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Toronto-Dominion Bank (NYSE:TD), commonly known as TD, surprised investors with a larger-than-expected dividend increase today. The bank increased its quarterly dividend by 9.3% from $0.43/share to $0.47/share after announcing its earnings for fiscal Q1/14 (TD's fiscal year ends on October 31). The large dividend hike demonstrates TD's ability to grow core earnings. For Q1/14, TD reported adjusted EPS of $1.00, up 6% year-over-year (YoY) due to strong momentum in its retail banking businesses. Graph 1 below provides a quick summary regarding its quarterly financial trends.

Graph 1: Quarterly Financials Summary

Source: TD Supplemental Financial Information

Reflecting on the solid performance in Q1/14, TD's CEO provided the following comments in today's earnings press release:

"TD performed well in the first quarter, delivering record adjusted earnings of $2 billion, up 6% from a year ago. We are pleased with these results in context of challenging environment. We remain confident that our customer oriented focused, retail-driven business model will continue to drive sustainable earnings growth" Ed Clark, TD's CEO

Investment Thesis:

TD is a compelling investment because of its solid earnings power and growth potential. Dividend growth will be driven by (1) Growth in its US retail banking business (2) Improvements in its Canadian retail banking business. TD is well capitalized and trades at a low multiple relative to its growth potential. The company has a good record of increasing its dividend and is best positioned to increase its dividend due to its lower payout ratio vs. its peers.

The company has an unparalleled banking network across Canada and Eastern United States. In addition, TD's excellent customer service and longer branch hours are key to its success in its retail banking businesses. The company has spent over $20 billion on its P&C banking business in the US over the past 5 years and the results are finally showing up on its financials. I'm confident that TD's aggressive US expansion strategy will drive future earnings and dividend growth. Given US GDP growth is expected to be above 3% in 2014, the bank made the right decision to expand its US business after the financial crisis.

Dividend Outlook:

As stated above, TD hiked its quarterly dividend by 9.3%, bring its payout ratio closer to the mid-point of its targeted 40-50% range. During the conference call today, TD's CEO, Ed Clark, stated that the bank changed its dividend policy. Instead of raising the dividend twice every year, the bank decided to only raise the dividend once per year, but at a much higher rate. TD's announcement is actually positive because one large increase is worth more than two small increases. Graph 2 provides a comparison of adjusted EPS and dividends per share (DPS). I also provided my forecasted EPS ($4.28) for fiscal 2014 in the graph. As shown in the graph, TD's payout policy is conservative and its payout ratio has been below the mid-point of its targeted 40-50% payout rate for the past 4 years. The bank may hike the quarterly dividend by another 4 cents next February (9% higher from the current rate of $0.47/share), which will increase the payout ratio to approximately 44.8%. Since the dividend payout ratio is much lower vs. other Canadian banks, future dividend increases will be larger than rivals.

TD targets earnings growth between 7-10% and management indicated that the dividend growth rate should be in-line with earnings growth. From 1983 to 2013, TD grew its dividend by a compounded rate of 10% and it can continue to grow its dividend in the future. TD's growth in the US will largely contribute to future dividend growth.

Graph 2: Adjusted EPS, DPS and Payout Ratio

Source: TD Supplemental Financial Information. 2014's numbers are estimated based on the author's own forecasts.

Graph 3: TD's 30-year Dividend History (1983-2013)

(click to enlarge)

Source: TD Investor Relations

Canadian Retail Banking:

Canadian retail banking includes TD's Canadian P&C banking, wealth management and insurance operations. Adjusted net income was up 5% YoY due to strong results in Canadian P&C banking and wealth management. Expenses are finally trending down and ROE has improved slightly quarter-over-quarter (QoQ). Table 1 provides a detailed breakdown of the results. Continued strength in its Canadian retail business is positive for future dividend growth.

Canadian retail banking was mainly driven by the double digit YoY increase in P&C banking income. Net income for TD's Canadian P&C business, commonly known as TD Canada Trust, increased 11.2% YoY to $1.05 billion. TD Canada Trust was finally able to break the $1 billion profit mark this quarter. Volume growth was modest with loan growth up 5.3% YoY and 1.5% QoQ. The improvement in net interest margin or NIM contributed to the improvement in earnings. NIM was up 3 bps YoY and 2 bps QoQ. Similar to RBC's (NYSE:RY) results yesterday, TD benefited from an improvement in margins. Going forward, the outlook for Canadian P&C banking is positive. TD recently acquired a large credit card portfolio, the Aimia Aeroplan credit card portfolio, from rival CIBC (NYSE:CM). Management indicated that the Aimia credit card portfolio experienced good growth in February and will continue to perform well, which will contribute to higher earnings and margins. The CFO provided positive comments regarding the outlook on NIM going forward during the conference call. NIM is expected to stabilize this year and increase in 2015. Loan growth is expected to be modest going forward, which implies growth will be similar to the 5.3% experienced in Q1/14. Operating leverage was 0.5% in its P&C business in Q1/14 and management is confident that it can achieve positive operating leverage going forward, which will give a boost to earnings.

The wealth management division experienced stellar growth in Q1/14 with net income up 18.6% YoY. The main driver of earnings growth was the increase in Assets under Administration (AUA) and Assets under Management (AUM). AUA increased 1% YoY and AUM increased 8% YoY. The favourable market environment and improving economic conditions have benefited the wealth business and it will continue to generate stable earnings growth. There is still room to improve its wealth business by limiting expense growth and targeting positive operating leverage.

The insurance sub-division is the main laggard in TD's Canadian retail business. Net income was $92 million in the latest quarter, down 44.2% YoY and is significantly lower than the average run rate of $150 million per quarter. Abnormal claims relating to severe weather contributed to the large profit decline in this division. However, earnings should gradually improve in the upcoming quarters. Management expressed optimism that this division can revert back to the previous run-rate of $150 million over time, although the next quarter or two may still be challenging.

