Elijah-Lovkoff
The Toronto-Dominion Bank (NYSE:TD)(TSX:TD:CA) took a huge dip Thursday, falling 4.6% in a single trading day. This was apparently not a sector move, as the Vanguard Financials ETF (VFH) only fell 1.27% in the same period. It may have had something do so with the strengthening U.S. dollar, as the Canadian sub-set of financials all did poorly on Thursday. For example, the Royal Bank of Canada (RY)(RY:CA) fell 3.8% on Thursday, in a move mirroring TD’s own.
There are definitely some big risks facing Canadian banks right now. Notably, the Canadian housing market is in a freefall, with house prices having declined 22% since hitting a peak in February. The decline has been most pronounced in certain parts of Ontario, a province where the banks do an above average amount of business.
Additionally, the U.S. dollar has been making gains against the Canadian dollar, which means that Canadian bank earnings, even if they’re strong in Canadian dollars, will be lower from the perspective of an investor trading in U.S. dollars.
For some Canadian banks, U.S. dollar strength may be a dealbreaker. If you’re a bank bringing in Canadian dollar income exclusively, then your returns to U.S. investors are going to be lower than that of a U.S. bank. However, TD is unique in that 36% of the company’s earnings come from the United States. It has a large U.S. retail banking business that has driven the lion’s share of its growth over the last decade, and that segment will expand if TD’s First Horizon National (FHN) deal closes in November. That latter point is subject to some uncertainty, as I’ll cover in a later section on risks, but TD’s existing U.S. operations remain very lucrative. For this reason, I remain bullish on TD Bank stock despite its recent turbulence.
TD’s Competitive Position
TD Bank enjoys a solid competitive position in both Canadian and U.S. banking. In Canada, it is the second-biggest bank by market cap and the biggest by total assets. In the U.S., it’s only the 9th biggest bank, but it has no U.S. investment banking operations, which means it’s less exposed to the weakest financial sub-sector of 2022 compared to other big U.S. banks.
First, let’s take a look at TD’s competitive position in Canada.
As the biggest Canadian bank by assets, TD has a lot of advantages. First, it has a presence in every major province, which gives it brand recognition that not all banks have. Second, it has the most downloaded bank app in Canada, suggesting that TD’s customers are making the transition to digital banking faster than other banks. For a bank to “go digital” is a good thing, as increasing online banking means the potential to save money on opening costly bank branches.
Now, let’s look at TD’s competitive position in the United States.
TD is currently the 9th biggest U.S. bank. The bank predicts that it will become the sixth biggest in the U.S. after the First Horizon Deal closes. Sheer size isn’t an advantage for TD in the U.S., but it does have another advantage:
A relative lack of investment banking.
Investment banking has been the thorn in many U.S. banks’ side this year. Tech IPO business all but dried up when this year’s tech bear market removed incentives to go public; as a result, underwriting fees declined. For example, in its most recent quarter, JP Morgan (JPM) experienced a 35% decline in investment banking revenue. Segment earnings may have declined even more than that.
TD Bank is mainly known as a retail bank in the United States. Its most recent earnings release does not list any U.S. investment banking segment. It is in the process of buying Cowen (COWN), but that deal hasn’t closed yet. For now, TD is mainly a retail bank as far as the U.S. is concerned. Additionally, the Cowen deal may actually be a positive, as TD made the deal when investment banks were already way down. It may have picked up a U.S. investment banking subsidiary at a lower price than would otherwise have been available.
TD’s Recent Earnings
Having looked at TD’s competitive position, we can look at its recent performance.
In its most recent quarter, TD delivered:
- $10.92 billion in revenue, up 1.9% from a year before (down slightly on a sequential basis).
- $1.75 in reported earnings per share (“EPS”), down 8.8%.
- $2.09 in adjusted EPS, up 6.6%.
- C$2.2 billion in Canadian retail net income, up 6%.
- $1.12 billion in U.S. retail net income, up 11%.
- $226 million in equity method net income from Charles Schwab (SCHW), up 47%.
Overall, it was an impressive showing. This year, many banks are under-performing because their investment banking segments are doing poorly. TD Bank is actually delivering positive growth on the top line. It’s delivering positive adjusted bottom line growth as well. TD Bank’s net income in Q3 was $3.8 billion, yielding a 34.8% profit margin. So the profitability picture is also pretty good.
The long term picture is similar. Seeking Alpha Quant calculates a 33% net margin for TD over a 12 month period—similar to what I calculated for the third quarter. Likewise, SA Quant records five year CAGR growth rates of 5.5% in revenue, 8.37% in EPS, and 7.64% in free cash flow. The profitability is solid for any company, while the growth rates are adequate for a company trading at only 9.4 times earnings and 1.45 times book value.
According to Seeking Alpha Quant, TD has $4.84 in 12 month EPS. If you use a 6% discount rate, assume that TD grows at 5% per year for 5 years, then stops growing after that, then you get a DCF model that values TD shares at $100. That’s 69% upside to today’s price. This suggests that TD stock is undervalued, but it could take some time for TD to reach the valuation this model implies. Financials are not in favor in today’s market.
Risks and Challenges
Having made a bullish case for TD, it’s time to look at some risks and challenges facing investors.
The first of these is the U.S. yield curve. TD does a lot of business in the United States, and the U.S. yield curve is inverted, meaning short term bonds have higher yields than long term bonds. Banks borrow on the short end of the yield curve and lend on the long end, so inverted yield curves eat into their margins. So far this year, TD has been reporting higher net interest income due to the Fed’s rate hikes, but if the inversion deepens, then that could take a bite out of TD’s growth.
The second risk is Canada’s housing market. The Bank of Canada is raising rates even faster than the Fed is, and Canadian house prices are going down. According to WOWA, the average Canadian house cost $637,000 in August, down 4% year-over-year. The lower Canadian house prices go, the smaller the mortgages Canadians take out. On the flip side, TD gets to charge higher mortgage rates when interest rates go up, so it might actually earn higher net interest income. Particularly if the yield curve normalizes.
Finally, we have the First Horizon deal. If TD can’t get all the regulatory approvals it needs by November, it will have to pay an extra $0.25 per share on an annualized basis to buy FHN. The deal was criticized for being expensive right from the beginning. FHN had $922 million in annual net income when TD announced it was buying the bank for $13.4 billion. So, the deal P/E ratio was initially 14.5. American banks have an average P/E ratio of 12, so the FHN deal looks expensive. TD says it will realize $610 million in cost synergies from integrating FHN, which will bring the deal P/E down to 8.9, but it remains to be seen whether that will happen.
The Bottom Line
The risks and challenges facing TD Bank are worth keeping in mind. The issues with the housing market are particularly important: higher interest rates aren’t going produce higher net interest income for TD if they go so high that Canadians start going bankrupt. In that scenario, house prices will fall even further than what interest rates would predict they should, as it will become structurally impossible for people to pay their mortgages, and they’ll have to sell just to make ends meet. The other two risks I mentioned (the FHN deal and the U.S. yield curve) are more temporary in nature, but they also merit a mention.
For my money, TD is a great value. After its recent dip, TD is trading at a mere 9.4 times earnings, among the cheapest valuations it has had in recent memory. Despite that, the bank still has positive earnings growth, in a year when many banks (especially investment banks) have dipped into negative growth territory. Overall, TD is a solid dividend play for income oriented investors.
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