Tuesday, April 22, 2008

TD Bank Update on Commerce Bancorp Acquisition

  
BMO Capital Markets, 22 April 2008

Event

TD held a conference call to discuss the details of its acquisition of Commerce Bancorp. While the operating news was positive, the bank’s capital ratios have been more strained than originally expected.

Impact

Slightly Negative. With the strong relative performance of TD shares, we are taking the opportunity to downgrade them to Market Perform.

Forecasts

Our forecasts are unchanged.

Valuation

We are reducing our target price to $71 from $75, to reflect the weaker balance sheet. Our target multiple is lowered by about half of one multiple point (12.3x 08E cash EPS).

Recommendation

We have long been fans of the TD Bank, and the stock price performance has been strong in absolute and relative terms. We believe that the additional leverage from the Commerce Bank deal increased the risks slightly, and we are downgrading the shares to Market Perform.

Details & Analysis

Over the past 12 months, TD shares have outperformed their peers and are down 5%, compared to a decline of 18% in the bank index. The next-best-performing large bank is down 12%. Furthermore, since our upgrade in November 2002, TD shares have doubled while the bank index is up 70%; again, TD has been the best-performing large bank stock. Today, we are downgrading TD shares to Market Perform. While we remain comfortable in our earnings forecasts, the bank’s capital position is now meaningfully weaker than those of the other large Canadian banks. Over the past year, we have viewed TD as our “recession resistant bank” with excess capital and a low risk business model. Now, with a Tier 1 ratio that will struggle to remain above 8% over the next 12 months (as a result of the combined effect of the Commerce Bank deal and Basel II implementation), we no longer view the bank in this light.

TD Bank held a conference call yesterday to give an update on its acquisition of New Jersey-based Commerce Bancorp (CBH). The transaction, totalling US$8.4 billion, closed on March 31, 2008. Management continues to be very positive on the deal. The Bank reiterated its original estimate for cost synergies of US$310 million by the end of 2009. Including these synergies, and some tax benefits arising from the transaction, TD’s U.S. P&C Banking segment should contribute roughly US$250 million per quarter (starting in Q3/08). For fiscal 2008, TD increased its segment earnings forecast to US$750 million from US$700 million despite higher loan losses and continued margin pressure. For 2009, the US$1.2 billion earnings estimate remained unchanged. These forecasts exclude US$420 million of restructuring charges, the majority of which will be taken in 2008 and 2009. When the dust settles, management anticipates this segment to contribute between 20% and 25% of total Bank earnings. It is impressive that the bank will still meet its estimates despite the deterioration in the U.S. economy.

From a credit perspective, TD provided further detail on its U.S. securities and loan portfolios. Within its US$26 billion investment portfolio, the bank holds US$9.2 billion worth of mortgage-backed securities (including US$3.7 billion worth of non-agency Alt-A MBS). These securities were marked-to-market as of March 31, and management indicated they believe the adjustments made to fair value were largely temporary. The bank remains comfortable with the portfolio’s credit quality.

Within the loan portfolio, the $30 billion commercial book appears to be performing relatively well. Some weakness has been experienced in the “residential for sale” portfolio, which makes up 6% of the overall portfolio—about $1.8 billion. The US$16 billion consumer book is made up of roughly 50% home equity loans. Management indicated that these loans are almost entirely bank-originated and 76% of them are secured with loan-to-value that exceeded 80% at origination. It is worth noting that the majority of the bank’s loan book is based in the U.S. Northeast, a region of the country that has been less impacted by the economic downturn than the Southern U.S. or California. That being said, the deteriorating credit environment is expected to increase loan losses to a run-rate of $75 million per quarter—up from a current range of $40–50 million.

