TD Bank Branch Bloomberg/Bloomberg via Getty Images
The Toronto-Dominion Bank (NYSE:TD) (TSX:TD:CA) flirted with 52-week lows last week, closing below $78 for the first time since October 2023. There was little news about the company at the time, however, the trading in bank stocks was generally weak during the period. This year, banks have somewhat counterintuitively been selling off whenever treasury yields rise, as depressed treasury prices contributed to bank failures during the Crisis of Spring 2023. Last week, treasury yields rose, leading to weakness in TD and other bank stocks.
Seeing that TD was trading at a historically low level, I snapped up some shares. Specifically, I sold a portion of my Bank of America (BAC) position to buy TD (BAC is still the biggest position in my portfolio).
This move definitely was not something that I had on my bingo card for 2024. My opinion on TD dimmed significantly when the company revealed that it was under investigation by the Department of Justice (“DOJ”) for facilitating money laundering. The investigation dealt with the behavior of a single employee at a New Jersey branch; nevertheless, his behavior was significant enough to attract the attention of Federal attorneys. Recalling that Warren Buffett sold his Wells Fargo (WFC) shares due to ethics concerns, I sold some 80% of my TD Bank stock.
That was then, this is now. On its last leg down, TD stock went all the way to $78 on the TSX ($57.91 on the NYSE). With $5.6 in adjusted EPS, that implies a P/E ratio of around 10 (the 14 P/E ratio given by Seeking Alpha Quant is based on earnings that include non-recurring First Horizon (FHN) deal cancellation fees). At 10 times earnings, TD is cheaper than Bank of America. Sensing a good relative valuation, I invested some of the proceeds I got from selling BAC into TD.
I had the idea of buying TD stock below $80 long before I actually pulled the trigger. In 2023, the stock often flirted with prices below $80, but rarely went significantly lower. It wasn’t until last week that the stock slipped below $78-lower than it had gone even during the Spring 2023 banking turmoil.
When I last covered TD Bank, I rated the stock a buy on the grounds that it was relatively cheap and operating in a good macro environment. Today, I still think that TD is a good value, but it’s even cheaper than it was the last time I covered it. Accordingly, I am upgrading my rating to strong buy.
TD Bank – Competitive Position
TD Bank is one of North America’s largest banks. It is the second-biggest bank in Canada by market cap, and the tenth biggest in the U.S. by total assets. Its main competitive advantage in Canada is its brand, which has been ranked the most valuable in the country. The bank also differentiates itself by its extended branch hours, which make it more accessible to customers who still rely on face-to-face service (e.g. older clients, people who still receive physical paychecks, etc).
Canada’s six biggest financial institutions enjoy the status of “systemically important banks.” This means that they are considered important to the economy as a whole and might receive bailouts in the event that they suffer a bank run. The perceived “too big to fail” status of systemically important banks can become something of a self-fulfilling prophecy. During the Spring 2023 banking crisis, depositors took their money out of regional banks and put it into banks like BAC and JPMorgan (JPM). The end result was that these large banks actually gained deposits at a time when deposit flight was such a concern for the regionals. TD is also a relatively large bank and benefits from the same perception of safety that drove clients to BAC and JPM.
Why TD’s Earnings Declined Last Year
TD Bank’s GAAP earnings declined in 2023. For the year, its revenue increased 3%, while its earnings declined 41%. To understand why this happened, we need to take a look at TD’s failed acquisition of First Horizon, a regional bank based in Florida.
In 2022, TD Bank announced that it would be acquiring First Horizon in a cash and stock deal worth $13.4B. TD touted FHN’s solid reputation and capital ratios as reasons for pursuing the deal. At the time the deal was announced, TD expected the deal to close with no issues. Later, however, it revealed that U.S. regulators weren’t allowing the deal to go through because they had concerns with TD’s money laundering safeguards. After more than a year of delays, the First Horizon deal was finally cancelled in 2023. The cancellation incurred several charges to TD Bank. For example, the company took a $200 million loss on its investment in First Horizon preferred stock. These charges were not large as a percentage of TD’s overall earnings, but were significant enough to contribute to a decline in overall earnings in the fourth quarter.
