2023-08-17 15:06:56 ET
Summary
- Toronto-Dominion Bank is one of the two largest Canadian banks with a wide moat and cost advantages.
- TD's profitability is solid compared to the "Big Four" banks in the U.S.
- The stock is undervalued and offers a solid forward dividend yield of 4.5%.
Investment Thesis
Being one of the two largest Canadian banks, Toronto-Dominion Bank ( TD ) enjoys its wide moat and cost advantages provided by its scale. The bank's profitability looks solid, even compared to the "Big Four" of the U.S., which operate at multiple times higher scales. TD has a well-diversified portfolio of offerings, which makes it less vulnerable to interest rate cycles and also provides massive cross-selling opportunities. The stock is about 40% undervalued and currently offers a solid 4.5% forward dividend yield. All in all, TD stock is a "Buy".
Company Information
Toronto-Dominion Bank is one of Canada's two largest banks, together with the Royal Bank of Canada ( RY ).
The bank's fiscal year ends on October 31 with the following business segments: Canadian Personal & Commercial Banking, U.S. Retail, Wealth Management & Insurance, Wholesale Banking, and Corporate. According to the latest annual report , Canadian Personal & Commercial Banking was the largest segment, representing about a third of the total revenue. The U.S. retail business comprises about a quarter of the total.
Financials
The bank demonstrates solid financial performance and profitability metrics compared to the U.S. "Big Four" banks. In terms of net profit margin and return on equity, TD is close to JPMorgan Chase ( JPM ), the biggest and most profitable bank in the U.S.
Strong profitability allows the bank to provide solid returns to shareholders. TD conducts multi-billion share repurchases every year, and dividend payouts are stable. The current forward dividend yield at 4.5% looks very attractive to me, especially given a stellar dividend history . The bank's balance sheet is solid, with a common equity Tier 1 ratio consistently above the 11% minimum.
The latest quarterly earnings were released on May 25, when the bank topped revenue consensus estimates but missed the bottom line. Revenue demonstrated solid growth momentum, with a 12% increase. The adjusted EPS was weak and narrowed from $1.58 to $1.42.
The upcoming quarter's earnings are scheduled on August 24. Quarterly revenue is expected at $8.94, representing a 6.8% YoY growth. Despite the top-line growth, the adjusted EPS is projected to shrink from $1.62 to $1.49.
To be honest, I am not very concerned about the narrowing EPS and negative TTM cash flow from operations. On March 1, 2023, TD completed the acquisition of Cowen and the effect of this merger means there are many extraordinary items in costs and cash outflows. That said, I expect TD's next couple of quarterly earnings to be bumpy. But these challenges for the bottom line are temporary and not secular. What is secular is the bank's wide moat due to its large scale, comprehensive portfolio of offerings to customers, and strong brand reputation. TD consistently holds one of the top three spots in each of the traditional banking metrics across Canada: loan portfolio, credit card issuance, assets under management, etc. Apart from it, the bank innovates in accordance with industry trends and has done well in it. TD's mobile banking app was ranked number one in the "Highest in Customer Satisfaction" for its Canadian mobile banking app. TD Direct Investing was also named the number one online brokerage in Canada in an annual ranking by The Globe and Mail.
TD's comprehensive portfolio of services makes it a strong choice for customers as a one-stop shop for financial services. That said, there are vast opportunities to cross-sell and drive customer acquisition costs down. Apart from TD's leadership in many dimensions and its strong customer base, the nature of the Canadian banking industry also helps to widen the bank's moat. The Canadian banking industry is called an "oligopoly" because "Big Five" banks hold approximately 80% of the market share. Canadian legislation also helps to maintain high entry barriers into the country's Financial sector. According to Thomson Reuters , the Bank Act prohibits foreign banks and entities associated with a foreign from engaging in or carrying on business in Canada, directly or through a nominee or agent. While doing business in Canada is prohibited, carrying on business from outside Canada with Canadian clients cross-border is permitted. And there are minimal exemptions to this rule. That said, I consider TD's market share and growth prospects safe.
Valuation
The stock demonstrated a 3% share price decline year-to-date, significantly underperforming the broad U.S. market. TD also slightly underperformed the Financial sector ( XLF ) this year. Seeking Alpha Quant assigns the bank an average "C+" valuation grade, suggesting the stock is approximately fairly valued. TD's price-to-book ratios are more than 30% higher than the sector median but lower than the bank's five-year averages.
I want to proceed with the dividend discount model [DDM] to get more confidence about valuation. I use a 9.5% WACC for the required rate of return. Dividend consensus estimates project an FY 2024 payout of $3.04. I use 6% for dividend growth, which is a slight round-up for the last ten-year CAGR.
Author's calculations
As you see, the stock's fair value is close to $87, representing a 40% upside potential for the share price.
Risks to Consider
As a financial institution, TD Bank faces significant macroeconomic risk. TD's profitability, loan quality, and overall stability are closely tied to the broader economic conditions in North America. Potential economic downturns and recessions are highly likely to pressure the bank's revenue sources and credit portfolio. Individuals and businesses face financial difficulties during economic turbulence, leading to higher loan defaults. Reduced demand due to high-interest rates also adversely affects a bank's growth prospects. Moreover, unexpected shifts in interest rates also lead to elevated market uncertainty and volatility, influencing investor sentiment regarding TD stock.
The banking industry is a highly regulated and complex web of laws, rules, and policies inherent to it. As one of the two largest banks in Canada, TD's operations are subject to thorough scrutiny. Changes in regulation can disrupt TD's operations and profitability. Non-compliance with evolving regulations can result in penalties, fines, and legal actions. This could adversely impact the bank's financial performance and reputation. Also, regulatory changes can affect the cost side if new procedures or increased reporting requirements are introduced.
Bottom Line
To conclude, TD is a Buy. The bank has an impressive market share in the Canadian banking industry and a strong presence in the U.S. The track record is strong across all business segments, which I can see from each profitability. Given the massive scale and wide moat, the bank has bright prospects to continue revenue growth and margin expansion. Moreover, the stock is undervalued with solid upside potential and attractive forward dividend yield.
For further details see:
TD Bank: Attractive Dividend Yield And Massive Upside Potential