In my previous GuruFocus article about the Royal Bank of Canada (RY, Financial) published on April 22, I was very bullish on the bank and estimated that the stock could rise as much as 25% based on the valuation at the time. Shares of the bank are up nearly 22% since then. Given the recent rise, is there still more upside for Canada’s largest bank?
The answer depends on your investment strategy. Income investors and value investors may have a different takeaway. In this article, we will examine the company’s recent earnings results and valuation to determine if either of these types of investors would want to buy the Royal Bank of Canada stock at current levels.
Quarter highlights
The Royal Bank of Canada, or RBC, reported earnings results for its second quarter of fiscal 2020 on May 27. During the quarter, revenue declined 12% year-over-year to $7.5 billion, which missed estimates by more than $500 million. Earnings per share decreased almost 55% to $0.75. This was $0.37 below analyst estimates.
The pandemic has caused many businesses to temporarily close in both Canada and the U.S. for a lengthy period of time. Non-essential employees were urged to stay home as a means to slow the spread of the virus. With businesses closed and consumers holed up for months, the economy came to a halt in many regions. This will undoubtedly lead to business and individuals not being able to repay loan obligations.
As a result, all Canadian banks had to significantly increase provisions for credit losses, aka PCL. RBC’s PCL was 2.83 billion Canadian dollars ($2.11 billion) for the second quarter of fiscal 2020. This compares to C$502 million in the prior year. This is a 464% increase year-over-year.
While this is a massive increase and could be an ominous sign, I don’t believe RBC is in a terrible position. The bank has a total loan portfolio of more than C$673 billion. Its allowances for credit losses stands at C$5.9 billion. This means that just 0.87% of RBC’s total loan portfolio is estimated to be at risk of becoming impaired. With all the economic impact the pandemic has had on both Canada and the U.S., investors may have expected a much higher percentage of loans to be impaired. RBC could just as likely be underestimating the amount of allowances it needs for PCL, but its impaired percentage is in the middle of the pack of the other Canadian banks.
Let’s look at how the individual segments of the bank performed in the second quarter. Personal & Commercial Banking had revenue growth of 2% year-over-year, though net income declined 66%. The decline in net income was mostly due to a 279% increase in PCL. Looking deeper, we can see that PCL masked otherwise solid results. Loan volumes increased 7% and deposits grew 11%, showing that RBC was still executing its business at a high level despite the backdrop it was facing. Net interest margins decreased 10 basis points to 2.7% due to lower interest rates. Lower purchase volumes led to lower card service revenue. This wasn’t surprising as consumers in both of RBC’s key markets were under stay at home orders for various lengths of time.
Wealth Management revenue declined 5% while net income decreased 28% compared to the same quarter in fiscal 2019. Excluding the U.S., revenue would have increased 2%. Market volatility surrounding the impact of the pandemic weighed on results. On the plus side, this segment benefited from higher average fees on client activity and higher volumes in the Canadian Wealth Management business.
Insurance revenue declined 87%, but net income improved 17%. Revenue suffered a steep decline due almost completely to the change in fair value of investments backing policyholder liabilities. Excluding this, revenue was actually up 2% from the prior year. Net income growth was strong due to favorable investments results as well as new longevity reinsurance contracts. Cost controls continue to be a bright spot for this segment as expenses were lower by 1%.
Investor & Treasury Services had revenue growth of 21% and a 50% increase in net income. Revenue and net income were higher on account of a benefit from interest rate cuts in the quarter. RBC’s Asset Services Business was aided by higher revenues from currency exchange due to client activity in a volatile market.
Revenue for the Capital Markets segment was up 7%, with net income falling 86%. Loan underwriting markdowns in the U.S. and Europe led to a 25% decrease in revenue for Corporate and Investment Banking. Offsetting this decline was a 37% increase in Global Market revenue. Higher commissions due to increased trading activity and an increase in fixed income trading were the primary drivers of growth in this business. As with other segments within RBC, higher PCL was the main culprit in the decline of net income.
As you can see, PCL weighed on results during the most recent quarter. Examining closer shows that RBC had a solid quarter when excluding PCL. Even with this drag on results, RBC’s stock has increased 21.7% from the last time I looked at the bank.
Analysts now predict EPS of $5.23 for full fiscal 2020, down from $6.72 at the time of my last article on RBC. This decline in estimates is likely due to higher PCL. However, as discussed above, allowances for PCL accounts for less than 1% of all of RBC’s loan portfolio.
Achieving analysts' EPS estimates would result in a 22% decrease from fiscal 2019. Over the last decade, RBC has only one year (2015) where EPS was lower than the previous year on a U.S. Dollar basis. That had to do with currency exchange headwinds, as RBC has increased EPS in Canadian dollars every year since 2010.
Using Friday’s closing price of $71.92, RBC has a forward price-earnings ratio of 13.8 compared to 8.8 at the time of my last article. This would be the highest annual average multiple in more than a decade if the stock were to average this multiple for an entire year. This is also above my target price-earnings range of 10 to 12 for shares of RBC.
However, compared to the S&P 500’s multiple of 22.9, RBC looks like a good value. In addition, shares of RBC offer a 4.5% dividend yield as of the most recent close, more than twice the average yield of the S&P 500. RBC had a 5.5% yield the last time I examined the company, but the current yield is still higher than the 10-year average yield of 3.9%. U.S. investors are expected to receive $3.24 of dividends per share this year. Using revised analysts estimates, this gives the stock a payout ratio of 62%. This is above the 48% average payout ratio that RBC has averaged since 2010, but still in an acceptable range in my opinion.
Final thoughts
As happened with the other large Canadian banks, provisions for credit losses were a major headwind to quarterly results. Underneath that, there were pockets of strength. Even with higher PCL, RBC’s impaired loans still seem expected to be very low.
Regions in RBC’s two most important markets, Canada and the U.S., are beginning to reopen even nonessential businesses.
Following a reduction in EPS estimates for the current year and a strong increase in share price, RBC now trades above my targeted valuation range. This is due to a combination of a reduction in EPS estimates and a 22% gain in the share price.
This doesn’t mean I believe investors should sell or trim their positions. Shares also offer a 4.5% yield based on the most recent closing price, and the dividend doesn’t appear to be in danger of being cut.
Value investors may choose to wait for a better moment to establish a position in the Royal Bank of Canada as the stock’s valuation has moved much higher since the end of April. Those searching for income will likely find the dividend yield appealing enough to consider buying.
Author disclosure: The author is not long stocks discussed in this article.
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