Toronto-Dominion's Yield and Valuation Make the Stock a Buy
The Canadian banks have always looked attractive to me as they are more conservatively run then their U.S. counterparts. These companies also weren't forced to cut dividends during the 2007 to 2009 recession, though most did pause dividend growth during this time.
The last major Canadian bank that I have to look at is Toronto-Dominion Bank (NYSE:TD). This 5%-plus yielding stock is down nearly 24% year to date, very similar to its peers. The most recent earnings showed some weakness, but I believe long-term investors buying shares of Toronto-Dominion today will be rewarded down the road. Let's look at why.
Quarterly results
Toronto-Dominion has a market capitalization of nearly $78 billion, making it the second-largest bank in Canada. The bank has been in existence since 1855 and has transformed into a worldwide bank over the years. Toronto-Dominion has more than 26 million customers in Canada, the U.S. and around the world. The bank operates three business segments: Canadian Retail, which includes TD Commercial Banking and TD Insurance, U.S. Retail, including TD Bank and TD Ameritade, and Wholesale Banking, which includes TD Securities.
Toronto-Dominion reported second-quarter earnings results on May 28 (the company's fiscal year ends Oct. 31). Results were mixed. All figures are in U.S. dollars unless otherwise noted. Revenue increased 0.8% to $7.2 billion, which was $152 million higher than expected. Earnings per share, on the other hand, decreased 52% to 62 cents. The analyst community had expected 64 cents.
The decline in earnings echoed that of the other major Canadian banks that recently reported quarterly results. The primary reason for this is a drastic increase in provisions for credit losses, or PCL, that Toronto-Dominion and its peers took during the quarter. The Covid-19 pandemic has required the shuttering of businesses and stay-at-home directives for consumers, both in the U.S. and Canada, in an effort to slow the spread of the virus. This has greatly slowed economic activity, making it likely that both individuals and businesses will have difficulty repaying loan obligations.
Source: Toronto-Dominion's Second-Quarter Earnings Presentation, slide 9.
PCL was 633 million Canadian dollars ($465.8 million) for Toronto-Dominion in the second quarter of fiscal 2019 and CA$919 million in the first quarter of fiscal 2020. In the most recent quarter, this figured ballooned to CA$3.2 billion, a 408% increase year overyear and a 250% rise quarter over quarter. Toronto-Dominion's total allowance for credit losses is now CA$6.9 billion.
This is a massive increase in the amount of loans in a short amount of time that Toronto-Dominion expects to become impaired. In a vacuum, this could be seen as extremely troubling and might make investors recall the days of the last financial crisis, when it feared that the U.S. banks might become insolvent.
Digging deeper, this doesn't appear to be the case for Toronto-Dominion (or the other Canadian banks for that matter). Toronto-Dominion has a total loan portfolio of CA$736 billion, meaning that the percentage of the loan portfolio that is expected to become impaired is just 0.94%. This is an extremely low figure even though it's the highest percentage of PCL among the Canadian banks. Toronto-Dominion could underestimate the impact of Covid-19 on its business, but we won't know until we see the next quarter's PCL figure. In the presentation, Toronto-Dominion did note that its expectations are for a gradual recovery. Pre-crisis economic activity isn't expected for some time, so its not as if the bank is looking at the current environment through rose-colored glasses.
Let's examine how each individual segment of the company performed during the quarter.
The Canadian Retail segment, which accounts for approximately 60% of revenue, grew 1% year over year. Net income decreased 37%, though this was mostly due to a 312% increase in PCL. Still, the PCL ratio was just 1.07%, 80 basis points above Q2 fiscal 2019. Wealth assets decreased 2%. Net interest margins declined 11 basis points to 2.83%, but this isn't unexpected given that interest rates are very low. Also impacting results was a 4% increase in expenses. On the plus side, loan volumes were up 5% while deposit volumes improved 10%, showing that there is some economic growth occurring and that Toronto-Dominion is capturing at least part of it.
Revenue for the U.S. Retail segment declined 7%. Net income was down 88% as PCL was up almost 380% from the prior year. The PCL ratio stood at 2.03% at the end of the quarter, a 158-basis point increase. Within this business, TD Ameritrade was lower by 9% as reduced fees, due to the brokerage firm's decision to slash trading fees on stocks and most mutual funds, and an increase in expenses more than offset higher trading volumes. As with the Canadian Retail business, loan and deposit growth was solid. Loan volumes were up 7% and deposits, not inclusive of TD Ameritrade, grew double-digits.