However, the news was negative on the capital front. Tier 1 after the deal will be 8.75–9%, and that is before the 180bp capital hit that TD will take in the first quarter of 2009 from Basel II. TD Bank has, in the recent past, operated with one of the better capital ratios in the Canadian banking system. As we indicated in our report of last week on Basel II, TD will face more pressure than its peers from the staged introduction of the new Basel II capital rules. We believed that there was still enough buffer from existing capital to offset these pressures. What is clear from yesterday’s presentation is that the Commerce acquisition has consumed about 60 bp more of incremental capital than was originally projected. In most cases, this is a rounding error. But when a bank will already be at the bottom end of its peer group range, this is material. We are confi dent that TD can manage around this, and that with its strong funding base, there is solid underpinnings to the capital. However, we can no longer point to TD as having a relatively strong balance sheet. It is reasonable to adjust the multiple applied to TD’s shares. In this case, we are lowering our target multiple by half a multiple point.

From a technical perspective, the additional pressure on capital for the CBH close has come from worse than expected marks on the securities book (which has increased goodwill) and higher-than-expected risk-weighting on the balance sheet.

The Commerce Bank deal positions the bank well for growth in the U.S. Given management talent, the solid market positions and the potential for synergies, the integration with Banknorth and CBH should go well. Having said that, the lower capital position means there is less margin for error. We remain cautious that although Canadian banks are some of the best capitalized in the World, and the Canadian economy should outperform that of the U.S., there are still material pressures on all banks from a funding and capital perspective. We would rather err on the side of caution, and we are downgrading the shares to Market Perform.
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RBC Capital Markets, 22 April 2008

TD Bank revised its earnings target for its U.S. P&C Banking segment, and the revised numbers are generally higher than what we expected. There is room for us to increase our earnings estimates if management delivers on its targets.

• The bank increased its earnings target from $700 million to a minimum of $750 million in fiscal 2008, and left its 2009 net income target unchanged at $1.2 billion. Our earnings estimate for the segment is $605 million in 2008 and $1.1 billion in 2009.

• The bank estimates segment earnings of $130 million in Q2/08 (which does not include Commerce Bancorp results) and a run-rate earnings of $250 million in Q3/08 (including Commerce Bancorp results reported with a one-month lag).

• The $250 million of earnings is split $130 million from Banknorth and $80 million Commerce, and includes tax optimization strategies, higher credit loss expectations for a slowing economy, and narrower deposit spreads due to competition.

• Management's outlook for earnings in 2008 reflects higher segment earnings and lower than expected funding costs.

• Management expects the proforma efficiency ratio to be about 63% initially, and expects improvements from deal synergies but does not intend to jeopardize its customer service

• Restructuring and integration charges of US$420 million pre-tax is expected to be recognized through 2008 and 2009. (At announcement the charges were expected to be US$490 million)

• Management expects to realize cost synergies of US$310 million by end of 2009, which is the same amount it expected at the announcement of the acquisition. The bank also hope to gain from revenue synergies down the road, and its wealth strategy (which TD Ameritrade is a part of) will likely work in tandem with TD Commerce.

• TD's integration plan appears to be on track, including the rebranding of most branches in 2008 and 2009.

• The transaction is expected to dilute earnings per share by 10 cents in 2008 and is neutral in 2009, which is what we originally modeled.

Fair value adjustments impacted goodwill

Negative fair value adjustments on securities and loan books were higher than originally expected due to high liquidity premiums in the current market and, in our view, a deteriorating economic picture, but management believes the intrinsic value of many securities are higher.

• The transaction value at March 31 was US$7.5 billion, down from $8.4 billion at announcement due to the decline in TD's share price. However, the accounting purchase price uses the $8.4 billion value at announcement, and goodwill is expected to be $5.8 billion.

• Markdowns were greater than originally expected and reduced Commerce Bancorp's book value.

New capital ratios lower than we expected

We expected the Tier 1 ratio, which was 10.9% at Q1/08 under Basel II, to come down with the closing of the acquisition of Commerce and the changes in capital calculations for TD Ameritrade at the end of the year. But management's Tier 1 ratio forecast of 8.0% at year end including all adjustments is lower than our 8.5% estimate at fiscal year end.

• The capital impact of the Commerce transaction was about 200 basis points, which was higher than previously disclosed estimate of 120-145 basis points. Approximately half of the difference came from fair value adjustments recorded at closing, and half was due to higher-than-expected risk weighted assets from Commerce Bancorp.

