Friday, August 29, 2008

TD Bank Q3 2008 Earnings

RBC Capital Markets, 29 August 2008

TD's core cash EPS of $1.43 were close to our estimate of $1.45, representing a 10% YoY drop.

• Results were ahead of our expectations in the U.S., and slightly ahead in Canada, offsetting a weak quarter at TD securities.

• The quarterly dividend was raised from $0.59 to $0.61, which surprised us positively and is an indication of management's confidence in earnings for upcoming quarters.

• Aggregate provisions for credit losses of $288 million compared to our $255 million estimate. Impaired loans rose on both a gross and net basis during the quarter in Canada and the U.S., indicating likely continued pressure on provisions for credit losses.

We have lowered our 2009 estimated core cash EPS from $6.35 to $6.15 on lower estimated contributions from both wholesale banking and U.S. retail banking (a function of pressure on margins, as well as loan losses in 2009). Our 12 month target price per share remains $69, which is based on a P/BV multiple of 1.7x, which compares to the current multiple of 1.7x.

We maintain our Sector Perform rating on TD's shares (we currently rate half our Canadian bank universe as Sector Perform and half as Underperform). TD's NTM P/E of 10.4x compares to 9.9x for bank peers.

• (1) We like TD's domestic retail franchise, which delivered the second highest YoY revenue growth in Q3/08 and is well positioned to expand operating leverage, in our view. (2) We believe that uncertainty related to writeoffs for TD's wholesale division is lower than for peers with structured finance exposures. (3) We are not as worried about U.S. loan losses near term as we are for peers with U.S. exposures. (4) Cost synergies from the Commerce acquisitions should offset a portion of the rising loan losses we expect.

• We continue to prefer the shares of lifecos.


U.S. exposure did not lead to higher than expected specific loan losses

Aggregate provisions for credit losses of $288 million compared to our $255 million estimate, although specific loan losses were $25 million below our estimate.

• Specific loan loses were 63% higher than one year ago and 9% higher than in Q2/08.

• Impaired loans rose on both a gross and net basis during the quarter in Canada and the U.S., indicating likely continued pressure on provisions for credit losses. However, the YoY increase in impaired loan formations was lower than for all six peers but CIBC

• Gross impaired loans represent 0.45% of total loans, up from 0.43% in Q2/08 and 0.34% in Q3/07.

• Specific allowances as a percent of impaired loans were 29.2%, up slightly from 28.1% in Q2/08, but down from 35.8% in Q3/07.

• Impaired loan formations rose 55% YoY versus the 6 Canadian bank total of 124%.

The area most at risk of seeing deterioration for TD relative to peers is U.S. banking, as the bank has 25% of loans in the U.S., compared to 28% at Bank of Montreal, 14% at Royal Bank, 7% at Scotiabank and 3% at CIBC.

• TD's U.S banking business has not yet seen major problems in its loan portfolio as some other U.S. banks have. We estimate that non-performing loans represent 0.78% of total loans, up about 10 basis points sequentially. U.S. banks with assets of $50-$200 billion have non-performing loans averaging 1.41% of total loans.

• We believe that TD will will be a positive outlier relative to peers but the U.S. credit environment is worsening in our view given the moribund state of the U.S. economy and broadening of credit losses to sectors other than those tied directly to residential real estate.

• We expect quarterly provisions for credit losses of $75 million in Q4/08 and $125 million each quarter through 2009. TD Banknorth and Commerce Bancorp would independently have combined for loan losses of about $50-60 million per quarter a year ago.

• Issues in TD's loan book are more likely to arise in 2009 than 2008 as TD fair valued Commerce Bancorp's loan book as at the acquisition closing date (March 31). The bank would have had a fair bit of visibility on potential near term impairments, in our view, and would have fair valued the loans that had the potential to become impaired in the near term. Mitigating the impact on income of a probable increase in impairments in 2009 is reserves.

• Provisions for credit losses again exceeded write-offs in Q3/08. Provisions for credit losses of $75 million were $40 million larger than writeoffs as the bank built reserves ahead of what is likely to be a more challenging credit environment.

• TD has been a positive outlier so far from a credit perspective, and we expect that to continue given a focus on in-market lending, underwriting to hold, not participating in loans originated by brokers, avoiding the sub-prime market and exotic types of real estate lending, not having had to "reach for assets" to generate earnings growth since deposit growth was more rapid than average, and being located in a geographic segment that has held up better than other areas of the U.S.

Capital ratios higher than expected; we still expect a drop in Q1/09

The Tier 1 capital ratio was 9.5%, up 40 basis points sequentially and 20 basis points above our estimate.

• Changes in capital calculations related to the investment in TD Ameritrade will lower this ratio by 130-140 basis points in Q1/09, which on a pro-forma basis would give TD the lowest ratio of the 6 Canadian banks, but well above the regulatory capital minimum of 7.0%.

• Other banks have Tier 1 ratios in the 9.5% - 10.0% range.

• TD has more room than other banks to issue innovative capital, which we expect will be acted upon to boost Tier 1 capital ratios. TD raised $500 million in non-cumulative preferred shares during Q3/08.

