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TD: A Low Risk, High Growth Play Among The Canadian Banks


Published December 5th, 2016 by The Financial Canadian

Great dividend investments come in all shapes and sizes. However, it is rare that a whole group of stocks constitute solid dividend performers for your portfolio.

The Big 5 Canadian Banks fit this category. Often considered among the soundest financial institutions in the world, this peer group has delivered outstanding total returns, great dividend growth, and minor risks to investors for a long, long time.

In terms of individual appeal, The Toronto-Dominion Bank (TD) has a lot of positives.They are my personal favorite among the Big 5, and I believe they are the most conservatively managed.

They also have fantastic growth prospects.

On December 1, TD announced their financial performance for the 3-month and 1-year period ending October 31, 2016. This article will cover the Bank’s financial results in detail, and overall growth prospects.

 Business Overview

 TD is a diversified financial services company serving customers in Canada, the United States, and worldwide.

After being formed in 1955 from the merger of the Bank of Toronto and the Dominion Bank, TD has grown to an international conglomerate with more than 80,000 employees and 25 million customers.

They divide their operations into three main lines of business:

I will now go on to outline the Bank’s financial performance before evaluating their investment prospects.

Financial Performance

On December 1, TD reported earnings for the 3-month and 1-year period ending October 31, 2016.

For the fourth quarter, financial results were strong, demonstrating robust growth on both a GAAP and adjusted basis. GAAP results grew ~25% and adjusted results grew ~7% on a year-over-year basis.

You may be curious about the large difference between GAAP results and adjusted results for the fourth quarter. There are two main causes.

The first is a significant charge incurred for the amortization of intangibles during the fourth quarter of 2016. In essence, the Bank is writing down some of the goodwill generated during previous acquisitions where the assets were bought at prices above their accounting value.

The second is an even larger restructuring charge of $243 million incurred during the fourth quarter of 2015, which is responsible for the large disparity between reported ($0.96) and adjusted ($1.14) EPS for the quarter.

The bottom line is that whether we are considering GAPP or adjusted results, TD’s earnings trend for the fourth quarter is very positive.

For fiscal 2016, results were similarly good.

 The reconciliation between GAAP and adjusted results can again be attributed to restructuring charges and the amortization of intangibles.

I will now explore the investment prospects of Canada’s second-largest bank.

 US Growth

For years, TD has been absorbing market share in the United States.

It has been a key driver of growth for the Bank – U.S. Retail earnings were up 18% year-over-year in Q4 on a GAAP basis and 9% on an adjusted basis. For fiscal 2016, the improvement is even more noticeable. TD’s U.S. Retail segment boasted GAAP earnings growth of 19% (or 16% on an adjusted basis).

This all started in 2005 when the Bank acquired a 51% stake in the U.S. company Banknorth, which was lately completely privatized as TD Banknorth and formed the foundation of TD Bank, America’s Most Convenient Bank.

TD was able to leverage their strong capital position during the financial crisis to purchase the business of distressed banks during the financial crisis. This helped them to rapidly gain market share south of the border.

Fast forward to today, and TD now has more branches in U.S. than in Canada. Most recently, TD paired with TD Ameritrade (in which it has a 42% stake) to purchase Scottrade. TD Bank will be picking up the banking assets of Scottrade in yet another power play to increase their scale in the U.S.

The following diagram displays TD’s branch network.

td-us-retail-branch-network

Source: TD Third Quarter Investor Presentation

Please note that the numbers in the above diagram are from the third quarter (not the fourth quarter discussed earlier in this article).

More importantly, notice that much of the U.S. currently has no exposure to the Bank.

I can say with near certainty that TD will continue to gobble up market share in the U.S. and that this will be a key driver of growth moving forward.

A Wide Economic Moat and Limited Competition

 The banking sector in Canada is extremely concentrated in the Big 5. This limited competition bodes well for the future success of TD.

Further, the Global Financial Crisis of 2008-2009 has resulted in many regulatory changes to improve oversight, increase compliance, and de-risk the financial markets.

This creates fixed costs that are tougher for small competitors to swallow. TD is well-positioned to adapt to these changes.

Another risk on the minds of many bank investors is the introduction of disruptive Financial Technology (“FinTech”) companies to the financial space.

