Royal Bank Of Canada: A Stable Dividend Grower With Tailwind From Capital Markets

Stock & Industry Snapshot

January is here again and as I throw another log into the fire and pour the maple syrup over a few waffles this cold morning, I’m also revisiting a few favorite Canada-based bank stocks I covered last year that often are under-covered or are hidden value gems.

For today’s research note, Royal Bank of Canada (NYSE:RY) is up next and we get to answer the question: is it time to buy and own a piece of non-US based financial stocks in our portfolio?

New readers of mine less familiar with this stock should know a few key company facts and that are that it is commonly known in Wall Street circles as “RBC” (which is also on its iconic brand logo), calls itself one of the largest banks in the world, has been around +100 years, and covers the spectrum of personal, commercial, wealth advisory, capital markets, and insurance solutions. Besides trading on the Toronto exchange it can also be traded on the NYSE.

In 2022, the Financial Stability Board listed RBC as a global systemically important bank.

An honorable mention is that after my October rating of RBC where I called it a buy, the share price since then has spiked +20%.

Since market bullishness on an entire sector could also affect this stock, from key market data on Seeking Alpha, we can see that this sector has risen nearly +8% in 1 year and +29% in 3 years:

Discussion of earnings data will refer to the fiscal 2023 Q4 results that was released on Nov. 30th, as the next earnings results are over a month away on Feb. 23rd.

Scoring Matrix

We use a 9-point scoring method that looks at this stock holistically and assigns a total rating score, using a score matrix.

Today’s Rating

Based on the score total in the score matrix, this stock is getting a rating of hold.

Since my last rating, this would be a downgrade from my prior buy rating.

Compared to the consensus rating on Seeking Alpha, my rating today is aligned more with the SA quant system.

Dividend Income Growth

What we can see from the dividend growth chart is that there has been a steady dividend growth from 2014 to 2023, a good sign for a dividend investor I think:

For example, the annual dividend went from $2.57/share in 2014 to $3.96/share in 2023, a 10 year gain of +54%.

Already for 2024 there is a growth to an expected $4.04/share annual, according to the dividend history.

Further, I think there is a strong probability for further dividend hikes in 2024 since earnings have shown a YoY growth lately, and I think a profitable company is more likely (though not guaranteed) to continue or increase dividends.

With that said, I would call RBC a buy in this category.

Dividend Yield vs Peers

The following dividend yield chart compares the dividend yield of RBC against 3 large peers in the banking sector, to decide who offers the best dividend yield for my capital if it was invested at the current share price.

In this peer group, I am comparing major Canada-based banks. CIBC (CM) leads the pack with a dividend yield of 5.49%, while peers Bank of Montreal (BMO) trails behind with 4.43%, Toronto-Dominion Bank (TD) at 4.43%, and RBC last at 3.96%.

Although RBC is last in this group, a nearly 4% yield is not so bad in my opinion, and as I expect continued modest bullishness in this sector it could lead to an even lower yield as the share price climbs further.

In this case I would call it a hold rather than a buy or sell, as the data supports a middle-of-the-road sentiment on this dividend yield.

Revenue Growth

From the income statement, we can get a picture of YoY revenue growth.

It tells us that revenue dropped to $8.87B in the quarter ending October, vs $8.94B in Oct 2022, a practically flat YoY revenue.

As I mentioned in recent articles on banks, a predicament they encounter in a high interest-rate environment is that although interest income climbs so does interest expense on deposits, so it pinches the net interest margin.

We can see for example that at RBC interest income climbed on a YoY basis but interest expense also climbed to $12.95B in October, vs $6.32B in Oct 2022, a +104% YoY growth in interest expense.

This helped net interest income growth to be almost flat on a YoY basis, whereas non-interest income growth was also mostly flat.

Looking into the most recent earnings data from the company at the end of November, the firm spoke of declines in personal/commercial banking, wealth management, and insurance, while capital markets grew by double-digits.

However, a positive point I want to highlight, particularly since this business also measures success by growth interest-earning assets, is that they actually have been growing those assets in their portfolio than earn money:

In my opinion, this growth in avg. earning assets going into the new year should lead to continued revenue growth from those assets, so my sentiment is positive.

