Take This One to The Bank
Deep Dive on the Jewel of Canada... RBC
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There is a curse in Canada.
Whenever a Canadian publicly traded company makes a run to pass RBC in market cap, they crumble.
In May of 2020, during the tech runup, Shopify surpassed RBC to become the highest market cap company in Canada. Since then? The stock is down 85% from its peak.
The previous company to take a run at RBC? Valeant Pharmaceuticals in July 2015. Months after it took the crown from RBC, the stock plunged amid controversies over business practices, accounting, and drug prices. The company has since been renamed Bausch and has a new management team and ticker symbol.
Before that? You might remember a little company called Blackberry. They passed RBC back in 2007 before failing to innovate, becoming a paperweight instead of updating their browser.
Before that? Nortel Networks swelled to a market value of $366B back in 2000 during the Dot Com bubble and accounted for as much as 35% of Canada’s benchmark index. Nortel ultimately filed for bankruptcy in 2009 and was liquidated.
As Omar on the TV show, The Wire once said…
“You come at the king, you best not miss”
Due to popular demand, I’m bringing back a deep dive in this week’s newsletter on the Royal Bank of Canada - one of the best capital compounders in the Biz.
This week, in <5 minutes, we’ll cover this storied institution:
Origin Story 👉 From Incorporation to Evolution
Overview of Structure 👉 Banking, Wealth Management, Insurance, Services, Capital Markets, Support
Key Metrics 👉 PCL, CET1 Ratio, Net Income, Return on Equity
Rates 👉 What do Rising Rates Mean for Banks?
Outlook 👉 Bull/Bear Case From Here
Let’s get started!
1. Origin Story 👉 From Incorporation to Evolution
This financial behemoth is the largest bank in Canada and the 5th largest in North America, and every goliath has a great origin story.
RBC was founded in 1864, 3 years before the dominion of Canada was officially born on July 1, 1867. It was founded as ‘the Merchants Bank of Halifax’ in Nova Scotia as a commercial bank to support the fishing and timber industries as well as the European and Caribbean import/export business.
By 1869 it was officially incorporated and received its federal charter in the same year, later expanding to the Maritime Provinces over the 1870s and 1880s. By 1901, the bank changed its name to reflect this westward expansion to the Royal Bank of Canada and moved its head office to Montreal.
RBC then merged with the union bank of Halifax in 1910 and built a branch in Winnipeg before improving its position in Ontario by merging with Traders Bank of Canada in 1912.
Through several more mergers, RBC continued to expand its footprint into different Canadian and international territories as well as different industries including a mortgage trust co. In the 1960s RBC created an insurance division through a merger with Ontario Loan and Debenture Company and installed their first computer in 1961—the IBM 1401—making them the first Canadian bank to use a computer.
One last little fun fact, then I’ll stop the history lesson…
In 1998, RBC proposed to merge with the Bank of Montreal, at the same time as the Toronto-Dominion Bank proposed to merge with the Canadian Imperial Bank of Commerce. Both mergers were examined by the Competition Bureau of Canada, and ultimately rejected by Paul Martin, at the time the Finance Minister of Canada, and future Prime Minister.
What a different world that would’ve been…
Under the Radar
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2. Overview of Structure 👉 Banking, Wealth Management, Insurance, Services, Capital Markets, Support
To get a better picture of the different moving pieces, RBC divides out the segments of the banks as followed:
Personal & Commercial Banking
Personal Banking offers a full range of products for individuals including home equity financing, personal lending, chequing and savings accounts, private banking, indirect lending (including auto financing), mutual funds and self-directed brokerage accounts, Guaranteed Investment Certificates (GICs), credit cards, and payment products and solutions.
Think of this arm as a lending service to both individuals and businesses. This is a GREAT indicator to dive deep into to assess the economic health of the overall population served.
Business Banking offers a wide range of lending, leasing, deposit, investment, foreign exchange, cash management, auto dealer financing, trade products, and services to small and medium-sized commercial businesses across Canada. RBC leads all of Canada in market share for business lending and deposits.
RBC provides a broad range of investment management services through mutual, pooled, and private funds, fee-based accounts, and separately managed portfolios.
They distribute their investment solutions through a broad network of bank branches, their self-directed and full-service wealth advisory businesses, independent third-party advisors and private banks, and directly to individual clients.
Wealth Management is a global fee-generating business serving HNW and UHNW individuals and institutional clients. The wealth management arm has $13.3B in total revenue, 5,500 client-facing advisors, $53B in AUA net flows, and over $75B in AUM.
RBC Insurance is the largest Canadian bank-owned insurance organization on a total revenue basis ($5.6B in total revenue) and operates under two business lines: Canadian Insurance and International Insurance.
