TD Bank Stock: I’d buy the colossal drop (NYSE: TD)
The Toronto-Dominion Bank (NYSE: TD)(TSX:TD:CA) plunged on Thursday, falling 4.6% in a single trading day. This was apparently not a sector move, as the Vanguard Financials ETFs (VFH) fell 1.27% over the same period. This may have had something to do with the strengthening US dollar, as the Canadian subset of financials performed poorly on Thursday. For example, the Royal Bank of Canada (RY)(RY:CA) fell 3.8% on Thursday, in a move mirroring that of TD.
Canadian banks are certainly at great risk right now. Notably, the Canadian housing market is in freefall, with home prices down 22% since hitting a high in February. The decline was more pronounced in parts of Ontario, a province where banks do above-average business volume.
Additionally, the U.S. dollar has made gains against the Canadian dollar, which means Canadian bank earnings, while strong in Canadian dollars, will be lower from the perspective of an investor trading in dollars. Americans.
For some Canadian banks, the strength of the US dollar can be a deciding factor. If you are a bank that exclusively earns income in Canadian dollars, your returns for US investors will be lower than those of a US bank. However, TD is unique in that 36% of the company’s profits come from the United States. It has a major U.S. retail banking business that has been responsible for most of its growth over the past decade, and this segment will grow if TD First National Horizon (FHN) ends in November. This last point is subject to some uncertainty, as I will explain in a later section on risk, but TD’s existing US operations remain very lucrative. For this reason, I remain bullish on TD Bank stocks despite its recent turmoil.
TD’s Competitive Position
TD Bank enjoys a strong competitive position in Canadian and US banking. In Canada, it is the second largest bank by market capitalization and the largest by total assets. In the United States, it is only the 9th largest bank, but it has no investment banking operations in the United States, which means that it has less exposure to the financial sub-sector the weakest of 2022 compared to other major US banks.
Let’s first look at TD’s competitive position in Canada.
As Canada’s largest bank by assets, TD has many advantages. First, it has a presence in all major provinces, giving it brand recognition that not all banks have. Second, it has the most downloaded banking app in Canada, suggesting that TD customers are transitioning to digital banking faster than other banks. For a bank, “going digital” is a good thing, as the increase in online banking means the opportunity to save money on opening expensive bank branches.
Now let’s look at TD’s competitive position in the United States.
TD is currently the 9th largest US bank. The bank predicts it will become the sixth largest in the United States after the closing of the First Horizon Deal. Size itself isn’t an advantage for TD in the US, but it does have another advantage:
A relative lack of investment banking.
Investment banking has been a thorn in the side of many US banks this year. Tech IPO activity all but dried up when this year’s tech bear market removed incentives to go public; as a result, underwriting costs have decreased. For example, in her last trimester, JP Morgan (JPM) experienced a 35% drop in investment banking revenue. Segment revenue may have declined even more than that.
TD Bank is primarily known as a retail bank in the United States. Its latest earnings release does not list any U.S. investment banking segments. It is being purchased cowen (COWN), but this agreement has not yet been concluded. For now, TD is primarily a retail bank as far as the United States is concerned. Additionally, the Cowen deal may actually be a positive, as TD entered into the deal when investment banks were already down. It may have acquired a US investment banking subsidiary at a lower price than would otherwise have been available.
Recent TD Earnings
After looking at TD’s competitive position, we can look at its recent performance.
In its most recent quarter, TD achieved:
- $10.92 billion in revenue, up 1.9% from the prior year (slightly down on a sequential basis).
- $1.75 reported earnings per share (“EPS”), down 8.8%.
- Adjusted EPS of $2.09, up 6.6%.
- C$2.2 billion in net retail sales revenue in Canada, up 6%.
- $1.12 billion in US retail net income, up 11%.
- $226 million in net income under the equity method Charles Schwab (SCHW), up 47%.
All in all, it was an impressive sight. This year, many banks are underperforming because their investment banking segments are doing poorly. TD Bank is actually showing positive revenue growth. It also generates positive growth in adjusted net income. TD Bank’s Q3 net income was $3.8 billion, generating a profit margin of 34.8%. The picture of profitability is therefore also quite good.
The long-term picture is similar. Seeking Alpha Quant calculates a 33% net margin for TD over a 12 month period, which is similar to what I calculated for the third quarter. Similarly, SA Quant is reporting five-year CAGR growth rates of 5.5% in revenue, 8.37% in EPS and 7.64% in free cash flow. Profitability is solid for any company, while growth rates are adequate for a company that trades at just 9.4 times earnings and 1.45 times book value.
According to Seeking Alpha Quant, TD has a 12-month EPS of $4.84. If you use a 6% discount rate, say TD grows 5% per year for 5 years and then stops growing after that, then you get a DCF model that values TD stock at $100. That’s 69% up from today’s price. This suggests that TD shares are undervalued, but it could take some time for TD to reach the valuation that this pattern implies. Financial services are not in favor in today’s market.
Risks and Challenges
Having made the case for TD, it’s time to look at some of the risks and challenges facing investors.
The first of these is the US yield curve. TD does a lot of business in the US, and the US yield curve is inverted, which means short-term bonds have higher yields than long-term bonds. Banks borrow short of the yield curve and lend long, so inverted yield curves eat into their margins. So far this year, TD has reported higher net interest income due to Fed rate hikes, but if the inversion deepens, it could hurt TD’s growth.
The second risk is the Canadian housing market. The Bank of Canada is raising rates even faster than the Fed, and Canadian house prices are falling. According WOW, the average Canadian home cost $637,000 in August, down 4% year-over-year. The lower house prices in Canada fall, the smaller the mortgages taken out by Canadians. On the other hand, TD may charge higher mortgage rates when interest rates rise, so it could actually earn higher net interest income. Especially if the yield curve normalizes.
Finally, we have the First Horizon agreement. 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 from the start. FHN had annual net income of $922 million when TD announced it was buying the bank for $13.4 billion. Thus, the P / E ratio of the transaction was initially 14.5. US banks have an average P/E ratio of 12, so the FHN deal looks expensive. TD says it will realize cost synergies of $610 million from the integration of FHN, which will bring the P/E of the transaction down to 8.9, but whether that will happen remains to be seen.
The risks and challenges facing TD Bank are worth keeping in mind. Housing market issues are particularly important: higher interest rates will not produce higher net interest income for TD if they rise so high that Canadians go bankrupt. In this scenario, house prices will fall even more than interest rates predict, as it will become structurally impossible for people to pay their mortgages, and they will have to sell just to make ends meet. The other two risks I mentioned (the FHN deal and the US yield curve) are more temporary in nature, but they are also worth mentioning.
For my money, TD is a great value. After its recent plunge, TD is trading at just 9.4 times earnings, among the cheapest valuations it has had in recent memory. Despite this, the bank still has positive earnings growth, in a year when many banks (especially investment banks) have plunged into negative growth territory. Overall, TD is a solid dividend play for income-oriented investors.