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Quick Idea for Toronto-Dominion Bank (TD)

Quick Idea for Toronto-Dominion Bank (TD)

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Published by benclaremon
The following is a brief write up for Toronto-Dominion Bank (NYSE: TD). All in all the shares look a little pricey at the current level but investors should look to accumulate shares in the $50-$55 range based on my estimate of intrinsic value around $66 a share. Buying in this price range would allow for a 20-25% margin of safety to protect against any overestimate or impairment of intrinsic value.
The following is a brief write up for Toronto-Dominion Bank (NYSE: TD). All in all the shares look a little pricey at the current level but investors should look to accumulate shares in the $50-$55 range based on my estimate of intrinsic value around $66 a share. Buying in this price range would allow for a 20-25% margin of safety to protect against any overestimate or impairment of intrinsic value.

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Published by: benclaremon on Dec 15, 2009
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The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Quick idea for Toronto-Dominion Bank (NYSE: TD)- 12/14/09 ($62.26)
 Does exposure to the US warrant a valuation discount?
Background
Toronto-Dominion Bank (TD) is a Toronto-based financial institution divided into four separate business lines. Collectively,Canadian Personal & Business Banking, Wealth Management, Wholesale Banking and US Personal & Commercial Bankingmake up what is known as TD Bank Financial Group. Through these subsidiaries the company offers a multitude of productsand services, ranging from asset management to retail banking to insurance. In addition, included within the results of theWealth Management segment are the earnings generated by the bank’s approximate 45% equity stake in TD AmeritradeHolding Corp. (NASDAQ: AMTD), a publicly listed brokerage company that caters to retail investors. Historically focusedon the Canadian market, TD has recently expanded its retail banking operations into the US through the acquisitions of BankNorth (completed in April 2007) and of Commerce Bancorp (completed in March 2008). The company now has around1100 branches in Canada, 1000 branches in the US, and serves over 17M customers worldwide. As of October 31
st
, 2009 TDhad over $170.9B in assets under management, $391B in deposits and $557.2B in total assets (all in Canadian dollars).
Investment PositivesStrong balance sheet and limited exposure to troubled markets and assets make TD a safe haven:
Given the toughoperating environment for banks as a result of the recent financial crisis and subsequent recession, the most importantoperating metrics to analyze are capital ratios and credit quality. On that basis TD is clearly viewed by investors as being oneof the safest banks in North America. Even though the bank’s tangible equity to tangible asset (TE/TA) ratio is a paltry3.29%, its tier one capital ratio is now up to 11.3%. While, most bank analysts look for a TE/TA ratio close to 5%, TD’slimited exposure to the worst real estate markets in the US and the relative resilience of the Canadian economy allows TD tomaintain lower tangible capital levels than its more stressed US-based peers. Specifically, according to company presentations the bank has no loan exposure to the weakest housing markets in Arizona and California and never engaged insubprime, Alt-A or low-doc lending. Nevertheless, the company has indicated that it expects to see continued stress in thefollowing portfolios: Canadian credit cards, Canadian and US commercial loans, and US commercial real estate loans.However, with nonperforming loans (NPLs) to total loans at only .90% and net charge offs (NCOs) to total loans at .58%, (asof 10/31/09) even a further spike in credit losses is not likely to be unmanageable.Additionally, sustained strong earnings in the Wholesale Banking segment and in Canadian retail banking should allow TD toearn its way through the cycle without any further dilutive capital raises. It should be noted though that the managementteam has indicated that the huge increase in Wholesale Banking net income from 2008 to 2009 was an extraordinary eventthat should not be viewed as sustainable. From only $65M of net income in 2008, mostly due to mark to market write downsand other trading losses, 2009 net income in this segment jumped to over $1.1B. This impressive reversal was driven bytighter credit spreads, improved asset values (especially in the bank’s proprietary investment portfolio), and higher demandfor underwriting. From a trading loss of $77M in 2008, TD recognized trading-related income of about $2.23B in 2009.These results clearly reflect the unusual operating environment in 2009 and analysts would be wise to normalize tradingincome when attempting to come up with a reasonable estimate of run-rate EPS.
Opportunity to expand TD’s footprint even further:
Given the unemployment situation in the US, it is not hard to make acase that the regional banking sector will remain under duress for the foreseeable future. Accordingly, if share prices were tostart to fall again or the FDIC was poised to take over a bank with an attractive footprint, TD could become an opportunistic buyer. Many of the recent FDIC-assisted transactions, including the Colonial Bank-BB&T deal, were very favorable for theacquirers as the FDIC backstopped a large percentage of the most impaired assets. Therefore, in a situation in which manyother buyers are hamstrung by toxic assets of their own, TD’s relative strength could allow the company to pick up assetsand/or deposits at very attractive valuations. In fact, on the Q4 2009 conference call the CEO indicated that TD could beinterested in smaller, tuck-in deals or accretive FDIC-assisted transactions.
The investment in TD Ameritrade will continue to pay dividends:
The stock market declines over the past two years thathave crushed the portfolios of many investors (even with the huge rally since March 2009) has left many people with thefeeling that actively managed funds and investment advisors may not be worth the substantial fees they earn. Consequently, itwould not be a surprise to see retail investors move more towards self-directed investing in the coming years. In that case,AMTD appears to be in a perfect position to capitalize on this secular trend given its focus on retail investors and an ever-expanding suite of easy to access products and capabilities. According to AMTD’s most recent monthly metrics report, clientassets have rebounded from $241 billion in October 2008 to $297 billion in October 2009 and the company continues to
Sources: Capital IQ, TD Company filings and presentations, Yahoo Finance, Google Finance, Personal Calculations, FDIC.gov
 