From the data, I am calling RBC a hold in this category on the basis of flat YoY revenue growth and rising interest expense, but offset by growth trends in income-earning-assets.

Earnings Growth

After looking at the top-line revenue, let’s also use the income statement to discuss YoY earnings growth.

We can see from the data that earnings (net income) grew to $2.97B vs $2.84B in Oct 2022, a YoY growth of 4.5%.

Some headwinds on the expense side, according to Q4 results, included:

Transaction and integration costs related to the planned acquisition of HSBC Canada added ~4% to expense growth.

Higher salary costs reflected the impact of higher severance due to cost reduction strategy and higher base salaries.

Higher professional fees and investments in technology and infrastructure to support business growth, acquisition integration and product innovation.

Despite those headwinds, the firm achieved positive earnings growth. The question now is whether it is sustainable going into the new year and beyond?

Since the HSBC acquisition was a short-term item, that one-time expense will go away soon, along with acquisition-related costs.

Earnings I think will also be given tailwind from greater top-line revenue. Let’s focus on the side of the house not exposed to interest-rate risk, and that is fee-based revenue. In their home market of Canada, we know “Canadian wealth management revenue was up 3% YoY” driven by “higher average fee-based client assets reflecting market appreciation and net sales. Global asset management also saw “higher average fee-based client assets reflecting market appreciation.”

I want to point out that the uptick in the equities market overall should continue to drive up the asset values of those portfolios managed by RBC, and hence the fees earned on those assets.

We can see from market momentum data that the S&P500 index 1 year price return has been nearly +22%.

So, I would argue that the business diversification this firm has beyond traditional consumer banking and its strength in capital markets particularly revenue growth in corporate and investment banking will provide tailwind in the new year, since I think improved equity markets and potential for interest rates to come down later this year should add confidence to more deals getting done by this firm’s corporate clients.

The evidence points to this category being a solid buy for RBC.

Equity Positive Growth

I have more good news from the firm’s balance sheet, which shows a decent YoY equity (book value) growth. This is a fundamental metric, I think, to a any well-managed company who can continue to keep assets well above liabilities and achieve positive equity.

We can see that the company’s equity is massive at $84.91B, vs $79.40B in Oct 2022, a YoY growth of +7%.

Another positive I want to highlight is that corporate long-term debt has declined to $111.26B, vs $120.64B in Oct 2022, a 7.7% YoY decline in long-term debt. This is relevant since it could mean lower interest expenses going forward, on corporate borrowing, since a large bank like this does not only rely on customer deposits but it also “borrows” in the money markets to maintain liquidity, and sometimes from other banks.

On the topic of capital, we also see that the CET1 ratio continues to improve and be well above Basel III regulatory minimums, and the liquidity coverage ratio (LCR) continues to be strong at this firm:

From the evidence, I call this stock a buy in this category, based on sustainable liquidity and equity growth.

Share Price vs Moving Average

Using the yChart below, we can see the relationship between the current share price and the 200-day SMA:

As I expected would occur, this chart indicates that this stock has been trading lately above its 200 day SMA, at a premium of +8.8% vs its moving average.

It appears we missed the great buying opportunity presented this autumn when the stock hovered around $78/share, whereas now it is past $100.

In case you’re wondering why I always use the 200-day SMA, it is because it provides a straightforward long-term price trend indicator that “smoothes out” the volatility in price and could give me some buying, holding, or selling signals. It is best used in combination with the other fundamentals I already discussed, rather than just going by the chart alone.

For instance, here we have a price trading at 8% premium vs its long term average, but at the same time revenue has shown flat YoY growth while earnings and equity has shown low single-digit growth, and the dividend yield of nearly 4% is still lower than 4 of its key Canadian banking peers.

In my opinion, the data points to this being a hold right now rather than a buy. I would not call it a sell because I expect further modest bullishness in the banking sector as potential for lower interest rates later this year could reduce the risk of defaults while increasing demand for mortgages as debt becomes cheaper again.

Valuation: Price-to-Earnings

I like to keep the valuation topic simple and so I use the GAAP-based forward P/E ratio to gauge the gap between price and earnings.

