05 April 2006

BMO NB Speculating on TD Securities' Sale

BMO Nesbitt Burns, 5 April 2006

The Sun Is Shining on Canada

Canada as an investment market is 'hot' currently. The TSX has outperformed most other developed country markets (see Chart 1) over the past several years. Strong commodity stocks (and bank stocks) coupled with a strengthening Canadian dollar deserve most of the credit for the outperformance. Several strategists (including our own Don Coxe) believe that Canada will continue to outperform on the back of increased demand for commodities, largely due to strong growth in China.

The strong market performance, coupled with the refining of the Income Trusts as an asset class, the strength of resource underwritings and low interest rates (which have buoyed M&A activity), has allowed the Canadian investment dealing industry to achieve, in 2005, another year of record profitability. The chart below speaks to the current strength of the investment banking business. We aren't bold enough to say what happens next other than to note that profits have historically been volatile.

The Valuation of Wall Street Firms is at a Record

Shares of Wall Street firms have performed well over the past several years. As we show in Table 1, the average P/Tangible Book value for these firms is currently 2.7x, with Bear Stearns with its smaller market cap trading at the bottom end of the range at 2.0x. P/Es range from 10.4x to 13.2x.

Of the five companies we reviewed, only three are overwhelmingly 'wholesale' franchises: Lehman, Bear Stearns and Goldman (i.e., most comparable to TD Securities). Looking back over time, it is interesting that the stocks of all three are generally trading at decade-high P/BV multiples.

It is noteworthy that these franchises have been very successful in the U.S. and several other markets, but to date none have achieved a meaningful and sustainable share of the Canadian capital markets. Goldman and Merrill (the latter having bought into Canada through the Midland purchase) have made the most progress, but with most of their success in M&A more often than not showing up in the top five.

TD is Best Positioned to Make Such a Move

We describe TD Bank as the 'un-universal' bank. Unlike its peers that have leveraged in-house credit capability, and have extensively used their retail broker platforms to sell new issues, TDSI has remained relatively true to the culture of Newcrest, as a niche player in capital markets. TD Securities' loan book is only $6 billion and its full-service brokerage network is relatively small (Table 2).

The more the investment bank interacts (or co-depends) on other parts of the organization, the more likely there will be negative side-effects from exiting the wholesale business. For example, RBC Capital Markets and CIBC World Markets have benefited from their large broker networks to lead the income trust market place. Without such an extensive distribution network, the odds are that underwriting would suffer. On the other hand, having an extensive full service brokerage sales force without access to a steady flow of underwritings could negatively affect contribution from the entire network. In the case of Scotiabank, the strong credit culture has ensured that corporate lending at the bank has remained a core business.

Without the investment dealer, Scotiabank would have less ability to extract ancillary fees from corporate relationships and would be more dependent on earning spreads. It is worth noting that BNS has a corporate loan book of $30 billion- five times that of TD Bank's.

Unlike BMO and Royal Bank, TD Securities is a relatively pure Canadian investment banker. The BMO includes the Harris midmarket loan book in with BMO Nesbitt Burns, while RBC Capital has the U.S. wholesale platforms acquired through Dain and Tucker. The RBC U.S. operations also have tie-ins with their U.S. brokerage platform because of the firm's strong position in municipal bond underwriting in the U.S.

National Bank also has very close ties between its brokers and its investment dealer subsidiary. Like the RY, BMO, CM and BNS, it would be difficult to truly isolate the wholesale operations from the retail without negatively impacting value.

What is TD Securities?

TD Securities is quite different from many of its bank peers. We have often described TDSI as a trading book- with an investment bank strapped onto the side. This acknowledges the fact that TDSI is more dependent on trading than its bank peers. On average, 50% of TDSI revenues come from trading (and probably a similar proportion of the earnings). We note that, contrary to the beliefs of many, this difference actually existed before the Newcrest purchase, and dated back to Don Wright, who fundamentally believed in a trading operation that continued to evolve over time, with new businesses (i.e., entered in the past two years) as a meaningful part of overall revenues. Newcrest, with its boutique focus, and the scaling back of corporate lending simply augmented many of the differences.

Today, we would summarize TDSI as being a top five (but not top three) player in underwriting and capital markets businesses, and a top 10 player in M&A in Canada. We believe that this partially reflects three factors: the lack of U.S. presence, a reluctance to use its loan book aggressively and TD's below-leverage scale in full service brokerage.

Overall, TDSI employs $33 billion of risk-weighted assets. We show our estimates of the make-up of these assets in Table 3, below. The majority of the RWAs arise from loans and commitments to lend in the future, with about $10 billion from the derivative and market risk associated with the trading operations.

As we look at the historical profitability of TDSI (see Table 4), one is struck by the volatility of the business as new management has grappled with restructurings. Results in 2002 included the sectoral charges taken to address the investment bank's heavy emphasis on telecommunications and power companies. 2003 included the writeoff associated with the equity option business in New York. Further charges were incurred in 2005. What is interesting is that even if we consider the average ROE excluding 'unusual items' (which is generous because profits in 2000 and 2001 included contribution from several businesses exited), we still get an ROE of only 13.5% over the period 2000-2006.

