- TD Bank is a great Canadian bank that gives investors consistent and growing dividends.
- TD Bank's retail business is well-established in Canada and in the U.S. East Coast. The bank can benefit from both markets' economic growth.
- The housing bubble in Canada is over-exaggerated and a soft landing is likely the scenario.
- TD Bank's risks are fairly low compared with the U.S. banks.
In one of my previous articles, I wrote that Royal Bank of Canada (NYSE:RY) is the best Canadian bank for long-term investing, followed by Toronto-Dominion Bank (NYSE:TD). Now, TD has become the largest Canadian bank in terms of assets, while RBC is still the largest in terms of market cap. One of the main reasons is that TD has been focused on expanding its retail and commercial businesses in Canada and the U.S. by acquiring loans and interest-bearing assets, while RBC has been focused on expanding its wealth and capital market businesses in the past several years.
As someone who has been living in Canada for more than 10 years, I have learned that it is nearly impossible not to bank with at least one of the Big Six banks-RBC, TD, Bank of Nova Scotia (NYSE:BNS), Bank of Montreal (NYSE:BMO), Canadian Imperial Bank of Commerce (NYSE:CM) and National Bank of Canada (OTCPK:NTIOF). They have the most branch locations across Canada, offer the most extensive banking services (e.g. retail banking, commercial lending, asset management, wealth planning and capital markets), and often have the most competitive banking products.
The Canadian banking industry is an oligopoly dominated by the Big Six banks (often referred to as the Big Five without National Bank because it's smaller). The Big Six controls about 90% of the total banking assets in Canada (source: OSFI). This is different from the U.S. banking industry that is largely fragmented with several major national players-Wells Fargo (NYSE:WFC), JP Morgan Chase (NYSE:JPM), Citigroup (NYSE:C) and Bank of America (NYSE:BAC)-and thousands of regional banks.
Among the Big Six banks, TD is one of the most competitive. Its retail business is known for opening early and closing late, superior customer service as well as being well-established in Canada and in the U.S. East Coast. TD is also a great Canadian bank for long-term investing because its risks are relatively low compared to most U.S. banks and it has steady and growing dividends that can be attractive for dividend growth investors.
TD's Business Segments
TD earns interest and non-interest revenues from a range of banking products and services (e.g. loans, mortgages, fees on bank accounts, credit cards, mutual funds, commercial lending, wealth planning, trading fees, etc.). It reports its financial results in the following segments:
- Canadian Retail-includes personal and commercial businesses, credit cards, auto finance, wealth and insurance.
- U.S. Retail-includes personal and commercial businesses, credit cards, auto finance, wealth management, and investment in TD Ameritrade (NYSE:AMTD).
- Wholesale-includes capital market and corporate lending businesses.
TD earns the majority of its net income from its Canadian and U.S. Retail segments. For example, the bank earned 89% of its adjusted net income from its retail segments while its wholesale segment contributed 11% for Q1 2014 (see image below). Compared to other banks that have more exposure in investment banking and capital markets, TD's risk is relatively lower because the bank is focused on traditional retail and commercial businesses.
Source: TD's Investor Relations site
Unlike other Canadian Banks, TD has a large retail business in the U.S. East Coast in addition to its retail business across Canada (see image below). This allows the bank to grow organically in both markets instead of limiting itself to Canada.
TD's Long-Term Growth and Economic Prospects
Like all Canadian banks, TD's long-term growth and economic prospects are largely dependent on the Canadian economy, including consumer spending, household income and debt, mortgage and loan origination, housing activities, GDP growth and many other factors. According to management, the bank expects that the U.S. economic growth will continue to outpace the Canadian economic growth. U.S. economic growth is expected to be around 2.7% in 2014 and 3.1% in 2015. Household credit growth in Canada should continue to slow, while consumer spending is expected to grow at a moderate pace. Moreover, the Canadian housing sector will likely have a soft landing (source: TD Q1 2014 Report).
While many people think that there is a housing bubble in Canada, I believe that it will likely show up as a small correction instead of a bubble because most Canadians are borrowing within their means when buying homes (based on my previous experience working in the bank), most properties' loan to value ratios (LTVs) are within the 80% limit and Canadian banks are very strict with approving loan applications. For example, borrowers are required to prove that they have enough income to service all existing and new debt before the bank can approve their applications. And borrowers cannot refinance their homes based on home equity alone without proof of income.
