Friday, August 18, 2006

RBC CM Preview of TD Bank Q3 2006 Earnings

  
RBC Capital Markets, 18 August 2006

TD is scheduled to report third quarter earnings on August 24. Our cash EPS estimate of $1.17 is 1¢ above the Thomson First Call mean estimate, indicating a 13% lift year over year, and up 7% sequentially. TD’s core businesses remain healthy but the bank should also benefit from a full quarter of revenue inclusion from its recent Hudons United acquisition and from the increased ownership of Ameritrade. Integration savings should accelerate in upcoming quarters. Last quarter, TD’s adjusted EPS (normalized cash earnings) of $1.09 missed consensus estimate by 3¢. However, we believe consensus (and ourselves) missed TD, given the difficulty in modeling this bank with all of its recent acquisitions and related stub periods.

Credit Loss Expected to Normalize. Our Q3/06 loan loss provision estimate of $120 million (0.29% of loans) compares to $16 million in Q2/06 and $40 million in the year ago Q205. Last quarter, TD’s impaired loans dropped again to only $349 million or 0.21% of total loans – TD’s reserve coverage was a league-leading 370%. Of all Canadian banks, given excess capital, coverage and business mix, we believe that TD looks best set to weather any unforeseen credit issues.

Expecting 9% Dividend Hike. TD is on schedule to raise its dividend this quarter (usually every second quarter) since the last hike was in February 2006. We are forecasting a 4¢ lift to $0.48 per share. We forecast TD’s peer leading Tier 1 capital ratio at 12.3% in Q3/06, compared to 12.1% in Q2 and 10.0% a year ago. We are looking for a group average of 10.1% this quarter, including TD, and 9.7% excluding TD.

Key Issues

1. Enron Class Action Trial Postponed. The trial date for the Enron class action suit (Newby) against TD and other investment banks, has been delayed until April 9, 2007 (previously scheduled Oct 16, 2006). In our view, this allows more time for TD to reach a settlement. It is also noteworthy that TD and Merrill Lynch are reportedly looking to have claims dismissed entirely on similar grounds to Barclays (dismissed from suit July 21). Overall, we see these developments as positive for TD, who has already set aside $538 million in provisions, $300 million of which was specifically tagged for Enron related litigation. Albeit difficult to assess using rational analysis, it would be our sense that the risk of a major financial hit, such as for CIBC last year, is much lower for TD.

2. U.S. Results About In Line with Our Expectations. Banknorth’s Q2/06 release indicates BNK will contribute $68 million (our estimate was $70MM) or 8% to TD’s Q3/F06 cash net income, up from 7.5% in Q2/F06. Ameritrade’s Q3/F06 indicated a $55 million contribution (our estimate was $59 million) to contribute 6.5% to TD’s income, up from 5% last quarter.

3. Chief Risk Officer Moves to TD Banknorth. TD’s Bharat Masrani, Chief Risk Officer, moved to the position of President, TD Banknorth at the request of Bill Ryan during the quarter. TD Bank is now looking to fill the void and we expect to hear about any progress made on the conference call.

Divisional Highlights

Domestic Retail TD’s Shining Light. TD Canada Trust has been generating roughly 10% revenue growth year over year, and holding expense growth below 5% to drive excellent operating leverage. Earnings growth has averaged 16% YoY for the past 10 quarters. Domestic retail profit was up 18% year over year last quarter. We are factoring another 17% YoY growth in Q3/06.

In 2006, we expect that TD’s recently renewed focus on small business banking, to retail brokerage, and to credit cards should help maintain the bank’s leading retail position. TD may also feel the benefit of improved market price discipline, as both BMO and CIBC have become more price conscious this quarter.

No small part of the good-news story has been TD’s timely leverage to home and auto insurance through Meloche Monnex, providing leading participation in the excellent P&C insurance sector profit dynamics. Judging by the P&C insurers’ Q2 reports, the good news trend appears to be intact again this quarter. TD is also bucking the industry trends somewhat, having opened more than 20 branches in the past year or two, likely setting up continued solid profit trends through 2006/2007.

Wealth Profit Still Building. We are seeing only slight moderation in the wealth division’s excellent momentum. In Q106, TD’s wealth profit grew 28% YoY, while in Q2 the division generated 16% growth – this quarter we have factored 17% upside YoY. TD’s mutual fund company has been a key driver, though the operating leverage in the bank’s domestic discount broker (not sold to Ameritrade) has also been a differentiator for TD, as it is probably still roughly double the size of the next closest competitor. We are seeing significant double-digit momentum from the small-but-high-growth full service Canadian retail brokerage.

U.S. Businesses Turning the Corner and Becoming Additive. Having seen the TD Banknorth numbers, we have not factored any additional upside in for the U.S. banking division beyond our estimated contribution. The most significant news this quarter was the stabilized net interest margin. Next quarter we start looking for rising momentum from the Hudson United and Interchange integrations. Another key dynamic is TD Ameritrade as: (i) integration benefits accelerate, and (ii) the equity pickup improves from 32% to 39.5% (TD bought back more stock).

Wholesale Division – Business Mix Improving Again. TD Securities recorded a solid $140 million in Q2/06 net income– we expect more of the same in Q3/06 at $135 million. Our estimate is driven by continued strong M&A, equity and debt underwriting momentum – our research indicates TD had very strong Q3/06 results in each. TD has managed a decline its Global derivatives trading book that will likely offset core business gains.

Valuation

Our price target of $70 is set at ~13.5x our 2007 cash EPS estimate of $5.20. Our premium target P/E reflects TD’s leading domestic franchise, retail-oriented business mix, unique U.S. assets and excellent management. Our target P/E is set at a 3% premium to the group though TD has traded at an average 6% forward P/E premium to its Canadian bank peers since 1998. We view positive execution on BNK as a catalyst for revaluation. Our price target is indicated at ~2.4x our projected book value of $29.25 (as at Jul 31/07). The primary risks to our price target are integration foul-ups and/or follow-on deal reinvestment risk.

Price Target Impediments

Potential for a unique earnings shortfall as distinct from normal systemic sector risk centres on (i) the BNK-Hudson United integration and (ii) TD Ameritrade deal risk. In our view, maintaining continuity of the BNK management team is also paramount to successful U.S. expansion, and this team has been together for fifteen years now. For its part, TD management has an excellent track record for major acquisitions, both with TD Canada Trust and previous trust deals, as well as numerous TD Waterhouse acquisitions (all cross-border).
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