Interestingly, ROEs in 2004, 2005 and 2006 are more stable and impressive. The question that TD's management needs to answer is how much of this improvement reflects a 'new and improved' business model, and how much simply reflects a 'bull market' for all Canadian investment dealers, as evidenced by performance of the IDA members.

What Could It Be Worth?

We estimate that TD Bank could sell TD Securities for $5-6 billion to various Wall Street banks that may be interested in developing a large, sustainable wholesale presence in Canada. This would translate into a multiple of 10x forecast operating results this year, and 1.8x tangible book value. We note that such a price would be lower than the trading valuations of U.S. potential acquirers. One would assume that the U.S. investor base of these firms would embrace such a transaction- as long as the deal is not perceived as hurting the fundamental value of TDSI.

In reality, one could make the case that the opposite would be true: TDSI would likely be a more powerful competitor were it owned, and integrated into a Wall Street dealer. We note that in its annual report, TD included a brief description of the Canadian Securities Industry. In it, it described the business as facing intense competition from the Canadian banks, the large global investment banks, and to an extent- small niche investment banks and dealers. 'TD also indicated that it 'is necessary to offer international expertise in order to service the Canadian based international corporate client base' and that TDSI needs to 'offer innovative solutions and ideas which span across products and regions.'

We wholeheartedly agree with these comments and not surprisingly we believe that TDSI as part of, say, Lehman would be a far more effective competitor for all Canadian bank-owned investment dealers.

To highlight the economics to Lehman of a TDSI purchase, we have put together an acquisition model, assuming a $5 billion price which would be funded 80% with debt and 20% with equity issuance. We note that such a deal would likely be accretive to Cash EPS immediately, would position Lehman to capitalize on the opportunities in Canada and would involve the issuance of only 6 million shares (less than 3% dilution of its existing share count).

We are assuming that TDSI's estimated earnings decline in 2007 to $540 million from $616 million in 2006. This is clearly more conservative than assumptions for Wall Street firms, where the 'Street' numbers are broadly calling for 5% higher profits in 2007.

One issue for any potential buyer is the lending book. While TDSI has significantly reduced its loans, it still has $6 billion outstanding and commitments to lend of $57 billion. Firms such as Lehman, Goldman and Bear Stearns are not opposed to lending, but have generally subscribed to a securities model (package and distribute) rather than a commercial bank model (make and retain loans) in support of their investment banking operations. Having said that, it is noteworthy that Lehman and Goldman typically rank in the top 10 as lead arrangers in the U.S. syndicated loan market.

It is possible to model other potential buyers such as Goldman or Citigroup but Lehman is a simpler, more transparent scenario.

Would TD Bank Be Better or Worse off Without TDSI?

Selling a business at 10x earnings is certainly dilutive to Cash EPS- even if one assumes that some of the proceeds are used to repurchase your own shares. In aggregate (and consistent with our assumptions for an LEH-TDSI tie-up scenario), we have assumed that TD sells TDSI for $5 billion, books a gain of $1.5 billion (after $500 million of taxes) and then uses $3 billion to repurchase its own shares at $65. In this scenario shown in Table 6, it is clear that there would still be dilution to TD's EPS.

On the other hand, there is one very tangible financial benefit: Tier 1 (largely because of TD having jettisoned TDSI's $33 billion in RWA) would sky-rocket to over 14%- even after a $3 billion share buyback. This would allow further expansion in the U.S. to be funded with additional debt.

The reality, however, is that the rationale for the transaction would have to be very strategic. Clearly, the downside is very tangible: lower earnings in the short-term.

It is interesting to note that if the price was $7 billion, the dilution could fall to 3.5%. The benefit would have to accrue from having created a retail-only entity with strong positions in Canada in retail banking and wealth management, and credible niche businesses in the U.S. The question is whether such an entity would be a 'better' entity in which to invest. As we look at it, there would be two very large positives to a TD Bank without TDSI.

First, the bank would have eliminated many of the risks that came with being in the investment banking business. Specifically, TD would not be exposed to deterioration in the corporate credit markets or a possible slowdown in activity in Canadian capital markets. History has shown that both of these businesses do exhibit volatility- and over the past three years, the trends have only gone in one direction.

The second benefit relates to the fact that TD would have eliminated a secular challenge: that Canadian capital markets are becoming more global, and that Canadian bank-owned parochial dealers will become less competitive over time as big Canadian issuers seek out global firms for advisory and underwriting expertise. This threat is certainly open to debate and the past three years suggest that this can be managed. Having been in the business for over 18 years, the author of this report can clearly state that this is a real long-term challenge.

Most importantly, the question is whether the market would revalue TD shares- ex TD Securities. The answer, in our opinion, would be a categorical yes. Indeed, for TD shareholders to benefit from a possible sale of TDSI, we would only need one additional multiple point on P/E. Given the more stable earnings base, the better balance sheet and the elimination of a strategically challenged business, this looks very achievable.

In the end, this analysis is quite speculative and TD Bank executives have not provided any reasons to believe this option is being considered. As we have said before, we don't believe anything is imminent, but this analysis does show that it is a valid option.