The Inoculated Investor http://inoculatedinvestor.blogspot.com/ bring in new assets at a reasonable rate. Therefore, the continued contribution to earnings of this investment as well as thefees TD generates from mutual fund assets under management should help to offset the impact of future credit losses.
Attractive dividend yield:
TD paid out $2.30 per share in dividends in 2009 and the stock now sports a very respectable3.7% dividend yield. With a payout ratio on adjusted income (income excluded impairments and other onetime items) of only45.6% in 2009, even given more financial market turmoil and/or necessary provisioning in the US subsidiaries, the currentdividend is likely to be safe. Therefore, any investor who was able to accumulate shares at a price below fair value wouldhave the luxury of being paid to wait for the market to correct for the unwarranted discount.
Valuation
The following chart provides a valuation comparison between TD and banks with similar market caps from both the US andCanadian markets:
(Figures in millions USD)
Company NameMarket CapTotal Assets Trailing 12 Mo. P/EPrice/BookPrice/Tangible Boo
Royal Bank of Canada (TSX:RY)$70,156.3$622.553.921.50x2.60x3.70xThe Bank Of Nova Scotia (TSX:BNS)$46,317.7$461,796.417.20x3.00x4.20xUS Bancorp (NYSE:USB) $44,043.1$265,058.028.90x1.86x3.70xBank of Montreal (TSX:BMO)$27,976.0$369,221.617.40x1.70x1.90xToronto-Dominion Bank (NYSE:TD)$52,927.2$525,457.5019.03x1.59x3.16x
With earnings depressed by credit losses and a low interest rate environment limiting the net interest margins of asset-sensitive balance sheets, the trailing P/E ratio is not a particularly useful metric. This is why most analysts’ current strategy isto compare banks on the basis of pre-tax, pre-provision earnings and on multiples of book and tangible book value. In termsof the first metric, which happens to be a good barometer of core earnings power, TD earned an impressive CAD $6.65 ashare in FY 2009 and is now trading at about 9.4x that amount. Further, as shown above, TD trades at the lowest multiple of  book and the second lowest of tangible book among the selected competitors. The question investors must ask themselves iswhether this discount is justified based on TD’s loan book exposures and capital levels.
Credit Quality & Capital MetricsTE/TATier 1 RatioAllowance/NPLsNPLs/Total LoansNet Interest Margin
Royal Bank of Canada (TSX:RY)3.37%13.00%58.42%1.92%1.65%The Bank Of Nova Scotia (TSX:BNS)3.57%10.70%72.86%1.46%1.68%US Bancorp (NYSE:USB)4.70%9.40%109.86%2.38%3.62%Bank of Montreal (TSX:BMO)4.65%12.24%57.69%1.94%1.63%Toronto-Dominion Bank (TSX:TD)3.29%11.30%102.47%0.90%2.54%
This chart provides some insight into the abovementioned question. While TD maintains the lowest TE/TA ratio of the group,the bank appears to employ a very conservative approach to allowing for loan losses. While its Canadian peers all haveallowance to NPL ratios below 75%, TD’s is above 100% and has the lowest percentage of NPLs to total loans. In other words, in comparison to the other Canadian banks, TD has so far experienced the smallest percentage of total losses and hasreserved properly for potential future losses. This is extremely important given the deteriorating credit quality of TD’s USsubsidiaries (discussed in much greater detail below). Finally, in 2009 TD achieved a net interest margin (NIM) of 2.54%despite the low rate environment and the company’s asset-sensitive balance sheet. This margin is far superior to those of itsCanadian competitors and may imply that TD has a more valuable franchise and a competitive advantage.
Historical P/E
 Average Multiple
Historical P/Tang. Book 
 Average Multiple
Historical P/Book 
 Average Multiple
200419.32x20044.11x20042.50x200516.00x20055.17x20052.56x200612.15x20065.16x20062.48x200714.65x20075.09x20072.51x200810.89x20083.82x20081.75xCurrent19.03xCurrent3.16xCurrent1.59x
 Previous 5 Year Average14.60x4.67x2.36x
Sources: Capital IQ, TD Company filings and presentations, Yahoo Finance, Google Finance, Personal Calculations, FDIC.gov
 
