Seeking Alpha
Value, deep value, contrarian
Profile| Send Message|
( followers)  

Toronto-Dominion Bank (NYSE:TD), commonly known as TD bank or TD, reported disappointing Q4 earnings yesterday, but it also raised its quarterly dividend by 1% and announced a 2 for 1 stock split. Like many other big 5 Canadian banks that reported fiscal 2013 results, TD reported a record profit for fiscal 2013 with net income of $6.7 billion. However, investors zeroed in on TD's poor Q4 results, which missed analyst's estimate by $0.09 and showed an unexpected growth in expenses. Although the share price dropped after its quarterly report, I believe it presents a great buying opportunity.

This article presents a comprehensive analysis of TD and presents my investment thesis. I will explain to readers why the bank is a great dividend growth play despite its disappointing Q4 results. Please note that all financial data are in Canadian Dollars except for the price target which is presented in US dollars and represents the price target for TD's NYSE listed shares. The company's reporting and functional currency is the Canadian Dollar so comparing the financial results in Canadian dollars provide a better picture of the underlying fundamentals. However, my price target is presented in US dollars for the reader's convenience.

TD's Dividend Growth:

As presented in my prior article on TD, I believe TD is the best dividend growth play among the big 5 Canadian banks. Although its dividend yield (currently at 3.6%) is the lowest among the big 5, it has the best potential for dividend growth in the future. As shown in graph 1, the payout ratio, based on fiscal 2013 data, is currently 43.5%. TD's current payout ratio is below the mid-point of its 40-50% target payout ratio. Other Canadian banks' payout ratios are higher than 45% (all banks have a 40-50% target range). Therefore, TD has the best potential to increase dividends next year because of its lower payout ratio vs. peers. In addition, it possesses a solid track record of increasing dividends as shown in table 1 and graph 2. TD grew its dividend by a compounded rate of 11% (OTCPK:CAGR) in the past 20 years, the highest among the big 5 Canadian banks. In fiscal 2014, the dividend should increase by around 10%, in-line with the growth rate of 10.8% in fiscal 2013.

As discussed in my introduction, TD raised its quarterly dividend by a penny from C$0.85 to C$0.86. Most investors believe TD made the move in order to facilitate the 2 for 1 stock split in January, 2014. Although the dividend increase was related to the stock split, I still believe the surprise dividend hike provides a positive signal and show management's confidence regarding the long term outlook of TD's businesses despite near term weakness. Furthermore, looking back at the historical stock splits announcements made by Canadian banks, the bank stocks had terrific performance after announcing stock splits. As Mark Twain famously said: "History doesn't repeat itself, but it does rhyme". The stock split does foreshadow some good gains ahead.

TD's current quarterly dividend of C$0.86 per share (before the 2 for 1 stock split in January, 2014) is paid in Canadian Dollars so US investors may face some FX risk. If the Canadian Dollar appreciates vs. the USD, US investors will receive more than C$0.86 per share. On the other hand, if the Canadian Dollar depreciates vs. the USD, US investors will receive less than the C$0.86 per share. Nonetheless, even if the Canadian Dollar depreciates 20%, TD's US investors will still receive a dividend yield greater than 2%, which is higher the dividend yield offered by most US banks.

Graph 1: Adjusted EPS, Dividend per Share vs. Payout Ratio

(click to enlarge)

Source: TD Q4 Financial Supplement

Table 1: Dividend Growth Rates

Period5Y10Y15Y20Y30Y
Rate5.1%9.4%9.9%10.7%9.9%

Source: Author's Calculations based on data from TD Investor Relations

Graph 2: TD's 30 Year Dividend History

(click to enlarge)

Source: TD Investor Relations

Investment Thesis:

TD is an excellent name to own for dividends and earnings growth. It has the highest dividend growth rate among the big 5 banks in the past 20 years and is best positioned to boost its dividend in the future. Over 75% of its earnings is generated from its P&C businesses (see graph 4 below), which is less risky than wholesale banking (investment banking and trading). It is undergoing a major transformation as management tries to fully integrate its large acquisitions especially in its US P&C Banking division. Given its excellent track record in the past, the US acquisitions will yield handsome rewards in the next few years. Those acquisitions position TD well and the bank can benefit from the growing US economy.

In the sections below, I will analyze each division in more detail and provide a 12 month price target for TD.

