2023-11-02 09:52:20 ET
Summary
- Canada's economy may be in a technical recession, with declining GDP for two consecutive quarters.
- TD Bank's U.S. business is likely to have performed well in the fiscal fourth quarter, similar to other U.S. banks.
- Banks that focus more on investment banking and wealth management are likely to have a harder time.
- TD Bank's focus on retail banking makes it well-positioned to thrive in the current economic turbulence in Canada.
- In this article, I explain why I'm still long TD Bank stock despite Canada likely still being in recession.
Canada’s economy may be in a technical recession. That’s the key takeaway of StatsCan’s latest GDP report, which showed GDP moving approximately 0% in the month of August. The third quarter report isn’t complete yet, but based on the July and August readings, it is likely to show a decline. If the September report shows a decline in real output, then that will be two quarters in a row of declining GDP–the definition of a technical recession.
It’s in this environment that Toronto-Dominion (TD)(TD:CA) finds itself. As a Canadian bank, it earns about 60% of its profit in Canada. The rest comes from the United States. The U.S. part of TD’s business appears likely to have done well in the fiscal fourth quarter, as U.S. banks’ third quarter earnings were strong . TD’s U.S. business is mainly a retail bank plus a large investment in Charles Schwab ( SCHW )--in other words, it’s similar to the big U.S. banks that reported last month, and they all delivered double digit earnings growth along with high margins.
So, things are looking up for 40% of TD Bank’s business. The question is, how will the other 60% perform? It’s all well and good that TD has a thriving U.S. business, but the Canadian business is still the majority of the company.
Unlike with TD’s U.S. earnings, we don’t have much to work with in forecasting the bank’s Canadian earnings. Some recent earnings releases that might tell us something include EQB Inc.’s ( EQB:CA ) and First National Financial ( FN:CA ). Both of those banks beat earnings estimates and delivered high growth in their most recent quarters . However, those banks use conventional calendar quarters as their fiscal quarters, while TD and other “big six” banks use a fiscal year that ends in October . So we don’t really have any competitors’ releases that can help us predict how TD and the other big six banks will do in their fiscal fourth quarters. EQB and FN’s second quarter overlap with TD’s fourth quarter only partially.
One thing we do have is macroeconomic data. Specifically:
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GDP growth. The economy grew at 0% in July and August. The official September stats have yet to be released but StatCan’s august announcement said that GDP was “likely” down slightly in September.
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Inflation. The most recent CPI report showed that the consumer price index (“CPI”) increased by 3.8% in September. The rate of inflation decreased sequentially but remained well above the Bank of Canada’s 2% target.
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Moderate levels of unemployment. Canada’s unemployment rate was 5.5% in September, higher than what policymakers aim for but lower than the pre-pandemic unemployment rate.
This combination of high inflation and low growth sounds an awful lot like stagflation , which is defined as simultaneous occurrence of high growth, high unemployment and high inflation. One of the conditions absent in Canada right now is high unemployment: Canada is still below the pre-pandemic unemployment rate. Still, two out of three criteria being met suggests that Canada is in something close to stagflation, if not stagflation itself.
What does this mean for banks?
So far, it has had lesser consequences for banks compared to other sectors of the economy. The big banks’ Q3 earnings aren’t out yet but small banks and non-bank lenders are seeing high growth. That’s to be expected: financials tend to fare well when rates are high provided that the economy is not in a steep recession. Their interest revenue rises alongside interest rates. This can occur in a mild recession. If the economy enters a steep recession, then the defaults and reduced loan origination overwhelm the positive effects of high interest rates. In mild recessions and high growth, high rate periods, banks tend to thrive.
That fact is significant because, if Canada is entering a recession, then it is a mild one. TD Bank’s Chief Economist Beata Caranci said that a recession is “two quarters of economic contraction,” where economic activity is “usually measured by GDP.” This definition of the word ‘recession’ has been challenged, but it has the virtue of being measurable. If we use the definition, then Canada may be in a small technical recession: we just need for September data to be in line with what preliminary data indicates, and the dreaded ‘R’ word will be a confirmed reality. However, the second quarter decline in output was a miniscule 0.2% , and the third quarter decline is expected to be just 0.1%.