The Inoculated Investor http://inoculatedinvestor.blogspot.com/Finally, the above data highlights the discount to historical multiples that TD is currently trading at. As mentioned above, thecurrent P/E ratio not necessarily the best metric to use in evaluating whether the stock is undervalued or not. In 2009, EPSwas skewed downward by a number of onetime charges that led to reported EPS of $3.27 but an adjusted EPS figure of $5.05. Using the adjusted figure, the trailing P/E multiple for TD is only 12.32x, a number that is well below the five year average of 14.60x. In addition, compared to a five year average P/TBV multiple of 4.76x, TD currently trades at 3.16x.Finally, in comparison to a five year average P/BV multiple of 2.36x, TD now trades at 1.59x. While these past multiplesappear to be a bit high given TD’s five year average ROE of about 16.8%, the wide discrepancy could indicate a potentialopportunity, especially at a lower price point.
Investment Risks:US subsidiary loan quality & profitability:
So far the company’s expansion into the US has not gone as anticipated. On theQ4 2009 conference call CEO Clark indicated that TD is not earning its cost of capital in the US and said investors shouldexpect continued losses due to the US recession to postpone TD from reaching its US earnings goals. After perusing what isknown as the FFIEC call report data (from the FDIC’s website) for the Delaware-based TD Bank subsidiary, it became clear why the management team is concerned about the US operations. Based on Q3 2009 figures (this is the most recent availabledata as call reports lag quarterly earnings reports by a month or more), noncurrent loans to total loans increased to 1.84%from .83% in Q3 2008. Additionally, the loss allowance to current loans ratio fell from 146.46% in Q3 2008 to 87.39% in themost recent period. However, the most troubling trends are illustrated by what is known as the roll rate. Ideally, investorswould prefer to see declines in the number of new 30-89 day delinquent loans and in the number of these early delinquenciesmoving into the more severe non-accrual bucket. This unfortunately has not been the case. In fact, the number of non-accrualloans increased from $568.7mm to $977mm year over year, an increase of about 72%. It appears that many of the 30-89 daydelinquent loans are rolling into non-accruals and are even being replaced by new delinquencies, as shown by the year over year spike in 30-89 day delinquencies from $576.7mm to $683.1mm.The recent fiscal year 2009 earnings release reinforced the above data. Impaired loans in the US were up 167% whencompared to FY 2008 and the allowance for loan losses attributable to the US was up 117% year over year. Given the factthat this segment has over $108B (USD) in assets, any further provisioning required to offset expected loan losses willcontinue to weigh on earnings and returns. However, the deteriorating credit condition of the US subsidiaries seems to bemore than priced into the stock and may be the reason (justified or not) why TD trades at a discount on a number of metricsto its Canadian peers.
A market downturn or increased risk aversion could negatively impact the Wholesale Banking segment:
The wildfluctuation in trading income that TD experienced from the lows of 2008 to the re-liquefied 2009 period caused a substantialswing in earnings and in book value. Given TD’s $95B in trading securities as of the end of FY 2009, both unrealized andrealized gains and losses have the potential to meaningfully impact book value and net income. As mentioned above, TD’sWholesale Banking division made over $1B more in 2009 than it did in 2008. This fact highlights how much TD’s earningsand stock price are correlated with the health of the credit and equity markets. This is more so for TD than for a bank likeUSB that depends on income from lending rather than on gains from investments and whose balance sheet has no tradingsecurities. As a result, if the financial markets were to tighten up again and equity values were to drop, both earnings andcapital levels for TD would fall, especially if losses were combined with further deteriorating loan quality for the USsubsidiaries.
The low TE/TA ratio leads to the need to raise capital as loan losses continue:
The ultimate risk of any unforeseenscenario like the one suggested above is that TD has to raise more capital. As discussed previously, TD has the lowest TE/TAratio of the Canadian banks and the need for further provisioning along with a reversal in trading gains could put pressure onTD to cut the dividend or sell more shares. Given the perception of strength among market participants when it comes to TD,a move to cut the dividend or unexpectedly raise capital could put pressure on the share price. While it is very unlikely thatthe company will suffer any type of impairment on its core franchise, any further dilution is obviously not in the interest of current shareholders.
Recommendation:
A good rule of thumb for financial institutions is as follows: a company that earns an ROE of 10% shouldtrade at about 1x book value and one that earns 20% should trade at 2x. Given TD’s 5 year average adjusted ROE of 16.8%,the current valuation of 1.59x book appears to be slightly below fair value based on an implied 1.68x multiple. Using a fair estimate of run rate ROE going forward of 17% implies a price to book multiple of 1.7x and a stock price around $66.60.However, the discrepancy between this relatively conservative estimate of intrinsic value and the current price of $62.26 doesnot leave a large enough margin of safety to recommend buying shares. Accordingly, a rating of Hold seems justified at thecurrent price.
Sources: Capital IQ, TD Company filings and presentations, Yahoo Finance, Google Finance, Personal Calculations, FDIC.gov

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