An Untimely Acquisition
Royal Bank of Canada (NYSE:RY)(TSX:RY:CA) has proposed a $13.5 billion takeover of HSBC Canada. HSBC Canada, the country’s seventh-biggest bank, would make the largest domestic bank acquisition in Canadian history. Royal Bank appears to have made a terrible decision at a time when the Canadian banking industry is experiencing historic amounts of debt.
Many HSBC clients in British Columbia are dissatisfied with this transaction because they value HSBC’s large global network. To reassure these customers, Royal Bank remarked, “You can expect the types of international capabilities that HSBC Canada’s clients value. “Furthermore, I feel Royal Bank is overpaying. At a valuation of $13.5 billion, Royal Bank would have paid 2.3 times the book value ($5.9 billion) and 17 times the earnings ($792 million) of HSBC Canada by the end of 2022. This comes at a heavy cost.
HSBC Canada has a considerable exposure to what looks to be a Canadian housing bubble because it conducts the majority of its business in Ontario and British Columbia, where property values are extraordinarily high. The world’s three least costly real estate markets are in Vancouver, British Columbia, and Toronto, Ontario, respectively.
This comes after major bidding wars in 2020 and 2021, which skyrocketed property prices in certain areas.
Given that the household debt service ratio (14.9%) is already greater than it was in early 2008 in the United States, I am concerned that rising interest rates may burst the Canadian debt bubble.
Unlike the United States, which reached the end of its long-term debt cycle in 2008, Canada has seen an increase in the ratio of household debt to disposable income, signalling the severity of the next downturn.
Residential mortgages account up a large chunk of HSBC Canada’s lending portfolio, with 25% having durations of more than 35 years and a sizable portion being uninsured.
The most remarkable fact in the aforementioned graph is that 90% of HSBC mortgages in British Columbia are uninsured.
This arrangement with HSBC Holdings Plc (HSBC) is expected to close in Q1 2024, but Canadian regulators must first approve it.
The Dividend Is At Risk
I also predict that Royal Bank could generate negative earnings during the next recession because it has only set aside 0.5% of its loan book as an allowance for loan losses. If Royal Bank reports low results, it will put additional strain on its CET1 ratio and may force the bank to reduce its dividend or issue stock. It would only take roughly 10% of Royal Bank’s $836 billion loan book to default, resulting in average losses of 30% of principal, for the bank to experience significantly negative profitability. This would result in a $21 billion loss above the loan loss allowance.
The thesis is at risk.
If the HSBC Canada acquisition fails, I believe it will be beneficial to Royal Bank. Furthermore, EPS growth could surpass expectations if Canadian deleveraging is less severe than I estimate and Royal Bank is not obliged to dilute shareholders.
Remember that RBC (Royal Bank of Canada) is not a bad bank. It’s well-known and plays an important part in wealth management. Its brand, which is identical to JPMorgan Chase’s in the United States, contributes to its low deposit costs and high fees, in my opinion.
At this sad time, the HSBC Canada acquisition has the potential to have a large negative impact on stockholders. Canada is nearing the end of its long-term debt cycle as high interest rates and massive debts combine. HSBC Canada, in my opinion, is undercapitalized and appears to be bearing a considerable level of risk. It doesn’t help that Royal Bank wants to pay 2.3 times book value and 17 times earnings to acquire it.
Given my forecast for a rocky landing, Royal Bank appears to have under-reserved for loan losses. This, together with the HSBC transaction, may force Royal Bank to decrease its dividend or dilute shareholders during the next crisis. As a result, I maintain my “Sell” rating on RY and RY:CA.