05 April 2013

TD Bank’s US Expansion Hasn’t Come Cheap

The Globe and Mail, Scott Barlow, 5 April 2013

The impending ascension of Bharat Masrani to the CEO chair at Toronto-Dominion Bank underscores the strategic importance of U.S. operations for the company as a whole, and provides an excellent opportunity to assess just how well TD Bank’s $17-billion (U.S.) foray into foreign territory is going.

The bottom line: It still faces considerable challenges. While U.S. expansion provides the bank with a useful counterbalance to its Canadian base, the venture is – for now – still a work in progress.

One question: can TD Bank maintain loyalty among its U.S. consumers? The Wall Street Journal recently published a brief report highlighting increasing customer dissatisfaction at its U.S.-based branches.

Meanwhile, return on equity (ROE), the most widely used measure of a bank’s profitability, has been running at about eight per cent per year on the company’s approximately $17-billion in U.S. acquisitions since 2004. This pales in comparison to TD Bank’s overall ROE of 14.8.

To be fair, the consumer data highlighted by the Journal is anecdotal and an ROE of eight per cent is perfectly acceptable for a relatively new expansion. But what does seem clear, with the benefit of hindsight, is that TD Bank paid a generous price for its primary U.S. assets.

The broader U.S. banking sector currently trades at an average price-to-book value of 1.2 times, according to Bloomberg data. TD Bank’s two major acquisitions south of the border, Banknorth Group Inc. in 2004 and Commerce Bancorp Inc. in 2007, were completed at far higher book value multiples of 2.6 and 2.8 times, respectively.

TD Bank spokespeople emphasize that the bank’s U.S. acquisition strategy is part of a long term initiative and that it was not trying to time the market when it made its U.S. purchases. Nonetheless, management can’t be thrilled with the evolution of U.S. book value multiples.

According to Brad Smith, analyst and head of research at Stonecap Securities, TD Bank’s U.S. operations have also required considerable financial support from the Canadian parent company. He estimates that TD Bank, N.A., the U.S. based holding company under which the bank’s U.S. operations legally sit, have required approximately $8.6-billion in loans – one assumes on favourable terms – from Toronto.

Mr. Smith also notes that the U.S. regulatory environment is likely to change. Foreign-owned bank holding companies south of the border are currently exempted from the U.S. regulatory system. But under the Collins Amendment, part of the Dodd Frank Financial reform bill, this exemption will end in 2015.

TD Bank spokespeople are correct in pointing out that rule changes will not be certain until the legislation is fully implemented. But under the Collins Amendment, TD Bank, N.A. would have to double its level of tier 1 capital to be considered “well capitalized” by U.S. regulators.

Mr. Masrani, who has been group head of U.S. personal and commercial banking, is well aware of all these issues, and he’s backed by a deep management team that has proven remarkably adept at running the bank’s Canadian operations.

Barring another financial-sector catastrophe, TD Bank N.A.’s balance sheet and its profitability are likely to improve as trust in the U.S. financial system is restored. The question is how high the upside is for the bank’s U.S. arm. To date, blind faith in the bank’s ability to repeat its domestic success in the U.S. appears misplaced.