(Published Dec. 5 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 Five 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, Financial) has a lot of positives. It is my personal favorite among the Big Five, and it is the most conservatively managed.
It also has fantastic growth prospects.
On Dec. 1, The Toronto-Dominion Bank announced its financial performance for the three-month and one-year period ending Oct. 31. This article will cover the bank’s financial results and overall growth prospects.
Business overview
The Toronto-Dominion Bank is a diversified financial services company serving customers in Canada, the U.S. and worldwide.
After being formed in 1955 from the merger of the Bank of Toronto and the Dominion Bank, The Toronto-Dominion Bank has grown to an international conglomerate with more than 80,000 employees and 25 million customers.
It divides its operations into three main lines of business:
- Canadian Retail including TD Canada Trust, Business Banking, TD Auto Finance (Canada), TD Wealth (Canada), TD Direct Investing and TD Insurance
- S. Retail including TD Bank, America’s Most Convenient Bank, TD Auto Finance (U.S.), TD Wealth (U.S.) and TD’s investment in TD Ameritrade
- Wholesale Banking including TD Securities
I will now go on to outline the bank’s financial performance before evaluating its investment prospects.
Financial performance
On Dec. 1, The Toronto-Dominion Bank reported earnings for the three-month and one-year period ending Oct. 31.
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.
- Reported diluted earnings per share were $1.20, compared with 96 cents (+25%).
- Reported net income was $2.303 billion, compared with $1.839 billion (+25%).
- Adjusted diluted earnings per share were $1.22, compared with $1.14 (+7%).
- Adjusted net income was $2.347 billion, compared with $2.177 billion (+8%).
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. 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 (96 cents) and adjusted ($1.14) EPS for the quarter.
The bottom line is that whether we are considering GAAP or adjusted results, The Toronto-Dominion Bank’s earnings trend for the fourth quarter is positive.
For fiscal 2016, results were similarly good.
- Reported diluted earnings per share were $4.67, compared with $4.21 (+11%).
- Reported net income was $8.936 billion, compared with $8.024 billion (+11%).
- Adjusted diluted earnings per share were $4.87, compared with $4.61 (+6%).
- Adjusted net income was $9.292 billion, compared with $8.754 billion (+6%).
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.
U.S. growth
For years, The Toronto-Dominion Bank has been absorbing market share in the U.S.
It has been a key driver of growth for the bank – U.S. Retail earnings were up 18% year over year in the fourth quarter on a GAAP basis and 9% on an adjusted basis. For fiscal 2016, the improvement is even more noticeable. The Toronto-Dominion Bank’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 completely privatized as TD Banknorth and formed the foundation of TD Bank, "America’s Most Convenient Bank."
The Toronto-Dominion Bank was able to leverage its strong capital position during the financial crisis to purchase the business of distressed banks. This helped it to rapidly gain market share south of the border.
Fast forward to today, and The Toronto-Dominion Bank now has more branches in the U.S. than in Canada. Most recently, The Toronto-Dominion Bank 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 its scale in the U.S.
The following diagram displays The Toronto-Dominion Bank’s 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 The Toronto-Dominion Bank will continue to gobble up market share in the U.S. and 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 Five. This limited competition bodes well for the future success of The Toronto-Dominion Bank.
Further, the Global Financial Crisis of 2008-2009 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. The Toronto-Dominion Bank 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.
The Toronto-Dominion Bank is proving to be nimble regardless of its size and continually makes digital improvements to improve its customer experience. A prime example of this is The Toronto-Dominion Bank MySpend app, which is a budgeting app very similar to Mint and only available to customers of The Toronto-Dominion Bank.
Source: Mobile Syrup
Introduced in April, the app has been a hit with customers and has more than 900,000 downloads.
Dividend growth and safety
Over the years, The Toronto-Dominion Bank has a fantastic record of increasing its dividend payments to shareholders.
Source: Publicly Available Financial Statements
Dividend growth from 46 cents 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 of its long-term record of dividend increases, the bank is a member of the Standard & Poor's Canadian Dividend Aristocrats Index, which is a group of select Canadian companies with five-plus years of consecutive dividend increases; not to be confused with the traditional Dividend Aristocrats Index, which are companies with 25-plus years of consecutive dividend increases. You can see the full list of "normal"Ă‚ Dividend Aristocrats here.
The Toronto-Dominion Bank is also a great example of dividend safety. For instance, in the 2008-2009 financial crisis, it did not cut the dividend although many of its U.S. counterparts did.
The payout ratio is also representative of the safety of its dividend. Based on fiscal 2016’s dividends per share of $2.16 and The Toronto-Dominion Bank’s adjusted diluted earnings per share of $4.87, the company has a payout ratio of 44.3%. This is well within its guidance of 40% to 50% and indicates that the bank has plenty of room to raise its dividend even in the unlikely case that earnings remain flat.