TD is proving to be nimble regardless of its size, and continually makes digital improvements to improve their customer experience. A prime example of this is the TD MySpend app, which is a budgeting app very similar to Mint and only available to the customer of TD.

td-myspend-example

Source: Mobile Syrup

Introduced in April of this year, the app has been a hit with customers and has more than 900,000 downloads.

Dividend Growth and Safety

Over the years, TD has a fantastic record of increasing their dividend payments to shareholders.

td-dividend-growth-history

Source: Publicly Available Financial Statements

Dividend growth from $0.46 in 2000 to $2.00 in 2015 is good for a CAGR of 10.29%. This is a level of dividend growth that is not achieved without profitable business growth, a sustained competitive advantage, and a wide economic moat.

In recognition for their long-term record of dividend increases, the Bank is a member of the S&P Canadian Dividend Aristocrats Index, which is a group of select Canadian companies with 5+ years of consecutive dividend increases; not to be confused with the traditional Dividend Aristocrats Index, which are companies with 25+ years of consecutive dividend increases.  You can see the full list of ‘normal’ Dividend Aristocrats here.

TD is also a great example of dividend safety. For instance, in the 2008-2009 financial crisis, they did not cut they dividend though many of their US counterparts did.

Their payout ratio is also representative of the safety of their dividend. Based on fiscal 2016’s dividends per share of $2.16 and TD’s adjusted diluted earnings per share of $4.87, the company has a payout ratio of 44.3%. This is well within their guidance of 40-50%, and indicates that the Bank has plenty of room to raise their dividend even in the unlikely case that earnings remain flat.

With yield, growth and safety all present, I am confident in TD’s dividend prospects looking forward.

An Attractive Earnings Mix

TD is known to be the member of the Big 5 with the most focus on retail banking.

This is reflected in the numerous accolades they have received for their customer service. For example, they ranked #1 in the J.D. Power Retail Banking Customer Satisfaction Survey for ten years in a row from 2005-2015. In 2016, they placed second to the Royal Bank of Canada. Still, this streak is very impressive.

For investors, this also translates to TD’s bottom line. The Bank derives a larger proportion of their earnings from their Retail Banking segment than most of their peers. This is partially due to the rapid expansion of their U.S. Retail segment. They are now the Canadian bank with the largest U.S. branch network.

In 2015, TD generated 91% of their earnings through retail banking. This number will likely increase over time as the Bank continues to gain market share in the U.S.

td-premium-earnings-mix

Source: TD 2015 Annual Report

TD’s concentration in retail banking is significant because retail banking earnings are much less volatile than, say, capital markets or wealth management.

Thinking logically, this makes sense – people are much more likely to withdraw from a mutual fund (Wealth Management segment) or sell their stocks (Capital Markets segment) during an economic downturn than they are to default on their mortgage (Retail Banking segment).

TD’s premium earnings mix is a positive for this stock.

Concerns About the Canadian Housing Market

I’ve spent most of this article so far talking about the strengths of TD as an investment opportunity. However, as with any other investment it is important to identify and manage risk.

In my eyes, an investment in TD Bank presents two main risks: exposure to the Canadian housing market and exposure to the oil & gas industry.

I will start by tackling the problem of a potential Canadian housing bubble.

Investors are increasingly concerned with the rising price of Canadian homes. Many are concerned that we are experiencing a housing bubble, and banks like TD will suffer from significant mortgage defaults if home price increases were to slow (or worse, decline).

Fortunately for investors, TD is well-insulated from any potential housing market crash. There are a few reasons for this.

td-canadian-housing-market Source: TD Fourth Quarter Earnings Presentation, Slide 21

First of all, a significant portion (50%) of TD’s Real Estate Secured Lending (RESL) in their Canadian Banking segment is insured through the Canada Mortgage and Housing Corporation (CMHC). This means that the bank is protected from mortgage defaults in exchange for monthly insurance premiums paid by the borrower along with their mortgage payment.

You may be wondering how the borrower benefits from CMHC insurance. This insurance allows them to purchase a home with a higher loan-to-value (LTV) ratio, and thus a lower down payment. CMHC insurance allows a 5% down payment rather than the traditional 20% required by financial institutions.

Secondly, the LTV ratios of TD’s uninsured residential mortgage portfolio are well-below their maximum level. The reading of 58% from the above chart is much less than its potential 80% peak.

