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Toronto-Dominion Bank (TD)

Toronto-Dominion Bank (TD) was founded in 1855 and is one of Canada's "big six" banks, which command over 90% of that country's market share according to the Department of Finance Canada. Toronto-Dominion had about $1 trillion in assets at the end of 2017 and over 25 million customers. The company is Canada's largest bank by customer deposits and the second largest by assets. 

In North America, Toronto-Dominion is the sixth largest bank by both market cap and assets. In total, the bank has over 2,300 total branches and more than 5,700 ATMs across the continent. 

Revenue is fairly balanced between net interest income (TD's lending businesses accounted for 58% of sales last year) and non-interest income operations (32% of revenue is from non-lending businesses such as insurance policies, card services, service charges, mutual fund management, credit fees, brokerage services, etc.).  

Toronto-Dominion organizes its operations into three primary business segments:

  • Canadian Retail (60% of net income): provides a full range of financial products and services (checking and savings accounts, personal loans, credit cards, car loans, mortgages, investments) to over 15 million customers in the Canadian personal and commercial banking, wealth, and insurance businesses. 

  • U.S. Retail (26% of net income): provides retail and business financial products and services to over 8 million U.S. retail customers. 

  • Wholesale Banking (10% of net income): provides capital markets, investment banking, and corporate banking products and services to big companies. Services include underwriting and distribution of new debt and equity issues, providing advice on strategic acquisitions and divestitures, and trading, funding, and investment services.

The bank operates at the retail level under the TD Canada Trust, TD Bank, and America's Most Convenient Bank brand names. Toronto-Dominion also owns 42% of brokerage firm TD Ameritrade, which has 11 million accounts and $1.2 trillion in assets.
Source: Toronto-Dominion Investor Presentation
The vast majority of TD's business remains in its home market, which accounts for 60% of net income. However, the U.S. business is growing slightly faster than the Canadian counterpart, meaning that America should become an increasingly important business driver over time. 

Overall, 90% of TD's net income is from low-risk retail banking activities, thanks to the company's traditionally very conservative banking culture. 

Business Analysis

In the U.S. banking is largely a commodity product, with consumers and businesses seeking access to dependable financing at the lowest interest rate possible. Banks with the largest low-cost deposit bases (i.e. cheap sources of funding to use for lending), most efficient operations, and conservative risk management practices tend to be best off. 

Unfortunately, significant regulation and intense competition (there are more than 9,000 U.S. banks) tend to reduce the level of profitability that is possible. However, even stricter regulations in Canada, where Toronto-Dominion generates approximately 60% of its net income, create just the opposite effect.

For example, the Canadian banking sector is known for its stability, even sailing through the global financial crisis with relative ease (no Canadian banks failed or required government bailouts). In fact, Canada hasn't had a banking crisis since 1840, largely due to strict regulations that cement the largest six banks as an effective oligopoly.

For one thing, Canadian regulators set very strict underwriting and credit standards, while also forcing banks to eat more of their own cooking. For example, Canadian banks are required by law to hold more loans (including mortgages) on their own books, rather than securitize (i.e. sell) them to third parties. As a result, lending practices tend to be far more conservative. 

Home mortgages also require a minimum downpayment of 5%, and any mortgage without at least 20% down payment requires default insurance. These conservative practices are one reason why Canadian banks suffered far less than many other financial institutions in 2008-2009. 

When combined with their impressive scale and geographic diversification across the country, Canada's largest banks enjoy durable competitive advantages, despite offering similar products and prices.

As you can see below, Canada's big six banks (the dashed line) have generated solid profitability through all types of economic periods for many years. They have also earned a superior return on equity compared to smaller Canadian banks, international peers, and the corporate sector overall.

Simply put, these behemoths enjoy some of the lowest cost sources of funding (massive deposit bases paying little interest), have thousands of retail locations across the country to cheaply acquire new customers, and have expanded their operations into hundreds of different product lines to continue growing. Smaller rivals struggle to compete with the giants' prices, services breadth, and reputation.

The industry's lack of differentiation and pricing competition has helped Toronto-Dominion, with the largest low-cost deposit base in Canada, firmly establish itself as the No. 1 or No. 2 player in nearly all retail banking product lines.

Thanks to the nation's favorable regulatory regime and the lack of formidable competition, the big six Canadian banks enjoy impressive economies of scale. As a result, their efficiency ratios (operating costs / revenue) put most of their U.S. counterparts to shame. 

For example, most U.S. banks have efficiency ratios of 56% to 65%, generate returns on assets of 1%, and are lucky to achieve returns on equity of 8% to 12%. In contrast, TD had an efficiency ratio of 53.6% last year, which means that Toronto-Dominion is one of the leanest run banks in the world.

Even more impressive has been the bank's ability to maintain very strong earnings and dividend growth. Over the past five years, the bank has compounded its adjusted EPS by 8.5% annually, and management believes it can continue that growth rate for several more years. 
Source: Toronto-Dominion Investor Presentation
The bank has also become a favorite among dividend growth investors. Not only has Toronto-Dominion paid a dividend every year since 1857, but for the last two decades, the company has raised its payout by a double-digit clip. That includes the recently announced 12% dividend increase for 2018.
Source: Toronto-Dominion Bank
But as the financial crisis showed us, strong growth in earnings and dividends are meaningless if a bank's balance sheet is unsafe and likely to implode during an economic downturn.

Fortunately, Toronto-Dominion, like almost all Canadian banks, has a very disciplined and conservative banking culture. The company has strict (and regulated) loan underwriting standards that keep it from making dangerous loans that are at higher risk of default during recessions.

