CA - First Horizon And Toronto-Dominion Bank: Will They Or Won't They?

Summary

• First Horizon sparked a 10%-plus sell-off on news in its 10-K that Toronto-Dominion had informed them that they will not be able to complete the merger by the established deadline.
• Toronto-Dominion recently unveiled its $50B community investment plan, but it typically takes months after such plans to get approval, and further concessions may yet be required.
• Toronto-Dominion management sounded committed to the deal on its earnings call, and the deal is a meaningful one for the bank, but TD may push for some concessions.
• First Horizon has little bargaining power and would not be entitled to compensation if the deal collapses, and would in fact see dilution from preferred stock issued to TD.
• With a standalone fair value in the low-$20s, I think First Horizon investors will be OK if the deal collapses, but a negotiated extension is the better outcome.

After years of regulators basically sleeping at their desks and rubberstamping mergers, times have changed. That's particularly so in the banking sector, where large deals now are almost certain to need extended timelines to close, as regulators drag their feet and politicians look to score points by insisting that deals be stopped (or at least delayed) until concessions can be squeezed out of the acquirer.

That brings me to the latest example, the deal between Toronto-Dominion ( TD ) and First Horizon ( FHN ). First Horizon informed investors earlier this week in its 10-K filing that, despite a relatively recent agreement to extend the deadline for the close of their merger, Toronto-Dominion had informed First Horizon management that they would not receive the necessary regulatory approvals in time to close the deal by that deadline.

First Horizon shares have dropped 12% since that news, and Toronto-Dominion management fielded multiple questions on their recent quarterly conference call about the outlook for the deal, so let's take a look at what may happen.

What's The Hold Up?

Nobody has said exactly why regulators have been slow to approve this deal, and it's well worth noting that many deals have faced extended timelines, as regulators have increasingly forced acquirers to jump through a series of hoops to get the needed approvals.

In some cases, these requirements are entirely reasonable (not even "hoops," really). Regulators have required some banks to divest branches where market concentration would be an issue (and, ironically, sometimes required pledges that banks don't close branches in underserved areas), while other banks have been forced to upgrade their compliance infrastructure (Bank Secrecy Act and/or Anti-Money Laundering systems) due to observed deficiencies.

In other cases, there have been concerns regarding bank conduct, including aggressive or improper sales tactics. In the case of U.S. Bancorp 's ( USB ) recently-completed acquisition of Union Bank from Mitsubishi UFJ ( MUFG ), deal closure was delayed by the need for U.S. Bancorp to reach agreement with regulators on a consent decree covering these sales practices.

Yet another "feature" of recent deals has been increasing requirements for acquiring banks to pledge to allocate substantial resources to increase lending and banking services to what politicians and regulators define as underserved communities. I'm absolutely editorializing here, but this is the emerging requirement that irks me most, as it appears to me that regulators are leveraging their administrative powers to achieve political ends/outcomes that go beyond their mandate as stewards of the banking system.

I absolutely grant that this is a debatable point, but in my view these are outcomes/issues better addressed by legislation and consistent law/rules that apply to all banks, not just banks seeking to growth through acquisition. It would seem preferrable to me that approvals for capital returns to shareholders should be tied to community reinvestment, rather than this scattershot approach that is tied to M&A activity.

In any event, Bank of Montreal ( BMO ) was obligated to commit $40B to such a community investment plan to secure approval for its acquisition of Bank of the West from BNP Paribas ( OTCQX:BNPQY ), while U.S. Bancorp pledged $100B in its plan for the Union Bank deal. Toronto-Dominion has already committed to a five-year, $50B in community investment plan, as well as opening new branches in targeted markets, not closing any First Horizon branches, and substantially increasing mortgage lending to low/middle-income and non-white borrowers.