I’d also like to speak to the very low probability that a housing crash will actually materialize. Given that the 2008-2009 financial crisis was largely caused by loose mortgage standards by financial institutions like TD, investors are wary.

But Canada in 2016 is significantly different than the United States in 2008. Lending standards have become tighter across the world in response to the events of 2008-2009. Homeowners have more equity in their homes and income verification procedures are much more robust. No Income, No Job, and No Assets (NINJA) mortgages no longer exist. Further, Canada is known for having the soundest banks in the world.

For all these reasons, I am confident that the risk of a Canadian housing market crash is over-hyped by the media.

In 5, 10, or 20 years, today’s investors in TD will be handsomely rewarded for having the clarity to understand this.

Exposure to the Oil and Gas Sector

Another risk that is on the minds of investors in the Canadian banks is the continued downturn in commodity prices, namely crude oil. For example, consider the price action of USO, the United States Oil Fund. This is an ETF designed to move with the price of crude oil.

united-states-oil-etf

While banks are not directly affected by this drop in the price of oil, they are lenders to many businesses who operate in the oil and gas industry. If these companies default on their loans due to low commodity prices, banks like TD would increase their provisions for credit losses, lowering their earnings.

Fortunately, TD has focused on mitigating this risk. Consider the following chart.

td-oil-and-gas-exposure

Source: TD Fourth Quarter Earnings Presentation, Slide 14

 There are a few facts I’d like to draw from this diagram.

First of all, a large proportion of TD’s oil and gas exposure is lent to midstream oil companies. These companies are paid for the transportation of oil and related products, and their revenues are generally contractual (meaning that their counterparties are legally obliged to pay for their services). Due to the very nature of their business models, midstream oil companies like Enbridge (ENB) are isolated from movements in commodity prices, so TD’s $2.9 billion exposure to this subsector is more conservative than the rest of its energy portfolio.

Another point worth noting is the proportion of TD’s undrawn exposure that is with investment grade counterparties is very high (65%). This means that the Bank will not experience a sudden increase in exposure to non-investment grade oil and gas companies – most will be investment-grade in nature.

Further, less than 1% of TD’s total lending portfolio is exposed to the overall oil and gas industry. This is yet another insulator from the Bank’s exposure to this sector.

With all these things in mind, and other news such as the OPEC recently agreeing to cut oil supply (which has already driven oil prices up), concerns around the Bank’s oil and gas exposure should not result in any material negative developments.

A Note on Valuation

 In recent years, TD has traded at a premium to its peers because of the view that it is a lower-risk option among the Canadian banks.

This is still true today. As I write this, TD is trading at the highest price-to-earnings ratio and lowest dividend yield among the Big 5. However, I believe that TD’s risk-focused business model, their premium earnings mix, and their fantastic expansion opportunities in U.S. Retail merit this premium.

However, the value-conscious investor should consider this before purchasing shares of this bank.

 Looking Ahead

 On the fourth quarter earnings conference call, TD’s CEO Bharat Masrani reduced earnings guidance for their Canadian retail segment. While this might concern investors, it shouldn’t – Mr. Masrani also made it very clear that slower growth in Canada will be offset by continued strength in their U.S. Retail segment. Here’s what he had to say:

 “With the yield curve largely flat out to five years, we think it is prudent to moderate our medium term growth expectations for the Canadian retail segment from the 7% plus target identified at our Investor Day to mid-single digits.”

By contrast, the economic picture is brighter in the U.S. The Fed appears likely to raise rates in the coming months and the market has responded with bond yields rising and the U.S. dollar on the upswing. While there are global risks, these conditions in the U.S. if sustain, will enable us to deliver total bank adjusted EPS growth for 2017 inside our 7% to 10% medium term target range.”

The underlying theme remains the same – TD’s US operations will remain a key driver for the Bank looking ahead.

The Bottom Line

 TD is a great company from a great peer group.

With a dividend yield just under 3.5%, great dividend growth prospects, and a reasonable payout ratio, they rank favorably using the 8 Rules of Dividend Investing. Further, they are a member of the Canadian Dividend Aristocrats Index, composed of Canadian companies with 5+ consecutive years of dividend increases.

TD is a compelling investment at today’s prices, and their growth prospects, premium earnings mix, and room for dividend growth make them a safe bet for the foreseeable future.


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