CA - Toronto-Dominion Bank And First Horizon: The Cancellation Is Bullish

2023-05-09 01:30:20 ET

Summary

• TD Bank and First Horizon agreed to terminate their $13.4 billion merger.
• In my previous article on TD Bank, I espoused that I was skeptical of the First Horizon deal.
• Cancellation is the best possible outcome for TD Bank shareholders, better than any realistic renegotiation would have been.
• In this article, I explain why I'm more enthusiastic about TD Bank stock than ever before thanks to the end of the First Horizon deal.

Last week, the Toronto-Dominion Bank ( TD:CA ) announced that it was backing out of its deal to acquire First Horizon ( FHN ) for $13.4 billion. The end of the deal had nothing to do with TD not liking FHN anymore–the press release made clear that both banks would have preferred to proceed –but rather the fact that TD couldn’t get regulatory approval.

The mutually agreed on ending is a best case scenario for TD shareholders. First, as I will show in subsequent paragraphs, the FHN deal was not a positive for TD or its shareholders. Management offered an arguably excessive price right from the get go, and the offer price just got more questionable as the regional banking crisis got underway. Second, because the deal was cancelled due to regulatory inaction, and because the cancellation was mutual, it is much less likely now that FHN will sue TD for cancelling the deal. After all, both companies agreed, and it likely would have been impossible to close anyway.

Personally, I was quite happy to see the First Horizon deal get cancelled. My most recent article on the topic said that I would like to see the deal get renegotiated, and in fact, a renegotiation to a truly rock-bottom price would have been better than cancellation. However, given the regulatory issues, that wouldn’t have been possible, and the outcome that we actually got was better than proceeding at $13.4 billion would have been. In this article I explain why I am more bullish on TD Bank stock than I was before, because of the cancellation of the First Horizon deal.

What TD Bank Was Offering for First Horizon

One reason why I’m bullish on TD Bank’s merger ending is because TD was offering a very steep price for FHN. According to the deal press release, TD was going to pay:

• $13.4 billion.

• $0.65 per share for every day in which the deal remained outstanding.

The offer price worked out to $25 per share and about half a year elapsed from the agreed on closing date to the cancellation date, so TD would have paid about $25.325 per share had the deal instead closed on that day.

The implied valuation of First Horizon at that price is far higher than what bank stocks are typically valued at today.

Some key per-share financial metrics for First Horizon according to Seeking Alpha Quant (for the trailing 12 month period):

• Revenue per share: $5.91.

• Diluted earnings per share (“EPS”): $1.91.

• Book value per share: $14.10 .

• Free cash flow per share: $4.21.

So, TD Bank was offering:

• 4.3 times sales.

• 13.25 times earnings (15 times earnings when the deal was announced).

• 1.79 times book value.

• Six times free cash flow.

By contrast, the average U.S. bank stock today trades at eight times earnings . And that’s all banks, including regionals which have in many cases fallen to five or six times earnings. Take a look at this list of multiples for large U.S. banks–the ones that are gaining deposits at the expense of smaller banks.

So, TD’s deal multiples were more expensive than all of America’s “big four” banks going by P/E and price to book, more expensive than most of them on price to sales, scoring a win only on price to cashflow. And this isn’t even First Horizon’s peer group! These are the large banks, all of which beat earnings last quarter (FHN missed ) and gained deposits at the expense of regionals. The idea that First Horizon was worth many multiples of what these banks trade at was always questionable. TD claimed in its deal press release that it would realize $660 million per year worth of “cost synergies” that would take the forward deal P/E down to 9.8. It’s true that bigger companies have more bargaining power than smaller ones, and that TD probably could have realized some synergies, but investors were expected to take the “$660 million” figure at face value. It looked to me like TD was trying to make the deal look more in line with typical bank valuations, perhaps falling victim to “wishful thinking.”

TD’s Own Valuation

Having looked at TD Bank’s implied valuation for FHN, we can now look at the bank’s own valuation.

At today’s prices, TD Bank trades at :

• 9.63 times earnings.

• 3.12 times sales.

• 1.43 times book value.

• 9.92 times operating cash flow.

Overall, a pretty typical valuation for a bank these days. Yet when we look at TD’s growth figures, we see it growing revenue at 7% CAGR and EPS at 8.8% CAGR over the last five years, these figures are above average. Likewise, TD has a juicy 31.5% net margin and a 14.7% ROE. So we’ve got TD scoring well on growth and profitability while not being particularly expensive. It looks like a good deal.

How would FHN have affected these multiples?

Well, FHN is a profitable company, and TD was offering cash rather than stock. So earnings, sales and cash flow multiples all would have gotten smaller and made TD optically cheaper had the stock price stayed the same. The problem is that TD’s capital ratios would have suffered because of the deal. By paying $13.4 billion all in cash for FHN, TD admitted that its 15.5% CET1 ratio would have fallen to 11.4%. It would have gone from having some of the best capital ratios in Canadian banking, to one of the worst. Additionally, it would have had to assume all of First Horizon’s deposits and debt as well as its assets, and FHN’s book value was only $7.5 billion as of this writing. So, by paying $13.4 billion in cash, TD’s own book value would have shrunk by $5.9 billion. The asset-based valuation would have gotten worse, not better.

Risks and Challenges

As we’ve seen, TD Bank has avoided some major risks by having regulators force its hand on First Horizon. It got to keep its enviable capital ratios, and got a convenient excuse to back out of the deal without being sued by FHN. It’s a win-win situation. Nevertheless, there are risks and challenges for investors to be aware of, including:

• A loss of future deal-making ability. It’s beginning to look like TD’s U.S. growth plan has been derailed by U.S. regulators. The reason why regulators wouldn’t approve the FHN deal was because TD was accused of abusive sales practices . It actually faced an investigation over these practices during the Trump administration, but was forgiven. It looks like the Biden administration is not turning a blind eye to these kinds of things, and that may impact TD’s U.S. deal making ability going forward. If the reason that TD Bank couldn’t buy FHN was because it was mistreating customers, then it would follow that it won’t be allowed to buy any regional banks in the future. The only way I could see it happening is if another bank goes through a First Republic style collapse and TD is the only big bank willing to save it. Apart from that one scenario, I don’t see TD being allowed to buy regional banks as long as Biden is in office. On the plus side, TD’s Cowen deal did close, so maybe TD can pivot its U.S. ambitions over to investment banking.

• Falling behind other Canadian banks. As a result of its FHN deal failing, TD could be at risk of falling behind other Canadian banks. Bank of Montreal ( BMO )( BMO:CA ) recently bought Bank of the West, Royal Bank ( RY )( RY:CA ) is gearing up to buy HSBC Canada, and there is no talk of that deal encountering regulatory hurdles. So, BMO and RY will get large increases in their earnings next year, while TD will have to be content with the relatively minor earnings boost it got from buying Cowen. It’s not ideal, but then again, TD’s capital ratios have been preserved, so the FHN deal failing is a positive from a risk management standpoint.

The risks above are worth keeping in mind. However, I am, on the whole, thrilled about TD Bank’s FHN deal collapsing. The offer price was pretty steep even when announced, and it became ridiculous once the regional banking crisis got underway. As a result of the deal being cancelled, TD will be able to retain its high capital ratios. Management may be unhappy about what happened, but I as a shareholder am elated.

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