Management stated that it is comfortable with a projected 8.0% Tier 1 ratio, but we believe it gives them very little room for slippage against profitability estimates. If the year goes as management plans, then we believe TD can improve the ratio quickly after Q4 because TD generates about 30-40 basis points of Tier 1 capital per quarter.

U.S. credit environment not good but TD expects to be a positive outlier

From a credit perspective, TD "will not be able to outrun a recession" but it is comfortable with its exposures and have provisioned for higher losses. This is the area that most concerns us versus management estimates.

• TD Bank expect higher credit losses, mainly as a result of a change in methodology for small business loans. Otherwise, non-performing loans were down QoQ at both TD Banknorth and Commerce.

• Run rate quarterly provision for credit losses of $75 million in Q3 through 2009 with Commerce is higher than normalized $40-45 million range, but the bank believes its credit performance will be better than peers.

• Marking the loan book to fair value at the closing of the transaction increases goodwill but decreases the need for provisions for credit losses in the near term.

Consumer loan portfolio (proforma $16 billion outstanding):

• The bank expects higher consumer loan losses as delinquencies are trending up, but within acceptable levels.

• Made up of: 48% home equity (just over half is from Commerce), 29% residential mortgage, 14% indirect auto and 9% other.

• In the HELOC portfolio, there is limited exposure to high loan-to-value collateral, with 76% of the home equity secured portfolio
having less than 80% loan-to-value at origination.

Commercial loan portfolio (proforma $30 billion outstanding):

• Made up of: 36% Investment real estate, 8% manufacturing, 8% health care, 7% retail trade, 6% wholesale, 5% finance/insurance,
31% other.

• Geography: 22% Massachusetts, 20% Metro NY, 18% Metro Pennsylvania, 17% North New England, 23% other.

• The bank noted that it had previously tightened underwriting standards and focuses on working out non-performers.

• The residential for sale portion (6% of total outstanding) of the investment real estate portfolio was highlighted as having some weakness, but other sectors appear to be performing as expected with no material negative trends.

Investment portfolio markdowns higher than expected

The negative marks on Commerce portfolios were higher than management originally expected. The bank stated that it did not sell any of Commerce's Alt-A book because it believes the intrinsic value is higher and future earnings will benefit from keeping it.

Investment portfolio ($26 billion) consists of:

• Mortgage-backed securities (non-agency Alt-A $3.7 billion and non-agency Jumbos $5.5 billion): majority older vintage (2005 or earlier), all securities remain AAA-rated and collateral 100% fixed rate mortgages with no rate reset features. TD states that it reviewed and stress tested in detail, and market value discounts are in excess of TD's worst case credit losses.

• The Alt-A portfolio, which was not sold at closing, was $4.7 billion at December 31, which implies a $1 billion writedown at closing.

• Asset-backed securities ($8.7 billion): asset pools consist of prime credit cards, prime autos, and government-backed student loan trusts. All are AAA-rated tranches of established securitization programs (predominantly sponsored by large US money centre banks), and there appears to be liquidity for these in current markets.

• Short-term agency discount notes ($7.8 billion): issued by government sponsored entities.

• Municipal bonds ($0.4 billion): terms less than a year.

Commerce updates at March 31, 2008:

• Deposit growth was 8% YoY and 1% QoQ. This growth rate is well below Commerce's historical average, probably due to funding pressure in wholesale markets leading larger banks to increase deposit rates in the retail market. Deposit margins continue to narrow reflecting competition.

• Loan growth was up 12% for consumer and up 16% for commercial. Loan spreads are widening.

Valuation

TD (Outperform, Average Risk): Our 12-month price target of $69 is based on a price to book methodology. Our P/B target of 1.8x in 12 months is in the middle of our target for banks given its relatively lower exposure to headline risks and leading domestic retail franchise, offset by a lower ROE. It implies an approximate forward multiple of 10.8x earnings, compared to the 5-year average forward multiple of 12.2x.
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Scotia Capital, 22 April 2008

TD Confirms US$310M in Synergies

• TD held a conference call on Monday, April 21, 2008 to discuss the financial implications of the Commerce Bancorp transaction which closed on March 31, 2008.

