CA - Toronto-Dominion: Near-Term Uncertainties Offset By Long-Term Optionality

2023-05-26 10:59:20 ET

Summary

• Toronto-Dominion missed FQ2 expectations on weaker net interest margins and higher expenses, as higher deposit costs work their way into the financials.
• The collapse of the First Horizon deal may point to issues with anti-money laundering compliance that management will have to resolve.
• TD has a strong core deposit franchise and a strong retail/consumer business, but weaker consumer spending and credit trends, higher deposit costs, and higher expenses are headwinds.
• Toronto-Dominion shares appear 10% to 15% undervalued on a long-term high-3% core growth rate, but banks remain out of favor, and the cycle still presents risks.

The last three months haven't been great ones for Canadian banks in general, and particularly those with substantial U.S. operations, as banks like Bank of Montreal ( BMO ), CIBC ( CM ), RBC ( RY ), and Toronto-Dominion ( TD ) have all seen double-digit declines. Since I last reviewed Toronto-Dominion Bank , the uncertainties around the rate cycle and the economies of Canada and the U.S. have only grown, with the added stress of increased investor focus on duration mismatches and operational liquidity.

Of course, Toronto-Dominion's performance over that time has also been significantly impacted by the abandonment of its attempted acquisition of First Horizon ( FHN ) and the uncertainties that now follow in the wake of that failed deal. While the loss of the First Horizon deal is a significant hit to the company's growth aspirations, TD still has an excellent retail banking franchise, an improved investment banking and wealth management operation, and abundant capital to fund future growth and returns to shareholders.

I do expect that it will take time for bank stocks to come back into favor, but I believe TD shares are around 10% to 15% undervalued today, and that is without assuming that meaningful amounts of the bank's surplus capital are reinvested into growth.

A Rough Quarter, But That's Not A Huge Surprise

Hurt by greater-than-expected pressure on net interest margins and higher costs, Toronto-Dominion came up short of analyst expectations in the fiscal second quarter. While misses are typically disappointing, TD isn't exactly in rare company this time around, as Bank of Nova Scotia ( BNS ), Bank of Montreal, and RBC all missed pre-provision profit expectations by as much or more than Toronto-Dominion's roughly 6% miss (6% to 11%), and CIBC was a rare outperformer with a small beat.

Revenue declined 4% sequentially on an adjusted basis, with both the Canadian Personal & Commercial (or P&C) and U.S. Retail operations down similarly (down 4% and down 5%, respectively) on net interest margin pressures. Net interest income declined 4.5% sequentially for both segments, with the Canadian banking operations seeing a 6bp sequential decline in NIM (to 2.74%) and the U.S. operations seeing a 4bp decline (to 3.25%).

Overall expenses increased more than 2% sequentially, leading to a roughly 11% sequential decline in pre-provision profits. PPOP declined 8% in the Canadian banking operations and 6% in the U.S. retail operations. Credit provisioning costs were actually about 13% lower sequentially, and credit quality has remained resilient - while TD has more exposure to consumer credit, the bank has also traditionally had fairly conservative underwriting practices.

Management expects a little more pressure on rates from here, as deposits reprice higher, and then stability toward the end of CY'23 and into CY'24. Further rate hikes in Canada don't seem particularly likely now, and management has expressed a view that rates aren't likely to decline quite as quickly as the forward yield curve would suggest.

Expenses remain a key unknown, though, and particularly in the U.S. operations. I'll discuss this more in a moment, but TD is looking at not only higher costs to drive organic growth in the U.S., but also likely higher compliance and remediation costs, and that will have some impact on margins and returns over the next couple of years.

On a positive note, the bank exited the quarter with a CET1 ratio of 15.3% and something in the neighborhood of C$16B in surplus capital.

The Collapse Of The First Horizon Deal Stings

Despite TD management's frequent reiterations of the perceived value of the acquisition of First Horizon (and their commitment to the deal), the two companies announced early in May that they were terminating the deal. As part of the termination, TD paid $225M to First Horizon in compensation and converted the Series G preferred shares it held (at $25) into common shares.