Banks Could Thrive
All this recession talk might sound scary–stocks usually fall during recessions after all–but it’s actually not. TD Bank would likely gain from a small recession of the type that Canada may be entering, it would not lose from it. Recall earlier when I said that banks thrive in mild recessions and “high growth high rate” periods. Obviously the second of these two scenarios is ideal, but the first one works too. The tendency of high interest rates to drive higher interest income is pretty solid, breaking down only in severe recessions where people lose work and stop being able to pay interest on time.
We can see this phenomenon at play in TD’s own earnings. In the second quarter of 2020 , when the COVID crash was in full swing, the bank’s profit got cut in half and revenue barely grew. In the second quarter of 2022, which was during a small two-quarter contraction that was never officially labelled a recession, TD was already back to growing its earnings .
What this means is that TD Bank is well positioned to thrive in the economic turbulence that Canada is now experiencing. Both the Q2 and (likely) Q3 contractions have been very small. Indeed, other economic indicators are consistent with that. The unemployment rate is unchanged month over month. Mortgage delinquencies are low . Credit card delinquencies are improving. Basically, Canada is in that sweet spot for banks where rates are high but not high enough to stop the consumer from spending.
TD’s Business Mix
As we’ve seen, the macro situation in Canada is a tailwind for lenders, as it lets them capture more interest income without assuming that much more risk. The question for TD investors is, “how well suited is TD to take advantage of this situation?”
The answer is, pretty well! TD Bank is first and foremost a retail bank, investment banking and wealth management are fairly small segments for it. In the third quarter , the Canadian retail bank did $1.65 billion in net income and the U.S. retail bank did $1.3 billion in net income. Total retail banking earnings were $2.95 billion. Total net income came in at $3.7 billion, so that’s 79% of TD’s earnings coming from retail banking. Many other banks have large percentages of their earnings coming from investment banking. For example, Royal Bank did $938 million in investment banking earnings last quarter, over 24% of total income. TD’s percentage of profits coming from investment banking was much smaller: just 7.35%.
This focus on retail banking is currently a major benefit for TD Bank. It’s retail banking and brokerage services that tend to benefit the most from high interest rates. These are the parts of a typical bank holding company most involved in what people think when they hear the word bank: lending money. Retail banks take deposits and issue loans, brokerages invest client funds and lend out shares bought on margin. These business activities become more lucrative as rates rise. Investment banking and wealth management do not. High rates disincentivize investment bank underwriting by raising the cost of capital, and harm wealth management businesses by encouraging clients to hold more cash and CDs. TD Bank has comparatively small operations in i-banking and wealth management, so it’s uniquely well positioned today.
Profitability and Growth
TD Bank’s business activities support the claim that it is able to thrive amid high interest rates, even in the event of a mild recession. Having established this, we can turn to TD’s most recent earnings, to gauge the company’s profitability and growth.
In the most recent quarter, TD delivered:
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$12.78 billion in revenue, up 12.3%.
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$3.7 billion in net income, down 0.2%.
The revenue growth was strong, in line with Royal Bank of Canada and Bank of America ( BAC ) in the same period. The earnings growth was lower than that of other Canadian banks in the same period, but that fact was mainly due to one-time charges pertaining to the cancellation of the First Horizon ( FHN ) deal. Apart from those non-recurring charges, growth was satisfactory. Also, profitability was high, with a 28% net margin.
Now let’s take a look at Seeking Alpha Quant’s trailing 12 month profitability metrics for TD Bank:
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Net margin: 29%.
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Return on equity: 13.8%.
Both figures were satisfactory and in line with what I calculated for Q3.
Next, let’s look at the longer-term (5 year) growth picture :
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Revenue: 7.12% CAGR.
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Net interest income: 6.6% CAGR.
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EPS: 5.7% CAGR.
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Book value: 10.3% CAGR.
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Common equity: 8.3% CAGR.
These are respectable growth rates for a bank. Revenue growth is only ramping up, and earnings should start growing again once all First Horizon deal related costs are absorbed. It looks like smooth sailing from here. Nevertheless, TD stock appears rather cheap, trading at 9 times earnings, 2.7 times sales and 1.3 times book value. It has a 4.96% dividend yield, even though its payout ratio is just 46%. TD has grown significantly over the last five years, and it will keep growing as long as Canada’s economy remains reasonably healthy. It will take more than a mild 0.1% contraction to sink this ship. The bank has a 15.2% CET1 ratio and a 123% liquidity coverage ratio. This isn’t a bank that will collapse in any “normal” recession. So, it’s a fairly safe income pick today.
For further details see:
TD Bank: Don't Panic About A Recession In Canada