(Published by Bob Ciura on March 14)
Toronto-Dominion Bank (TD, Financial) stock is down 5% in the past month.
The sudden decline is largely due to a recent report in a Canadian newspaper that alleged the bank has pressured employees to open accounts for customers they did not need.
The article raises questions about TD Bank’s sales targets. In the aftermath of the report, several analysts downgraded the bank, with some drawing parallels to the Wells Fargo (WFC, Financial) fake accounts scandal.
TD Bank does not qualify as a Dividend Achiever, a group of 271 stocks with at least 10 years of consecutive dividend increases.
You can see the full Dividend Achievers List here.
It does have a consistent track record of dividend growth however. It recently hiked its dividend by 9%.
Due to its recent share price dip, the stock has a dividend yield almost twice the S&P 500 Index average yield, which is why TD Bank may be a bargain.
Business overview
TD Bank is a major financial institution. In fact, it is the fifth-largest bank by total assets and the sixth-largest bank by market capitalization.
It has more than 2,400 locations across North America, most of which are in Canada.
Source: 2017 Investor Presentation, page 4
TD has three main segments:
- Canadian Retail (61% of earnings)
- S. Retail (30% of earnings)
- Wholesale Banking (9% of earnings)
The Canadian and U.S. retail segments operate basically the same businesses, which are personal banking, credit cards, auto loans and commercial banking.
The Wholesale Banking segment includes research, investment banking and capital markets services.
With a huge network of branches and ATMs and a strong brand, TD has generated strong earnings growth for many years.
Source: 2017 Investor Presentation, page 12
Over the past five years, TD grew earnings per share by 8.4% per year on average.
Future growth will come from several potential catalysts, which include rising interest rates and cost controls.
Growth prospects
In the Canadian retail segment, TD’s growth will be fueled by cost cuts, higher loans and deposits. This will help turn around the Canadian business, which saw earnings inch up by 0.8% last year.
Separately, the company’s U.S. retail business is an even more attractive growth catalyst. Last year, the U.S. retail business posted an 8.8% increase in profits.
Source: 2017 Investor Presentation, page 27
The U.S. business will benefit from expanded productivity measures, but more importantly rising interest rates.
The Federal Reserve raised interest rates in 2016 for the first time since the financial crisis and Great Recession of 2007 to 2009.
The Fed is expected to raise rates as many as three more times in 2017.
This will help banks like TD increase profitability by expanding net interest margin. This is the spread banks earn between what they pay to depositors, versus the interest collected from loans.
As a result, a return to a rising rate environment would be a strong tailwind for the company.
The benefits of rising interest rates are already being felt. In the first quarter, TD’s revenue and adjusted earnings rose 6% and 13%, respectively, from the same quarter last year.
One potential headwind for TD’s future growth is its exposure to oil and gas loans.
Source: 2017 Investor Presentation, page 18
This is particularly worrisome for banks that operate in Canada because the energy sector represents a large portion of the Canadian economy.
When commodity prices crashed in 2015 and 2016, banks with heavy exposure to the oil and gas industry suffered losses from increasing loan defaults.
TD Bank has $2.7 billion of outstanding loans made to oil and gas producers. This is worrisome because production companies are among the most vulnerable to falling commodity prices.
The concern is exacerbated by the fact 63% of loans made to production companies have credit ratings below investment grade.
Fortunately, TD also has $2.7 billion in loans outstanding made to midstream companies and refiners, which are much less exposed to commodity prices. Approximately 67% of these loans have investment-grade credit ratings.
Now that commodity prices have significantly recovered since February 2016, TD has seen an improvement in its credit portfolio's performance.
Overall, TD expects to grow adjusted EPS by 7% to 10% per year over the next several years.
This would be more than enough growth to generate satisfactory shareholder returns moving forward.
Valuation & expected total returns
TD Bank is an attractively valued stock. Based on trailing EPS, the stock trades for a price-earnings (P/E) ratio of 13.9.
This compares very favorably to the S&P 500 Index, which trades for a P/E ratio of 26.
This is what could make TD stock a true bargain. A higher valuation multiple is easily justified based on the company’s strong brand and high single-digit earnings growth.
In addition to expansion of the valuation multiple, future returns will be based on EPS growth and dividends.
A potential breakdown of future returns is as follows:
- 5% to 7% revenue growth
- 1% growth from cost cuts
- 1% growth from share repurchases
- 6% dividend yield
Using these assumptions, total returns could reach approximately 10.6% to 12.6% per year.
Dividend analysis
TD Bank has a long history of delivering steady dividend increases to shareholders each year.
Source: 2017 Investor Presentation, page 14
From 1995 to 2016, the company grew its dividend by 11% per year.
Importantly, TD maintains a strong credit portfolio. It has kept credit losses at a manageable level, which helps the sustainability of its dividend.
Source: 2017 Investor Presentation, page 17
TD holds a credit rating of AA- from Standard & Poor’s, with a stable outlook. It also gets an Aa1 rating from Moody’s.
These are strong credit ratings in both cases.
This has helped the company maintain a strong balance sheet. For example, the company holds a 10.9% Common Equity Tier 1 ratio.
TD has an annual dividend payout of roughly $1.78 per share. This comes out to a 3.6% dividend yield.
Final thoughts
TD Bank has a strong, highly profitable business model and pays consistent dividends to shareholders.
The recent newspaper report has resulted in an elevated level of headline risk.
But after the news broke, TD Bank responded with a strong defense of its sales practices. The company stated it received a relatively small number of customer complaints last year and will continue to investigate the matter.
Assuming the scandal does not escalate further, income investors could view the recent decline as a buying opportunity.
Disclosure: I am not long any of the stocks mentioned in this article.
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