Is Royal Bank of Canada a Safe Bet Right Now?

Royal Bank of Canada (TSX:RY)(NYSE:RY) is holding up well, but the market is nervous about earnings headwinds.

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Royal Bank of Canada (TSX:RY)(NYSE:RY) has fallen 10% since the start of the year, and investors are wondering if the stock is now a bargain.

Let’s take a look at Canada’s largest bank to see if deserves to be on your buy list.

Earnings strength

Economic headwinds are keeping investors on the sidelines, but Royal Bank’s recent earnings performance suggests things aren’t all that bad.

The bank wrapped up its third quarter with net income of $2.475 billion, 4% higher than the same period last year. The solid number is a testament to the company’s balanced revenue stream.

Canadian personal and commercial banking accounted for about 52% of Royal Bank’s earnings over the past 12 months, and the division just delivered record results in the third quarter. Net income hit $1.24 billion, up 5% compared with Q3 2014.

The bank’s capital markets group contributed 23% of profits in the past year. This segment tends to be more volatile than the retail operations, and that was evident in the most recent quarter as year-over-year net income dropped by 15%.

Wealth management activities kicked in 11% of profits over the past year. The division earned $285 million in the third quarter, which was about the same as Q3 2014.

Royal Bank is in the process of closing its US$5.4 billion acquisition of City National, a California-based wealth management firm. The deal gives Royal Bank a solid platform to expand its American footprint, and investors should see the asset management segment become more important in the coming years.

Insurance is another area Royal Bank is turning to for growth. In fact, the division added a full 8% of earnings in the past 12 months.

Investor and treasury services contributed the remaining 6% of the company’s earnings during the past year.

Geographic hedge

Royal Bank gets a good chunk of its revenues from business conducted in the United States. The diversification is important for investors right now as concerns build around the health of the Canadian economy. On a geographic basis, Canada accounts for 63% of earnings, the U.S. contributes 19%, and Royal Bank’s international operations add 18%.

Dividend outlook

Royal Bank increased its dividend when it reported its most recent results. The new payout of $0.79 per share yields 4.4%. Investors should be comfortable with the safety of the distribution, although the size and pace of the increases could be tempered in the near term if global and Canadian economic headwinds start impacting earnings.

Loan risks

Royal Bank had $201 billion of Canadian residential mortgages on the books when it closed out the third quarter. About 60% of the portfolio in not insured and the loan-to-value (LTV) ratio on those mortgages is about 55%.

Compared with its peers, Royal Bank carries a hefty percentage of uninsured mortgages. This could be cause for concern, especially if the housing market really falls out of bed. The company’s LTV is low enough that the property market would have to drop significantly before Royal Bank is materially affected, but investors should keep the situation in mind when evaluating the stock.

Analysts generally believe the Canadian real estate market will pull back gradually. If that’s the way things pan out, the bank should be fine.

On the energy front, Royal Bank has oil and gas exposure of about $7.5 billion. Wholesale loans to the sector represent just 1.6% of the overall loan book, and management says the portfolio isn’t seeing any significant trouble.

Royal Bank is well capitalized with a CET1 ratio of 10.1%.

Should you buy?

As a long-term investment, Royal Bank is a solid holding, and the stock now trades at an attractive 10.4 times forward earnings. Having said that, Canadian bank stocks are out of favour right now, and that trend might continue in the near term, especially if the sector’s Q4 earnings come in lighter than expected. I suggest wading in slowly if you decide to buy.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Andrew Walker has no position in any stocks mentioned.

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