• We believe that TD can organically generate 20 basis points of Tier 1 capital ratios quarterly.

Retail banking should benefit from increased operating leverage

Domestic banking net income was slightly ahead of our estimate, rising 8% YoY.

• Revenue growth is second best among the 6 banks, driven by strong asset and deposit growth (real estate secured up 11%, personal deposits up 10%, consumer loans up 11%, business loans up 14% and business deposits 10%). We expect asset growth to slow in 2009, particularly in mortgages.

• Net interest income margins were down 8 basis points YoY in higher funding and deposit costs. We expect continued pressure.

• We expect operating leverage to increase in upcoming quarters (there was no operating leverage on a reported basis, although revenue growth outpaced expense growth by 1% if excluding the reallocation of some U.S. businesses to Canada). The reason for our optimism is that the year over year impact of the increase in staffing levels and extended hours, which started in Q4/07, should abate.

• Loan losses of $194 million were in line with Q2/08, but up from $151 million a year ago on higher retail volumes and business losses rising from $18 million to $37 million. We expect continued pressure on losses in business lending,w here losses have been low for quite some time.

Wholesale results weak; impact to total earnings mitigated by size

Wholesale core net income was $102 million ($37 million reported), below our $159 million estimate and well down from $253 million in Q3/07.

• The pre-released mis-marking of financial instruments had a $96 million negative impact on revenues and a $65 million impact on the bottom line.

• Securities gains were down, as were trading revenues.

• The mis-marking, as well as weaker than normal equity and credit trading offset good fixed income and foreign exchange trading results. Trading revenues of $43 million were down from $101 million in Q2/08 and $308 million in Q3/07.

• Securities gains, on a consolidated basis, were $14 million, down from $110 million in Q2/08 and $94 million in Q3/07. We got the sense that management was not looking for a major near term rebound in securities gains.

• Advisory fees were also down, as were corporate lending revenues on higher funding costs. TD is less dependent on wholesale income than its peers so the large shortfall in that division's income had a much lower impact on EPS. Just under 9% of core income came from wholesale activities in the quarter, compared to 10% in Q2/08 and 21% in Q3/07.

• We have lowered our 2009 forecast income for TD Securities from $634 million to $537 million, representing a 16% return on the $3.4 billion in excess capital.

• Management did not sound overly confident about the outlook for earnings and the bank has historically targeted a 20% return in normal times, and has outpaced that return in good times, but fallen short in the last two quarters as capital markets conditions slowed.

U.S. results ahead of our estimate

U.S. earnings of $273 million were ahead of our $240 million estimate, mainly because of lower than expected expenses.

• Comparisons to prior quarters are not meaningful since Commerce Bancorp results were included in TD's income for the first time.

• Provisions for credit losses of $75 million were in line with expectations, and $40 million larger than writeoffs as the bank built reserves ahead of what is likely to be a more challenging credit environment. As mentioned above, we expect quarterly provisions of $125 million in 2009.

• The bank reiterated its guidance for TD Commerce to contribute at least $750 million to earnings in 2008 and $1.2 billion in 2009 despite the tough economic environment and an expected increase in loan losses. Initiatives to grow earnings from the Q3/08 earnings of U.S. $270 million include organic balance sheet growth, improved spreads on loans and securities, expense initiatives and synergies from integrating TD Banknorth and Commerce. Total U.S. retail earnings made up about 24% of total earnings in Q3/08.

• Margin pressure is expected in upcoming quarters as management has raised deposit rates in certain markets to reflect competitive conditions. Some competing banks that have seen their cost of wholesale funding rise have increased their retail deposits rates as a way to raise alternate source of funds. Initially, TD did not follow suit but deposits declined during Q2/08 and management has reversed course and increased deposit pricing to protect market share. We expect margins to drop in the next quarter.

Other highlights

• Canadian wealth management net income of $122 million declined 3% from Q3/07, and was in line with our estimate. Revenue was up 4% but expenses were up 7% as the bank continued to invest and add new advisors (the bank is targeting 130 advisors this year, and currently has 1,267 advisors and planners or 140 more than a year ago).

• TD Ameritrade's contribution to TD's earnings was $79 million, up 15% YoY. The U.S. discount broker has reported good results with stronger growth than at E*Trade and Schwab in average trades per day (11% versus -8% and 9%, respectively) and client assets (4% versus -20% and 2%, respectively) in July.

• The Corporate segment generated a net loss of $40 million, in line with our estimated net loss of $43 million but compares to income of $11 million in Q3/07 because of higher unallocated expenses and lower securitization activity. Management has historically guided to a net quarterly loss of $20-40 million for this segment.

• Other comprehensive income will be negatively impacted by the U.S. mortgage backed securities portfolio in Q4/08, unless valuations improve. Management disclosed a $233 million decline in the value of its US$3.6 billion Alt-A RMBS portfolio in July (which will impact Q4/08). Declines likely continued in August and the value of other mortgage backed securities likely declined as well. TD's U.S. mortgage backed securities portfolio inherited from Commerce Bancorp is approximately $26 billion, including the Alt-A portfolio.

