Canadian Tire Corporation Ltd. (TSX:CTC.A) Shareholders: Have You Considered This Major Risk?

Canadian Tire Corporation Limited (TSX:CTC.A) has built a financial services division that’s both its greatest asset and its potential Achilles’ heel.

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Canadian Tire (TSX:CTC.A) released its quarterly earnings this morning, and the results were excellent.

Total retail sales increased 4.4% during quarter, while total revenue surged more than 11%. Earnings per share performed even better, increasing to $3.11 per share, an increase of 21.7% versus the same quarter last year. If we strip out acquisition costs of coat maker Helly Hansen and other one-time expenses, earnings per share were $3.47.

Management also announced a 15% increase in the dividend, boosting the annual payout to $4.15 per share. The company also intends to buy back $300-400 million worth of its stock.

These are solid results. It’s hard to find bad news anywhere. And yet, I think investors should turn cautious on the company today. Here’s why.

Not a true retailer

Canadian Tire’s push into financial services has been incredibly successful.

It started way back in 1968, when the company purchased a small credit card-processing company. Its credit cards came along starting in 1995. Then came various banking services, like mortgages, bank accounts, and insurance. The mortgage division was sold, but the company still offers the other two. These days, the company’s Triangle Rewards program allows customers to accumulate electronic Canadian Tire money from purchases at a number of different retailers.

Canadian Tire’s push into financial services was so successful that Bank of Nova Scotia bought a 20% stake in the division back in 2014. The price paid was $500 million.

These days, the credit division is a true behemoth. More than two million shoppers are current Canadian Tire credit card holders who are carrying a balance. The company has nearly $6 billion worth of credit card receivables on its balance sheet. Approximately 40% of Canadian Tire’s earnings thus far in 2018 have come from its financial services division.

The risk

It’s easy to see why Canadian Tire continues to go full speed ahead with its financial division. It’s a good business — at least most of the time.

But as we all know, there are certain parts of the credit cycle where being a high-risk lender is not the place to be. Losses mount as tough overall economic conditions erode the average consumer’s ability to pay. Credit cards are often the first obligation to be ignored as all resources are dedicated to the mortgage or car loan. That’s the danger of issuing unsecured credit.

Canadian Tire is doing a nice job of keeping its defaults in check today. Write-offs over the last 12 months have been just 5.4%. But investors have to remember the Canadian economy is chugging along nicely. Credit card write-offs should be low.

The real test comes during the next recession. Let’s face it; Canadian consumers are awash with debt. Our collective debt-to-disposable income ratio has been at an alarming level since 2009. The Bank of Canada continues to hike interest rates — a move that could hit heavily-indebted homeowners hard.

If the perfect storm happens and rates stay higher while the underlying economy takes a hit, it could mean very bad things for an unsecured lender. Remember, financial services profits are a major part of the bottom line. The fate of the company is tied to this division.

The bottom line

Canadian Tire has built a business that’s doubly exposed to the Canadian consumer. When the economy is rolling along nicely, like it is today, you’ll see the company post great results. But when the overall economic picture turns cloudy, Canadian Tire will be faced with a double whammy of tepid retail results and elevated write-offs from its credit card portfolio.

Investors must keep in mind this risk, and perhaps put off buying shares until it’s fully priced in. In other words, the time to buy Canadian Tire shares is when there’s blood in the streets. I’m not sure when that will be, but one thing is for certain: it’s not today.

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 Nelson Smith owns Bank of Nova Scotia shares.   

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