Financial securities broker TD Ameritrade (NASDAQ:AMTD) is quickly becoming a strong dividend growth stock. The company has raised its dividend nine consecutive years. The dividend's strong growth rate caught our attention, but when you take a closer look, there is a lot to like. A growing and diverse revenue base, strong profit metrics, and a healthy balance sheet combine to offer investors a strong investment option that seems to fly a bit under the radar. When you consider the stock's attractive valuation, TD Ameritrade is an appealing total returns opportunity for long-term investors.
TD Ameritrade is a holding company that brokers a variety of financial services, securities, and other products to investors/traders. The company has been operating since its founding in 1971. The company holds more than $1.2 trillion in total assets and generates more than $5 billion in annual revenues. The revenues stem from a cluster of different categories, including commissions and transaction fees on security trades, deposit fees on cash handling services, interest revenue on assets held, and fees from managed products such as mutual funds.
Source: TD Ameritrade
TD Ameritrade has seen steady growth over the past decade, as the recovery of the financial markets has been a huge tailwind for the company. The company also gained a boost by acquiring rival Scottrade in 2017. Over the past decade, revenue has grown at a CAGR of 8.06%, and EPS at a CAGR of 6.89%.
When we look at the operational metrics of a potential investment, we focus on a few specific metrics. We want a company that is consistently profitable, so we look at the operating margin. We look for strong cash flow generators, so we review the conversion rate of revenue into FCF. Lastly, we want a business that is well run, and not overly capital-intensive. Therefore, we look at the company's cash rate of return on invested capital (CROCI). Specifically, we have three benchmarks:
- Operating margin: consistent or expanding margins over time.
- FCF conversion: conversion rate at 10% or greater.
- CROCI: Consistent rate of return at 11-12% or greater.
The company's total operating expenses of $2.8 billion over the trailing 12-month period result in an operating margin of approximately 57%. It has been one year since the company's large acquisition of Scottrade, so these metrics need to be followed to establish a new trend of performance. If we look at FCF conversion, the rate is very strong at 31.43% - even if it has been a bit choppy over time. The CROCI is also solid, although this is another metric that needs to recalibrate following the Scottrade deal. Overall, TD Ameritrade is operating profitably and generating a ton of free cash flow.
Next, we look at the balance sheet. A company that holds assets and lends money must remain financially disciplined as liquidity is the ultimate priority.
The company is in great shape here. Although TD Ameritrade has more than a billion in debt coming due in the next few years, it operates from a net positive cash position, so it can easily pay this down.
Dividend & Buybacks
Operating at a high margin, high cash flow level, TD Ameritrade is able to distribute cash to investors. This is what ultimately put TD Ameritrade on our radar for this review. The dividend has been raised each of the past nine years. The current payout of $1.20 per share (annual sum of quarterly dividends) yields 2.20% on the current stock price. Although it yields less than treasury notes, the upside is in how management has grown the payout. Although sporadic with some special dividends mixed in, the total payout has grown at a CAGR of 19.0% over the past five years. The dividend also consumes a very small portion of cash flow, just 10.78%. While the company will act conservatively to preserve liquidity, the dividend still has plenty of room to continue growing at a strong rate.
TD Ameritrade also has an established record of buying back stock. Several hundreds of millions are spent buying shares each year, and the share count has diminished over time. The company had to issue stock as part of the Scottrade deal, but they have already restarted the process of retiring stock.
Growth Opportunities & Risks
The company is growing organically and through acquisitions. We have already mentioned the company's deal to acquire Scottrade. The deal was worth $4 billion and closed near the tail end of 2017. With the company's balance sheet still in great shape, we could see a similar deal taking place in the future. It has already been rumored that TD Ameritrade may be interested if competitor E*TRADE (ETFC) is put up for sale.
Organic growth has been solid as well since the merger. From Q1 2018 and forward, TD Ameritrade has grown new net client assets between 7% and 10% by the quarter. This figure doesn't include appreciation such as the inflation of a stock price, so this is impressive.
Source: TD Ameritrade
While this is great, investors need to note that we are in a stretched bull market. During markets like this, investing activity tends to increase. When the market turns lower, human psyche will pull assets out of the market and reduce trade frequency. We find that TD Ameritrade has the financial chops to navigate through a downturn, but such an event would certainly stifle the company's growth. The prospect of a recession also poses other systemic risks to TD Ameritrade. Similar to a bank, the company holds and lends money and other assets. The company must run itself conservatively to protect its liquidity. A downturn could stress TD Ameritrade in this regard. But, as we said, we find a recession as a growth headwind. The company is on a solid financial footing and would be able to navigate all but apocalyptic scenarios.
The stock has drifted lower since last summer. Now trading at just under $55 per share, TD Ameritrade is at the midpoint of its 52-week range.
Analysts are projecting TD Ameritrade to earn approximately $4.07 per share for FY2019. This places the stock at 13.75X full year earnings, a 29% discount to the stock's 10-year median. This perceived discount to TD Ameritrade's value is backed up by a couple of other metrics. The company's dividend yield of 2.20% is 52% higher than its 10-year median yield of 1.44%.
In addition, the stock's yield on free cash flow is near its high point over the past decade. Considering all variables, we view that TD Ameritrade is currently trading at an attractive valuation. While the risk exists for recession-induced headwinds, the stock's discounted valuation provides a margin of safety for long-term investors. We like the stock's price up to approximately $64 per share where it begins to approach fair value.
The need for brokers in the financial markets gives TD Ameritrade staying power as a prominent player within its industry. The company's scale only grew with the acquisition of Scottrade. We like the company's profitability, cash flow generation, strong balance sheet, and dividend growth as the foundation of a bull thesis. When you factor in valuation, we suspect that TD Ameritrade will be a profitable investment five years from now.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.