Growing Concerns About The Consumer Overshadowing TD Bank Heading Into Fiscal Q3 Results

The last three months haven’t been strong ones for Toronto-Dominion Bank (NYSE:TD) (TSX:TD:CA), as the shares of this Big Six bank have lost about 7% of their value since my last update and underperformed the peer group in what has generally been a weak stretch for Canadian banks in general relative to U.S. regional and money center peers.

A weakening outlook for the Canadian economy in general and consumer spending in particular seems to be weighing more heavily on TD, and I wouldn’t be surprised if there were some concerns tied to the extended review process of the bank’s proposed acquisition of First Horizon (FHN). At the same time, though, TD is one of the better-reserved banks in its peer group and still offers the highest asset-sensitivity of its peer group.

Given where it is trading on a P/TBV and P/E basis relative to expected near-term results, I do believe TD Bank is undervalued, but I also believe sentiment is a tough headwind for the shares now given the worries about the Canadian housing market. I do see longer-term value here, but there are other options (particularly U.S. regional banks) where earnings momentum and sentiment seem more in favor of investors over the next six months.

Going Counter-Cyclical With Cowen

At a time when U.S. money center banks have fallen out of favor in part due to weakness in capital markets, Toronto-Dominion made a counter-cyclical move earlier this month by agreeing to acquire Cowen (COWN) for $1.3 billion. The 1.7x premium to book that TD is paying looks basically in line with similar deals, and it will enhance the company’s capabilities in equities. At 11% of ’21 revenue, capital markets activities aren’t a particularly large part of TD’s mix, and I think this is a reasonable diversification move at a time of weak near-term expectations for the equity capital markets.

In conjunction with a reduction in its stake in Schwab (SCHW) from around 13% to 12% (selling 28.4M shares), TD Bank is in effect trading off some retail exposure for more institutional exposure, and that seems like a logical move, particularly with cross-selling capabilities in its U.S. commercial lending operations.

More Noise Around The Proposed First Horizon Deal, But Likely No Insurmountable Hurdles

Toronto-Dominion is still waiting for regulators to give their approval on their proposed acquisition of First Horizon. Large bank acquisitions are taking longer to approve now, and that process is likely not going to be helped by the mid-June request from Senator Warren to the OCC to halt the approval process.

Sen. Warren has alleged that TD Bank has engaged in abusive sales practices in the U.S., but I haven’t seen meaningful substantiation of those accusations. TD Bank was one of the 40 or so banks that went through a more intense scrutinization in 2018 after the Wells Fargo (WFC) scandal and nothing has happened since then in terms of fines, consent orders, or so on. That said, these processes can take a while, and U.S. Bancorp (USB) recently agreed to a consent order tied to overly aggressive sales practices.

I certainly don’t rule out the risk that TD Bank could see a similar consent order, but I don’t expect that it would block the First Horizon transaction. The bigger risk I see at this point is that the deal is delayed beyond initial expectations and that the bank has to make a larger payout to First Horizon shareholders as a result (there are provisions in the merger agreement to increase the payment if certain deadlines are missed).

Increasing Concerns About The Canadian Consumer Are Overshadowing The Shares

I believe the biggest issue with TD Bank shares at present are the growing concerns about the Canadian economy in general and the health of the Canadian consumer in particular. There have been numerous articles about the unsustainable pace of housing price appreciation in Canada, and an unstable housing market is always a threat to the larger economy.

Around 40% of TD Bank’s lending is in the Canadian housing market (mortgages and amortizing HELOCs), but TD Bank is also more exposed than its peers to credit card lending. While relatively less exposure to Canadian mortgages would be a good thing on balance as housing prices deflate, a recession in Canada would still hit the bank through weaker card spending and higher card charge-offs.

TD Bank’s high rate sensitivity is also a mixed blessing at this point of economic uncertainty. While being the most rate-sensitive of its peer group does give the bank more leverage to higher rates, the risk of recession in Canada is leading to lower rate expectations, and that erodes the core profit growth outlook for 2023 and 2024, though expectations are still calling for strong mid-to-high teens pre-provision profit growth in FY’23 (the best among the Big Six).

TD Bank’s extensive U.S. operations (generating around 20% of recent pre-provision profits) should be an important offset, and I expect this business to pick up on rate sensitivity and higher loan demand. Unlike the Canadian operations, TD Bank’s U.S. lending operations are more balanced between consumer and commercial lending, and while competition from other banks is a threat, I’m looking for an acceleration in commercial lending activity.

The Outlook

TD Bank beat FQ2 pre-provision profit expectations by a significant amount (around 15%) and a similar beat would certainly be a positive for sentiment, particularly if coupled with stronger results from the U.S. operations. Still, I expect the concerns about the Canadian housing market and consumer confidence will be the predominant driver of sentiment for a while longer.

I believe TD Bank is set up for at least two and a half years of strong earnings growth relative to its peer group, provided that the Canadian economy avoids recession, but the stock price performance is not reflecting that sort of outlook, even though the bank has been outperforming peers on loans, deposits, and core earnings growth.

The Bottom Line

Looking at where TD Bank should be in terms of earnings and return on tangible equity in FY’23 (around $8.65 and 20%, respectively), the shares do look undervalued today by about 10% to 15%. With a tougher macro outlook, though, I can understand if investors don’t consider that sufficient near-term compensation for the risk of a bigger downturn in Canada, and particularly given that there are several U.S. regional banks with cleaner macro outlooks and equal or better undervaluation.