- TD Bank is in the process of closing its acquisition of First Horizon Corporation.
- The deal has been highlighted by U.S. senators for extra scrutiny, but it will probably go through.
- Regulators have already reviewed TD's sales practices.
- In this article, I make the case that TD Bank is likely to complete its takeover of First Horizon and become the 6th largest bank in the U.S.
Canadian bank stocks are known for having high yields. Long before the 2022 bear market, TSX banks were offering yield aplenty, when U.S. stocks offered barely any yield at all. In 2021, when the S&P 500 yielded a mere 1.21%, Canada’s big banks were all yielding over 3%. The fact that Canadian banks skated through the 2008 financial crisis without a single failure only added to the appeal.
Today, though, the picture looks a little different. Canadian houses cost nearly twice as much as U.S. houses in nominal terms (about 1.6 times as much in PPP terms), and Canadians have more mortgage debt than Americans. This picture certainly looks similar to the U.S. before the subprime meltdown, and I wouldn’t be the first to say it. When you’ve got a high level of variable-rate debt and rising interest rates, the risk of defaults looms large. For investors, these potential defaults are a problem.
The Toronto-Dominion Bank ( TD ) is one stock that arguably solves the problem. TD lets investors get Canadian dividends with heavy U.S. exposure. Like most Canadian banks, TD has a huge yield–4.4% as of this writing. Unlike other Canadian banks, it derives a large percentage of its income from the U.S.--about 36% of it, in the most recent quarter . With TD Bank, you get all the yield you’d expect from Canadian banks, but with more U.S. exposure.
Furthermore, TD’s U.S. exposure is set to increase. The bank is currently in the process of acquiring First Horizon National ( FHN ), a bank out of Memphis with $89 billion in assets . The acquisition will make TD Bank the 6th largest bank in the U.S. if it closes.
The question of whether it will close is somewhat controversial. Last month, Senator Elizabeth Warren asked the Office of the Comptroller of the Currency (“OCC”) to reject the TD-FHN deal, claiming that TD had committed “ abusive practices ” similar to those of Wells Fargo ( WFC ). If Warren succeeds, then the First Horizon deal could be delayed. If regulators do a thorough investigation of Warren’s claims, it could take months to complete. That would push the deal past the target close date (Q1 2023), which means TD will have to pay an extra $0.65 per share on an annualized basis.
There is some risk in TD’s acquisition of First Horizon. However, there is no reason to assume it won’t close. A senator asking regulators to block a deal isn’t the same as regulators actually doing it. Warren is a legislator, not a member of Biden’s cabinet –- she doesn’t have direct authority over the OCC. For this reason, it’s safe to assume that the First Horizon deal will go ahead, and that TD will continue expanding its reach into the US.
Why the First Horizon Deal is a Positive
Before getting into the likelihood of the TD-FHN deal closing, I first need to establish that the FHN deal is a positive. This isn’t uncontroversial. TD offered to pay a premium price for FHN, and will pay even more if closing is delayed. Some therefore think that TD would be better off without FHN than with it.
First things first:
Based on historical financials, TD is undoubtedly paying a huge premium for FHN. To establish that, let’s look at some of FHN’s key metrics:
-
Trailing 12-month (“TTM”) net income: $961 million.
-
Market cap: $11.57 billion.
-
Upcoming quarter’s earnings estimate: $0.35.
-
Forward 12 month EPS assuming Q2 is an average quarter: $1.40
-
TD’s buy price: $25.
From the metrics above, we can compute two different P/E ratios for FHN:
-
Trailing GAAP P/E: 12.11, which is close to Seeking Alpha Quant’s number.
-
Forward P/E based on TD’s purchase price: 17.85.
The current earnings multiple isn’t crazy, but the implied forward multiple is very high by the standards of a bank stock. It’s for this reason that some people think TD will be better off if its FHN deal gets rejected. However, people are ignoring one crucial factor:
Synergies.
TD expects to achieve $610 million in pre-tax cost synergies from the FHN deal, and there are reasons to think its expectations are valid. In its press release announcing the deal, TD said that it expected to achieve synergies through:
-
IT systems consolidation.
-
Operational efficiencies.
The second term is vague, but we know what TD means when it talks about IT systems.
TD Bank has cloud infrastructure that it uses for storing and manipulating customer data. It uses the exact same vendor that First Horizon uses for its cloud, so all of FHN’s data can immediately be transferred to TD’s cloud. The merged entity will benefit from economies of scale as cloud services get cheaper when bought in mass quantities. TD also mentioned that it will get rid of some legacy systems housed on-site at branches, which could bring in some cost savings as well.