Graph 3: Annual EPS vs. ROE

(click to enlarge)

Source: TD Q4 Financial Supplement

Graph 4: TD's Earnings by Division (Fiscal 2013)

Source: TD Q4 Financial Supplement

Canadian P&C Banking Segment Review & Outlook:

The Canadian P&C Banking division is the backbone of TD, similar to other big 5 Canadian banks. The profitability of this division is extremely attractive with ROE near 50%. TD is a great operator and has traditionally kept the efficiency ratio (non-interest income divided by total revenue) at around 45%. Investors were disappointed after the bank reported that the ratio increased 150 bps to 46.5%. Loan growth is slowing from high-single digits to mid-single digits, which is surprising given the higher loan growth reported by other banks. I believe those negatives mentioned above stirred up negative sentiment among investors, but the underlying fundamentals of TD's P&C Business have not changed. One positive that should not be ignored is TD's ability to stabilize its Net Interest Margin (NYSE:NIM) near the 2.80% as shown table 2.

Looking at the financials, this division is performing well. Adjusted net income was $948 million in Q4/13, which represents a 14.1% year-over-year (Y/Y) increase from Q4/12. The division earned a record $3.77 billion in fiscal 2013 vs. $3.47 billion in fiscal 2013, which represents a 10.5% increase. ROE is stable in the high 40s and TD is achieving positive operating leverage. I expect this division to continue to generate solid earnings although earnings growth is likely to slow to match the slower loan growth. In TD's MD&A, management gave the following guidance regarding Canadian P&C Banking:

"Earnings growth rate expected to moderate, retail loan growth rate generally in line with 2013 levels, business lending to remain strong, modest downward pressure on margins in 2014, tightly manage expense growth" (Page 23)

Table 2: Canadian P&C Banking Related Data

(click to enlarge)

Source: TD Q4 Financial Supplement

Graph 5: Canadian P&C Loan Book

(click to enlarge)

Source: TD Q4 Financial Supplement

US P&C Banking Segment Review & Outlook:

TD's US P&C Banking segment will drive future earnings growth and contribute meaningfully to the bank's long term earnings power. Although it is still early to assess the full benefits of TD's US acquisitions, there are several positives that are starting to show in its reported results. In the latest quarter, loan growth was healthy at 21.1% and NIM is growing, instead of contracting. NIM is up 9 bps Q/Q and 41 bps Y/Y. Although investors was mainly focused on the rising efficiency ratio and negative operating leverage, they should not overlook the improvements in NIM and healthy loan growth. Expenses should trend down in the future as further integration of its prior acquisitions lead to cost savings. Although it may be impossible to drive the efficiency ratio down in the mid 40s, I believe the bank can at least improve the ratio by 500-1,000 bps from Q4/13 levels, which will help drive positive operating leverage

Looking at the financials, the division earned $399 million in Q4/13 which is a 13% Y/Y increase compared to Q4/12. For fiscal 2013, it earned $1.63 billion compared to $1.42 billion in fiscal 2013, a 14.8% Y/Y increase. For fiscal 2014, I expect the growth momentum to continue although profit growth is likely to be in the high single digits due to slower refinancing activities. In TD's MD&A, management gave the following guidance regarding US P&C Banking:

A challenging year ahead with expected modest growth in adjusted earnings characterized by a higher net interest margin offset by lower levels of security gains and higher levels of PCL. Expense growth to moderate while continuing to invest in growth and regulatory compliance. Loan growth will likely slow due to lower levels of mortgage refinancing (Page 30)

Table 3: US P&C Banking Related Data

(click to enlarge)

Source: TD Q4 Financial Supplement

Graph 6: US P&C Loan Book

(click to enlarge)

Source: TD Q4 Financial Supplement

Wealth and Insurance Segment Review & Outlook:

Like other Canadian banks, the wealth and insurance division is one of the most profitable divisions because of low reinvestment of capital and stable income streams. However, TD's insurance division hit a few potholes in the past year. It recorded a $418 million charge due to bad weather conditions and changes in regulation.

A common overlooked asset is TD's 42% stake in TD Ameritrade (NYSE:AMTD). AMTD's stock price has increased over 75% in the past year and contributed $246 million to TD's bottom line through the equity method of accounting. For those who are unfamiliar with the equity method of accounting, TD basically reports 42% of AMTD's net income on its own earnings statement. The market value of this stake is about $6.7 billion or 8% of TD's total market cap despite AMTD only contributes 3.5% to TD's bottom line. AMTD is benefiting from the improving market conditions, which drives new account openings and commission income. I believe many investors are undervaluing TD's stake in AMTD because the equity method force TD to record its stake of AMTD on its balance sheet at book value (unlike an available-for-sale security which is recorded at market value).

Looking at the financials for the Wealth and Insurance division, adjusted net income was $405 million in Q4/13 which is a 38.2% Y/Y increase from Q4/12. For fiscal 2013, it earned $1.15 billion compared to $1.37 billion in fiscal 2013, a 15.7% Y/Y decrease. Investor are paying too much attention to the 15.7% drop in earnings in fiscal 2013 due to abnormal charges in its insurance division. Insurance earnings will be marginally better in fiscal 2014. Wealth earnings will drive future profit growth in the year ahead as Assets under Management (AUM), which benefit from the improving investor sentiment, continues to grow at double digits rates as shown in table 4 below.