In Canada, they offer life, health, travel, home, and auto insurance products, wealth accumulation solutions, annuities, advice, and services. Outside Canada, they operate globally in the reinsurance and retrocession markets offering life, disability, and longevity reinsurance products.
Ahh, insurance - what Buffet famously built his empire on - every bank needs this recurring revenue stream.
Investor & Treasury Services
Investor & Treasury Services provides asset servicing, custody, payments, and treasury services to financial and other investors worldwide. This arm has $4.6T AUA, 14% ROE, and an average client deposit of $64.4B.
They are a trusted partner with offices in 16 countries in North America, Europe, the U.K., and Asia-Pacific with a focus on safeguarding client assets and simplifying client operations in support of their growth.
Think of this business as a “plumbing” of the financial system business. Highly technical.
RBC Capital Markets is a global investment bank providing expertise in advisory & origination, sales & trading, and lending & financing to corporations, institutional investors, asset managers, private equity firms, and governments globally.
While the Wealth Management business is mostly fee-generating recurring revenue, you can think of the Capital Markets business as volume and transaction-based. This side of the business therefore more accurately measures a “pulse” of deal flow and how transactions are shaping up in the overall ecosystem.
Corporate Support consists of Technology & Operations. This arm provides the technological and operational foundation required to effectively deliver products and services to clients.
We’ll put this mostly into the “other” basket, as it is not really a meaningful driver of growth/revenue and serves mostly as an administrative function. It’s also a cost centre, which is why it is bucketed differently.
Let’s take a look at the most recent Income statement quarterly breakdown by division:
Before we continue, let’s check in with our Outrageous Chartered FinMEME Analyst Dr. Patel!
3. Key Metrics 👉 PCL, CET1 Ratio, Net Income, Return on Equity
Now that we understand the different arms of the bank - let’s get to the meat of the topic. How do we measure performance? Here is a great snapshot of its overall report card over the most recent quarter:
So let’s pick a couple of things out of this, then dive into what they mean.
PCL (Provisions for Credit Losses)
The PCL is an estimation of potential losses that a company might experience due to credit risk. This is treated as an expense in financial statements as the bank “sets aside” more capital for loans that it has reason to believe might default or become unrecoverable.
If we look at a company’s balance sheet, accounts receivable (AR) are expected to come in as a cash inflow within one year. However, if this is no longer collectible, the current asset on the balance sheet may be overstated, so banks protect against this by “writing off” the amount they believe will default as PCL.
We can use this as a readthrough on macroeconomic activity. If PCLs are increasing across the board, the overall economy is expected to default on more and more loans as a result of a slowdown in activity where revenue pulled in is no longer sufficient to cover (a potentially increasing) cost of borrowing.
In the example above, we see an increase in PCL, but there are nuances to this figure. The PCL was up mostly due to provisions they are now taking in the current quarter vs. releases of provisions in the prior quarter.
CET1 (Common Equity Tier 1)
CET1 is a measure of bank solvency that gauges a bank’s capital strength. It was put in place largely after the 2008 financial crisis in order to protect banks from downside in the event of a crisis.
CET1 comprises a bank’s core capital and includes common shares, stock surpluses resulting from the issue of common shares, retained earnings, common shares issued by subsidiaries and held by third parties, and accumulated other comprehensive income (AOCI).
That covers the numerator. When we look at CET1, we then look at a ratio:
Common equity Tier 1 ratio = common equity tier 1 capital / risk-weighted assets
Because not all assets have the same risk, the assets acquired by a bank are weighted based on the credit risk and market risk that each asset presents. For example, a government bond may be characterized as a "no-risk asset" and given a zero percent risk weighting. On the other hand, a subprime mortgage may be classified as a high-risk asset and weighted 65%.
According to Basel III capital and liquidity rules, all banks must have a minimum CET1 to risk-weighted assets (RWA) ratio of 4.5%.
As you can see in the quarterly report above, a CET1 Ratio of 13.1% at RBC is well above regulatory requirements.
So that covers two measures that are related to risk and exposure buckets, now let’s shift to growth drivers.
Net income is probably the single most important driver when it comes to balancing growth and costs. It’s always a delicate balance in terms of how the bank is deploying capital in order to go after new and exciting markets.
Internal decisions are frequently made on an NPV or ROI basis when it comes to capital allocation strategies.
The positive for this metric is that it is a great snapshot of the overall growth of the business. The negative is that there are so many moving parts so the footnotes are often long.
For example, in RBC’s most recent quarter, the pre-provision and pre-tax earnings of $4.9B were down 3% YoY as a result of lower revenue in Capital Markets including the impact from loan underwriting markdowns, largely driven by market conditions.