• $368 million in intangibles related to Commerce Bancorp (which would have been mostly brand-related) were transferred (tax effected) to goodwill as the Commerce brand will no longer be used.


Our 12-month price target of $69 is based on a price to book methodology. Our P/B target of 1.7x in 12 months is slightly lower than our target for banks given a lower ROE offset by its relatively lower exposure to headline risks and leading domestic retail franchise. It implies an approximate P/E multiple of 10.9x 2009E EPS, compared to the 5-year average forward multiple of 12.2x.

Price Target Impediment

Risks to our price target include the health of the overall economy, sustained deterioration in the capital markets environment and greater than anticipated impact from off-balance sheet commitments. Additional risks include an unexpected acquisition, integration risk with Commerce Bank, TD Ameritrade and TD Banknorth, pricing pressure in the discount brokerage industry, a rising Canadian dollar, litigation risk and a worse than expected impact from Enron-related litigation (although it appears that risk has declined, given a court ruling in another Enron trial).

Company Description

TD Bank Financial Group is Canada's second-largest bank by market capitalization. TD currently has more than 1,110 retail branches in Canada, 1110 branches in the U.S. and 250 retail brokerage offices. Our estimated 2008 earnings mix is as follows: TD Canada Trust (54%), US Personal & Commercial (16%), TD Securities (13%), TD Wealth Management (10%), and TD Ameritrade (7%).
Scotia Capital, 29 August 2008

• Toronto-Dominion Bank (TD) operating earnings were strong at $1.43 per share, in line with expectations. Operating earnings declined 11% from a record $1.60 per share a year earlier. Reported earnings were $1.35 per share including a previously announced write-down on mispriced financial instruments of $96 million or $65 million after-tax or $0.08 per share.

• TD increased its dividend 3.4% to $2.44 per share.

What It Means

• Operating earnings continue to be driven by Canadian P&C which recorded a solid 8% increase, with Ameritrade earnings strong increasing 25% YOY. U.S. P&C earnings increased 150% to $273 million due to the Commerce Bancorp (CBH) acquisition. U.S. P&C represented 23% of TD's operating earnings. Domestic Wealth Management earnings were flat YOY with Wholesale Banking earnings extremely weak down 60%.

• We maintain our 2-Sector Perform rating on the shares of TD based on its strong retail franchise and high quality earnings. We consider TD, along with RY, the high quality, high growth banks.
Financial Post, John Greenwood, 28 August 2008

With Royal Bank, TD and National all posting strong third quarter-earnings with only limited losses from investments linked to subprime home loans, the worst of the structured credit debacle is probably over for the sector, said Dundee Securities analyst John Aiken.

"We are no longer overly concerned for [the banks] in terms of writedowns," Mr. Aiken said.

Royal, in particular, performed well, posting "the best earnings of the quarter," Mr. Aiken said. "That was the one bank that meaningfully beat [analysts'] consensus."

For the three months ended July 31, Canada's largest bank had a profit of $1.26-billion, or 92 cents a share, down nearly 10% from last year.

The results included a $498-million in writedowns related to structured credit investments that have fallen out of favour amid the credit crunch.

According to Mr. Aiken, the charge was in line with expectations and evidence that the bank is reducing its holdings.

As the bank with the lowest exposure to subprime mortgages, TD also reported a strong performance, though offset by loan losses in its U.S. Subsidiary Commerce Bancorp.

TD had a net profit of $997-million, or $1.21 a share, down 9% from last year.

The only player with a rise in profits was National Bank, which reported earnings of $286-million, or $1.73 a share, up 18% on higher results from its consumer business.

Results at the sixth biggest bank were "very good across all segments," Mr. Aiken said.

Now that all the banks have come out with earnings, investors are breathing a sigh of relief as the negativity that gathered over the sector last week dissipates.

Many feared that the losses from investments in structured credit products such as CDOs and SIVs would be a lot higher and that the pain would be spread into 2009.

Canadian Imperial Bank of Commerce and Bank of Montreal -- which reported earlier this week -- have so far posted the biggest writedowns on structured credit investments, but even they are now seeing light at the end of the tunnel.

"I think the pessimism going into the quarter was a little bit overdone," said Juliette John, lead manager of the Bissett Dividend fund. "In the banks that reported yesterday as well as today, the worst-case scenario has not materialized. CIBC was not as bad as it could have been and with Royal and TD, their businesses are actually in very good shape. Across the board capital levels are all very strong."

Ms. John predicts that next fiscal year will see a return to more normal times with dividend growth and stronger earnings.

That does not necessarily mean the banks will be enjoying the kind of heady profits common in the days of the credit bubble. With the U.S. mortgage market continuing to decline and rising unemployment south of the border, the Canadian economy is starting to feel the pinch. Analysts warn that means banks must brace themselves for a jump in loan losses and a general slowing of business typical in a struggling economy.

"That's the next shoe to drop," Mr. Aiken said.