Profile: Toronto Dominion Bank

March 3, 2022 | Toronto Dominion Bank (TD) trades at a higher multiple to book value than JPMorgan Chase (JPM) and sports a modest 0.87 market beta, but the financial performance of the $1.7 trillion asset universal bank is not that good compared to the top US financials. Asset returns below 1% and return on equity in single digits? TD just announced the purchase of another wonderful example of mediocrity, First Horizon Corp (FHN), at about 1.5x book, a 40% premium to market when the deal was announced. At a time when many US banks are reducing footprint in retail banking, TD is buying more.

Management led by CEO Bharat Masrani is buying yet another retail bank franchise even though wealth management is the primary support for TD's public valuation. Analysts and well-wishers hail the transaction as a sign of growth for this colossus of the north. We see more value destruction in store for TD’s long suffering shareholders. The list of M&A transactions closed by TD Group is long and varied for this financial conglomerate.

TD, we should recall, is known primarily as an asset manager in Canada and not a lender, but it is the largest bank by assets in the country. Instead of adding to its higher value wealth management business, TD has decided to buy another retail bank in the US. Like the other Canadian banks before it, TD has a decidedly mediocre record building a profitable banking portfolio in the US.

TD acquired Commerce Bancorp for $8.5 billion in 2007, a premium valuation. TD US also holds the 9.7% stake in Charles Schwab (SCHW) that arose from the 2020 sale of TD Ameritrade. The acquisition of FHN will add another $4 billion to the intangibles of the group. In 2005, it sold TD Waterhouse USA to TD Ameritrade Holding for $2.9B, which eventually was acquired by SCHW.

Even as asset peers like Banco Santander (SAN) are making a bee line for the door to exit US retail banking, those generous souls in Toronto have decided to double down. Indeed, Masrani does not even talk about wealth management when he talks about creating a new “TD brand” in the US.

“Transactions that are strategically compelling, financially attractive, fit within our risk appetite and are culturally aligned are rare,” Masrani effused on a call with stock analysts. “We’ve been patient in waiting for the right opportunity, and in First Horizon we have found it.”

Analysts and investors can view the US business of TD in the BHC performance reports prepared by the FFIEC for TD Group US Holdings LLC (RSSD 3606542). The first thing to note is that TD US business is not very profitable, lying in the bottom decile of the 132 bank average for Peer Group 1. Funding costs are quite low, but the profitability of the $500 billion business (not including FHN) is poor, with net interest income in the bottom third of the group. Return on earning assets has been consistently below peer for the past five years.

While the income of TD’s US business is low, the credit losses are 3x peer in Q3 2021. Indeed, net losses have been elevated compared with the peer group for quite a number of years. The pricing on the bank’s US loan book is dead on peer, but the operating expenses of the TD US business are above peer, including a big number for other corporate expenses. Since just 32% of the bank’s assets are in loans and the rest in low yielding securities, it is hard to make money. Yet despite the fact that its US loan book is smaller than its peers, TD US manages to lose more money as a percentage of total assets.

Source: FFIEC

TD US has an efficiency ratio in line with or even below Peer Group 1, but the efficiency ratio saw a spike to 66 in Q3 2021. Expenses at TD US have been growing 2-3x faster than assets for the past several years.

Source: FFIEC

TD US had $58 billion in total equity capital at the end of Q3 2021, but also carried $20 billion worth of intangibles from previous acquisitions in the US. TD has been buying banks in the US going back decades, including the 2006 acquisition of control of Bank North and Hudson United.

FHN had been trading around book value prior to the announcement of the acquisition, not a rousing testimonial given the performance of financials over the past several years. F/K/A First Tennessee, FHN has performed well in some periods in the past, but more recently has been wallowing in the bottom half of Peer Group one in terms of net income and asset returns. The bank has over 400 retail branches in a dozen states.

Interest expense for FHN is below the peer average as you would expect and credit losses are also below the peer group, but the pricing on loans is likewise weak, at just 3.5% gross yield vs over 4% for the peer average. At least FHN is reasonably well deployed in terms of loan assets, with 65% of total assets in loans and leases. Perhaps the folks from TN can teach their Canadian partners something about better managing earning assets.

Like TD, FHN’s efficiency ratio (Overhead Expenses / Net Interest Income + Non-Interest Income) was over 66% in Q3 and has been above 60% going back five years. FHN has been chasing opportunities in the secondary mortgage market in recent years, one reason that compensation expenses are well above peer. Personnel expenses at FHN were more than 41% of operating income vs just 32% for Peer Group 1.

Looking at the financials of FHN, it is hard to see how the purchase adds anything to the TD business in the US other than size. What is the point of Masrani buying more retail deposits if the TD bankers cannot fill the existing balance sheet with quality loans? Or to put it another way, adding a business that trades at 1x book to the existing TD franchise is unlikely to result in higher shareholder returns. The significant premium to book paid by TD for FHN is illustrated in the chart above.

The most significant comparable to TD is SCHW, but for some reason TD has decided to continue to buy retail banking franchises rather than paying up for asset managers. SCHW trades over 3x book, while FHN was just barely 1x book prior to the announcement of the acquisition. To us, spending $13 billion on acquiring more SCHW makes more sense than buying FHN. If the past experience of Canadian and other foreign banks is any guide, Masrani may come to regret this investment.