With yield, growth and safety all present, I am confident in The Toronto-Dominion Bank’s dividend prospects looking forward.
An appealing earnings mix
The Toronto-Dominion Bank is known to be the member of the Big Five with the most focus on retail banking.
This is reflected in the numerous accolades it has received for its customer service. For example, it ranked No. 1 in the J.D. Power Retail Banking Customer Satisfaction Survey for 10 years in a row from 2005 to 2015. In 2016, it placed second to the Royal Bank of Canada (RY, Financial). Still, this streak is impressive.
For investors, this also translates to The Toronto-Dominion Bank’s bottom line. The bank derives a larger portion of its earnings from its retail banking segment than most of its peers. This is partially due to the rapid expansion of its U.S. retail segment. It is now the Canadian bank with the largest U.S. branch network.
In 2015, The Toronto-Dominion Bank generated 91% of its earnings through retail banking. This number will likely increase over time as the bank continues to gain market share in the U.S.
Source: TD 2015 Annual Report
The Toronto-Dominion Bank’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 to default on their mortgage (retail banking segment).
The Toronto-Dominion Bank’s premium earnings mix is a positive for this stock.
Concerns about the Canadian housing market
I’ve spent most of this article writing about the strengths of The Toronto-Dominion Bank as an investment opportunity. However, as with any other investment it is important to identify and manage risk.
An investment in TD Bank presents two main risks: exposure to the Canadian housing market and exposure to the oil and gas industry.
I will start by tackling the problem of a potential Canadian housing bubble.
Investors are increasingly concerned with the rising prices of Canadian homes. Many are concerned that we are experiencing a housing bubble, and banks like The Toronto-Dominion Bank will suffer from significant mortgage defaults if home price increases were to slow (or worse, decline).
Fortunately for investors, The Toronto-Dominion Bank is well insulated from any potential housing market crash. There are a few reasons for this.
Source: TD Fourth Quarter Earnings Presentation, Slide 21
First of all, a significant portion (50%) of The Toronto-Dominion Bank’s real estate secured lending (RESL) in its Canadian banking segment is insured through the Canada Mortgage and Housing Corp. (CMHC). This means that the bank is protected from mortgage defaults in exchange for monthly insurance premiums paid by the borrowers along with their mortgage payments.
You may be wondering how borrowers benefit 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 The Toronto-Dominion Bank’s uninsured residential mortgage portfolio are well-below its 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 The Toronto-Dominion Bank, investors are wary.
But Canada in 2016 is significantly different than the U.S. 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 overhyped by the media.
In five, 10 or 20 years, today’s investors in The Toronto-Dominion Bank 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.
While banks are not directly affected by this drop in the price of oil, they are lenders to many businesses that operate in the oil and gas industry. If these companies default on their loans due to low commodity prices, banks like The Toronto-Dominion Bank would increase their provisions for credit losses, lowering their earnings.
Fortunately, The Toronto-Dominion Bank has focused on mitigating this risk. Consider the following chart.
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 The Toronto-Dominion Bank’s oil and gas exposure is lent to midstream oil companies. These companies are paid for by 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 nature of their business models, midstream oil companies like Enbridge (ENB, Financial) are isolated from movements in commodity prices so The Toronto-Dominion Bank’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 The Toronto-Dominion Bank’s undrawn exposure that is with investment grade counterparties is high (65%). This means that the Bank will not experience a sudden increase in exposure to noninvestment grade oil and gas companies – most will be investment grade in nature.
Further, less than 1% of The Toronto-Dominion Bank’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, The Toronto-Dominion Bank 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, The Toronto-Dominion Bank is trading at the highest price-earnings (P/E) ratio and lowest dividend yield among the Big Five. However, I believe that The Toronto-Dominion Bank’s risk-focused business model, its premium earnings mix, and its 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, The Toronto-Dominion Bank’s CEO Bharat Masrani reduced earnings guidance for its Canadian retail segment. While this might concern investors, it shouldn’t – Masrani also made it clear that slower growth in Canada will be offset by continued strength in its 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.
The underlying theme remains the same – The Toronto-Dominion Bank’s U.S. operations will remain a key driver for the bank looking ahead.
The bottom line
The Toronto-Dominion Bank 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, it rank favorably using the 8 Rules of Dividend Investing. Further, it is a member of the Canadian Dividend Aristocrats Index, composed of Canadian companies with five-plus consecutive years of dividend increases.
TD is a compelling investment at today’s prices, and its growth prospects, premium earnings mix and room for dividend growth make it a safe bet for the foreseeable future.
Disclosure: I am not long any of the stocks mentioned in this article.
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