Table 1: Canadian Retail Banking Data

(click to enlarge)

Source: TD Supplemental Financial Information

Graph 4: Canadian Retail Banking Loan Book

Source: TD Supplemental Financial Information

US Retail Banking:

US retail banking will be the main driver of future growth. TD is well positioned to capitalize on the strength of the US economy. Earnings growth have accelerated in recent quarters. In Q1/14, adjusted net income increased 15.8% YoY to $492 million because of strong volume growth and a weaker Canadian Dollar. On a constant currency basis, adjusted net income experienced a healthy growth of 8.2% YoY. Loan growth was robust, growing 14.3% YoY and 1.9% QoQ. Expenses are still high in this division because the bank is still integrating several large acquisitions and realigning its focus. However, expenses did continue to trend down as shown by the drop in the efficiency ratio. Net income in previous quarters were boosted by higher available-for-sale (AFS) gains that were $50 million higher. Therefore, excluding that impact, core earnings growth would have been much higher.

Volume growth and expense reduction should lead to double digit earnings growth in this division going forward. Higher interest rates will give a huge boost to earnings in the future. As shown in table 3, NIM was up 55 bps YoY due to higher interest rates. As the Fed continues to taper QE, interest rates should gradually rise in the US. However, management expects competition to intensify somewhat, which will slightly offset the benefits of higher interest rates. I believe TD can improve its US retail operations and deliver ROE in the mid-teens within the next two years. The two main drivers for future growth will be (1) lower expenses and (2) higher NIMs. Management is targeting an efficient ratio in the high 50s in the medium term, which implies that the current ratio of 63.4% should decrease about 500 bps over the next few quarters.

Table 3: US Retail Banking Data

Source: TD Supplemental Financial Information

Graph 5: US Retail Banking Loan Book

Source: TD Supplemental Financial Information

Wholesale Banking:

As mentioned in my previous article on TD, the low profit number in Q4/13 should reverse and it did in Q1/14. Net income increased 44.7% YoY to $230 million, up from $159 million in Q1/13. The increase was largely driven by higher trading revenues (up 40.2% YoY), higher advisory and underwriting fees. Expenses also returned to a more normalized level as shown by the large reduction in the efficiency ratio, which was down 840 bps YoY and 1,290 bps QoQ.

Looking ahead, wholesale banking should continue to benefit from higher client activities and a more favourable trading environment. Although future quarters won't be as strong as Q1/14, trading revenues should continue at a run-rate of approximately $300 million and net income should be closer to the $200 million level.

Table 3: Wholesale Banking Data

Source: TD Supplemental Financial Information

Credit & Capital:

TD's credit quality remains stable, although provisions for credit losses (PCL) was up YoY and QoQ. Excluding the low PCL charge in Q4/13, PCL remains stable at about 0.4% of total loans. Gross impaired loans increased 14.7%, but the gross impaired loans to total loans ratio remained near 0.6%. PCL and gross impaired loans are slightly higher due to recent acquisitions, such as the acquisition of CIBC's Aimia credit card portfolio. Going forward, credit quality will stabilize according to the company's chief risk officer.

Table 4: Credit Related Data

Source: TD Supplemental Financial Information

TD is well capitalized with a tier 1 common equity ratio (CET1) of 8.9% under Basel III rules. As I stated in my RBC article, Canadian banks' capital ratios were impacted by the implementation of the new Credit Valuation Adjustment (CVA) rule.

Table 5: Capital Ratios

Source: TD Supplemental Financial Information

Valuation:

TD is trading at 1.85X book and 11.5X consensus fiscal 2014 earnings. These are cheap valuations for a bank that has demonstrated consistent earnings growth. As shown in graph 6, TD has traded between 1X and 2.8X book, with the average at 2X book. Graph 7 shows TD's valuation against its domestic peers. Its discount vs. peers narrowed over the past year as the market became more comfortable regarding its US expansion strategy. I believe the market was initially skeptical regarding the TD's US expansion strategy. Given the more robust outlook for the US economy and higher interest rate environment in the US, the market is starting to realize that TD's aggressive US expansion strategy can be profitable.

Graph 6: TD's Historical Price to Book (PB) Multiples

Source: Bloomberg Data

Graph 7: TD's PB Multiples vs. Peers

Source: Bloomberg Data. Peers include Royal Bank of Canada, Scotiabank (NYSE:BNS), Bank of Montreal (NYSE:BMO) and Canadian Imperial Bank of Commerce

My 12 month target for TD is US$52.90 (for TD's NYSE listed shares) or C$58.75 (for TD's TSX listed shares). My price target is calculated by multiplying my estimated Q1/15 book value of US$26.45 ($C29.36) by the 10-year average PB multiple of 2. My price target is about 18% higher than the current price and a total return of 21.7% can be realized if my price target is achieved. Table 8 provides a sensitivity analysis of my valuation. If TD's US retail banking segment grow faster than expected, then the PB multiple may expand. I believe a multiple expansion is more likely than a multiple contraction.

Table 8: Sensitivity Analysis of PB Multiple Valuation

Source: Author's calculations. The light blue cases are below the current price of US$44.71 and the light green cases are above the current price.

The Bottom Line:

TD is trading at attractive valuations and is well positioned for strong dividend growth over the medium term. The solid performance of its Canadian retail banking business and high growth potential in its US retail banking business are two key factors that will drive future dividend growth. TD is best positioned among the Canadian banks to take advantage of a more robust US economy. As TD grow its earnings, investors should be rewarded with additional dividend increases down the road.

Source: Toronto-Dominion Bank: Excellent Retail Banking Results Will Drive Dividend Growth