In fact, even during the financial crisis loan losses never approached 1%, and today loan losses are just 0.49% of total loans. 
Source: Toronto-Dominion Bank
The bank's common equity tier 1 capital ratio (the international standard for safe balance sheets) also stands at 11.8%. To put that in context, the U.S. Federal Reserve (which regulates U.S. banks), has a minimum CET1 ratio of 8.5% to 9.5%, depending on the size and systematic importance of the bank.

In other words, Toronto-Dominion appears to have a very strong balance sheet composed of mostly low-risk and high-quality loans. These types of loans are unlikely to lead to enormous losses, a bank failure, or a dividend cut, even in a recession.

Not surprisingly, the bank enjoys one of the highest credit ratings from both S&P and Moody's. You can see that TD's ratings are higher than not only most U.S. banks, but also most of its conservative Canadian peers.
Source: Toronto-Dominion Bank
Over the past decade, Toronto-Dominion has been making big inroads into the U.S. market, starting with its 2007, 2008, and 2016 acquisitions of Banknorth, Commerce Bancorp, and Scottrade’s online bank, respectively. The bank also took a 42% stake in TD-Ameritrade.

Toronto-Dominion now operates in seven of America's nine wealthiest states, and four of its largest metro areas. The bank's U.S. footprint means that it's potential customer base exceeds 80 million, although TD only serves around 9 million customers in its service territories today. In other words, TD has plenty of growth runway in the states, especially since the U.S. population is nearly nine times the size of Canada's.

As Canada's second largest bank, Toronto-Dominion enjoys an entrenched and profitable market position created by a favorable regulatory environment. The bank has developed numerous competitive advantages over its many years in operation, including industry leading economies of scale, one of the lowest cost structures in the world, massive distribution channels, and conservative risk management practices.

However, Toronto-Dominion is still a bank and has several risk factors that investors need to understand before investing.

Key Risks

First, Canadian regulators can change rules, though the positive nature of the relationship between big banks and regulators means they don't usually arbitrarily do so. 

However, Canada did recently raise the capital reserve requirements on its banks years ahead of international standards. This change means that Canadian banks need to hold 1% more capital, which will slightly decrease their profitability in the future.

And speaking of profitability, be aware that while the U.S. banking market represents a meaningful growth opportunity for Toronto-Dominion, it's also likely to be much less profitable. That's because the bank's U.S. operations lack many of the competitive advantages it enjoys in Canada.

In America, retail banking is much more competitive, and historically Toronto-Dominion's U.S. returns on equity have been no higher than 15%. While that's still much higher than most U.S. banks, it is far below the return the bank enjoys in its Canadian business.

Additionally, like all banks, Toronto-Dominion's results can be cyclical and largely tied to the economy of its home country. The risk most investors worry about is that Canada's consumers are more heavily indebted than their U.S. counterparts. For example, the household debt/GDP ratio in Canada is  around 100% compared to less than 80% in the U.S.
If Canada is nearing the top of its current credit cycle, any negative economic shocks could result in Toronto-Dominion's loan losses rising. This is especially true when it comes to housing as Canada's housing market has been overheating for years (mostly in Toronto and Vancouver).

Property prices were rising as much as 30% per year as lots of foreign capital (such as from Chinese real estate investors) came pouring into properties as a means of diversifying their wealth. 

Thanks to stricter mortgage financing rules imposed by regulators in recent years, along with the modest rise in interest rates, Canadian housing sales and prices have begun to drift lower. Should Canadian housing prices crash at the same time as the economy enters a downturn, then mortgage defaults could rise and hit Canadian banks' earnings.
Source: The Canadian Real Estate Association

The good news is that regulators' actions to tighten mortgage lending should reduce the financial system's risks and reduce the potential future damage from a more serious downturn in the housing market.

Residential mortgages account for about 17% of Toronto-Dominion's assets. For context, U.S. banks mortgage assets before the housing bubble popped were less than 10%. The good news is that those mortgages are highly conservative, with strong credit scores backing them, large down payments, and most are insured. 

In the last quarter, Toronto-Dominion's residential mortgage loan loss rate was 0.33%, which is actually down from 0.41% in Q1 of 2016 when Canadian home prices began their gradual but steady decline. In fact, over the past two years the bank's mortgage loan loss rate has been steadily falling, indicating that Canada isn't currently experiencing a U.S.-style housing crash. 

The U.S. housing bubble was largely a result of dangerous lending practices, including zero downpayment loans made to subprime lenders at adjustable rates.

However just be aware that there is still a small possibility that a severe Canadian housing downturn, in conjunction with a recession (such as 2009) might cause the bank's earnings to decline meaningfully. 

For example, in 2099 Toronto Dominion experienced a 19% drop in revenue and a 30% decline in earnings. However, the bank remained profitable (with a healthy return on equity of 14%), and the dividend was easily maintained, though frozen for one year.

While Toronto-Dominion's earnings can be cyclical, and it faces some exposure to Canadian recessions and a potential housing crash, such risks seem unlikely to put the payout at risk.

Closing Thoughts on Toronto-Dominion Bank

Banking is a notoriously complex, cyclical, and sometimes downright scary industry for dividend investors. The global banking crisis proved that even large blue-chip banks weren't safe dividend stocks, so many U.S. income investors prefer to shy away from the sector entirely. 

However, banking is done very differently in Canada, where conservative balance sheets and disciplined underwriting is followed with near religious zeal. And among Canadian banks, Toronto-Dominion is a standout business thanks to its entrenched market position, extremely low-cost deposit base, and favorable regulatory environment. 

Although Toronto-Dominion may have its eyes set on strong growth into the U.S. banking sector, the firm's disciplined corporate culture is likely to persist in America. In other words, TD seems likely to remain a source of safe and growing income for many years to come. 

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