Hedge Funds Dig into Royal Bank of Canada
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Royal Bank of Canada (NYSE: RY)
(The following write-up is an abbreviated pitch pulled from the SumZero community.)
Recommended Action: Short
Current Price: $52.50 Target Price: $36.00
Source: Hedge Fund. New York, NY.
Thesis:
A short position in Royal Bank of Canada common equity has little downside risk, offers modest upside, and should be effective as a portfolio hedge.
Royal Bank of Canada is one of the better managed and soundest banks in the developed markets, but its stock is over-valued. At 2.6x tangible book value and 13-14x sustainable earnings, the stock is richly valued and ought to decline 20-50% under a range of likely scenarios. It is highly unlikely that the stock will appreciate more than 15-20% from the current level. 2011 EPS were identical to 2007 EPS. The company will have no growth over the next several years and 2014 EPS - at best - could be similar to 2011's level.
Investors under-estimate RBC’s position as a global investment bank and resulting exposure to European sovereigns and banks as a counter-party in derivatives transactions and repurchase agreements. But what is even more important and not well known is the recent credit boom in Canada: house price/ rents and consumer debt/ disposable income both exceed levels seen in the US and UK. Charts of home prices, credit growth and housing valuation multiples for the US and Canada (lagged a few years) are remarkably similar.
Catalyst:
Unfortunately there are no catalysts specific to RY that are relevant to the thesis. The primary reason the stock is expensive relates to the nature of the Canadian equity markets. RBC is one of the largest public companies and domestic investors essentially have to choose between owning resources or financials. This strong home bias has provided a steady bid for the stock while valuations of mega-cap banks everywhere else in the world have relentlessly declined (with the exception of Australia, where the situation with listed banks is remarkably similar).
Scenarios:
Bad: 2012 ROA 1.00%, P/TB 3.1x, P/E 13.5x, price $60, downside (20%)
Base: 2012 ROA 0.80%, P/TB 1.8x, P/E 10.0x, price $36, upside 27%
Good: 2012 ROA 0.65%, P/TB 1.1x, P/E 7.5x, price $22, upside 55%
Risks:
RBC’s management has to be given credit for running a conservative and high quality bank. This company is not remotely like Citibank (NYSE: C) or RBS (LSE: RBS.L). Rather, it is in the same league as Wells Fargo (NYSE: WFC) and HSBC (NYSE: HBC). As such, the risky exposures at RBC will lead to a reduced level of earnings and compressed multiples from investor apprehension, rather than financial distress or forced capital raises.
On the surface, RBC appears to have out-sized counter-party exposure in derivatives and repos to Europe. Disclosure is commendably thorough, and the annual report shows $129b in gross exposure to Europe broadly. Net exposure is shown as only $43b. Through collateral, hedging, and mark-to-market, I doubt the risk is as scary as these big numbers would imply. So the issue really is one of uncertainty - no one really knows what will happen if a major derivative counter-party or sovereign issuer defaults.
Timeline:
The holding period is expected to be 6-15 months. Events serving as validating sign-posts include: Fears over counter-party exposure increasing in 2012 after more problems in Europe; greater appreciation of the credit boom in Canada and the beginning of a housing downturn in 2012.
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