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Morningstar | Tougher Near-Term Market Conditions, but Longer-Term Outlook Remains Unchanged for RBC

Wide-moat Royal Bank of Canada reported OK fiscal first-quarter 2019 results, and our long-term thesis on the firm remains unchanged. As expected, earnings growth has slowed a bit, and after normalizing for the one-time tax-related write-off in the first quarter last year, earnings per share were only up 1%, at CAD 2.15, for the quarter. This fits broadly within our thesis for slowing growth and a more difficult operating environment as loan growth slows, credit costs pick up, and the general environment in Canada and the U.S. remains difficult over the next several years. We are maintaining our fair value estimate for the Canadian shares at CAD 111, and due to changing exchange rates, we are increasing our fair value estimate for U.S. shares to $84 from $83 per share.

The bank's return on equity remained near the 17% level, at 16.7% for the quarter. RBC continued to push increased investments as the bank beefs up organic growth efforts, particularly in the United States. As a result, expenses were up 5% year over year. The bank continues to invest in technology upgrades, new bankers, and is even expanding into new markets, such as Washington and New York. We expect this general theme to continue, as banks have to maintain heavy technology investment to keep up, and as more banks increasingly look to expand into new markets, causing even more investment, and more competition.

Credit quality hit a bump in the quarter, as provisioning was up roughly 50% from first-quarter 2018, to CAD 514 million. This was admittedly off of a small base, as credit costs have been exceptionally low, and was primarily due to a single credit within the U.S. utility sector. We would guess this was likely related to the California wildfires and PG&E. However, provisioning also generally increased a small amount in the bank’s Canadian banking segment, as well. Either way, the utility event was idiosyncratic, and delinquency rates remained steady in all key portfolios. We don’t know when credit losses will pick up, but we expect they eventually will, with provisioning potentially more than doubling from current levels at some point in the next three years.

While capital markets had a less-than-stellar quarter, due to the credit event, as well as, less favorable market conditions (investment banking activity was down, as was fixed-income trading), the core personal and commercial banking unit did fine. Loan growth remained surprisingly strong in Canada and net interest margins were up, leading to good net interest income growth. Despite expenses being up 6% and fee income being roughly flat, the strong net interest income growth lead to an increase in net income of roughly 4%. Average residential mortgage balances were up 5% year over year, and we would expect this to moderate as the housing cycle matures in Canada.

Given the recovery in markets followed the declines at the end of 2018, assets under management were still up 5% year over year. RBC continues to be at the front of the pack when it comes to flows, as the bank has consistently improved all-in market share. The bank also recently partnered with BlackRock on new set of iShares products, which will be offered through RBC and branded as RBC iShares. This immediately makes RBC a key player in the ETF space, whereas previously it had somewhat lagged in market share. This is a smart move in our view, as we see the space consistently moving in this direction.