Saturday, January 07, 2006

RBC : Problems at Centura Largely Behind It

Financial Post, Wojtek Dabrowski, 7 January 2006

For the past two years, Gord Nixon, Royal Bank of Canada's chief executive, has had to contend with nagging criticism about the bank's performance in the United States. RBC Centura, the regional southeastern U.S. bank that Royal bought in 2001, was hardly living up to expectations.
Even though a relatively small piece of Royal's overall business, the Raleigh, N.C.-based institution had become a beacon of negativity as observers honed in on weak results and uncertain strategy. In 2004, Royal's U.S. banking earnings plunged by $324-million on poor performance from Centura and RBC Mortgage, the Chicago-based mortgage bank sold last year, as well as goodwill and restructuring charges.

Now, following a tough year of changes at Royal and the stabilization of Centura's rocky performance, investors and analysts are anxious to once again talk about the big picture. For Mr. Nixon, who became the bank's president and CEO in April, 2001, about two months after the Centura acquisition was announced, it's a welcome change.

"In a way, it's a positive, because for the last year or so, nobody's been asking about what we're going to do next," Mr. Nixon said in an interview. "Now, all of a sudden, people are starting to ask."

Centura's problems aren't completely in the past, but it's clear Mr. Nixon, 48, is pleased to discuss the subsidiary's budding recovery.

"The performance of Centura is moving in a positive direction at a time when there are some challenges within the banking market in the U.S.," Mr. Nixon says, seated in his office on the eighth floor of one of Royal's towers in downtown Toronto. Still, he is also quick to point out that a turnaround is still far from complete.

The market seems to be behind his efforts thus far -- RBC stock posted a robust total one-year return in 2005 of 46%, the best of Canada's Big Five banks. Now, the question on the minds of many investors and industry observers, including many of those who heaped criticism on Centura, is will Mr. Nixon be buying again, particularly south of the border?

"I think, from a management's perspective, our most important function is to ensure that we are well-positioned to take advantage of opportunities if and when they arise," Mr. Nixon responds. "There is no intention in the short term of going out and making a big acquisition for the sake of a big acquisition." He also points out that Royal's businesses have continued to grow in recent years without major deals.

Genuity Capital Markets analyst Mario Mendonca thinks shareholders may not be ready for a big acquisition just yet.

"I don't know that the market's quite ready yet for Royal to go out and do a big deal," he says, adding that something smaller, however, could be more palatable.

"I don't think they're out of the woods yet entirely," Mr. Mendonca says. "What was important about Centura in 2005 is that it stopped deteriorating. It's not that it improved. I think a few quarters of improvement in Centura might give them the leeway to go out and do something a little larger in the U.S."

Mr. Mendonca says while Royal's executives have signalled Centura's performance is on the upswing, it's not certain whether Centura is making money.

"You can't be conclusive on [profitability]; the disclosure isn't there," he notes. Indeed, Royal now reports Centura's performance as part of its U.S. and international personal and business operations. That segment accounted for 15% of revenue from continuing operations in 2005.

For now, it seems Centura's continued turnaround will largely be organic.

Today, RBC Centura has total assets of more than US$20-billion, ranking it among the five largest banks in North Carolina. It has 273 branches and 3,740 employees in five southern states, including Georgia and Florida.

As well, the team of Peter Armenio, Mr. Nixon's lieutenant in the United States, has focused on pushing Centura into the faster-growing urban centres of the southeast, such as Atlanta, while selling some branches in rural areas.

"While our market share may not be as high in Atlanta, relative to what it might be in Raleigh or parts of North Carolina, et cetera, certainly it's moving in the right direction," Mr. Nixon says, adding that efforts are also under way to bring underperforming branches to shape, with a focus on Centura's core strengths.

Royal, meanwhile, sold off its U.S.-based mortgage business in the summer to New Century Financial Corp., a California real estate investment trust.

Mr. Nixon argues that Royal, the biggest bank in Canada, doesn't have to be a giant in the United States to be successful there.

