This Canadian Bank Is Still Overvalued

GuruFocus.com

- By Mark Yu

Last week, Motley Fool Canada pitched that investors should buy the Toronto-Dominion Bank (TD) dip and ignore the recent media report by the Canadian Broadcasting Corp. that linked the $96 billion company to possible wrongdoing.


According to Reuters, the CBC report suggests the bank's customers were moved to higher fee accounts or their overdraft and credit card limits were increased without their knowledge to help staff meet targets.

Post-news report, Toronto-Dominion shares fell more than they have in eight years, according to Bloomberg

Earnings performance

Toronto-Dominion reported its first-quarter fiscal 2017 results on March 2. For the quarter, the bank delivered 5.9% sales growth to 9.12 billion Canadian dollars ($6.8 billion) and 13% profit growth to CA$2.46 billion --a 26.9% profit margin versus 25.2% in the year earlier quarter.

The bank has increased its credit losses provision by 15.5%, but recorded 1.9% lower insurance claim and related expenses.

"We are pleased with our start to 2017. Our focus on organic growth, combined with favorable market conditions this quarter led to strong results in our retail and wholesale business segments on both sides of the border," Bharat Masrani, president and CEO, said.

Valuations

After suffering a drop in share price, Toronto-Dominion still traded at par with its industry peers. According to GuruFocus, the Canadian bank had a trailing price-earnings ratio of 13.45 times versus an industry median of 13.5 times, a price-book value of 1.8 times versus an industry median of 1.15 times and a price-sales ratio of 3.45 times versus an industry median of 3.28 times.

Toronto-Dominion also had a 3.42% trailing dividend yield with a 46% payout ratio.

Using Reuters data, the bank would be trading on price-sales and price-earnings figures of 3.55 times and 12.6 times, respectively, on expected fiscal 2017 average sales and earnings per share figures.

Total returns

Despite the recent slump, Toronto-Dominion's local Canadian shares outperformed the broader S&P500 index in the past year. Toronto-Dominion delivered a 21.9% total return versus S&P500's 19.06% return in the past year, according to Morningstar data. In the past five years, the S&P500 index has outperformed the bank by one percentage point.

Toronto-Dominion

Toronto-Dominion Bank was founded in 1955 through the merger of the Bank of Toronto and the Dominion Bank, which were founded in 1855 and 1869.

Toronto-Dominion Bank is the second-largest Canadian bank in terms of assets, as of second-quarter 2016, and the sixth-largest bank in North America by branches as of first-quarter 2017.

As of October 2016, 66.3% or CA$400.7 billion of Toronto-Dominion's net loans were in Canada, 33.1% in the U.S. and the remaining in Europe and other countries.

Toronto-Dominion has three key business segments: Canadian Retail, U.S. Retail and Wholesale Banking.

Canadian retail

As per company filings, the Canadian retail segment provides a full range of financial products and services to customers in the personal and commercial banking, wealth and insurance businesses. Canadian retail contributed 59% of total Toronto-Dominion sales in fiscal 2016.

In first-quarter 2017, assets under management were CA$390 billion versus CA$342 billion in the year earlier quarter.

Return on common equity, meanwhile, was 43.2%, an increase from 42.6% a year ago, and had an efficiency ratio of 42.8%, versus 41.3% previously.

The efficiency ratio, which typically applies to banks, in simple terms is defined as expenses as a percentage of revenue (expenses / revenue), with a few variations. A lower percentage is better since that means expenses are low and earnings are high.

Canadian retail sales grew 3.4% to CA$5.2 billion and delivered 30% profit margin, which was similar to fiscal 2016 performance.

U.S. retail

U.S. retail comprises the bank's retail and commercial banking operations under several brands, including TD Bank, America's Most Convenient Bank, auto financing services and wealth management services in the U.S. The segment generated 28% of Toronto-Dominion sales in fiscal 2016.

The segment had 1,257 U.S. retail stores as of January compared to 1,264 stores the year before.

Assets under management were $18 billion for the recent quarter, up from $16 billion the year prior. Return on equity, meanwhile, was at 9.1%. The efficiency ratio for the quarter was 56.7%.

U.S. retail sales grew 5.3% to CA$2.53 billion and delivered 31.7% --the highest profit margin among the segments.

Wholesale banking

Wholesale banking provides a wide range of capital markets, investment banking and corporate banking products and services, including underwriting and distribution of new debt and equity issues, providing advice on strategic acquisitions and divestitures and meeting the daily trading, funding and investment needs of its clients.

The segment generated 9% of total Toronto-Dominion sales in fiscal 2016.

