Right now, it seems like major Canadian banks can do no wrong.
In particular, Royal Bank of Canada (RY) is having a good time of things, after reporting very strong earnings on May 30. And with the economy growing at the fastest rate in two years, buying the stock seems like a no-brainer.
But is everything really that clear cut? Here are 3 pros and 3 cons of owning its stock. (All figures Canadian dollars unless mentioned otherwise.)
Earnings: Royal Bank’s second quarter earnings excluding certain items increased 13% year-over-year to $1.97 billion. Six months into the year, the company has increased earnings by 12% to $4.04 billion. Gord Nixon, the company’s CEO, was especially happy with the fact all five of its operating segments increased earnings this year. Ally Financial, the Canadian auto finance business that RY acquired February 1 for $3.7 billion, contributed an additional $20 million to earnings and looks like a solid growth business for the company.
Canadian Business: Quite frankly, this is what’s keeping the company moving in the right direction. In Q2 its Canadian banking business generated $1.04 billion in net income — an 11.3% increase year-over-year, and 54% of Royal Bank’s overall net income from continuing operations. Outside of personal and commercial banking, Royal Bank generated an additional $485 million of net income in Canada from its four other segments which include wealth management, insurance, investor & treasury services and capital markets. The company’s U.S. net income was $189 million in Q2, or 9.8% of its overall total. And its international business actually out-earned its American counterparts with $222 million in the quarter.
Personal Financial Services: This is the largest of Royal Bank’s three segments, with $1.68 billion in second-quarter revenue — 56% of its total Canadian revenue. Excluding $42 million in revenue from Ally Financial, its personal financial services revenue in Canada grew by 4.3% in Q2 thanks to positive contributions from residential mortgages and higher mutual fund fees. At the end of April, it had $201.1 billion in outstanding residential mortgages, up from $198.3 billion six months ago. Including personal loans and credit cards, the segment’s total retail exposure is about $409 billion. With $1.2 trillion in outstanding residential mortgage debt in Canada, RBC has approximately 16.8% market share, meaning there’s definitely room to grow.
Excessive Pay: Royal Bank CEO Gordon Nixon was the fourth-highest-paid banker in North America in 2012 with total compensation of $12.6 million. Nixon is the highest-paid of his Canadian counterparts but don’t feel sorry for the rest of the Canadian bank presidents; six Canadian bank CEOs were in the top 20. Nixon’s pay might pale in comparison to Goldman Sachs’ (GS) Lloyd Blankfein, who earned $26 million in 2012, but it’s still a lot of cash. As a Canadian I have mixed feelings about this. On the one hand, it’s about time that we got paid on the same level as our American counterparts. On the other hand, Canadian banks historically haven’t been nearly as productive as those in the U.S., so CEO’s don’t have as much justification for seven-figure salaries. And because there are only six big banks in Canada controlling much of the banking business, Royal Bank and its peers don’t have to work nearly as hard as banks in the U.S. do. (Only Ed Clark of TD Bank (TD), whose bank has been competing up and down the eastern half of the U.S. for more than a decade, deserves compensation in the same ballpark as Jamie Dimon.)
Slowing Housing Market: Economist David Madhani of Capital Economics believes the Canadian housing market is exhibiting many of the same signs the U.S. housing market experienced at the beginning of its slowdown in 2007. Another economist, Will Dunning, sees 150,000 job losses in the construction industry as the housing slump continues. Furthermore, if housing prices drop 25%, as predicted by Madhani, the same “underwater” scenario that’s played out in the U.S. will happen in Canada. The last time this happened, in 1989, homeowners didn’t recover from negative equity until well into the new millennium. While the bank can shift its attention to commercial lending, it won’t be enough to prevent the deterioration in its overall business, especially since a significant amount of its income is tied to Canadian residential mortgages.
U.S. Business: Compared to TD or Bank of Montreal (BMO), Royal Bank has relatively weak business south of the border. With the U.S. economy on the mend and Royal Bank doing very little elsewhere, it must turn to its capital markets segment to make inroads in the American market, where its revenues are much greater than in Canada. In the first six months of 2013, its capital markets segment generated $850 million — 14.6% higher than the first six months of 2012. Given that the capital markets segment is the bank’s second-largest revenue producer, it makes sense to focus on this area of its business. However, I just don’t see it being enough of growth driver for the bank.
Canada’s biggest bank is probably also its most conservative. Buying its stock gives you a dividend yield that is currently higher than JPMorgan Chase (JPM) or Wells Fargo (WFC). However, like every other Canadian bank, its exposure to residential mortgages in one of the few places on earth yet to have a real estate correction, makes it a questionable investment at this point.
Therefore, I’ll recommend that you pass on Royal Bank and consider one of the bigger U.S. banks such as JPMorgan. You might not get as big a yield on your dividend, but I think you get a safer investment given where Canadian real estate prices are headed.
As of this writing, Will Ashworth did not own a position in any of the aforementioned securities.