"There is a bit of a perception out there that one has to be very big in terms of market share -- or potentially very small -- in order to survive," he says. "If you actually look at the relative performance of those with large market share or small market share versus those in the middle, that theory does not necessarily hold true."

Total shareholder returns of Western banks (in U.S.-dollar terms) seem to bear out that logic: Citigroup Inc. delivered a one-year return of 6.2% as of Oct. 31, 2005. Bank of America Corp. came in with 1.7% during the same period. By comparison, the much-smaller Royal had a one-year total return of 40% as of Oct. 31.

In 2005, the bank earned $3.39-billion, up 21% from 2004. Without a $326-million after-tax reserve related to Enron Corp. litigation, the jump would be even more impressive, up 32% from the prior year. Revenue was $19.22-billion, up 8% for the year.

But it's unfair to call 2004 a dismal year for Royal overall -- four of its five divisions had record performance, Mr. Nixon says. Banking was the laggard, dragged down by weak U.S. results.

Some observers maintain Royal may be better off abandoning Centura altogether, even though a turnaround has begun to take root.

"There's nothing they can buy that would transform [Centura]," says Gavin Graham, director of investments at the Guardian Group of Funds in Toronto.

"If [Mr. Nixon] wants to go and do something else, it may well be sensible to go somewhere else completely -- get out of the southeast, where there's a lot of big competitors and not many suitable targets to buy."

But Mr. Nixon insists the woes at Centura weren't what worried him most during 2004.

"The most concerning aspect of 2004 to me was not necessarily the U.S. -- I mean, that was concerning as well -- but it was the fact that if you looked at the trend for the bank after three or four very strong years in terms of revenue growth, operating leverage, the revenue growth was starting to slow down, our expenses were not starting to slow down and as a result, our operating ... performance was deteriorating."

Structural realignment, as well as the need to expand revenue while keeping costs down, was the catalyst for Royal's three-year Client First plan -- what Mr. Nixon calls a "rallying cry" for the bank.

He would not provide dollar specifics, but the strategy consists of 50% in cost cuts and 50% in revenue growth, running into 2007. The elimination of more than 1,600 positions that began in late 2004 and a top-echelon shakeup of management showed the bank meant business. As part of the process, Barbara Stymiest, the former TSX Group Inc. chief executive, was brought on as chief operating officer.

The bank's five business lines were consolidated into three groups and Royal created a centralized technology and operations group, consolidating its information technology and business infrastructure units under one umbrella. It also set up what it calls a Transformation Management Office, which tracks its progress toward meeting goals set out as part of its plan.

So far, it looks as if the bank is doing well at reining in costs aggressively and continuing to show strong growth in its domestic operations, Genuity's Mr. Mendonca says.

"I think they still have good momentum in their domestic business -- and improvements they made in the U.S. business -- that a deal isn't necessary in 2006 to outpace their peers in terms of earnings growth."

Canada is by far the most important piece of Royal's business. Sixty-five per cent of 2005 revenue from continuing operations and 68% of net income came from its Canadian personal and business division.

Mr. Nixon certainly agrees that Canada is far from tapped out in terms of growth potential.

"We still think there's good growth potential for us in the domestic Canadian marketplace," he says.

Sure, there are products -- such as mortgages -- facing margin compression, but there is also strong growth in such areas as Royal's mutual funds and credit cards.

As well, "the growth in their personal loans has been astonishing," Mr. Mendonca notes. "I think, at some point, that could come back to haunt them, although Royal is pretty adamant that they're getting well-compensated in terms of yield for the additional credit-card exposure they're taking on."

At the fourth quarter of 2005, the bank's Canadian credit card balances, including securitized assets, grew 12% from the fourth quarter of 2004 to $9.1-billion, while Canadian personal loans jumped 14% to $32.3-billion during the same time.

However, Mr. Mendonca cautions that could mean higher provisions for credit losses "if the Canadian consumer kind of rolls over.