Return on common equity for the period was 17.5% versus 10.6% the year prior. Meanwhile, the efficiency ratio declined to 61.1% in the period from 64.6%.

In the recent quarter, wholesale banking sales grew 29.1% to CA$857 million and delivered a profit margin of 31.2%, up from 24.2% the year prior.

Financial metrics

Net interest margin

Investopedia defines net interest income as the difference between the revenue generated from a bank's assets and the expenses associated with paying out its liabilities.

(Q1 Report 2017, Toronto-Dominion)

Net interest margin for Toronto-Dominion Bank declined to 1.96% in the first quarter from 2.06% in the comparable quarter of 2015.

Return on equity ratios

According to Investopedia, return on equity (ROE) is the amount of net income returned as a percentage of shareholders' equity. Return on equity measures a company's profitability by revealing how much profit it generates with the money shareholders have invested.

(Q1 Report 2017, Toronto-Dominion)

Return on common equity for the recent quarter improved to 14.4% from 13.3% the year prior.

Provision for credit losses

Per Investopedia, the provision for credit losses, or default probability, is treated as an expense on the company's financial statements as expected losses from delinquent and bad debt or other credit that is likely to become default and unsatisfied.

(Complete Report and Report to Shareholders, Toronto-Dominion)

Provisions remained steady for the recent quarter, but observably grew in 2016 from 2015.

Capital adequacy in Tier 1 and revenue per risk weighted assets

Tier 1 capital

Tier 1 capital consists of shareholders' equity and retained earnings. Investopedia says tier 1 capital is intended to measure a bank's financial health and is used when a bank must absorb losses without ceasing business operations.

Under Basel III, the minimum tier 1 capital ratio is 6%, which is calculated by dividing the bank's tier 1 capital by its total risk-based assets.

(Complete Report and Report to Shareholders, Toronto-Dominion)

For the period, common equity tier 1 capital ratio improved to 10.9%. It was 9.9% in the comparable quarter in 2015

Sales and profits

(Complete Report and Report to Shareholders, Toronto-Dominion)

On average, Toronto-Dominion had three-year sales and profit growth and profit margin averages of 7.97%, 10.4% and 26%, per Morningstar data. In the most recent quarter, the bank delivered profit margins of 28%.

Cash, debt and book value

According to Morningstar, as of January, Toronto-Dominion had CA$3.75 billion in cash and due from banks, CA$8.39 billion in long-term debt with a debt-equity ratio of 0.12 times.

Further, 1.6% of CA$1.19 trillion assets were in goodwill and intangibles with a book value of CA$71.68 billion, an increase from CA$70 billion in the first quarter of 2016.

Cash flow

(Report to Shareholders, Toronto-Dominion)

For the first quarter, Toronto-Dominion's operational cash flow fell by 51% to CA$7.95 billion. Most cash outflow came from changes in securities sold short, trading loans and securities and fewer deposits.

Capital expenditures were CA$21 million, leaving Toronto-Dominion with CA$7.93 billion in free cash flow, down from CA$15.8 billion the year prior. Forty-five percent, or CA$3.55 billion, of the free cash flow was provided as shareholder payouts, treasury share buybacks and dividends to non-controlling interests.

(Complete Report and Report to Shareholders, Toronto-Dominion)

On average, Toronto-Dominion paid out 31% of its free cash flow in dividends and share repurchases--including preferred share repurchases. As observed, the bank also issued a good amount of common and preferred shares quarterly and buys less than the amount back per period.

In the recent quarter, the Canadian bank also invested CA$7.74 billion in available-for-sale securities, net proceeds received. Toronto-Dominion also received CA$3.23 billion in proceeds from held-to-maturity securities and another CA$603 million in proceeds from debt securities classified as loans.

Conclusion

Toronto-Dominion exhibited good growth in its overall business in the recent quarter. The bank still has some ways to go to reduce its more costly expenses in the U.S., but exhibited improved profitability nonetheless.

Toronto-Dominion has also generated bountiful free cash flow in recent years, along with a solid balance sheet.

(Toronto-Dominion ADR Share Price and P/E Ratio, GuruFocus)

Last week, RBC Capital Markets downgraded Toronto-Dominion ADR shares to sector outperform and lowered its price target to $68 from $73. Meanwhile, the average share price target of six analysts was $52.89 a share.

For Toronto-Dominion to trade at par with its book value, it would need a 42% decline from today's share price of $49.5.

In summary, Toronto-Dominion shares are overvalued with a value of $41 per ADR share.

Disclosure: I own shares of Toronto-Dominion.

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This article first appeared on GuruFocus.