Deal Collapse Leaves First Horizon, TD Bank Undervalued

The acquisition of First Horizon Corp. (FHN, Financial) by financial company Toronto-Dominion Bank (TD, Financial), which was announced in February 2022 and valued at $13.4 billion, was called off by both parties due to regulatory uncertainties earlier this week.

The deal would have created the sixth-largest bank in the U.S., with assets of over $600 billion and operations in 22 states. However, the prolonged approval process and the recent turmoil in the regional banking sector have eroded investor confidence and caused First Horizon's stock price to drop below the offer price of $25 per share.

According to the terms of the agreement, TD Bank, which is the name Toronto-Dominion operates under, will pay a termination fee of $200 million and reimburse $25 million worth of expenses to First Horizon.

The deal also raised questions about TD's U.S. expansion strategy, as it had faced competition from other Canadian and U.S. banks for acquiring U.S. assets. The failure of the acquisition coincided with the recent crisis in the regional banking sector as several banks collapsed due to deposit outflows and liquidity issues. TD investors are relieved about getting out of the deal, while First Horizon investors are chagrined about losing out on a substantial premium.

Now, First Horizon faces the challenge of retaining its deposits amid the banking crisis that has led to the collapse of three other regional banks since March. The company has a high proportion of uninsured deposits, which are more vulnerable to customer withdrawals in times of stress. Although the bank has maintained its stability and profitability so far, analysts believe this was partly due to the merger expectations. With TD out of the game, First Horizon will need to demonstrate its resilience and growth potential as an independent entity in order to regain market trust and valuation.

The main concern is that about 45% of First Horizon's $62.2 billion deposits are uninsured. This means that around $28 billion could be at risk if the bank's stability is questioned by customers. This increases its business risk. Further, there is a risk the company might face difficulties on its own.

The deposit outflows that started in the first quarter of 2022 for U.S. regional banks was driven by two main factors: higher interest rates and economic uncertainty. Customers and firms sought higher returns elsewhere, while some also used their deposits to handle increased expenses. A common factor among failed banks is that they increased their borrowings before collapsing. They used these borrowings to cope with deposit withdrawals. However, they also had to pay higher interest rates than what depositors wanted. For First Horizon shareholders, the positive news is the company did not have a big rise in short-term borrowings. At the end of the last quarter, this was $6.48 billion, higher than the $2.51 billion in the previous quarter.

The main factors that affected the banks' performance were their exposure to certain regions and sectors. Banks that invested in California and New York faced more losses than others, because these states had a high concentration of venture capital, private equity and early-stage enterprises . These are risky investments that depend on the growth potential of new companies . First Horizon, on the other hand, did not have this kind of exposure. Its main markets apart from its home market in Tennessee were Texas, Florida, Louisiana and North Carolina, which were less affected by the downturn.

First Horizon has a strong presence in the southeast U.S., where it offers a range of banking and financial services to consumers and businesses. The company has a diversified revenue mix, with fee income accounting for about 40% of its total income. The company also has a solid capital position, with a common equity tier 1 ratio of 10.5% as of March 31. The company has opportunities to expand its market share and cross-sell its products to its existing customers, as well as to pursue organic and inorganic growth initiatives.

The company is still in good shape based on the available data as of March. It might face some challenges if many depositors withdraw their money in the months following. However, this risk is going down given the company's strength and the resilience of the main street economy.

GuruFocus valuation metrics for First Horizon are as follows. The company pays a dividend yield of 5.2%.

TD Bank, on the other hand, is the second-largest bank in Canada, the seventh-largest U.S. bank by deposits and the 11th-largest bank in the U.S. by total assets. Canada has a oligopolistic banking market where six large banks dominate. They are also highly regulated and the banking system is considered to be one of the most stable in the world. TD has been using its solid base in Canada to expand its operations in the U.S. over the years, acquiring 10 companies in the U.S., including Commerce Bancorp in 2007, The South Financial Group in 2010 and TD Waterhouse USA in 2005.

Due to its exposure to the U.S., the company's stock has been underperforming the Canada banking sector, losing 11% of its value since January, while the average decline was only 4.3%. The bank reported lower-than-expected earnings in the second quarter, but showed resilience in managing credit losses compared to its peers. The bank's valuation is attractive with a price-earnings ratio of 9.11 and a forward price-earnings ratio of 9.5, both below historical averages. TD Bank pays a dividend yield of 4.78%.

TD Bank's GuruFocus valuation rank metrics are as follows:

Conclusion

The collapse of the deal has left both banks significantly undervalued, in my opinion.

TD Bank is, of course, a safer bet given its status as a very large financial institution. First Horizon is more risky, but much more beaten down given the additional fear surrounding regional banks in the U.S.