.S. Retail Banking operations “RBC Bank (USA)” to PNC Financial Services Group Inc. (PNC) for $3.62 billion. JP Morgan Chase was its advisor on the transaction.

- RY recorded a $1.6 billion loss on the transaction, however, RY took a $1 billion write-down in 2009.

- The purchase price includes $3.45 billion for the U.S. retail bank and $165 million for related credit card assets. Closing is expected in March, 2012.