• TD reconfirmed synergies of US$310 million pre-tax to be realized by the end of 2009. Restructuring charges are estimated at US$420 million to be taken over the next two to three years.

U.S. P&C Earnings - 2008E Increased to $750M; 2009E $1.2B Unchanged

• TD provided earnings estimates for its new U.S. Personal & Commercial Banking segment which will include TD Banknorth and Commerce Bancorp. Q2/08 earnings excluding the Commerce Bancorp acquisition are expected to be $130 million versus $127 million in the previous quarter. Earnings for fiscal 2008 are estimated at $750 million up from the previous estimate of $700 million. The new estimate implies run rate earnings of $250 million per quarter for the segment with TD Banknorth contributing $130 million and Commerce Bancorp contributing $80 million with $40 million being made up by synergies. Fiscal 2009 earnings are forecasted to be $1.2 billion, unchanged from the previous estimate.

• The purchase price as of the announcement date of the transaction is $8.4 billion; however, TD estimates the economic value of the transaction to be $7.5 billion. The difference in values is due to the decline in TD's share price since October 2, 2007, the date the transaction was recorded.

• The purchase price of $8.4 billion represents 17.5x Commerce Bancorp estimated run rate earnings of $480 million (including synergies). The economic value of $7.5 billion represents 15.6x estimated run rate earnings.

Net Book Value - $1.5 Billion

• Based on the $8.4 billion transaction price, goodwill is estimated to be $5.8 billion with intangibles valued at $1.1 billion for a total of $6.9 billion. Based on an economic value of $7.5 billion, goodwill is estimated to be $4.9 billion or $6.0 billion including $1.1 billion in intangible assets.

• Therefore, the net book value of the transaction is $1.5 billion with the purchase price representing 5.6x net book value and the economic value representing 5.0x net book value.

• The net book value is lower than management originally estimated due to a fair value adjustment that was $400 million greater than originally estimated. This was partially offset by a greater-than-expected value of intangibles due to liquidity premium on core deposits.

Tier 1 Ratio Estimated to be 8.0% by End of 2008

• Management indicated on the conference call that the Tier 1 ratio at the end of fiscal 2008 is estimated to be 8.0% (including the impact of TD Ameritrade and Basel II), versus the bank group at 9.9%. The Commerce Bancorp transaction impacted the Tier 1 ratio by 200 bp, approximately 60 bp more than originally estimated. The Commerce Bancorp transaction added $30 billion to risk-weighted assets. An increase in risk-weighted assets contributed to half of the decline in Tier 1 and the fair value adjustment accounted for the other half.

Securities Portfolio Update

• TD provided an update on Commerce Bancorp's securities portfolio. The assets in the portfolio total $26.1 billion with $7.8 billion in short-term agency discount notes, $8.7 billion in asset-backed securities, $9.2 billion in mortgage-backed securities and $0.4 billion in municipal bonds. These values have been mark-to-market and represent fair value.

• Management stressed the restructuring process was largely for the purpose of mitigating interest rate risk and not credit risk as the majority of the portfolio remains rated AAA. All the securities are classified as available-for-sale.

TD Commerce Bank - America's Most Convenient Bank

• Both TD Banknorth and Commerce Bancorp will be rebranded as TD Commerce Bank in the U.S. TD plans to open an additional 25-35 new stores in the next year as well as refurbish existing TD Banknorth branches.

• TD is marketing the new TD Commerce Bank as "America's Most Convenient Bank".

Recommendation

• We view the acquisition of Commerce Bancorp as positive from a strategic standpoint and necessary to improve the bank's return on its U.S. retail platform. However, the price was very high in the context of the market. The transaction is negative in terms of the larger-than expected reduction of Tier 1 capital and higher fair value adjustments. Overall TD's favourable earnings mix with 85% of earnings from retail banking and strength of TDCT operating platform, we believe, will be the main driver of long-term share outperformance.

• Our earnings estimates are unchanged at $5.95 per share for 2008 and $6.70 per share for 2009. Our 12-month share price target is unchanged at $95 per share representing 16.0x our 2008 earnings estimate.

• Maintain 2-Sector Perform rating.
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