Earnings of The Toronto-Dominion Bank (TD) decreased by 50% quarter over quarter to C$0.80 per share in the second quarter ended April 2020. A surge in provision expense amid the COVID-19 pandemic led the earnings decline. Earnings will likely recover in the second half of the year as provision expense will most probably decline because the jump in provisioning in the second quarter will help in future quarters. However, the provision expense will likely remain above-normal in the second half of the year due to TD’s exposure to the oil and gas segment and the personal and consumer segment. Moreover, a compression in net interest margin following the interest rate cuts in Canada and the United States will pressurize earnings in the coming quarters. For the full year, I’m expecting earnings to decline by 18% year over year to C$5.11 per share (US$ 3.78 per share). There is a chance that actual results will differ from the estimates because the impact of COVID-19 on future provision expense is uncertain. The October 2020 target price suggests a high upside from the current market price. However, the risks and uncertainties will likely keep the stock price from rising to its fair value; hence, I’m adopting a neutral rating on TD.
Personal, Oil and Gas Segments Likely to Drive Provision Expense
TD’s provision expense surged to C$3.2 billion in the April-ending quarter, from C$0.9 billion in the first quarter of the fiscal year 2020. The provision expense will likely decline from the second quarter’s high but remain above normal in the remainder of the year. As mentioned in the second quarter’s conference call, the management expects to see a high level of impairments in the future quarters but also expects the material reserve build in the second quarter to help in the coming quarters.
I’m expecting TD’s exposure to personal and consumer finance to drive provision expense in the remainder of the year. As mentioned in the second quarter’s investor presentation, indirect auto made up 6.6% of total loans, and credit cards made up 3.9% of total loans as of April 30, 2020. The high unemployment in the United States and Canada has worsened the asset quality of personal auto loans and credit cards; therefore, these loans will likely drive future provision expense. Additionally, around C$12.2 billion worth of loans were to the oil and gas segment, representing 1.6% of total loans. I’m expecting international crude oil prices to remain low for a prolonged time; hence, the asset quality of the oil and gas segment will likely suffer in the year ahead. The low oil prices will also have an indirect impact on overall asset quality because the economies of three Canadian provinces, namely Alberta, Saskatchewan, and Newfoundland and Labrador, rely heavily on the oil market. As mentioned in the presentation, loans in these provinces (excluding real estate secured, consumer, and small business) represented 2% of total loans and acceptances.
Considering the factors mentioned above, I’m expecting TD to book provision expense of C$7 billion in the full fiscal year 2020, up from $3 billion in 2019.
Rate Decline in the US and Canada to Pressurize the Rate-Sensitive Margin
The target policy rates in both Canada and the United States have dropped by 150 basis points since the beginning of the COVID-19 pandemic. TD’s net interest margin, NIM, is quite rate-sensitive; hence, the decline in interest rates will adversely affect NIM in the third quarter. A simulation conducted by the management shows the rate-sensitivity of net interest income to changes in the interest rates. According to the simulation, a 100-basis-point decrease in interest rates can reduce net interest income by C$1.14 billion, or around 4%. The following table from the second quarter’s shareholder report shows the result of the simulation.
From the above table, we can tell that NIM is moderately sensitive to interest rate changes. Considering the rate sensitivity, and assuming no further changes in interest rates in the remainder of the year, I’m expecting NIM to decline by 22 basis points. For the full year, I’m expecting NIM to decline by 23 basis points, as shown in the table below.
Loan growth will likely decelerate in the second half of the year from the first half due to the current economic slowdown. I’m expecting the economies of Canada and the United States to start recovering in 2021; hence, the demand for credit will likely remain subdued this year. However, TD’s participation in government-sponsored funding programs will likely boost loan balances in the third quarter. As mentioned in the presentation, TD had financed C$5.7 billion of loans under the Canada Emergency Business Account and funded US$8.2 billion worth of loans under the Paycheck Protection Program till May 18, 2020. Considering these factors, I’m expecting net loans to stand at C$777 billion as of October 31, 2020, up 13.5% from the end of the fiscal year 2019.
Expecting Earnings per Share to Dip by 18%
TD’s earnings in the remainder of the year will likely recover from the second quarter’s low due to a decline in provision expense. However, the provision expense will likely remain elevated on a year-over-year basis, which will hurt full-year earnings compared to 2019. Further, NIM compression in the third quarter will pressurize earnings. Overall, I’m expecting TD’s earnings per share to decline by 18% year over year to C$5.11 in the fiscal year 2020 (US$ 3.78). The following table shows my estimates for the income statement items.
Actual results can differ materially from the estimates because the provision expense will depend on the COVID-19 pandemic. As the magnitude and duration of the pandemic are unknown, the provision expense can give a negative surprise in the year ahead. Additionally, I have assumed that the exchange rate will remain stable at C$1.35 per US$ in the remainder of the year. Fluctuations in the exchange rate can affect the earnings per share from Canadian operations in US dollar terms. I expect the risks and uncertainties to keep TD’s stock price from rising to its fair value in the near term of around three months.
Expecting a Dividend Yield of 5%
I’m expecting TD to maintain its quarterly dividend at the current level of C$0.79 per share (US$0.58 per share) in the remainder of 2020 and 2021. Historical data available since 1969 shows that TD has not cut dividends in Canadian dollar terms since that year. It seems highly unlikely that TD will break that trend now; hence, I’m quite confident that the bank’s dividends are secure. Moreover, the earnings and dividend estimates suggest a payout ratio of 61% for the fiscal year 2020, which is manageable. Furthermore, TD is currently well-capitalized, which reduces the threat of a dividend cut from regulatory requirements. As mentioned in the shareholders’ report, TD reported a common equity tier I capital ratio of 11.0% as of April 30, 2020, above the minimum requirement of 7.0%. Assuming an exchange rate of C$1.35 per US$, the dividend estimate suggests a dividend yield of 5.0%.
Year-End Target Price Suggests a 33% Upside
I’m using the historical price-to-book ratio, P/B, to value TD. The bank has traded at an average P/B of 1.68 in the past, as shown below.
Multiplying the average P/B ratio with the forecast book value per share of US$36.6 gives a target price of US$61.5 for October 2020. The price target implies a 33% upside from TD’s June 16 closing price. The following table shows the sensitivity of the target price to the P/B ratio.
As discussed above, the risks and uncertainties will likely restrain the stock price in the near term of around three months. In my opinion, the risks will overshadow the attractive valuation; hence, I’m adopting a neutral rating on TD.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: This article is not financial advice. Investors are expected to consider their own investment objectives and risk tolerance before investing in the stock mentioned in the article.