It wasn’t all bad news from TD that year on the M&A front in 2023. The company successfully closed its acquisition of Cowen Inc., a medium-sized investment bank with expertise in the tech sector. However, the immediate impact of TD’s attempted deal making in 2023 was to hold earnings back, as the preferred stock investment and other cancellation-related charges were subtracted from net income.
Looking Ahead
Having looked at TD Bank’s failed FHN deal and the financial damage it caused, we can now turn to the company’s future prospects. Because TD’s 2023 results included FHN deal termination fees, we can safely assume that if the bank’s revenues just stay flat, it will grow on the bottom line. TD’s tax rates haven’t changed, and its headcount has actually decreased. Deposit interest expenses are up compared to 2021, but shouldn’t be too different from the levels seen in the fourth quarter, when the Federal Reserve and Bank of Canada paused their interest rate hikes. On the expense side, 2024 should be better for TD than 2023 was.
As for net interest income (“NII”), things are more mixed on that front. TD is guiding for flat margins in the U.S. retail business in 2024 (i.e. it expects margins to be unchanged compared to last year). This is consistent with the guidance that U.S. banks provided in their third quarter earnings releases. Banks posted high revenue growth in 2023 thanks to the higher interest rates seen that year compared to 2022. With interest rates now staying put, the banks lack that growth catalyst, so stable revenue should be the default assumption. Nevertheless, TD had enough deal-related expenses in the base period that modest bottom-line growth can be expected.
Valuation
Having looked at TD’s recent performance and forward guidance, we can now turn to a valuation. According to Seeking Alpha Quant, TD trades at:
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10.17 times adjusted earnings.
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14.8 times GAAP earnings.
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11.8 times forward GAAP earnings.
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3 times sales.
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1.4 times book value.
These multiples are consistent with my theory that earnings will rise this year thanks to the non-recurring character of the FHN deal termination charges, as the forward P/E ratio (calculated with the same stock price as the trailing P/E ratio) is higher than the trailing P/E ratio. TD’s price/sales and price/book multiples are fairly typical of banks in 2024. The value of its earnings per share, assuming no growth and discounting at the 10-year treasury yield, is $93.95. Overall, it is a modestly valued stock.
Risks and Challenges
As we have seen, TD is a modestly valued bank stock that ran into some temporary setbacks in 2023. On a forward-looking basis, the stock appears to be worth the investment at $59.94. Nevertheless, there are many risks and challenges to be on the lookout for, including:
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Fines related to the money laundering investigation. In January, Seeking Alpha reported that Canada’s FinTRAC agency was mulling fining TD $7.43 million owing to its anti-money laundering slip ups. The U.S. DOJ investigation could also result in fines. It’s not clear what dollar amount of fines we are looking at on the U.S. side, but could be substantial. Wells Fargo has had to pay out billions in fines and settlements related to the cross-selling scandal it was embroiled in throughout the 2010s. The allegations against TD are no less serious than those that got Wells Fargo in trouble, so the possibility that the bank will take a materially impactful number of fines can’t be ruled out.
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Yield curve inversion. Canada’s treasury yield curve is currently inverted, as is America’s. This is in theory a risk to TD Bank. When the yield curve inverts, banks face pressure to raise deposit interest. In the meantime, they face downward pressure on the interest rates they charge on loans. These two factors together tend to reduce their margins. At least in theory. In 2023, the yield curve was inverted all year long, but bank margins remained healthy. Nevertheless, we can’t rule out the possibility of margins shrinking in 2024 as more and more depositors hear about the generous yields available on treasuries.
The risks above are worth keeping in mind, but are not thesis-breaking. At today’s prices, TD stock is modestly valued, and still growing on the top line. Taking everything into account, it is a buy.
