Stock Analysis: Toronto-Dominion Bank (TD; November 23, 2012)

Following the most recent financial debt crisis of 2008-2009, I am guessing that most investors are still somewhat leery when it comes to the idea of investing in financial institutions. Many shareholders were burned during the collapse, watching so many companies: crumble, declare bankruptcies, slash dividends, and see their shares nose dive in value. After watching and observing from afar these past few years, it seems like the worst is finally over (baring another major economic collapse).

U.S. Large Caps

Two of the largest U.S. banks, Wells Fargo (WFC), and JP Morgan Chase (JPM) passed the Federal Reserve stress test earlier in March of this year, and were thus granted the right to raise dividends and proceed with share buybacks. The stress test aimed to determine whether or not banks could survive another financial meltdown, simulating a case study where unemployment reached 13%, housing prices dropped by 21%, and the slowdown in both Europe and Asia was prolonged. Surprisingly (or not), 15 out of the 19 large banks tested, passed.

As a result, JP Morgan Chase raised its dividend by 20%, and has seen its share price appreciate steadily throughout 2012. JPM currently sports a 3.04% dividend yield.

Wells Fargo raised its dividend by an even greater percentage, a whopping 83% (from $0.12 to $0.22), and now boasts a dividend yield of 2.76%.

With such respectable dividend yields, dividend growth investors may have already started looking into adding one of these large-cap banks to their portfolios. After all, if this is just the start of many more dividend increases, it’s always better to get in at the beginning. That way, the YOC will grow at a more rapid rate, and there will be ample room for the payout ratio to grow before it starts to saturate.

The Alternative

I’ve had both JPM and WFC on my watchlist for a few months now. With the recent market pullback, I’ve been strongly considering adding shares of WFC to the Early Financial Independence Portfolio. However, thanks to a good tip from a fellow dividend growth investor, Compounding Income, I’ve started to look at alternatives outside of just the big U.S. names. Just north of the border, there’s another intriguing company by the name of Toronto-Dominion Bank (TD).

Toronto-Dominion

First off, Toronto-Dominion Bank is a Canadian bank. It is the second largest bank in Canada, focused on four key market segments: Canadian Personal and Commercial Banking, Wealth and Insurance, U.S. Personal and Commercial Banking, and Wholesale Banking.

Toronto-Dominion Bank owns less than 45% of TD Ameritrade (AMTD).

TD is very focused on the customer experience, where it has received raved reviews (TD Canada Trust won J.D. Power for highest customer satisfaction for the seventh year in a row). Adjusted earnings show that over 89% of TD’s revenue comes from its retail sector. TD features over 1150 branches, and 2800 ATM’s located throughout Canada. In the U.S., there are over 1290 stores and 1870 ATM’s.

Dividend

With the introductions out of the way, the first thing any dividend growth investor will want to scrutinize is the dividend. When analyzing the dividend, we want to know:

Dividend Yield: 3.82% (Using November 16 closing price of $82.19; assuming quarterly yield of $0.77, or yearly yield of $3.08)

Dividend Growth: 9.94% CAGR (from 2002 through 2012)

TD’s dividend growth has been very impressive over the past 10 years, with an annual growth rate just short of 10%. Though the dividend was held static from 2009-2010 at $0.61, before increasing to $0.66 in April of 2011.

Investors who tuned in to the Q3 earnings report should be pleased to know that TD’s management is very committed to growing the dividend moving forward. CEO Ed Clark has this to say, “Earnings growth permitting, the board has indicated that they would like to continue increasing our dividend twice a year as we progress towards a mid-point of our new higher payout range.”

I don’t know about you, but I sure get excited when I hear a CEO and board talking about raising dividends to reward shareholders!

Dividend Payout

Increasing the dividends twice a year is nice, of course, if the dividend payouts are sustainable.

The following table shows the payout ratio with respect to earnings starting from 2003:

As we can see, the trailing twelve months payout ratio is basically right at 40%. So, there is room for the dividend to grow, and it doesn’t look outstretched by any means. This is inline with the board’s directive to increase the dividend. The higher payout range, as previously mentioned, would take TD’s payout ratio from 40% to 50% of adjusted earnings. In the short term, the dividend increases will outpace the EPS growth.

Earnings

Through the first three quarters of 2012, adjusted earnings were up to $5.3 billion, which represents an 11% over 2011. From the Q3 conference call: EPS growth for 2012 is expected to be up between 7% to 10% over 2011.

Over a 5 year period, the CAGR is over 13%, with adjusted EPS over 8%.

Headwinds

Although TD is expected to exceed EPS goals for 2012, there are headwinds to consider moving into 2013. With the slowing down of the global economy, the ever decreasing interest rate environment could squeeze margins even tighter. Even with so much uncertainty ahead, the CEO “is confident that we have made the right investments in organic growth and the new strategic initiatives to achieve that target over the medium term.”

