Toronto-Dominion And Royal Bank: Q4 Earnings, Canada’s Not Collapsing (NYSE:RY)

The Toronto-Dominion Bank (NYSE:TD)(TSX:TD:CA) and Royal Bank of Canada (NYSE:RY)(TSX:RY:CA) released their fiscal fourth quarter earnings this morning. TD beat on revenue and missed on earnings, while RY beat on both metrics.

These twin Canadian bank releases show that Canada’s economy has plenty of fight left in it. Although TD’s earnings declined on higher provisions for credit losses, both TD and RY showed revenue rising in the fourth quarter (I refer to ‘adjusted revenue’ in TD’s case). Additionally, TD’s Canadian segment actually performed better than its U.S. segment in the quarter (normally the reverse is the case). Finally, Royal Bank’s Canadian retail bank performed better than its U.S. and global wealth management business. Canadian banking earnings declined only 2%, while earnings at the global wealth business declined 74%.

Broadly, these earnings suggest that Canada’s economy is stronger than many think.

For years, Canada’s housing market has been a major concern for investors. Canada’s house price to income ratio is among the highest in the developed world, and has historically prevented younger Canadians from buying homes. This fact would not normally be the biggest concern for bank investors, as Canada has strict lending rules that prevent overly risky loans from being issued. However, housing affordability is without a doubt a problem today, as many people bought homes back in 2020 and 2021, when benchmark interest rates were near 0% and mortgage rates were close to 2%. In Canada, mortgages come up for renewal every five years (or less), even when they are nominally “fixed rate” mortgages. As a result, few Canadian homeowners are able to avoid the sting of interest rate hikes when they occur. This year, that’s a problem, because the Bank of Canada has been hiking rates for over a year. Few homeowners–even those who bought in the 2020 era of near zero interest rates–will be able to escape higher rates if they persist long term.

The problem is that many Canadians today can’t afford the mortgage interest they have to pay, or will soon have to pay. Many Canadians have variable rate loans, and the interest on those has increased with each passing month. Additionally, those Canadians with fixed rate mortgages will have to renew them eventually. Defaults are already rising in Toronto, the nation’s biggest housing market. Many economists expect the trend to spread to cheaper markets if rates don’t come down soon.

Presently, mortgage defaults are within an acceptable range nation-wide. However, the banks seem to think that they are about to increase. TD and Royal Bank both raised their provisions for credit losses (“PCLs”) in the fourth quarter, in anticipation of coming defaults. Because mortgages in Canada tend to have recourse to the borrower’s assets, many think that the banks will make out a-OK. I personally think that Canadian banks will be basically fine in the year ahead, consistent with other Canada bulls. However, the fact that Canadian loans are recourse loans does not mean the housing market isn’t a risk for the banks. Having “recourse to” $0 worth of assets isn’t much of an advantage. Canadians under 35 have only $48,800 in savings on average, which isn’t much compared to the size of a typical residential mortgage.

Still, on balance, Canadian banks are in a good place right now. TD and Royal Bank both raised their PCLs last quarter, which contributed to negative growth at the former and slow growth at the latter. However, mortgage origination is still rising at both banks, with TD having increased its mortgages by 8% year-over-year. As long as the Bank of Canada can manage the dual challenges of inflation and a slowing economy at the same time, then the country’s banks should make out fine in the end. In this article I elaborate on this and other reasons why I’m bullish on TD and Royal Bank heading into 2024.

Earnings Recap

TD and Royal Bank both delivered fairly strong results for the fiscal fourth quarter. TD delivered:

• $2.8 billion in adjusted revenue, up 9%.

• $2.9 billion in GAAP net income, down 57%.

• $3.5 billion in adjusted net income, down 14%.

• $1.49 in GAAP EPS, down 57%.

• $1.83 in adjusted EPS, down 16%.

• A 14.4% CET1 ratio.

Royal Bank for its part delivered:

• $13.03 billion in revenue, up 3.9%.

• $4.1 billion in GAAP net income, up 6%.

• $3.96 billion in adjusted net income, up 1%.

• $2.90 in GAAP EPS, up 6%.

• $2.78 in adjusted EPS, unchanged.

• A 14.5% CET1 ratio.

Both TD and Royal Bank came in fairly strong on the revenue front. TD’s GAAP revenue declined but net interest income was impacted by some gains on hedging securities in the prior year quarter. Absent that and some other adjusting factors–which made the base period interest income artificially high–TD’s revenue increased 9%. A number of items related to the termination of the First Horizon (FHN) deal affected TD’s U.S. retail bank, and contributed to that segment–usually a strong grower–seeing declining earnings.

Royal Bank fared better than TD in fiscal Q4. Its revenue and earnings increased, both in GAAP terms and adjusted terms. A big part of Royal Bank’s strong performance was its capital markets segment, which announced unexpectedly high investment banking fees.

TD and Royal Bank – Risk Matters

Broadly speaking, both TD and Royal Bank think that their loans and other investments are getting riskier. Both banks increased their PCLs for the quarter, which is the main reason why the earnings growth was negative at TD Bank. Royal Bank managed positive earnings growth because its capital markets business made up for weakness in the core lending operation.

TD and Royal Bank – Valuation

Because TD and Royal Bank’s most recent earnings releases included both fourth quarter and full year sums, we can easily calculate the two banks’ valuation ratios using the data contained in the releases. Normally I rely on Seeking Alpha Quant for valuation multiples, but in this case they’re easy enough to calculate by hand. Here’s the key trailing 12 month data for both banks:

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Using Thursday’s TSX closing prices, we can calculate the following valuation multiples for each bank:

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So, we have both banks looking relatively cheap, TD being the cheaper of the two. Normally I’d say that makes TD the better buy, but since RY’s most recent quarterly results were better, I’ll call this one a draw. TD and RY stocks are both worth adding to your portfolio.

The Bottom Line

There are two big takeaways we can glean from TD and Royal Bank’s most recent earnings releases.

First, about the banks themselves: their shares are cheap, both are growing the top line, and Royal Bank is growing the bottom line too. The combination of growth and value make these stocks worth looking at.

Second, about the Canadian economy: it’s not collapsing any time soon. Many internet pundits have spent the better part of the last year crying that the sky is falling in Canada, because the housing market is so expensive that the youth will never be able to afford houses. While it’s true that Canada’s housing affordability is relatively poor, it is not a structural problem for the economy just yet. Both TD and RY increased their mortgage balances in Q4, despite being subject to Canada’s relatively strict banking regulations. These facts suggest the economy still has some fight in it, even if GDP growth has been disappointing lately.

Basically, Canada’s two largest banks are both decent buys right now. They’re cheap, the economy they operate in is not falling apart–and even if it were, both TD and Royal Bank are internationally diversified. I’m comfortable owning TD Bank stock, and I think that those who own Royal Bank stock should be comfortable too.