Managements of both companies have been guarded in their commentary about the deal collapse, with First Horizon management noting that the issues were not tied to their bank. Reports have since come out suggesting that deficiencies in Toronto-Dominion's anti-money laundering policies were the ultimate impediment to the deal, and this sounds credible to me. Several large regional banks have had to strengthen their AML practices in recent years (including M&T Bank ( MTB ) and U.S. Bancorp ( USB )) and the process can take years to complete (it took around four years for M&T), with bank regulators typically holding up M&A approvals until the remediation process is complete.

If there are meaningful AML issues at TD, management will have to address them, and that will take time and money - likely meaningful amounts of money. M&T reportedly spent more than $400M to upgrade its AML compliance systems, and U.S. Bancorp paid over $600M in fines for its AML compliance issues (above and beyond remediation costs). Whether those are reasonable benchmarks and/or ballpark estimates for TD remains to be seen, but given the size of the bank's U.S. operations, meaningful AML remediation will be expensive (if that is, in fact, something TD has to do going forward).

I continue to believe that First Horizon would have been a strong strategic deal for Toronto-Dominion, not only extending the U.S. banking operations into the faster-growing markets of the Southeast U.S. but also accelerating the bank's efforts to grow its U.S. commercial lending operations and expand into more strategic specialty verticals. The deal would have also helped grow the capital markets business, as First Horizon has a large-for-its-size bond trading operation that TD could have built upon in the years to come.

It remains to be seen whether the First Horizon deal is forever dead. Clearly, Toronto-Dominion has issues to resolve with U.S. banking regulators, but if they can solve those issues over the next year or two, a revisit of the deal wouldn't be out of the question in my view. What's more, TD is likely out of the market for any U.S. bank M&A until and unless these compliance issues are cleaned up, though there are opportunities outside the U.S. and in areas like asset/wealth management (outside the purview of banking regulators) that First Horizon could explore.

The Outlook

Spread pressure from deposit pricing will be a headwind for a bit longer, and I do also expect TD to see a combination of slowing loan growth (up 1% QoQ in Canada and 2% in the U.S.) and higher credit costs as the economies of Canada and the U.S. continue to slow - management has said they're expecting a recession in both countries by the end of 2023. As a reminder, TD is much more skewed to retail customers than business customers, particularly with its large card business, and a slowdown in consumer spending (likely in Canada as mortgages reprice higher) does appear to be a threat.

With First Horizon no longer in the mix, I expect a slower long-term core growth rate for Toronto-Dominion (in the 3%s versus over 4% previously). There is substantial excess capital here, though, and I do expect that to be deployed into growth (particularly into capital markets and asset/wealth management) and returns of capital to shareholders.

I also note that management will be moving forward with organic growth plans in the U.S., including 150 potential new branches across the Southeast U.S. by 2027 - while banking regulators can block banks from opening new branches due to inadequate AML/BSA policies, it would appear that Toronto-Dominion's issues don't rise to that level (regulators apply a scale to such matters, so it's not unheard of for the bank to be blocked from M&A, but still allowed to expand existing operations).

Between discounted core earnings and a P/E-based approach, I believe Toronto-Dominion shares are currently about 10% to 15% undervalued. With that, I'm not factoring in any explicit redeployment of the excess capital (so there could be an upside to core earnings and/or per-share earnings), nor any compliance remediation costs (including potential fines). My "core" earnings expectations are also lower now, as I expect TD to see higher deposit costs and higher expenses relative to my prior outlook, as is the case with most banks now.

The Bottom Line

The failure of the First Horizon deal is a rare black eye for what has otherwise been a well-run bank. I continue to believe that there are still a lot of positives here, as TD enjoys a strong core deposit franchise, a strong consumer business (including cards) in Canada), and a lot of optionality with its growth and capital deployment plans. There's work to do, though, and the overall operating environment for banks and bank stocks is not so great at the moment. I think patient long-term oriented investors can make money here, but I do think it will take some time for the shares to regain their momentum.

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