Debt to Equity

How’s the debt? The debt-to-equity ratio for TD compares quite favorably to its U.S. peers: JPM (1.3), WFC (0.92), and BAC (1.30). It is slightly higher when comparing to other Canadian banks: BMO (0.16), RY (0.20), BNS (0.25).

Safety Counts

For dividend growth investors planning to rely on passive income to fund retirement, safety is of paramount importance. The best dividend yield in the world means nothing if the payouts are unsustainable. Further, when choosing a financial institution, it’s also important to consider one that has a proven history of being able to get through tough times.

The financial crisis, still fresh in most investor’s minds, is a good litmus test. How did TD navigate through this rough patch?

TD was one bank able to escape the subprime mortgage fiasco without having to face any write-ups. While most banks were cutting, or eliminating dividends completely, TD managed to keep its dividend constant at $0.61.

TD is a growth company, but does so without taking unnecessary risks. TD’s product offerings are conservative, with terms usually lasting for 5 years or less. It also helps that Canada’s banking system is well regarded as being amongst the safest and most reliable in the entire world.

The rules are different up North, and lending is much stricter. Almost all Canadian loans are considered “full recourse”, since the borrower is entirely responsible for the mortgage, even in the event they enter foreclosure. Lenders like TD have recourse to both borrowers and property in most provinces. Mortgages also typically carry a fixed-interest rate for a maximum term of only 5 years, renewable at maturity. Even mortgage interest rates, for example, are not tax-deductible in Canada. This can help weed out “bad” borrowers, since there are no tax-advantages gained from owning a home as opposed to renting.

TD Bank was recently ranked by Global Finance Magazine as the 15th safest bank in the world. TD’s proven track record and industry recognition for safety should go a long ways towards easing any potential concerns investors may have when it comes to risk management.

The cherry on top? TD Bank consistently boasts strong credit ratings, having received the highest possible Aaa grade from Moody’s Investor Service (C is the lowest grade).

TD Credit Rating

Valuation

At a current share price of $82.19, TD’s P/E is 12.00. The forward P/E is about 10. True valuation of a stock is debatable (there are many techniques), but one popular and quick way of calculating fair value is to use the Graham number:

Book Value Per Share (BVPS) obtained from Morningstar; TTM, in USD.
Earnings Per Share (EPS) obtained from Google Finance.

Conclusion

TD looks to be an attractive alternative to the usual large cap U.S. banks (JPM, WFC, and BAC). With a current dividend yield of 3.82%, it is already a high yielding player, offering payouts far superior to that of the Big 3. Further, management has demonstrated its commitment to increasing the dividend, having raised it four times in the past two years.

The latest Q3 earnings call should inspire even more confidence, with the CEO announcing TD’s plans to continue increasing the dividend payout twice each year, targeting a higher, 50% payout ratio.

Earnings growth has been strong, with an annual growth rate of over 13% over the past 5 years. TD’s “superior ability to generate capital… [the board] determined that the timing was right to make this change in our payout ratio.”

So, what do we have?

Market presence? Second largest bank in Canada. Focused on organic U.S. growth primarily through retail banking. $74.9 billion market cap. Check!
Strong current dividend yield? 3.82%. Check!
Dividend growth? Twice each year moving forward. Just under 10% annual growth over past 10 years. Check!
Manageable payout ratio? 40%, moving to 50%. Check!
Earnings growth? 2012 earnings will increase from 7% to 10% over 2011. 13% annual growth over the past 5 years. Check!
Manageable debt? Decreasing/constant debt-to-equity trend over past few years. Check!
Low-risk assessment? Top-notch credit rating. Follows strict, conservative lending practices. Check!

At it’s current market price, I would wait for a slight pullback before initiating a position in TD. Overall though, the stock looks like a winner to me!

Disclosure: No position in TD, but strongly considering going long!

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Compounding IncomeDividend MantraJC @ PassiveIncomePursuitFI FighterExecutioner Recent comment authors
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Executioner
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I assume any dividends paid by TD in a US account would be subject to foreign tax withholding, right?

Dividend Mantra
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FI Fighter, Nice analysis here. TD seems like a high quality bank. The debt level is especially impressive, especially compared to our banks. The Canadian banks in general seem to have better operating results than U.S. banks, but I do fear a real estate bubble is on the horizon in the Great White North. I’ve often thought I’d like to eventually have 4-5 banks in my portfolio once things finally calm down. WFC and USB are prime candidates, and perhaps one bigger bank (TD could fit the bill here) along with one smaller bank to compliment my SBSI position. TD… Read more »

Compounding Income
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Nice analysis there! I’m a little late here as I’ve been extremely busy recently. I like Canadian banks a lot because the lending practices are strict. You simply don’t see bank failures in Canada like here in the US. I believe that at some point in the future, US banks are going to go crazy and get themselves in trouble again. Now it might not be for a decade or two, but I bet it will happen. History tends to repeat iteself. Why even invest in American banks? They will do anything (even it hurts in the long run) to… Read more »

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