Wednesday, June 14, 2006

Scotia Capital Downgrades TD Bank

Scotia Capital, 14 June 2006

Downgrading TD Bank to 2 Sector Perform

• We are downgrading TD Bank to 2-Sector Perform from 1-Sector Outperform based on disappointing performance in the bank's wholesale operations, continued earnings weakness at TD Banknorth, and risk of deceleration in relative earnings growth at TDCT led by a slowdown in insurance revenue growth. The bank is unduly relying on TDCT for earnings momentum, and with disappointing earnings from some of its other businesses.

• TD's share price is expected to perform more in line with the bank group. In addition, with the absence of TD share buybacks and a lower dividend payout ratio, investors will likely begin to require higher returns from the bank's "growth" investments. We view acquisition risk as higher at TD than the bank group.

• We continue to believe that TD's P/E multiple should expand relative to the bank group to a 10% premium over time based on earnings mix, profitability and capital levels. However, given the disappointing performance in the bank's wholesale business, earnings shortfalls at TD Banknorth, and market concerns about its strategic position in the US and return on capital, P/E expansion is expected to be delayed until some of these uncertainties are resolved.

Wholesale Banking Continues to Underperform

• The bank's wholesale operation has been very inconsistent in its results over the past few years with Q2 earnings, in our view, the weakest of the bank group. In Q2, the banks wholesale earnings declined 30% sequentially and 15% from a year earlier versus its major competitors whose wholesale earnings increased 24% from a year earlier. Excluding the impact of security gains, wholesale banking segment earnings declined 40% sequentially in Q2/06.

• Trading revenue was particularly weak at TD declining 21% from a year earlier versus an increase of 28% for the other major banks, due in part to TD losses on global structured products. The bank has taken restructuring charges in this business over the past 18 months as it exits the global structured product area. The losses from exiting this business have been larger than expected and taken longer than expected. The bank indicated on its Q2/06 conference call that it was only 50% complete in exiting this portfolio. We expected the bank to have dealt with this by now.

• The bank's competitive position in wholesale banking remains a concern. It would seem that the bank's competitive position erosion began in 1987 with the bank's strategic decision to build an investment dealer versus buy. TD's 1987 annual report stated that "rather than buy an established full-service investment dealer, we have chosen to build our own in-house securities operation, and capitalize on our existing strengths and expertise". The other major five banks of course all purchased full-service investment dealers.

• If we use 1967 as a base of 1.0, TD's relative performance versus the Bank Index is currently 2.57 representing substantial outperformance since 1967, the best of the bank group. However, it is interesting that this is actually lower than its 1988 performance level of 3.27 with the 1987 strategic decision appearing as a major negative inflection point for the bank.

• It would seem that the bank is struggling to define itself and its market position in this business line, post the $1.45 billion sectoral loan losses taken in 2002. The bank has lowered its risk profile in this business and reduced its overall earnings reliance. It is difficult to gauge the underlying earnings power of this business especially given that the magnitude of the earnings drag of the global structured products area is not known.

TD Banknorth - 2006 Earnings Estimates Decline 12%

• Earnings estimates (IBES) for 2006 for TD Banknorth have been reduced by 12% with earnings expected to decline by a similar amount from 2005 level. In addition the US$ will have declined by 7% in fiscal 2006 versus 2005 based on the current level of the C$/U$ of $1.10.

• TD Bank reported that in Q2/06 its return on invested capital for TD Banknorth was 4.4%. This represents an exceptionally low return on capital especially given that 39% of the current share price of $59.11.

• TD's August 2004 acquisition of Banknorth was not very timely as its book value is estimated to be $2.0 billion or $2.82 per TD share below the recent market value (BNK US$ 28.97). In addition the bank issued 44 million common shares at $44.89 in conjunction with the acquisition with TD's current share price being nearly 30% higher representing an additional $600 million in implied/opportunity costs.

Competition is Increasing

• The Dow Jones News service reported May 26, 2006 that Citigroup is entering the highly competitive Boston and Philadelphia retail banking markets, with plans to open several branches in each city this year and expand in the future. The forays into Boston and Philadelphia are part of an ambitious retail growth plan that Citigroup unveiled late last year. New Jersey is another focal point for Citigroup with the company planning to open 15 to 20 new branches this year.

• TD Banknorth has a solid presence in Boston with plans to expand and grow in New Jersey. Bank of America, Wachovia, Citizens, and Sovereign are formidable competitors in the region. TD Banknorth has also stated that it wants to enter and grow in the very competitive New York market which has very large players such as Chase, Citigroup, North Fork, Bank of America, HSBC, Wachovia, Washington Mutual, Commerce and Sovereign.

TD Ameritrade Earnings Estimates Reduced 5%

• TD Ameritrade earnings estimates (IBES) have been reduced 5% to US$0.91 per share from peak of $0.96 per share going into 2006 due to the announced fee cuts.

TDCT Exceptional Growth - Tough Comps Going Forward

• TDCT and its wealth management businesses have been performing exceptionally well. TDCT has been performing so well it is difficult not to see a deceleration in earnings growth. TDCT results have been aided by significant growth from insurance and we expect a substantial slowdown in growth, further compounding a lower TDCT growth outlook.

• TD Banks' Property and Casualty wholly owned subsidiary Meloche Monex recorded DPW (Direct Premiums Written) 5 year growth rate of an impressive 25% with growth expected to slow significantly to the 5% range. In fact, ING growth is forecast at a very modest 2% - 3% for 2007 versus its 5 year growth of 14% (as provided by Scotia Capital Insurance Analyst, Tom MacKinnon).

Wealth Management - Mutual Fund Sales Weakening

• In addition to slower growth from insurance it appears that mutual fund sales performance is weakening due to higher reliance on fixed income and an asset class shift away from this area given the sharp rise in interest rates. TD has the highest reliance on Fixed Income mutual funds of any bank at 28% of assets versus a low of 11% for RY and 12% for the overall mutual fund industry. TD mutual fund sales of long term assets (LTA) declined 79% year over year. In contrast, Royal Bank's LTA sales increased 40%.

Earnings Estimates and Target Price

• We are reducing our 2006 and 2007 earnings estimates to $4.50 per share and $5.00 pre share, respectively, from our slightly aggressive $4.60 per share and $5.10 per share due to ongoing weakness in wholesale banking and increasing earnings pressure at TD Banknorth.

• We are reducing our 12 month share price target to $70 from $75 per share due to lower earnings forecast and slower P/E multiple expansion.