Toronto Dominion: Set For A Good 2021, But A Return To Pre-COVID Performance Now Reflected In The Share Price

by The Compound Investor

A year ago it might have been tough to imagine Toronto Dominion (TD) putting down the kind of financial results it has of late. The economic environment was obviously pretty darn scary back then, with the early economic data resembling nothing ever seen before. The potentially devastating impact to bank stocks in the form of credit losses probably doesn’t require much extra commentary. Indeed, that Canadian giant TD has managed to comfortably maintain its dividend streak perhaps sums up just how well the industry has held up.

The bank has still felt a pinch of course, just as most other industry players have. Its interest income has come under pressure from lower interest rates, while TD also set aside C$7.2b for potential bad debt last year. That was up from just over C$3b in 2019 and C$2.5b in 2018. Still, a few factors have kept things from being much worse here. Firstly, the unprecedented downturn was met by an equally unprecedented fiscal and monetary response from the powers that be. TD also implemented its own loan deferral programs for struggling customers. Secondly, the group’s investment banking segment is contributing record profit numbers as a result of the stimulus measures. That has helped pick up some slack elsewhere. The bank also realized a chunky gain on the sale of broker TD Ameritrade to Charles Schwab last year, where it retains a 13.5% stake.

The first time the bank featured here last September I wrote that it was worth a closer look. Its stock offered up a 5.1% dividend yield at the time, making it a suitably “low bar” investment candidate. I mean, being a play on the Canadian economy and Canadian households, and to a lesser extent the United States, probably means a base case long-term outlook in the 5% area in terms of annual growth. A 5%-plus starting yield meant that was more than okay, notwithstanding the uncertainties due to COVID and so on. I still like the bank a lot, but with the stock taking out record highs since last coverage the investment case is obviously a bit less compelling now.

Core Business Shows Resilience

I think it’s fair to say that TD’s core numbers have held up reasonably well, though its US retail business has been a drag recently versus Canadian peers. The challenge in terms of interest income is clear enough, and interest margins slipped sequentially on both sides of the border in the bank’s fiscal first quarter. That was offset by growth in domestic mortgage volume. Canada’s housing market looks white hot right now – worth noting since loan growth elsewhere looks tough – and Canadian mortgages on the loan book increased by circa C$3.5b quarter-over-quarter. Anyway, that dynamic contributed to sequentially flat net interest income of circa C$6b in Q1.

Of course, interest income is not the be-all and end-all here. Non-interest income has generally been a boon for the banks during this downturn, and TD is no exception. The gain booked on TD Ameritrade helped boost the numbers last year, while underlying performance has picked up this year. Some areas remain subdued, with credit card fees still down on pre-COVID levels being one example. Still, other lines like fee and transaction-based Wealth have helped make up for that. Non-interest income in the Canadian retail segment increased 11% year-on-year last quarter to C$3.4b, more than offsetting tougher numbers south of the border.

Wholesale banking also continues to throw off elevated profit numbers versus its pre-COVID baseline. Same story with the 13.5% Schwab stake – housed in the US retail segment – which is good for circa C$240m in quarterly profit at the moment.

Provision Expense Slides

Putting together all of the above leads to decent numbers in terms of the core business. I have pre-provision profit before tax up circa 5-6% last quarter based on the straight math. That looks fairly impressive all things considered, even if it was lower than Canadian peers thanks to US Retail. Anyway, that was then boosted by a circa 15-year low provision expense for bad debt. TD set aside just C$313m in the first quarter, down around C$600m on the pre-COVID year-ago period. That reflects the large amount set aside in fiscal 2020 as well as ongoing stimulus measures and so on. All said and done, the above was good for double-digit overall profit growth in the first quarter. After-tax profit clocked in at C$3.2b, or C$1.77 per share, up around 10% year-on-year.

Outlook

The obvious exposure for investors here is to Canadian households, where bubble talk in terms of the housing market is obviously not new. Price-income ratios have ballooned over the years, with households taking on more and more debt as a result. Concerns will only have intensified given annual house price growth has reached the 20-25% area. As far as TD is concerned, around 40% of the loan book is in Canadian residential real estate. The regulatory situation in Canada means the bank is less exposed to outright defaults than would otherwise be the case. It also has a reputation as a relatively conservative underwriter, with LTV ratios and so on looking reasonable. Even so, the risk in terms of future income growth is clear enough.

On the flip side, the bank has a few levers it can pull. Efficiencies on the cost-side of the equation mean that performance in line with GDP can turn into above average profit growth. The ongoing push into digital and mobile banking obviously forms a part of that. Management also seems keen on expanding south of the border, possibly using the Schwab stake as funding. US retail is a lower quality business than the Canadian counterpart as TD lacks key advantages there. It is still a decent business though, while the US also enjoys relatively good long-term growth prospects in my view.

TD stock currently trades around the C$82.25 mark in Toronto. Analyst estimates now point to EPS in the C$6.80 per share region, putting the stock at around 12x earnings. The quarterly dividend remains stuck at C$0.79 per share, albeit with growth set to resume this year. Capital levels have strengthened here thanks to retained profit generation – TD’s CET1 ratio stood at 13.6% at last count – as has the general economic outlook thanks to the vaccines, so it seems nailed on that regulators will give the green light for dividend growth. The current dividend is good for a yield of around 3.8%, and longer-term I think the nature of the bank probably supports a circa 5% growth rate on top. Discounting that back to the present probably puts the shares around about fair value right now.

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