On the cost side, higher salaries (from wage inflation), technology investments, and discretionary costs to support client-driven growth were high, also leading to a Net Income squeeze.
When looking at the quarterly figures by segment, NI was down 16% YoY with lower results in capital markets, P&C banking, Corporate support, and insurance while the retreat in these was partially offset by higher results in Investor & Treasury Services and Wealth Management.
Return on Equity (ROE)
RBC uses ROE to gauge the health of the individual segments through return vs. total capital invested in the segment. This allows the bank to look at investment and resource allocation decisions independently to account for comparability by segment against competitors.
ROE = Net Income / Total Average Common Equity
Here’s the most recent breakdown by quarter as well as the last three quarters:
This gives the bank two yardsticks of measurement when it comes to capital allocation strategies. Between segments internally and vs. competitors externally.
4. Rates 👉 What do Rising Rates Mean for Banks?
There is a little bit of a double-edged sword when it comes to thinking about how the current rate-hiking environment affects banks.
Banks often hold large balances of cash through customer deposits and business activities. Increases in the interest rate directly increase the yield on this cash, dropping the proceeds to the bottom line.
Banks make a spread by lending out at a higher interest rate than they pay out to customers. They profit off of the marginal difference between the yield they generate with this cash invested in short-term notes and the interest they pay out to customers. When rates rise, this spread increases, with extra income going straight to earnings.
A rising rate environment generally means a growing economy. But let’s think about why rates are skyrocketing this time and the impact on a potential hard landing.
In order to fight inflation, a lot of central banks are raising rates rapidly. When interest rates are increased too much too quickly, borrowing demand starts to suffer and we start to experience a retreat in both new loans and refinancing volume.
If a recessionary period proceeds, the lending environment will continue to erode and this increase in spreads will fail to make up for the drastic drop-off in volume. As goes the strength of the underlying consumer and business clients, so goes the health of the banks.
5. Outlook 👉 Bull/Bear Case From Here
Achieve a “soft landing” by avoiding a recession on the back of appropriate central bank policy that threads the needle between squashing inflation and not handcuffing growth.
Valuations have been corrected accordingly. US banks are currently trading at a forward P/E ratio of 8.7x and 1.0x BV.
How much of the recessionary fears are “baked in”?
CET1 and liquidity ratios are much stronger this time around, should we get a recessionary event.
The housing market continues to soften as the mortgage market sees a steep downturn.
Credit card debt soaring while household savings rates and consumer confidence are plummeting - could create individual turmoil.
Weakening goods demand, bloated inventories, and weak commodity prices are all suggesting a slowdown in business loan originations
Is there going to be “the big one” when it comes to structural failure this time around?
With plenty of valid cases on both sides of the table, this earnings period for banks will prove to be an interesting one. JPM’s Dimon came out ahead of earnings and said that a recession was likely in 6 to 8 months.
Look to the earnings period for any clues that will provide a great “temperature check” on all the different moving pieces here. Here is what we have so far:
GS 0.00 Goldman Sachs plans to undertake one of the biggest reshuffles in the bank's history.
BAC 0.00 Bank of America's profits fell year-over-year, with the earnings per share figure beating Wall Street's estimate.
JPM 0.00 JPMorgan's revenue rose 10%, but it took a nearly $1 billion loss on securities.
MS 0.00 Morgan Stanley misses. Profit fell 29%. A dearth of deals battered investment-banking revenue.
WFC 0.00 Wells Fargo's profits missed expectations but revenue beat. It took a $2 billion charge executives haven't said much about yet.
C 0.00 Citigroup profit fell 25% but revenue rose 6%, beating expectations. It set a timeline for exiting Russia.
CS 0.00 Credit Suisse will pay $495 million to settle a civil suit regarding allegedly “toxic" residential mortgage-backed securities.
When it comes to RBC, paid subscribers to my newsletter are well aware that I’m long and strong when it comes to big blue.
After all… RBC has paid a dividend every year since 1870.
I’ll take that one to the bank.
Until next time. Always Yours. Incessantly Chasing ROI,
-Genevieve Roch-Decter, CFA
What else we Grittin’ On?
FORECASTS. Bloomberg economists are forecasting a 100% chance of a recession within 12 months. The models are up from 65% in the previous update.
GOLDMAN. Goldman Sachs will fold its biggest businesses into 3 divisions. This will be one of the biggest reshuffles in the company's history.
HYDROGEN. BMW thinks hydrogen will be the next trend after electric vehicles. The automaker is already selling some fuel-cell vehicles.
PEAK SEASON. What is typically peak season for freight operators has seen demand crumble. Pre-pandemic normalization or foreshadowing?
MORTGAGES. The average rate on a US 30-year fixed mortgage reached 6.94% this week. That's the highest since 2002.
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