- Canadian banks are known and beloved by dividend investors for their impressive dividend track records.
- Toronto-Dominion's first quarter results beat expectations but it was the 12% dividend hike that really excited me as a dividend investor.
- TD Bank is making strong inroads into the U.S. market and is positioned for further growth in its business as well as dividend growth for investors.
- To build great income all you need is patience, time and a stock solidly and reliably growing its dividend for years and decades.
Canadian banks with their century-long dividend history have rewarded investors dearly over decades.
Source: Marketing Mag
A year ago, I termed Toronto-Dominion Bank (NYSE:TD) the "best bank for dividend investors" and with the recently published earnings and dividend announcement the bank cemented that status once again. Hiking the dividend by 12% brings the yield to 3.6% (in CAD) and represented the single largest dividend increase over the last 6 years. Propelled by record U.S. earnings thanks to its strong U.S. footprint, the bank is positioned for further growth and will also benefit handsomely from Trump's tax reform. Valuation and dividend growth prospects signal an attractive long-term buying opportunity.
What is going on at Toronto-Dominion Bank?
In its latest FY 2018/Q1 earnings release, the company beat expectations top and bottom line. Net income rose by 15% boosted by very strong growth in TD Ameritrade (+23% Y/Y) and U.S. retail banking (+19% Y/Y) partially offset by a moderate 4% Y/Y growth in wholesale banking. While a one-time tax charge of C$405M affected overall profitability, this is good news for investors as it showcases the bank's strong standing in the U.S. and points to lucrative tax benefits from the U.S. tax reform going forward. More on that after we review the current quarter.
A record profit of C$952M in the bank's U.S. retail division (U.S. Retail Bank and TD Ameritrade together) lifted net income considerably. TD's rapid and significant expansion into the U.S. market has been a great strategic move. The segment is now contributing 41% of the bank's total earnings and is set for further growth.
Almost 2,400 retail locations is testament to TD's strong market position and being ranked a Top 10 North American bank as a Canadian bank is quite a feat. Interestingly, the company has more stores in the U.S. than in Canada and its U.S. branch is rapidly catching up on other metrics as well.
Over the years, the bank has evolved from a traditional dealer to a client-focused dealer by increasing its retail focus through various acquisitions and reducing overall risk. Out of Canada's Big Five banks, TD is the one focusing the most on retail and small business banking rather than capital markets and wholesale banking.
This does not sound as rewarding as high-profile investment banking but having been able to grow earnings at a 5-year CAGR between 8-10% clearly falsifies that assumption. As such the 15% EPS growth reported for the most recent quarter came in unexpectedly high and could signal a permanent shift to higher earnings growth momentum for the bank.
How about the U.S. tax reform?
With a significant amount of earnings originating in the U.S., the bank is set to benefit substantially from the U.S. tax reform. CFO Riaz Ahmed estimates that by significantly lowering the bank's U.S. retail bank tax rate, it can expect an annual benefit of up to C$240M and up to C$300M if including the bank's stake in TD Ameritrade.
This translates to a full-year EPS impact of around C$0.16 or, based on the latest declared dividend, represents 6% of its annualized dividend. As the bank continues to grow its U.S. operations that tax-driven earnings boost will scale up accordingly.
Dividend Growth is in the Teens
The company currently boasts a forward yield of 3.6% thanks to today's announced 12% dividend hike and has been growing its dividend by an annualized growth rate of 10% over the last 20 years.
That impressive growth in the dividend growth is fully supported by growing earnings as mentioned above. The company is targeting a payout ratio in the 40% to 50% range. In Q1/2018, the dividend payout ratio was at 38% and thus below the company's target corridor. Factoring in the increased C$0.67 quarterly dividend would have resulted in a payout ratio of 43%, right at the sweet spot of that range.
The bank's dividend increases have been occurring like clockwork and for dividend investors who want to experience the power of compounding dividend growth with a company solidly and reliably growing earnings for decades, TD is the place to be. A simple model, using CAD amounts, shows potential dividend returns for an investor starting out with TD right now with a 3.6% starting gross dividend yield.
