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 Banking make up what is known as TD Bank Financial Group. Through these subsidiaries the company offers a multitude of products and services, ranging from asset management to retail banking to insurance. In addition, included within the results of the Wealth Management segment are the earnings generated by the bank’s approximate 45% equity stake in TD Ameritrade Holding Corp. (NASDAQ: AMTD), a publicly listed brokerage company that caters to retail investors. Historically focused on 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 around 1100 branches in Canada, 1000 branches in the US, and serves over 17M customers worldwide. As of October 31st, 2009 TD had over $170.9B in assets under management, $391B in deposits and $557.2B in total assets (all in Canadian dollars). Investment Positives Strong balance sheet and limited exposure to troubled markets and assets make TD a safe haven: Given the tough operating environment for banks as a result of the recent financial crisis and subsequent recession, the most important operating metrics to analyze are capital ratios and credit quality. On that basis TD is clearly viewed by investors as being one of the safest banks in North America. Even though the bank’s tangible equity to tangible asset (TE/TA) ratio is a paltry 3.29%, 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’s limited exposure to the worst real estate markets in the US and the relative resilience of the Canadian economy allows TD to maintain 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 in subprime, Alt-A or low-doc lending. Nevertheless, the company has indicated that it expects to see continued stress in the following 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%, (as of 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 to earn its way through the cycle without any further dilutive capital raises. It should be noted though that the management team has indicated that the huge increase in Wholesale Banking net income from 2008 to 2009 was an extraordinary event that should not be viewed as sustainable. From only $65M of net income in 2008, mostly due to mark to market write downs and other trading losses, 2009 net income in this segment jumped to over $1.1B. This impressive reversal was driven by tighter credit spreads, improved asset values (especially in the bank’s proprietary investment portfolio), and higher demand for 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 trading income 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 a case that the regional banking sector will remain under duress for the foreseeable future. Accordingly, if share prices were to start 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 the acquirers as the FDIC backstopped a large percentage of the most impaired assets. Therefore, in a situation in which many other buyers are hamstrung by toxic assets of their own, TD’s relative strength could allow the company to pick up assets and/or deposits at very attractive valuations. In fact, on the Q4 2009 conference call the CEO indicated that TD could be interested 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 that have crushed the portfolios of many investors (even with the huge rally since March 2009) has left many people with the feeling that actively managed funds and investment advisors may not be worth the substantial fees they earn. Consequently, it would 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 everexpanding suite of easy to access products and capabilities. According to AMTD’s most recent monthly metrics report, client assets 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 the fees 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 respectable 3.7% dividend yield. With a payout ratio on adjusted income (income excluded impairments and other onetime items) of only 45.6% in 2009, even given more financial market turmoil and/or necessary provisioning in the US subsidiaries, the current dividend is likely to be safe. Therefore, any investor who was able to accumulate shares at a price below fair value would have 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 and Canadian markets:
(Figures in millions USD) Company Name Royal Bank of Canada (TSX:RY) The Bank Of Nova Scotia (TSX:BNS) US Bancorp (NYSE:USB) Bank of Montreal (TSX:BMO) Toronto-Dominion Bank (NYSE:TD) Market Cap $70,156.3 $46,317.7 $44,043.1 $27,976.0 $52,927.2 Total Assets $622.553.9 $461,796.4 $265,058.0 $369,221.6 $525,457.50 Trailing 12 Mo. P/E 21.50x 17.20x 28.90x 17.40x 19.03x Price/Book 2.60x 3.00x 1.86x 1.70x 1.59x Price/Tangible Book 3.70x 4.20x 3.70x 1.90x 3.16x