As far as “operational efficiencies” go, that could refer to any number of things. However, TD did mention in its acquisition conference call that FHN would benefit from TD’s purchasing power. Because TD is a much larger entity than FHN, it can buy supplies (e.g. computers) in bulk, giving FHN savings on procurement. Over time, those savings could start to add up.
This all adds up to the possibility of a beneficial deal for both FHN and TD. FHN will benefit from TD’s scale, while TD will benefit from increasing its presence in key U.S. markets like Florida.
Obstacles to the Deal Closing
Having looked at a plausible reason why the FHN deal will pay off, we need to consider some possible obstacles to it closing.
The first is, obviously, Elizabeth Warren’s letter. Warren is a Senator, and part of the Senate Banking Committee no less. When she speaks, the regulators probably listen. However, that does not mean that the OCC will actually block TD’s deal. The OCC investigated TD for the exact practices Elizabeth Warren is accusing it of in 2017, and the investigation ended with no reprimand . To re-open the investigation would be costly and potentially embarrassing to an agency that put the matter to rest 5 years ago.
We can’t put a numerical value on the odds of the TD-FHN deal closing. However, deductive reasoning suggests that it will. The OCC investigated TD in 2017, and if the investigation was thorough, there is no need to re-investigate. The first premise here is confirmed to be true, and the conclusion follows if both of the premises are true. The only possible weak link in this reasoning is the second premise: the one about the thoroughness of the 2017 investigation. It’s possible that the OCC’s investigation of TD was not thorough, but the human tendency toward confirmation bias would make it hard for the agency to admit that. Numerous psychological studies show that people resist acknowledging that they were wrong in the past.
So there is reason to believe that the main obstacle to this deal closing will be overcome. As for other obstacles: many of those have already been dealt with. Shareholder approval has already been gained . The financing is already available on TD’s balance sheet. The deal looks ready to go ahead.
Value of TD’s Earnings After the Deal Closes
Having looked at the FHN deal itself, it’s time to ask the all-important question:
How much TD will be worth after it closes?
Here’s what we know so far:
-
FHN has $961 million in TTM net income.
-
TD Bank has $11.5 billion in TTM net income .
-
TD Bank has said that the deal values FHN at 9.8 times “fully synergized” earnings.
Given that TD is paying $13.4 billion for FHN, the ‘9.8 fully synergized multiple’ implies that TD expects FHN to earn $1.313 billion. Add that to TD’s TTM earnings, and you get to $12.813 billion. TD expects $1.3 billion in M&A costs, so subtract that, and we get to $11.513 billion, assuming no organic growth. So we get a $13 million earnings boost after M&A costs, and a $1.313 billion boost once those costs are absorbed.
TD’s current market cap is $112.41 billion, so it has a 9.76 earnings multiple after the deal closes, if TD’s stock price doesn’t change. Assuming 0% growth and no change in the stock price, it’s at an 8.77 earnings multiple after merger costs are absorbed. This is comparable to Bank of America’s ( BAC ) current earnings multiple , but TD has a higher yield than BAC does. So, it appears to be a worthy value play for income-seeking investors.
A Big Risk to Keep in Mind
As we’ve seen, TD stock will still be cheap after it closes its FHN deal. Even when you factor in M&A costs, you still get an earnings multiple below 10. Based on this, it looks like TD is not overpaying for First Horizon.
However, all of this is going off of TD’s estimate of how much money it can save due to synergies. TD expects synergies to add $610 million to FHN’s earnings, and its valuation model implies $1.313 in 2023 earnings. Yet TTM earnings are just $961 million. So, TD thinks that through IT integrations and cost savings, it can juice FHN’s earnings by 36%. That’s a pretty rosy forecast. Although I wrote earlier that TD can in fact help FHN save money, a 36% earnings jump is a bold claim. Nothing I have written in this article implies that THAT kind growth is possible. So do not be surprised if FHN’s earnings fall a little short of TD’s forecasts. They are optimistic, to put it mildly.
The Bottom Line
Putting it all together, we can say this about TD Bank:
It’s a fine bank with FHN, and it’s a fine bank without it. If the FHN deal fails, TD will still be the most American of Canadian banks, well insulated from housing bubble fallout. If the deal goes ahead, then TD will increase its U.S. presence and its geographic diversification. All this bodes well for investors who want Canadian style dividends from a U.S.-style bank. Just don’t take TD’s “fully synergized earnings” claims at face value. It appears to be paying more for FHN than it wants to believe.
For further details see:
TD Bank: U.S. Buyout Likely