Reinvesting the dividends every quarter (assuming you are with a broker where you can buy incremental shares), results in a personal net YoC of above 11% assuming the bank continues to grow its dividend at a 10% clip. Also, not factoring in any capital appreciation or exchange rate effects, an investor already received more than 60% of his initial investment over that time.
These results are already impressive but it gets better yet equally simple if we start investing additional capital into the stock every quarter. Here are the parameters:
- Starting yield: 3.6% gross
- Initial investment: $1,000
- Ongoing quarterly investment: $500
- Reinvest dividends every quarter
- 10% dividend growth
- 15% Tax rate
- Exchange rate and stock price appreciation are not considered
After 10 years, this results in the following:
A YoC of 8.9% paired with total invested capital of $21,000 is generating annual dividends of $1,857 or roughly $460 on a quarterly basis. At current prices, the latter would be sufficient to buy 8 more shares just with the quarterly dividend.
Admittedly, that scenario is making two very strong assumptions: First, 10% dividend growth over 10 years is a challenging task but based on the bank's track record and growth potential certainly achievable. Secondly, the model simplifies by not factoring in an appreciating stock price. Naturally, a higher stock price means that the dividends we receive and capital we contribute will buy less and less stock. Assuming the stock grows by 8% p.a. would for instance only allow us to buy close to 4 shares or almost half of what the model is factoring into. A future and revised model will account for that parameter as well.
Despite these constraints, the power of compounding dividend growth becomes clearly evident. Leaving the parameters set as mentioned above and changing the dividend growth assumption to 8% would already result in a remarkably different picture.
After 10 years, 2pp lower dividend growth per year translates into an annual dividend that is 18% lower. That differential will only widen further as the years go by. Thus, for a long-term oriented portfolio dividend growth is much more important than a high starting yield. With TD Bank, we get a market-beating starting yield of 3.6% combined with 10% annualized dividend growth. A very powerful combination and a very easy way to experience the power of dividend growth investing.
Canada's "best bank for dividend investors" goes ex-dividend on April 9 with payment due end of April. Given the favorable macroeconomic environment in both the U.S. and Canada, the bank is expected to continue on its growth path.
To keep track of dividend payment and ex-dividend dates, I use the Dividend Calendar & Dashboard Tool, which shows my expected dividend payments, in this case for February 2018. I'd be happy if you download the free tool and give it a try on your own.
Similarly to the Royal Bank of Canada, TD is a top quality stock at a cheap price. It is currently trading at around 14 times earnings and thus in line with its Canadian peers. Its higher valuation is more than justified by its higher dividend growth and potential future growth in and catalysts from the U.S. market.
The bank’s avenues for growth are manifold and paired with the bank’s traditional strength and stability driven by its major retail focus will be providing plenty of income and growth for savvy investors that are willing to accept exchange-rate risks.
You simply can't beat the Canadian banks.
Now that all of the Big Five have reported earnings with all of them proving analysts wrong and posting higher than expected profits, all except Bank of Montreal (BMO) also hiked their dividend: Canadian Imperial Bank (CM) by 2.3%, Royal Bank of Canada (RY) by 3%, Bank of Nova Scotia (BNS) by 3.8% and TD Bank by a staggering 12%. TD Bank clearly stands out from the pack here, which also does not change if we consider that the others typically announce two similar-sized dividend hikes over the year.
Overall, favorable macroeconomic conditions in Canada as well as rising interest rates in North America and the U.S. tax reform have helped and will help TD to further expand margins and increase profitability while at the same time managing risk and keeping loan losses under control.
It is surprising to see that now that the market is potentially expecting 4 instead of 3 dividend hikes, all major North American banks are selling off although that should clearly help them to expand margins.
You don't have to be a genius to build great income.
In fact, it is probably the simplest task you can think of. All you need is patience, time and a stock solidly and reliably growing its dividend for years and decades. With TD you get the latter. You are responsible for the first two ingredients.
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Analyst’s Disclosure: I am/we are long CM, RY, BNS, TD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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