Royal Bank of Canada's Impairment Charge a Sign of the Times

| About: Royal Bank (RY)

Some investors might be wondering what to think about the $850-million goodwill impairment charge Royal Bank of Canada confirmed it will record in the second quarter. Blackmont Capital analyst Brad Smith says its a sign of the times.

The C$.73 per share charge (after tax) will reduce reported GAAP earnings but will not impact cash EPS, which is currently expected to be in the low C$.80 range, the analyst told clients. Mr. Smith also noted that the charge will not impact RBC’s regulatory capital.

So while the recording of a charge is never something to celebrate, he is encouraged by its relatively small size.

The analyst said:

We are also encouraged to see management address full-on the fact that pre-crisis acquisition pricing now appears to have been inflated resulting in failure to meet planned hurdle rates of return.

This serves as confirmation of his long-held view that while available rates of return on U.S. financial sector acquisitions by Canadian banks were attractive from a capital deployment perspective, they proved to disappoint.

Mr. Smith said that it is fortunate for RBC that the relative level of its pre-crisis capital allocation to its U.S. expansion strategy is small compared to its domestic peers.

He rates RBC shares a “buy” with a C$42 price target.

Given the ongoing deterioration in the U.S. economy and the prospects for further operating losses from banking there in 2009, this impairment charge should not come as a surprise, according to Credit Suisse analyst Jim Bantis. He called the move “prudent and a reality check.”

He also said it perhaps shows that management is unlikely to ‘throw good money after bad’ in expanding the U.S. retail franchise – at least in the near-term.

Mr. Bantis continues to rate RBC at “outperform” with a C$37 price target.

Michael Goldberg at Desjardins Securities told clients that since the goodwill is valued against the operating segment that it is related to, the remaining goodwill in the Canadian segment should be virtually immune from being written down.

The analyst said RBC’s announcement also spurred speculation that other Canadian banks such as Toronto-Dominion (NYSE:TD) and Bank of Montreal (NYSE:BMO) might record similar goodwill impairment charges related to their U.S. banking operations. TD’s management confirmed to him that it remains comfortable with the goodwill valuation of its U.S. banking operations.

While the impact of an impairment charge comes as a one-time hit to earnings, Mr. Goldberg noted that there is no impact on regulatory capital or tangible common equity. As a result, one might think banks would be indifferent to recording such an impairment charge.

The analyst said:

However, the bigger issue is that a goodwill impairment charge sends the message that the franchise is impaired. The question now is: What will Royal do with this business and the capital deployed in it to increase the return on that capital?

He continues to rate the stock a “hold” with a price target of C$41.50 per share.