TD

Toronto Dominion Bank (The)

66.28
USD
0.71%
66.28
USD
0.71%
62.81 86.02
52 weeks
52 weeks

Mkt Cap 119.95B

Shares Out 1.82B

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Toronto-Dominion Undervalued, But Not Exactly Defensive

The market sell-off hasn't spared that many companies, but Canadian banks have done at least relatively "less bad" so far this year, with most of the group down only around 5% to 8% so far on a year-to-date basis. Rate hikes remain a potent potential driver of earnings leverage, but that is offset at least in part by growing risks around the Canadian housing market and the consumer sector. Looking specifically at Toronto-Dominion (NYSE:TD), I see a bank with above-average rate sensitivity and attractive long-term growth opportunities from the First Horizon (FHN) deal, but also with execution/integration risk and a need to drive better loan growth. A 20% discount to apparent fair value isn't bad, but the sell-off has created a lot of opportunities, and investors can afford to be selective now. At a minimum, I would definitely advise paying attention to loan growth results and commentary in the upcoming fiscal second quarter earnings report. The Near-Term Outlook Is Getting Rougher With greater economic uncertainty, expectations for Toronto-Dominion's earnings have been coming down in recent weeks, with a roughly 4% decline in FY'22 EPS expectations over the last month. A key factor remains the outlook for rates, as well as the demand for consumer loans and the opportunities for the bank to drive better operating leverage. Rate leverage is a key driver for Toronto-Dominion. While there are always uncertainties when it comes to calculating rate sensitivity (deposit betas, for instance, are notoriously hard to forecast), TD's interest rate sensitivity looks to be roughly double that of the average for the Canadian bank group. The consensus outlook for rates still calls for multiple further hikes, but recession worries are starting to mount and that could ultimately temper some of the rate expectations. TD is also heavily exposed to consumer loan demand, as only about one-third of the loan book is in commercial lending. On the negative side, the Canadian housing market has started to cool (from a high peak) and several consumer lending categories are already comfortably above pre-pandemic levels. On a more positive side, credit quality still looks quite good and card lending, a category that can drive disproportionate profitability for TD, is still around 15% below pre-pandemic levels. First Horizon Provides Attractive Long-Term Opportunities TD has built a significant U.S. branch-based banking business over the last two decades, and some readers may be surprised at just how significant those operations are - Toronto-Dominion is the eighth-largest bank in the U.S. by assets and holds around 2% national deposit share while operating in 16 states representing about 60% of the U.S. deposit base. Acquiring First Horizon will expand the company's franchise into Southeastern/Southern markets, including attractive growth markets like Florida, Georgia, North Carolina, and Tennessee. On top of branch-based core banking, First Horizon also offers the opportunity to expand countercyclical businesses like fixed-income trading (and TD is already working to expand its capital markets operations) and mortgage warehousing. It's important to remember that First Horizon is a deal that is more about driving long-term revenue growth opportunities than near-term cost savings. Though there are some overlapping operations and the opportunity to eliminate some First Horizon corporate expenses, this isn't a cost-driven acquisition and there will not be significant branch closings. While that reduces some of the near-term operating leverage from the deal, it should also aid the regulatory approval process, as regulators have started taking a less favorable view of banking deals that involve substantial footprint/branch reductions. Given TD's history of acquiring and integrating U.S. bank deals, I'm not that worried about the integration risks here. Regulatory delays are a risk (and the deal anticipated those by offering First Horizon shareholders additional consideration if the closing is delayed), but I don't think there is a sound anti-trust/anti-competitive argument for blocking the deal. I do see some modest operational risk. With the IberiaBank deal still relatively recent, there could be some "deal fatigue" at First Horizon, and retaining talent could create some risks and challenges. Toronto-Dominion management has anticipated this with a talent retention program (that will further limit near-term synergies), but Southeastern bank markets are very competitive and banks like Pinnacle (PNFP) are always looking to hire productive loan teams that are unhappy with their current employer. I'd also note that First Horizon doesn't have the best operating track record over the past couple of years. Improving upon this track record has been part of my bull thesis on First Horizon, and I see opportunities for Toronto-Dominion to drive better results, but there is a risk of lackluster operational efficiency mitigating some of the benefits of the deal. What To Watch For Operating leverage is a key focus for Wall Street now when it comes to banks, and while TD is not an inefficient bank, I don't see operating leverage improvement as a major near-term driver. That puts more pressure on the bank to come through on the revenue side of the equation. The rate situation is what it is. TD management can't make rate hikes happen, but I'll reiterate that this is the most rate-sensitive of the Canadian banks (I'd also note that it's quite rate-sensitive compared to many large U.S. banks as well). Loan growth, though, is a key watch item in the upcoming quarterly report. TD has lagged its peers in terms of loan growth recently, and the bank's skew to consumer lending makes it even more sensitive to the health of the consumer, and credit card lending in particular. Trends are positive here, but I do think management's commentary/outlook for loan growth is a key watch item for the quarter. The Outlook I expect low single-digit long-term growth from TD on an as-is basis, but I do see the First Horizon deal boosting the growth rate into the low end of the mid-single-digits, particularly if the bank can leverage some of First Horizon's capabilities in capital markets, mortgage warehousing, and specialty lending across its larger U.S. footprint. In terms of valuation, I expect a mid-teens return on tangible equity (around 18.75%) for FY'22 and an ROE just below 15%. Between discounted long-term core earnings, ROTE-driven P/BV, and a P/E-based approach, I believe fair value is around the low-$90S today (or a 1.7x book value and an 11.25x PE). While I do think that Toronto-Dominion is well-positioned to weather this period of economic uncertainty, I'd note that recent troughs for price/book value were around 1.1x, so there's definitely downside risk in a more bearish scenario for banks. The Bottom Line I'm a fan of buying good businesses during market freak-outs, and I think Toronto-Dominion qualifies as a good business. I like the long-term potential of the First Horizon deal, and while this isn't the most conservative of the Canadian banks (I'd say Royal Bank of Canada (RY) fits that title), I think the likelihood of a collapse in the Canadian housing market and/or consumer sector is relatively low. Is a roughly 20% discount to fair value enough to argue for buying TD today? That's for readers to decide for themselves. I think there are better bargains among U.S. banks now (let alone outside the banking sector), but the combination of undervaluation and relative safety here is nevertheless attractive if not compelling. Disclosure: I/we have a beneficial long position in the shares of FHN either through stock ownership, options, or other derivatives. 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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