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RBC retreat from U.S. leaves earnings more volatile

Royal Bank of Canada has admitted defeat at the hands of the U.S. market, leaving investors with a stock whose future earnings are likely to be far more volatile than before.

Canada's largest financial institution hoisted the white flag Monday on its highly touted diversification foray south of the border. The bank came, it saw, and it got conquered – or perhaps walloped would be a better description, considering the amount of red ink involved.

The bank is selling its U.S. regional retail business, which it spent the better part of a decade trying to develop at a cost of about $7.5-billion, to PNC Financial Services Group. Inc. for $3.62-billion (U.S.).

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RBC is taking an after-tax loss on the transaction of $1.6-billion (Canadian), having previously taken a writeoff of about $1-billion. The bank will provide a clearer picture on the losses in its next quarter's results.

The bank's exit from its U.S. retail strategy has some positives for investors. By getting rid of an operation that lost money in the first half of the year, the sale will boost RBC's bottom line by 10 cents a share in 2012, according to the bank's own estimates. And by shedding assets, the bank will improve its capital ratios, an important factor when many international lenders are hobbled due to weak balance sheets.

The immediate benefits cheered investors, who bid up the shares Monday on the Toronto market. The bad news is that RBC spent billions with little to show for it. The bank tried to put the best spin on its retreat by saying in its news release that the move "refocuses" its U.S. growth strategy.

The failure to build a viable U.S. retail banking franchise will leave the bank's bottom line heavily exposed to the vicissitudes of its capital markets division, where profits depend on deal flow and buoyant financial markets activity.

The bank's biggest money spinner is its coveted Canadian retail banking operation, which typically accounts for a half to two-thirds of its operating profits. Capital markets come next, earning sizable amounts, followed by modest contributions from insurance, wealth management and international banking.

A big exposure to the ups and downs of capital market operations is a downer for banks, which receive higher valuations from investors if they have more consistency in their earnings.

"They still don't have enough diversity to really combat the volatility associated with the capital markets side," says Michael Goldberg, bank analyst at Desjardins Securities.

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Bulk Up, or Get Out

Still, Mr. Goldberg rates RBC a "buy," with a $65 price target over the next year. He has long been calling for the bank to either bulk up in the U.S. or get out, because its existing operations didn't confer enough market clout to make it a significant player. "There is no point being in this business in the United States and being what I've called the No. 10 bank in Tulsa," Mr. Goldberg says.

With the sale and its strong capital position, RBC will be in a position to make acquisitions. Bank president Gordon Nixon said as much Monday in a conference call, explaining that the bank has now has "great flexibility to take advantage of opportunities in an unstable market."

Investors often get nervous when companies go on the prowl for acquisitions, based on the view that most buyouts don't work, and managers, caught up in the excitement of the chase, often overpay for targets.

Barclays Capital analyst John Aiken in a client note warned as much, saying that "we believe the spectre of acquisition risk may offset some of the valuation benefit from a higher earnings forecast."

Perhaps the biggest worry for investors in RBC and other Canadian banks is that the financial institutions have had a good run and are richly priced.

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RBC, for instance, trades at about three times tangible book value - or the amount that would be left for shareholders if all the institution's hard assets were liquidated and its debts repaid. The valuations weren't so lofty for RBC's U.S. bank. It sold for less than tangible book value.

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About the Author
Investment Reporter

Martin Mittelstaedt has had a varied reporting career at the Globe and Mail, covering politics, the environment and business. He opened up the Globe's New York bureau for the Report on Business, and has also been on the banking and capital markets beats. He's written extensively on investing themes. More

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