The Conference Board of Canada recently stated that the housing bubble in Canada is over-exaggerated and that a 'soft landing' is likely the scenario. Here are some of the highlights (source: housing briefing):
- A stable economy is buoying Canadian housing markets, despite regulatory cooling attempts.
- Housing bubble fears hinge on ratios of house prices to apartment rents and to incomes. These ratios are high, but misleading. The ratio of mortgage payments to rents and to incomes are better indicators and much less alarming.
- The low proportion of mortgages in arrears suggests that any market downturn would not be amplified by a wave of "distressed" home sales, as in the United States.
- Resale markets in major cities are generally balanced.
Canada's economic growth may trail behind the U.S. in the next several years due to the cooling down of the housing market. However, TD will still benefit from the faster U.S. economic growth because it has a sizeable retail business in the U.S. East Coast, which should contribute to TD's net revenue growth.
In the past decade (Oct. 2004 to Oct. 2013), TD's total net revenue grew from $10.83 billion to $27.26 billion, representing a compounded annual growth rate (CAGR) of 9.68% each year. Its net income grew from $2.31 billion to $6.56 billion, representing a CAGR of 11.00%. And its diluted earnings per share (EPS) grew from $1.70 per share to $3.46 per share, representing a CAGR of 7.36%. Total shareholder return was on average 12.1% each year in the last ten years, assuming that all dividends were reinvested in additional TD shares (source: TD Q1 2014 Quick Facts).
While history does not always repeat itself, I believe that TD's total net revenue, net income and EPS will continue to grow at similar growth rates in the next decade. The reasons are that the overall Canadian economy is still strong-although it is expected to grow at slower pace than the U.S.-, the bank is expanding its retail and commercial businesses in Canada and the U.S., and the bank's assets are growing steadily. As long as the Canadian economy is growing, the Big Six banks-including TD-will continue to earn more revenues due to the increase of bank assets, customer deposits, loan origination, commercial lending, wealth management and capital market activities.
In February this year, the bank announced a 13% year-over-year dividend increase and is expecting its dividend payout to be between 40 to 50% of its net income for fiscal 2014. The payout ratio is much higher than many U.S. banks'. Moreover, TD's dividends have grown steadily for more than 15 years (see image below).
Source: TD's Investor Relations site
TD's primary risk is credit risk. However, the bank is well-capitalized with a Basel III Common Equity Tier 1 (CET1) ratio of 8.9% as of January 31, 2014 (the CET1 is a capital ratio that measures a bank's capital adequacy compared with its total risk-weighted assets). In addition, the bank only had 'a gross impaired loan as a percentage of total loans' of 0.6% and the 'loans that are past due but not impaired' were about 2.4% of total loans. I also think that TD's credit risk is relatively low because the Canadian banking industry is well-regulated and is considered to be the soundest in the world, according to the World Economic Forum.
The rise of interest rates is another risk for the bank (this is normal for all Canadian and U.S. banks). However, Canada's current inflation rate is fairly low-1.1% in February this year. Interest rates will eventually rise but it will be a gradual process so that its impact on the economy will be minimal.
The possibility of a housing bubble was mentioned above. The Conference Board of Canada stated that the housing bubble in Canada is over-exaggerated and that a 'soft landing' is likely the scenario.
At the time of writing this, TD is traded at $46.54 per share or at a market cap of $85.53 billion. The stock is likely fairly valued (close to its intrinsic value) if we compare its P/E and Price/Book with its peers. Its forward dividend yield is at 3.6% (see image below) as of March 28. Management expects that the next dividend increase will likely be next year because they already increased dividend once in February that was larger than they have delivered in the past (source: 2014 Q1 Conference Call Transcript).
The Bottom Line
TD Bank should be a great Canadian bank for long-term investing because it has strong retail and commercial businesses in both Canada and the U.S. East Coast, its risks are relatively low and it pays consistent and growing dividends. The Canadian economy may be growing at a slower pace than the U.S., but I believe that TD's retail segments (U.S. & Canada) will still benefit from both markets' economic growth.
Sources: TD 2014 Q1 Report and Conference Call, Department of Finance Canada, The Conference Board of Canada, OSFI, Morningstar and Yahoo Finance.
About the Author: Victor Liang is a co-founder of Intelligent Stocks, a stock recommendation service that is dedicated to helping investors outperform the market.