Toronto-Dominion Bank Beats Earnings, I'm Staying Long

The Toronto-Dominion Bank (NYSE:TD, TSX:TD:CA) just released its fiscal Q1 earnings and beat expectations on most headline metrics. The release beat expectations on revenue, missed on GAAP earnings, and beat on adjusted earnings.

Heading into the release, my expectations were pretty high. As I’ve written in many articles, I’m liking banks this year, because central bank rate hikes mean that they charge higher interest on loans. They also pay higher interest on term deposits, but that hasn’t hurt their earnings so far. As we saw in TD’s Q1, the inverted yield curve isn't hurting margins. TD’s GAAP earnings fell, but net interest income (“NII”) increased 22% year-over-year, consistent with the theory that higher interest rates should boost NII.

Shortly before it released earnings, TD closed its acquisition of Cowen. The deal is adding about $128 million in earnings to TD’s bottom line. TD didn’t pay an overly high price for Cowen – about 11.9 times earnings – so the deal could really pay off later in the cycle when investment banking regains momentum. The deal P/E ratio was similar to Goldman Sachs’ (GS) P/E ratio; a 0.41% premium to a similar public company seems reasonable for the right to full control.

It’s been a momentous few months for TD. Between the proposed First Horizon Corporation (FHN) deal, the closed Cowen deal, and the interest rate tailwind, there’s been a whole lot going on. TD has had among the best earnings growth rates among big banks this year, but has been facing some risks as well. In this article, I will explore TD Bank’s first quarter earnings release and why I’m still enthusiastic about the stock after its publication.

Earnings Recap

In its most recent quarter, TD exceeded analyst estimates on most key metrics, including:

• $12.22 billion in reported revenue, up 8.3%.

• $13.1 billion in adjusted revenue, up 16%.

• $2.23 in adjusted earnings per share (“EPS”), up 7.2%.

• $0.82 in GAAP EPS, down 58%.

• $7.7 billion in net interest income, up 22%.

• A 15.5% CET1 ratio.

A pretty strong showing. TD’s most important earnings metrics increased, and its capital ratios remained high. So, the bank performed well while following sound risk management principles.

The Status of TD’s Two Deals

In TD’s first quarter release, we got major updates on two of the deals that the bank has been working on: First Horizon and Cowen. The Cowen deal closed on schedule and the First Horizon deal has been delayed yet again. TD no longer expects the FHN deal to close before the May 27 deadline–which itself is an extended deadline.

The FHN delays are becoming pretty costly to TD Bank. The bank booked $127 million in costs related to deals in Q1, partially stemming from an agreement to compensate FHN shareholders if the deal didn’t close on time.

I'll be frank here:

The FHN deal looks less and less appealing with each passing day. At the time TD announced the deal, it was paying a steep price: $13.4 billion for a company that earned $890 million in the 12 months prior to the announcement. So, the trailing deal P/E ratio was 15. Fairly high in the financials space.

The good news is that FHN’s earnings have been increasing in recent quarters. In the most recent quarter, it earned $0.45 per share. If the next four quarters were similar, then we’d have $1.80 in forward earnings and a 13.88 deal P/E ratio. That’s still very high for a bank, but it’s normal for acquiring a company to command some kind of premium. The right to control something is a special benefit that a buyer of public equities doesn’t have.

Now, TD said in its deal press release that it can get the deal P/E ratio down to 9.8 after closing. It says that it can do this by way of cost synergies. It thinks that it can get FHN’s costs down by $660 million. This is at least plausible. Bigger companies have more bargaining power than smaller companies, so they can negotiate better prices on goods (e.g. servers, office chairs, computers etc.). I believe that TD will be able to improve FHN’s operating performance if it closes the deal, but not enough details have been provided for me to truly endorse the $660 million figure.

Basically, if FHN’s earnings keep rising and TD achieves the synergies, then the deal is worth it. However, the problem is that TD is paying a fee for each day that works out to $0.65 per share per year. Throw $0.65 on top of $25 (which is what happens if closing is delayed all the way until November), and you get a $25.65 price and a 15.73 trailing deal P/E ratio (not counting the synergies). That’s extremely expensive for a bank, and I am not all that enthusiastic about this deal in a scenario where the all-in price runs up to $25.65 per share. There are things that could change this, of course. For example, if FHN’s earnings growth continues to be strong, then the trailing multiple will come down. But I’m not just going to bet on consistently superior earnings growth. If closing is dragged out until the end of the year, I will probably have soured on the deal by that point. In the Tweet below you can see an example of how I was thinking when I heard that the FHN deal was delayed yet again. By and large, I still feel the way I felt when I composed the tweet.

The good news is that TD’s Cowen deal has closed, and TD didn’t pay too much for that company. Based on the public statements that were available when Cowen was a public company, I calculated the deal P/E ratio at 11.9. That’s only slightly more expensive that Goldman Sachs is today. Before it became a TD subsidiary, Cowen’s earnings were trending downward. As I’ve written in past articles, investment banks are getting hit by the loss of tech IPO business. Tech stocks went down over the last 12 months, so startup founders became hesitant to go public. Tech IPO business dried up. That’s bad now, but looking ahead, there’s a lot of potential. Cowen is a relatively small investment bank, but a well-known one, its research frequently being cited in financial media, including Seeking Alpha. Cowen’s ability to get its research publicized could be an asset, both in getting clients and finding buyers for offerings. The company has a particular edge in healthcare, where it works on deals involving complex Biotech companies. Specialist knowledge like this helps investment banks differentiate themselves. On the whole, I am happy that the Cowen deal closed. The valuation was fairly modest–not dirt cheap by the standards of banks these days, but not insanely expensive either. There’s a lot of potential for Cowen to make some real money for TD in the next phase of the cycle when deal making ramps up again.

Valuation

Having looked at TD’s most recent earnings release and its two main catalysts, it’s time to look at its valuation. According to Seeking Alpha Quant, TD currently trades at:

• 10.3 times earnings.

• 3.44 times sales.

• 1.56 times book value.

• 4.27 times operating cash flow.

This is relatively inexpensive. The multiples are about typical for a bank. Banks are cheaper than the S&P 500, because they’re not expected to grow rapidly and are occasionally subject to systemic risk. There’s definitely some uncertainty in the banking sector, but on the plus side, you’ve got a fairly obvious undervalued situation here even if there’s no growth. If you simply assume that TD’s earnings growth is 0% for the rest of eternity and you discount its trailing 12-month EPS at the treasury yield (4%) plus a 5% risk premium (so 9% total), you get a $77 price target. That’s 19.4% upside not even including dividends, and with no growth!

The Bottom Line

The bottom line on The Toronto-Dominion Bank is that things are mostly going well for it this year. Revenue is rising rapidly, net interest income is up 22%, and adjusted earnings are up as well. The First Horizon deal is becoming a headache, but it’s not the end of the world. If TD terminates in June, it will have spent about $200 million on the delayed closing fees, when the company earned $12 billion last year. TD will survive. As for whether it will actively thrive, that’s anybody’s guess, but The Toronto-Dominion Bank does not even need growth to be a good value proposition at its current price. I’m staying long.