At this point, the remaining issues are likely tied to past accusations regarding improper behavior in TD's U.S. banking operations. Sen. Elizabeth Warren demanded an investigation last year, and others have taken issue with the overdraft fees that Toronto-Dominion charges, as well as how they disclose and present (or rather, don't) these fees. Resolution of this would likely be in the form of certain pledges/guarantees, and possibly a consent decree depending upon the specific activities involved.

What Happens Now?

It's worth noting that U.S. banking regulators haven't actually formally rejected a deal in 15 years, but in several cases banks have abandoned proposed mergers due to either onerous requirements or approval timelines that continue to stretch on with no visibility on the end of the process. To that end, I would note that it took five months after the community investment plan proposal for U.S. Bancorp to get its required approvals (likely due to delays tied to the consent decree process).

In any case, First Horizon noted that Toronto-Dominion has re-engaged them in discussions about another extension to the merger deadline and based upon the comments from the conference call, I believe discussions are underway.

The fact that First Horizon needed to disclose that the deal wouldn't be completed on time and that there wasn't a simultaneous announcement of a new extension, is a concern to me. It may simply be a matter of timing - perhaps between the deadline for filing the 10-K and Toronto-Dominion's work in closing up their quarter and completing the Cowen deal, there just wasn't time. But there could be more to it.

Considering the concessions that regulators are extracting, the First Horizon deal could now be looking more costly than what TD management may have initially contemplated. Moreover, bank stock valuations have declined in the time since the deal was announced (regional bank stocks are down about 11%).

It's possible that Toronto-Dominion may try to renegotiate the terms of the deal in exchange for continuing on with the transaction. That could mean a reduction in the core offer ($25) and/or a cap or waiver for the ongoing contingent payment ($0.0017808 per day, from Nov. 27, 2022 until close). I don't consider this particularly likely - if Toronto-Dominion has intentions of executing additional deals in the future, you can bet that a renegotiation of this deal will become a factor in future negotiations with other sellers.

It's also possible that Toronto-Dominion will throw up their hands and give up. Unfortunately for First Horizon shareholders, they and First Horizon management hold no real leverage here. Toronto-Dominion isn't obligated to pay a termination fee and if the deal fails to close due to a failure to obtain regulatory approval, the Series G preferred shares that First Horizon issues to Toronto-Dominion will convert to 19.7M shares (adding close to 4% to the share count).

Of course, should the deal fall apart, I can all but guarantee that there will be lawsuits, with attorneys for shareholders conceivably going after both management teams, and possibly attempting to argue that Toronto-Dominion dragged its feet and/or didn't act in good faith to complete the merger.

The Outlook

I continue to believe that this deal will happen - so much so that I re-entered a position in First Horizon when the stock dropped on the disclosure that the deal wouldn't finish by the deadline. I believe First Horizon has every reason to work cooperatively with Toronto-Dominion to see this deal happen. I also believe Toronto-Dominion is (or should be) highly motivated to close this deal - expanding into the fast-growing Southeast U.S. is an important part of their growth strategy, as is expanding their middle-market lending and capital markets capabilities.

With no deal, I believe First Horizon shares should be worth around $20.50 - $21.50, underpinned by mid-single-digit long-term core earnings growth and/or a 10.5x multiple on 2023 earnings. First Horizon has seen quality employees leave since the deal was announced, and that's a threat to the business, but not an unrecoverable issue. First Horizon has strong share in multiple attractive markets, and while the breakdown of this deal would be a significant setback, I believe the bank would still have a strong future on a standalone basis.

The Bottom Line

In my view, the Street is pricing in a real chance that the deal does not go forward, and I believe that's probably too bearish given that we have two parties with incentives to complete the deal. Those incentives are not equal, though, and I certainly think it's possible that the deal falls apart. That would be a lot worse for First Horizon than for Toronto-Dominion, and I do believe the shares would fall below my near-term estimate of fair value, but First Horizon shareholders would be OK in time. Whether stepping into this uncertainty makes sense for you as investor is of course up to you, but I do think there is still path forward for a Toronto-Dominion/First Horizon merger.

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