Whole Sale Banking revenue improved 42%, but net income was down 5%. Revenue growth was fueled by higher salesfrom trading-related activities and debt underwriting fees. Net income declined due to higher PCL and a 3% increase in expenses.
Results for the second quarter were mixed as revenue inched higher, but earnings suffered a steep decline due to increased provisions for credit losses. Following second-quarter results, analysts expect that Toronto-Dominion will earn $3.69 per share in fiscal 2020. The company had been expected to earn $5.32 per share previously. This decline is due to second-quarter results and the likelihood of further PCL over the next two quarters.
While this year is likely to see a decline in earnings per share due to PCL, Toronto-Dominion has seen an increase every year since 2010 even as the share count has risen slightly. Earnings per share has increased by an average of 9.4% over the last decade while net income has improved at an annual clip of 9.7% over that same period.
Even considering the headwinds that Toronto-Dominion faced in the quarter, I still like the stock for its dividend yield and valuation.
Dividend and valuation analysis
Toronto-Dominion paused its dividend during the last recession, but has increased its dividend payment every year since 2011 in Canadian dollars. U.S. investors have received an increase over this same time period, expect for 2015 when the dividend payment dipped slightly. This was due to currency exchange and not a lower payout amount.
U.S. investors have seen their dividends increase with a compounded annual growth rate of:
6.4% per year for the past three years.
6.2% per year for the past five years.
6.3% per year for the past 10 years.
Investors received a 6.7% dividend increase for the payment distributed this past April 30. Toronto-Dominion has been remarkably consistent with its dividend growth over the past decade, with the recent increase slightly higher than the averages listed above. Income investors looking for exposure to the financial sector should take note of the stock's 5.4% yield, which compares quite favorably to the 10-year average yield of 3.6%. The stock also has a yield that is more than double the average yield of the S&P 500.
U.S. shareholders should receive $2.31 of dividends per share this year. Using the revised estimates for 2020 results in a payout ratio of 63%. For context, Toronto-Dominion has an average payout ratio of 43% over the last decade. The bank has a long history of maintaining a conservative payout ratio. Due to reduced earnings expectations, this payout ratio is now higher than usual. I don't believe this means that the dividend is in danger of being cut. A sharp drawdown in earnings per share from 2007 to 2009 resulted in pause, not a cut. Therefore, I believe the dividend to be safe unless Covid-19 has a more significant impact on results.
Using Friday's closing price of $42.80 and expected earnings for the year, shares of Toronto-Dominion have a forward price-earnings ratio of 11.6. This compares to the 10-year average price-earnings ratio of 12.1. Therefore, I have a valuation target range of 11 to 13 times earnings. Applying this to expected earnings per share for the fiscal year results in a target price of $41 to $48. This would be a 4.2% decrease from the current price at the low end, while the high end would reward investors with a 12.1% gain. Even falling to my low-end target price would result in an overall positive result for the position due to the stock's dividend yield. Achieving the higher end of range would be a solid return on shares of a company that produced weaker results due to something (the Covid-19 pandemic) outside of its control.
Final thoughts
As with the other Canadian banks, Toronto-Dominion's second-quarter results were negatively impacted by higher provisions for credit losses. This shouldn't have surprised investors given the number of businesses closed and consumers required to stay home due to the impact from the pandemic.
Even following the increase in PCL, less than 1% of Toronto-Dominion's entire loan portfolio is expected to become an issue for the bank. This percentage is comparable to the other banks that have reported, which I take to mean that the Canadian banks don't believe that Covid-19 will cause as much disruption to their business as some might think. And aside from this, the quarter was solid for Toronto-Dominion. Loan volumes and deposits were higher in both the Canada and U.S. retail segments.
Toronto-Dominion also offers a strong dividend yield. While the payout ratio is elevated compared to previous years, it is not yet in a dangerous area in my opinion. The stock also remains cheap against its historical average. Toronto-Dominion has much more upside than downside potential using my target valuation range. Because of this, I believe that the stock can be bought at the current price.
Disclosure: The author is not long any stocks mentioned in this article.
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