What it tells us is that the forward P/E is now at 12.28x earnings, or about 12% above the sector average which is hovering closer to 11x earnings.

I think clearly the driver of this 12x multiple is the spike in share price, since earnings only grew by single digits in a year. This is causing a rift between price and earnings.

In its peer group I would go for CIBC as its valuation is just 9.8x forward earnings while it also showed a 22% YoY earnings growth, so it presents a smaller gap between price and earnings.

So, I think RBC’s valuation indicates more of a hold than a buy at this valuation.

Valuation: Price-to-Book Value

Also from valuation data, we want to see the gap between price and equity (book value).

We can see the forward P/B ratio is now 1.62x book value, or about +37% above the sector average which is hovering around 1.18x book value.

The driver of this is clearly the share price now trading at an 8% premium to its moving average, while equity only grew 7% in a year.

Again, I think its peer CIBC presents a better valuation here if I was buying, having a valuation of 1.16x book value while also achieving a nearly 4% YoY equity growth.

I would call RBC a hold in this case because of its single-digit equity growth and continued capital strength, while the share price however is +$22/share above its autumn low, which is quite a price spread and not the best buy opportunity right now.

Risk Analysis

A key risk in the banking sector which I keep mentioning time and again in my research notes is exposure to the commercial real estate market, but particularly exposure to office property.

This is what RBC’s portfolio of CRE assets looks like:

What we can learn from this data is that their CRE book is just under 10% of their total loan book.

Within CRE, its largest exposure is to industrial/warehouse (30%) while office is around 19% of the portfolio.

Their US business has a slightly larger exposure to office than the Canadian business.

Keep in mind that an article by Morningstar just 6 days ago highlighted the risk of headwinds in the CRE market going into 2024:

Regulators in December said the near $6 trillion pile of outstanding commercial real-estate loans, of which about half were owned by banks, was a top threat to the financial system in 2024.

Loan delinquencies and defaults, while still well below past crisis peaks, have been picking up in recent months as more borrowers struggle to modify, pay off or refinance maturing debt.

Further, the UK’s Daily Mail newspaper on Jan. 1st brought up the issue of rising default risk in the US among office properties:

US office buildings face $117BN debt time bomb: Mortgages due this year threaten to sink US economy as thousands of workplaces remain empty.

About $117 billion worth is expected to be due this year and needs to be repaid or refinanced, according to the Mortgage Bankers Association.

A big chunk of it is at risk of defaulting and costing banks and developers huge sums, sending some into insolvency.

Now that we know that the risk probability and potential impact is there going into 2024, what does that mean for RBC?

I would argue that their office exposure is a very low part of its overall loan book, according to the data, and within its CRE portfolio it is less than 1/4th of the portfolio.

At the same time, if there is a wave of office defaults in 2024 it could cause investors to get spooked and pull back a bit on any bank stock with CRE exposure. This can present a headwind to a firm like this that otherwise has strong fundamentals.

For that reason, in the risk category I would call this stock a hold, for the reasons I outlined and downside risk potential. We saw last spring, for example, a lot of bearish sentiment in the market on the banking sector overall because just a few regional banks failed, since there is always that fear of systemic spread, whether that fear is justified or not it is a reality of the markets.

Quick Summary

To summarize, this time around from the holistic scoring system I use it appears RBC presents a hold opportunity.

Right now it is trading at quite a premium to its long-term moving average, and its peers present a better dividend yield opportunity, while its revenue and earnings have only seen flat or single-digit growth.

Its exposure to office loans is not significant, however if defaults rise in 2024 it could spread fear in markets to cause a bit less bullishness in banking stocks, though I think there will still be sector strength in banking if overall equity markets continue to climb as they have lately and the next few Fed meetings lead to lower interest rates, providing some relief perhaps on those squeezing interest margins banks have faced as well as a potential relief for defaults as credit becomes cheaper slowly.

My portfolio strategy with RBC would be to hold on to it as a systemically critical bank and a global banking leader, to earn stable quarterly dividend income rather than selling it off just yet. For me to sell off a valuable global bank like this it would have to climb at least another 10-20% above its 200-day average.