- Royal Bank of Canada saw a strong earnings season for Q1 2020 as a result of Capital Markets growth.
- However, the market fallout from COVID-19 is likely to have a significantly negative impact on earnings going forward.
- I remain long, but will not be adding more shares until the economic situation improves considerably.
Back in June of last year, I made the argument that while the Royal Bank of Canada (NYSE:RY) remained a fundamentally strong business, the bank had been overly dependent on US operations to sustain growth, and the economic situation in Canada itself remained on shaky ground with high household debt levels and uncertainty at the time regarding a renewed NAFTA trade deal.
That said, COVID-19 has clearly been a game-changer, with Royal Bank of Canada declining significantly as a result of the market fallout:
With social distancing measures in place across most of the world as well as outright lockdowns, demand for oil has plummeted. We see that while Canadian Crude Oil (CCX) had recovered from lows at the end of 2018, price has since plunged to 5.08 at the time of writing:
Given that oil forms a large part of Canada’s export market, the major financial institutions in Canada also have a sizable exposure to fluctuations in this commodity.
For instance, when taking a look at the bank’s PCL (provision for credit losses), we see that while the overall PCL fell heading into Q1 2020, PCL for capital markets did increase by $1 million from the previous quarter, which the bank cites as being a result of higher provisions for the Oil & Gas industry and Other Services.
With that being said, this increase is minuscule when compared to the bank’s overall PCL, and it is also noteworthy that Royal Bank of Canada has the lowest loan exposure to this sector of all the major Canadian banks.
Moreover, while the market fallout from COVID-19 will invariably have an impact on the Royal Bank of Canada, Q1 2020 earnings results prior to this were actually quite encouraging.
Revenue was up by 9% YoY to $12.8 billion – fundamentally driven by growth of 21% in Capital Markets. Meanwhile, diluted EPS was up by 12% YoY to $2.40.
As a matter of fact, capital markets saw the largest growth from Q1/19 of the bank’s business segments:
It is expected that the bank will be set to see a significant decline in capital market activity which will affect earnings. As the second largest business segment by net income, this is likely to result in a significant drop in earnings going forward – particularly if this is accompanied by a significant drop in personal and commercial banking.
Last month, the Canadian government started to negotiate with the nation’s banks to establish a funding scheme for SMEs in Canada, whereby registered companies can avail of interest-free loans to keep such businesses afloat during this crisis. As the loans are guaranteed by the government up to a value of $25 billion, this means the Canadian taxpayer is assuming the risk that some loans may not be repaid and this minimises the default risk for banking institutions insofar as possible under the current circumstances.
While the Personal & Commercial Banking segment could see a drop in net income as a result of a reduction on interest on loans, we might see a situation where this is minimized should a larger number of SMEs ultimately avail of financing options to stay afloat.
Like the broader market, the Royal Bank of Canada is likely to see some tough times ahead. A decline in capital market activity as well as interest on loans stands to affect the bank’s bottom line. I remain long this stock, but would not be inclined to add more shares until the broader economic situation improves considerably.
This article was written by
Analyst’s Disclosure: I am/we are long RY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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