BMO - Toronto-Dominion Could Stand Out In This Next Phase Of The Cycle

Summary

• Toronto-Dominion is going into the next earnings cycle with elevated concerns about its rate sensitivity and exposure to credit risk, but underlying earnings power looks stronger than for most peers.
• Management continues to work to close the First Horizon deal, recently pledging $50B in lending to underserved communities.
• Low-to-mid-teens pre-provision operating profit growth through 2025 should set Toronto-Dominion apart, and the bank has more capital flexibility and potential M&A leverage.
• Long-term core growth in the 4% range can support a fair value above C$100, as can a 10.5x forward P/E multiple that is in line with longer-term averages for the peer group.

Banking is going to get even more challenging in 2023, as banks in Canada (and much of the world) will be dealing with weaker loan growth, an inverted yield curve, rising funding costs, and rising credit costs, including questions about whether the housing market can find a soft landing. While the state of Canada's economy doesn't worry me that much, earnings momentum will be harder to come by.

With lingering asset sensitivity, good capital, and potential deal momentum, I think Toronto-Dominion ( TD ) could stand out. Peak net interest income is a concern, of course, but that's at least partly counterbalanced by opportunities from the Cowen ( COWN ) and First Horizon ( FHN ) deals. Provided that Toronto-Dominion can generate long-term core earnings growth of 4% (or better), I do think the shares are more than 15% undervalued today and worth a look.

Making New Commitments To Get The First Horizon Deal Done

I consider it unlikely that Toronto-Dominion will have much additional certainty about the regulatory approvals of the First Horizon deal by the time of the March 2 earnings report. The bank previously announced that it had extended the close date for the transaction to May 27, and management continues to work on a path forward to regulatory approval.

Here of late, it seems that banks are increasingly facing shakedowns from regulators in order to get deals approved, with regulators (and politicians) insisting on pledges of increased lending to underserved groups. Bank of Montreal ( BMO ) pledged $40B in such activities to secure approval for its Bank of the West deal, and TD has recently committed to $50B in lending to low-income and other underserved groups, as well as pledging not to close any First Horizon branches (which likely was never going to be much of an issue anyway).

Given that there really aren't valid reasons to deny the TD-First Horizon deal under previously-established M&A law and precedent, hopefully, this offering will be the final major hurdle to the needed approvals and the banks can close the deal around midyear.

Once closed, I expect the First Horizon deal to be meaningfully accretive for Toronto-Dominion. Expense synergies will not be a major factor in the long-term benefits of the deal, but rather the added exposure that TD will gain from operating in faster-growing banking markets in the U.S. Southeast, as well as the opportunity to leverage and expand some of First Horizon's fee-generating businesses (including its capital market operations).

Navigating A Trickier Banking Environment

Meanwhile, the core operations for Toronto-Dominion are going to see more challenging conditions in both Canada and the U.S. in 2023. While TD has benefited from its asset sensitivity, and the bank has a relatively attractive overall loan/deposit ratio (more so in the U.S. operations than in Canada), rising funding costs are a challenge for almost every bank now. With that, I expect investors to be keenly focused on commentary around interest spreads and whether management believes they have seen (or are soon about to see) the cyclical peak for net interest margin.

TD is also likely to see an impact from moderating loan demand. TD's commercial lending had been outperforming for a few quarters before lagging its peers in the last quarter, while the company has been comparatively less active on the mortgage side. A key question now is the outlook for card lending. I expect card lending to be an area of relative strength in 2023, but I do have some concerns about deteriorating credit quality over the next year or so.

Operating leverage should become more important in an environment where spreads are pressured and loan growth is trailing off. TD had the best efficiency ratio of its peer group in the last quarter and that should continue to serve the bank well, though this could be one of those scenarios where above-average cost control is actually perceived as a negative given less room/opportunity to improve relative to less-efficient banks.

Boiling it all down, I'm expecting low double-digit annualized pre-provision profit growth over the next three years that I expect will lead the group, though Bank of Montreal won't be too far behind. CIBC (CM.TO) could end up doing better on a core banking business (excluding capital markets, banking operations outside of North America, etc.), but it won't likely be by a wide margin and I don't think you necessarily ought to exclude these ancillary operations from the analysis - part of the argument for diversifying into areas like capital markets is to offset some of the banking cycle risk.

The Outlook

As I said above, I'm expecting low double-digit core pre-provision earnings growth from 2022 to 2025. Provisioning expense is going to head meaningfully higher, though, as banks start seeing deteriorating credit quality. I'm expecting provisioning expense to reach C$4B in FY'24, and that will likely push core earnings growth over the next three years down toward the mid-single-digits, partly offset by share buybacks that should keep the bank toward the top of the list for EPS growth.

Longer term, I'm expecting core earnings growth in the neighborhood of 4% and modestly higher returns of capital (dividends and buybacks) over time. That level of core growth can support a fair value above C$104 today. Other methods, like ROTCE-driven P/TBV and P/E give me broadly similar results, and that includes using a 10.5x forward P/E (in line with long-term median forward P/Es for Canadian banks) on my C$9.07 2023 EPS estimate that drives a mid-C$90's fair value.

The Bottom Line

I do expect TD to have more sensitivity to the rate cycle and credit cycle than other Canadian banks, and it may seem counterintuitive to like the bank at this point in the cycle. It's really a function of underlying earnings power, though, as I believe TD will be an outperformer on pre-provision earnings growth and has more capital flexibility than many/most of its peers. I also see above-average opportunities from its M&A program, though the First Horizon deal is not yet fully derisked. While I don't consider Toronto-Dominion "can't miss cheap", I think it's a worthwhile name to consider, even with the perception of elevated spread and credit risk going into fiscal first quarter earnings.

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