With earnings depressed by credit losses and a low interest rate environment limiting the net interest margins of assetsensitive balance sheets, the trailing P/E ratio is not a particularly useful metric. This is why most analysts’ current strategy is to compare banks on the basis of pre-tax, pre-provision earnings and on multiples of book and tangible book value. In terms of the first metric, which happens to be a good barometer of core earnings power, TD earned an impressive CAD $6.65 a share 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 is whether this discount is justified based on TD’s loan book exposures and capital levels.
Credit Quality & Capital Metrics Royal Bank of Canada (TSX:RY) The Bank Of Nova Scotia (TSX:BNS) US Bancorp (NYSE:USB) Bank of Montreal (TSX:BMO) Toronto-Dominion Bank (TSX:TD) TE/TA 3.37% 3.57% 4.70% 4.65% 3.29% Tier 1 Ratio 13.00% 10.70% 9.40% 12.24% 11.30% Allowance/NPLs 58.42% 72.86% 109.86% 57.69% 102.47% NPLs/Total Loans 1.92% 1.46% 2.38% 1.94% 0.90% Net Interest Margin 1.65% 1.68% 3.62% 1.63% 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 have allowance 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 has reserved properly for potential future losses. This is extremely important given the deteriorating credit quality of TD’s US subsidiaries (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 its Canadian competitors and may imply that TD has a more valuable franchise and a competitive advantage.
Historical P/E 2004 2005 2006 2007 2008 Current Previous 5 Year Average Average Multiple 19.32x 16.00x 12.15x 14.65x 10.89x 19.03x 14.60x Historical P/Tang. Book 2004 2005 2006 2007 2008 Current Average Multiple 4.11x 5.17x 5.16x 5.09x 3.82x 3.16x 4.67x Historical P/Book 2004 2005 2006 2007 2008 Current Average Multiple 2.50x 2.56x 2.48x 2.51x 1.75x 1.59x 2.36x

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, the current P/E ratio not necessarily the best metric to use in evaluating whether the stock is undervalued or not. In 2009, EPS was 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 multiples appear to be a bit high given TD’s five year average ROE of about 16.8%, the wide discrepancy could indicate a potential opportunity, 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 the Q4 2009 conference call CEO Clark indicated that TD is not earning its cost of capital in the US and said investors should expect continued losses due to the US recession to postpone TD from reaching its US earnings goals. After perusing what is known 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 available data 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 the most recent period. However, the most troubling trends are illustrated by what is known as the roll rate. Ideally, investors would prefer to see declines in the number of new 30-89 day delinquent loans and in the number of these early delinquencies moving into the more severe non-accrual bucket. This unfortunately has not been the case. In fact, the number of non-accrual loans increased from $568.7mm to $977mm year over year, an increase of about 72%. It appears that many of the 30-89 day delinquent 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% when compared to FY 2008 and the allowance for loan losses attributable to the US was up 117% year over year. Given the fact that this segment has over $108B (USD) in assets, any further provisioning required to offset expected loan losses will continue to weigh on earnings and returns. However, the deteriorating credit condition of the US subsidiaries seems to be more than priced into the stock and may be the reason (justified or not) why TD trades at a discount on a number of metrics to its Canadian peers. A market downturn or increased risk aversion could negatively impact the Wholesale Banking segment: The wild fluctuation in trading income that TD experienced from the lows of 2008 to the re-liquefied 2009 period caused a substantial swing in earnings and in book value. Given TD’s $95B in trading securities as of the end of FY 2009, both unrealized and realized gains and losses have the potential to meaningfully impact book value and net income. As mentioned above, TD’s Wholesale Banking division made over $1B more in 2009 than it did in 2008. This fact highlights how much TD’s earnings and stock price are correlated with the health of the credit and equity markets. This is more so for TD than for a bank like USB that depends on income from lending rather than on gains from investments and whose balance sheet has no trading securities. As a result, if the financial markets were to tighten up again and equity values were to drop, both earnings and capital levels for TD would fall, especially if losses were combined with further deteriorating loan quality for the US subsidiaries. The low TE/TA ratio leads to the need to raise capital as loan losses continue: The ultimate risk of any unforeseen scenario like the one suggested above is that TD has to raise more capital. As discussed previously, TD has the lowest TE/TA ratio of the Canadian banks and the need for further provisioning along with a reversal in trading gains could put pressure on TD 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 that the 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% should trade 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 does not leave a large enough margin of safety to recommend buying shares. Accordingly, a rating of Hold seems justified at the current price.
Sources: Capital IQ, TD Company filings and presentations, Yahoo Finance, Google Finance, Personal Calculations, FDIC.gov

The Inoculated Investor

http://inoculatedinvestor.blogspot.com/

Having said that, given TD’s conservative stance on allowing for loan losses, premium net interest margin, and investment in AMTD, it is not hard to argue that TD is the best of breed among the Canadian banks. This is despite trading at lower price to book multiples than the other large banks. While the bank’s TE/TA ratio and the loan quality of the US subsidiaries are certainly concerns, investors should look to become more constructive on the stock anywhere in the $50-$55 range. At that level there would be a sufficient margin of safety to intrinsic value (of about $66) and investors should be able to accumulate shares of a very solid financial institution at an attractive multiple to book value.

Sources: Capital IQ, TD Company filings and presentations, Yahoo Finance, Google Finance, Personal Calculations, FDIC.gov

Sign up to vote on this title
UsefulNot useful