WFC - Toronto-Dominion Bank Should Renegotiate The First Horizon Deal

2023-04-11 11:47:32 ET

Summary

• When TD Bank announced its First Horizon deal last year, it was accused of offering too much for the acquired company.
• Today, with many regional banks trading at low single digit P/E multiplies, that claim appears truer than ever.
• TD Bank claims that it can achieve $660 million worth of synergies that take the deal P/E ratio down to 9.8, but that's just a forecast.
• In this article I make the case that TD Bank should renegotiate the First Horizon deal, and aim for a better price.

In any discussion of Toronto Dominion Bank ( TD )( TD:CA ) stock today, First Horizon ( FHN ) is a topic that’s sure to come up. FHN is a bank that TD is in the process of acquiring. TD is paying $13.4 billion for FHN, which is about 16.7% of the former’s book value (with the balance sheet converted to U.S. dollars). It’s a big acquisition for TD, and one that it thinks could add substantially to its earnings. FHN earned $266 million last quarter. If it can simply keep up that earnings level–let alone grow–it will add more than $1 billion a year to TD Bank’s earnings.

However, there is a big problem:

The required approvals for the deal are proving hard to obtain. Just last month, FHN reported that TD Bank had faced another delay in its quest for approvals. Shortly afterward, Seeking Alpha reported that TD was under a Department of Justice (“DOJ”) investigation . If TD really is being investigated by the DOJ, the regulatory approvals may be a long time coming; presumably the relevant regulators will want to see what the DOJ concludes before approving any deals.

This is a problem because TD’s FHN deal includes a clause that says TD will have to pay $0.65 on an annualized basis for every day in which closing is delayed. The original closing date passed, so now the deal is getting slightly more expensive for TD with each passing day.

At this point, I think the best thing TD could do for its investors would be to either scrap or renegotiate the First Horizon deal. When the deal was announced at $25 per share, it implied a P/E ratio of about 15. TD said it could get the earnings multiple down to 9.8 by realizing $660 million worth of synergies. TD might be able to achieve the synergies, but it has already racked up so many delayed closing costs already (about $0.325 per share) that the 9.8 deal P/E ratio probably isn’t happening. Additionally, it’s possible that the DOJ investigation could result in TD Bank booking fines, in which case the FHN deal will have been the source of regulatory scrutiny resulting in diminished shareholder value. In this article I’ll make the case that TD bank should either abandon or renegotiate the FHN deal at a better price, and I’ll also explain why I’m still long the stock despite its recent troubles.

How Much TD Can Make by Buying FHN

To get one thing clear: owning First Horizon would add a lot of earnings power to TD Bank. I’m not disputing that.

In its most recent quarter, FHN earned $266 million. In its most recent 12 month period, it earned $900 million. If the company can continue earning what it did last quarter, it will bring in $1.064 billion in new earnings for TD Bank. If it can continue earning what it did in the last 12 month period, it will bring in $900 million in new earnings. TD earned $11.4 billion in the last 12 months. So, we’re talking about an earnings increase between 7.8% and 9.3%, depending on whether TD’s future quarters resemble its most 12 month period, or its most recent quarter.

That is a substantial increase to TD’s net income. The problem is that TD is paying up to $13.722 billion to get all this new earning power. You’ll recall that the original deal price for the FHN deal was $13.4 billion. If the deal is delayed an entire year, then the delayed payment fees will add up to $0.65 per share or $322 million. This implies that TD is paying nearly a million dollars per day this deal fails to close.

If the FHN deal increases to $13.72 billion in value, then the deal P/E ratio, based on ttm earnings, is 15.24. Based on last quarter’s earnings annualized, the deal P/E ratio is 12.89. The latter P/E ratio is not totally out of the ballpark for a financial stock these days– Charles Schwab ( SCHW ) has a similar multiple . But we can’t say for sure that FHN will meet or top last quarter’s earnings in the upcoming quarters–Q4 was a major beat for the company.

In any case, 15.24 times earnings is very high for a financial stock these days, and 12.89 times earnings is relatively high. According to a 2022 Investopedia article , banks were at an average P/E ratio of 11.25 at the time the article was written. The multiple may be even lower now that regional banks have sold off. The point is, TD is paying a higher multiple than what is typical in the banking sector.

Additionally, TD may end up paying even more than it appears to be paying. We know that various regulatory agencies started investigating TD after it announced its FHN deal. The deal hasn’t closed, and rumor has it that even the DOJ is on the case now. If the DOJ is investigating TD right now, then it’s most likely because of Elizabeth Warren’s allegation that TD had forced customers into unwanted products, much like Wells Fargo ( WFC ) had . Wells paid out $3 billion over its pushy sales tactic controversy. If TD has to pay out the same amount, then that’s essentially $3 billion added to FHN’s price tag, as this entire controversy began as a result of the FHN deal. Prior to the deal, TD had managed to convince the Trump administration to let it off with a reprimand, no fine. Right now, I’m just dealing with a hypothetical, but should a scenario like the one just mentioned come to pass, then TD’s FHN deal will look like it wasn’t worth it.

Why I’m Still Bullish on TD Bank Stock

Despite all the issues with the FHN deal, I’m still bullish on TD Bank stock. Why is that?

For one thing, the stock has a fairly attractive valuation.

At today’s prices, TD stock trades at :

• 9.14 times adjusted earnings.

• 9.46 times GAAP earnings.

• 2.95 times sales.

• 9.4 times operating cash flow.

This is a pretty attractive valuation for a bank. It isn’t quite the level of cheapness you’ll find with Bank of America (BAC), which has been below book value for several weeks now. But it’s pretty cheap if you’re looking at the S&P 500 as your universe of stocks, as that index has a multiple of 22 .

We can also value TD Bank in terms of a conservative discounted cash flow model. There are too many variables at play to forecast TD’s earnings well out into the future, but we can just value it as if its current earnings level were to continue indefinitely. This seems like a conservative assumption, given that TD’s 10 year CAGR earnings growth rate was 8.8% .

TD had $4.92 in diluted earnings per share (“EPS”) in the trailing 12 month period. At a 0% growth rate and a 3.5% discount rate (the 10 year treasury yield), that gives a fair value estimate of $140. There is considerable upside under this assumption. If we use an 8.5% discount rate (the 5 year treasury plus a 5% risk premium), then the fair value estimate is $58.23. At this discount rate, TD is about fairly valued. Most likely, the appropriate risk premium is somewhere between 0% and 5%, so in most scenarios, even with no growth, TD should have some upside.

The Bottom Line

The bottom line on TD Bank is that it’s still a great company, but its ongoing First Horizon deal is turning out to be a real headache. If TD can renegotiate the deal and get a better price, it may be worth it. If not, it might be better off backing out. That’s not to say that TD is buying a lemon with FHN. First Horizon is a great bank, a regional that made it through the March banking crisis with no major liquidity issues. Nevertheless, TD is offering a very princely sum for the bank, at a time when many regional banks are trading at fire sale prices. For this reason, I only rate TD a ‘buy’ at this time, in contrast to the ‘strong buy’ I rated it at in my previous article on the topic.

Nevertheless, I plan to continue holding my TD shares. The offer price for FHN is a little high but not outrageously so; measured in decades rather than years, it could still pay off for TD. Plus the 4.7% dividend yield is adding a considerable amount of income to my portfolio.

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