Table 4: Wealth and Insurance Related Data

(click to enlarge)

Source: TD Q4 Financial Supplement

Wholesale Banking Segment Review & Outlook:

One of the big negatives in its Q4 and fiscal 2013 results is the weak earnings from its wholesale division. The division reported earnings of $122 million, which represents a 60.5% Y/Y decline. Q4's weak earnings is the second quarter in a row that this division delivered double digit Y/Y earnings decline. ROE has decreased from 30.3% in Q4/12 to a mere 12.0% in Q4/13. Despite all the negatives mentioned above, investors should be reminded that the earnings contribution from its wholesale banking division is less than 10% of total earnings. Also, the current run-rate for wholesale earnings is significantly below the long term average and should improve in the next few quarters. Investors should not extrapolate Q4/13's weak results into the future.

Table 5: Wholesale Banking Related Data

(click to enlarge)

Source: TD Q4 Financial Supplement

Credit Analysis & Capital:

TD is benefiting from the improving credit conditions, in particular in the US. Provision for credit losses (NYSE:PCL) was $352 million in Q4/13, down 37.7% Y/Y. PCL has decreased from 0.55% of total loans to about 0.32%. Gross impaired loans increased 6.9% Y/Y in Q4/13, but the figure is relatively stable at 0.6% of total loans. Gross impaired loan formation, the additional gross impaired loans added, increased 2.1% Y/Y to $1,244 million in Q4/13.

As shown in table 7 below, TD's capital ratios are strong. Under Basel III rules, TD reported a Tier 1 Common Equity (CET1) Ratio of 9.0% and Tier 1 Capital Ratio of 11.0%.

Table 6: Credit Related Data

(click to enlarge)

Source: TD Q4 Financial Supplement

Table 7: TD's Capital Ratio under Basel III

Q1/13Q2/13Q3/13Q4/13
Tier 1 Common Equity (CET1)8.8%8.8%8.9%9.0%
Tier 1 Capital Ratio10.9%10.8%11.0%11.0%

Source: TD Q4 Financial Supplement

Valuation:

Graph 7: TD's Historical PB Multiple vs. Peers

(click to enlarge)

Source: Bloomberg Data and TD Q4 Financial Supplement. Peers include Royal Bank of Canada (NYSE:RY), Bank of Nova Scotia (NYSE:BNS), Bank of Montreal (NYSE:BMO) and Canadian Imperial Bank of Commerce (NYSE:CM)

Graph 8: TD's Historical PB Multiple

(click to enlarge)

Source: Bloomberg Data and TD Q4 Financial Supplement. SD is standard deviation.

Currently, TD is trading at 1.85X book and 2.6X tangible book. Similar to other Canadian banks, the absolute levels of the price to book (NYSE:PB) multiples are high. Nonetheless, investors should recognize that these banks have consistently delivered ROE in the mid to high teens and stable earnings growth, which justify the premium Canadian banks trade vs. US peers. On an earnings basis, TD trades at 11.4X estimated consensus fiscal 2014 earnings, which is about 0.6X lower than its historical average. As shown in graph 8, TD has traded near 2 times book value on average. By combining the average PB multiple of 2 and my estimated fiscal 2014 year-end book value of US$52.51(C$55.92), I arrive at my 12 month price target of US$105.00 ($C112.00). My price target is 20.8% higher than the current price of US$89.58 on a total return basis. Readers should look at table 8 below for a sensitivity analysis. The base case assumption of a 12.5% earnings growth appears aggressive but fiscal 2013's EPS number contained various large charges that are one-time items in my opinion. Excluding those items, earnings growth next year is around 6-7%, which is reasonable in a slower growth environment.

Table 8 Sensitivity Analysis of Price Target (in USD)

Source: Author's Calculations

Conclusion:

All in all, TD's surprise dividend hike and stock split announcement do provide clues that management is confident about TD's long term earnings growth despite near term weakness. Investors wishing to own a bank that has exposure to the improving US economy and a solid P&C banking franchise in Canada should add TD to their portfolio. Income investors should buy TD because of its long term dividend growth potential. Given TD's share price has lagged peers in the past three months, its share price will perform better in 2014.

Source: Toronto-Dominion Bank's Surprise Dividend Increase Is Overlooked By Investors

Additional disclosure: This article is for informational purposes only and does not constitute an offer to buy or sell any securities discussed in the article. The stock mentioned in this article does not represent financial advice. The target price presented in this article is based on current information and are subject to change without further notice. Investors are recommended to conduct further due diligence before committing capital to any investment.