TD Bank’s Fentanyl Probe: Assessing The Damage (NYSE:TD)

The Toronto-Dominion Bank (NYSE:TD)(TSX:TD:CA) stock was in a freefall during today’s trading hours, as details regarding the Department of Justice’s probe of the company’s alleged fentanyl money laundering made their way through the media. Months ago, news broke that TD’s First Horizon (FHN) deal was cancelled due to allegations of aiding money laundering by unnamed drug cartels. Earlier this week, TD announced that it had booked a $450 million charge related to that investigation. Yesterday, the Wall Street Journal reported that the money laundering specifically involved fentanyl-related transactions at a branch in New jersey. The stock sold off today in massive volume as news about the allegations became widely known.

It’s normal for financial improprieties to cost banks money. In the 2010s, Wells Fargo (WFC) took billions in fines related to its cross-selling scandal, in which the company was caught pushing customers into products they didn’t ask for. The current TD scandal is potentially on a different level. Fentanyl is one of the most dangerous illicit drugs on the market. It is a major factor in political confrontations between the U.S. and China, the main producer country. It is lethal at doses barely visible to the naked eye. It was the primary “non-methadone opiod narcotic” contributing to that category’s 70,601 U.S. overdose deaths in 2021. So, there is potential for serious public outcry here, exceeding that generated by Wells Fargo’s purely financial misdeeds.

Although the $450 million in provisions TD has booked is a drop in the bucket, investors are evidently worried about more fines rolling in. When Wells Fargo was caught pushing customers into products they didn’t need back in 2016, it kicked off years of follow up investigations whose financial penalties ultimately dwarfed those of the initial investigation. Violation Tracker has Wells Fargo’s fines since 2000 totalling $27 billion.

The total charges that TD could take because of the Fentanyl money laundering probe are unknown. However, it would be imprudent for shareholders to assume that they will end with the $450 million TD has booked. First, TD itself has said it expects further charges. Second, Wells Fargo’s experience argues that total fines could go into the billions.

Although I’m not selling my TD shares because of the fentanyl scandal–I actually added to my position twice today–I do think that the ongoing investigation presents material risks to TD investors. In particular, there is a risk of the stock underperforming for prolonged periods of time should the amount of fines and settlements go far beyond $2 billion–a factor that wasn’t in the picture when I wrote my previous article on the stock. In this article I will explore the charges that TD could face owing to the money laundering investigation, and how much of a discount investors should demand because of these charges.

How Much Will TD Have to Pay Out

The big question for investors pertaining to TD Bank’s fentanyl probe is “how much will the bank have to pay out?” We know that TD has already prepared for one potential $450 million fine, but the potential for a Wells Fargo style series of fines and settlements can’t be ruled out. So, we should try to estimate exactly how much TD will have to pay out here. Here’s what we know:

• TD Bank settled a lawsuit for $1.2 billion last year without admitting wrongdoing. The plaintiffs sought damages from a Ponzi scheme they lost money in and alleged that TD facilitated.

• Canadian banking insider Gabriel Dechaine said that he expects something like $2 billion.

• The biggest ever settlement paid by a North American bank was $13 billion, paid by JPMorgan Chase (JPM).

• The biggest series of fines/settlements ever paid by a bank for a single incident was $30 billion by Bank of America (BAC), the fines/settlements being paid out over a period of six years.

So, how much of TD Bank’s margin is under threat because of the current investigation?

I would say $1.2 billion could be a good estimate of the absolute low end of our range. That’s what TD itself paid in a single year owing to one infraction last year.

Dechaine’s $2 billion estimate seems like a good “consensus estimate,” since it is the work of a non-TD Canadian banker who presumably is talking to Canadian bankers every day.

I will rule out the possibility of a JPMorgan-style $13 billion one-time payout, as the current $450 million set-aside indicates that the penalties TD will take from the fentanyl scandal will come in waves rather than all at once.

The extreme worst case scenario is Bank of America’s massive $30 billion six year ordeal, which averages out to $5 billion per year.

So, we have three estimates here: $1.2 billion (extreme low end), $30 billion spread over six years (extreme high end), and $2 billion (expert-derived estimate). In the next section we can take a look at how these various hypothetical costs could impact TD.

TD’s Fundamentals

In its most recent fiscal year, TD Bank had:

• $37 billion in revenue, growing at 5%.

• $22 billion in net interest income.

• $8.9 billion in net income.

• 1.8 billion shares outstanding.

Here’s how our various potential fines impact these results, assuming next year looks similar to this year:

• The $1.2 billion fine takes us down to $7.7 billion in net income and $4.27 in EPS.

• The $2 billion fine takes us down to $6.9 billion in net income and $3.83 in EPS.

• The BAC-style $30 billion “staggered” fine takes us down to $3.9 billion in net income and $2.05 billion in EPS.

• The company’s revenue growth, were it repeated in the next 12 months, would improve these amounts, though not by a lot.

Having arrived at these estimates, we can now move on to a valuation.

Valuation

At today’s prices, TD Bank trades at:

• 10.17 times trailing adjusted earnings.

• 12.3 times trailing GAAP earnings.

• 2.8 times sales.

• 1.3 times book.

This seems fairly cheap, but of course, the coming fines will likely reduce the next few quarters’ net income. What’s the forward P/E, then?

Seeking Alpha Quant’s estimate is 10.24 or 11.55, depending on whether you’re talking about adjusted or GAAP earnings. My fine estimates above produce the following P/E impacts:

• P/E given $1.2B fine with everything else unchanged from last year: 12.8.

• P/E given $2B fine with everything else unchanged from last year: 14.26.

• P/E given $5B fine with everything else unchanged from last year: 26.65.

At 26.65, you’re talking about a multiple that North American banks really don’t go to these days. Also, the BAC-style $30 billion fine scenario has a major effect on a DCF valuation for TD Bank. Most such models have a discrete forecast period of five years, followed by a perpetuity valuation. If you start off with TD’s actual $4.71 in EPS, assume 5 years of 5% growth, then no growth after that, and use a 10% discount rate, you get a 58.47 price target, or 7% upside. If you do the same exercise assuming a $5 billion haircut taken through all of the discrete forecast period, you end up with severe downside.

Put simply: in a scenario where TD takes fines comparable to those taken by Bank of America in the 2010s, it is not worth the investment. But in the other two scenarios we considered, it is. Personally, I continue to buy shares.

A note on my rating is appropriate here given that I’m actively buying a stock while rating it a hold. Seeking Alpha has acquired a large and diverse readership over the years, consisting of not just retail investors, but professional investors and fund managers too. I do not consider TD a buy at heavy weighting for an investor with high liquidity needs, such as a pension fund manager. I also don’t consider it appropriate for fund managers with ESG mandates, at least not for now: we can’t rule out the possibility of the DoJ investigation uncovering serious wrongdoing reaching all the way up to the C-Suite level. Finally, TD is not appropriate as an overweight position for retail investors with high living expenses relative to income. As for me personally: I have an above-average risk tolerance as well as a higher than average ability to bear risk (specifically low living expenses relative to income and savings). I consider TD at today’s prices a very intriguing buy for an investor exactly like me. For most of the investing public, I do not think a position at greater than index-weighting is well advised.