Toronto-Dominion Is Managing Difficult Economic Conditions Well; Shares Modestly Undervalued

Equity Analyst

Michael Miller

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Toronto-Dominion is one of the two largest banks in Canada by assets and one of six that collectively hold roughly 90% of the nation's banking deposits. The bank derives approximately 55% of its revenue from Canada and 35% from the United States, with the rest from other countries. Toronto-Dominion has done an admirable job of focusing on its Canadian retail operations and growing into number-one or -two market share for most key products in this segment. The bank also has number-two market share for business banking in Canada. With over CAD 400 billion in Canadian assets under management and top-three dealer status in Canada, and being the number-one card issuer in Canada, Toronto-Dominion should remain one of the dominant Canadian banks for years to come.

Toronto-Dominion has also established a significant presence in the U.S. by having the most branches in the U.S. among Canadian banks as well as a 12% ownership stake in Charles Schwab. While we like the higher exposure to more growth in the U.S., the segment has lower returns on equity than the Canadian segment, partially because of goodwill but also partially because returns are naturally lower on average. We also like Toronto-Dominion’s positioning as a major discount brokerage player because we believe this industry is ripe for growth as investors seek out lower-cost alternatives, and the bank could leverage its knowledge of the industry for future growth in Canada.

The bank has taken a number of charges (such as integration charges, restructuring charges, and more). Many of these have been related to acquired card portfolios. We expect that as these card relationships mature, the bank should be well positioned in what is a higher-return business. TD will no longer acquire First Horizon. We did not feel the deal added any value, so this development does not impact our view of the bank. Meanwhile, the acquisition of Cowen was recently closed. Expect fairly messy earnings (lots of one-time items) for the next year, and we also would not be surprised if the bank sees some fallout related to recent regulatory inquiries into the bank's AML/BSA compliance.

Business Strategy & Outlook

With its solid funding base, leading share in the Canadian banking market, moaty nonbank businesses, and the ability to primarily operate in the favorable Canadian banking environment, we believe Toronto-Dominion deserves a wide Morningstar economic moat rating.

We argue that bank moats are derived primarily from two sources: cost advantages and switching costs. We see switching costs in the Canadian system being driven by a tightly regulated oligopolistic market structure, which limits excess competition and stabilizes product pricing, giving customers less incentive to switch banks. Cost advantages stem from three primary factors: a low-cost deposit base, excellent operating efficiency, and conservative underwriting, with regulatory costs a final factor that must also be considered. We think the Canadian banking environment offers systemic cost advantages for the banks under its domain. These advantages manifest in the form of lower operating costs, lower credit costs, lower regulatory costs, and lower absolute levels of and better diversification of risks, all of which allow the banks to achieve greater risk-adjusted returns.

In our view, Toronto-Dominion has a wide moat because it has superior market share in the advantageous Canadian banking environment, a better deposit mix, and exposures to moaty nonbank businesses. Toronto-Dominion has consistently had one of the lower percentages of wholesale funding among the major Canadian banks. This has kept funding costs low, leading to consistently better net interest margins, even as credit costs remained well in line with the other Canadian banks. Extra yield from its credit card portfolio has helped as well. Toronto-Dominion is one of the two largest banks in Canada (along with Royal Bank of Canada) and has dominant market share in many categories, including number-one or -two share in all key retail banking products. Toronto-Dominion is also one of the dominant investment banks in Canada. Once you reach the scale and reputation required to source and execute deals, offerings, and advice that Toronto-Dominion has, we believe the investment banking business becomes more moaty. The bank also has a significant ownership stake in Charles Schwab (formerly in TD Ameritrade), a wide-moat-rated brokerage and investment firm operating out of the U.S., and the third-largest amount of assets under management among the Canadian banks. U.S. retail operations are also strong, earning 13%-15% returns on tangible common equity, with number-one deposit market share in its largest metro area. We believe all of these operations combined warrant a wide moat rating.

We believe the Canadian banking environment offers systemic cost advantages, which lead to returns above the cost of capital, allowing the main banks operating under its jurisdiction to possess moats. 

Barriers to entry are very high in the Canadian banking system. Regulations prevent foreign competition, as non-Canadian residents may not own more than 25% of the shares of a bank unless approved by the government (preventing foreign takeover), and foreign banks can operate in Canada only under certain restrictions (preventing significant direct foreign competition). Domestic competition is also controlled, as Canada’s banking system historically developed to favor a few large banks controlling the majority of the domestic market, and this is actively enforced through the handling of chartering by the federal government exclusively. Additionally, the rejection of merger proposals in 1998 between Royal Bank of Canada and Bank of Montreal, and between Toronto-Dominion and Canadian Imperial Bank of Commerce, created a precedent for regulators accepting no further consolidation.

Having larger banks helps spread fixed costs across a larger operating base, increasing operating efficiency, as the four largest Canadian banks are all bigger than the largest U.S. regional bank. The Canadian banks, because their branch networks spread throughout Canada, arguably have some of the country’s most powerful distribution networks. This offers cost advantages via lower customer acquisition costs. In addition, the banks are involved in nearly every major financial product, including asset management, wealth management, insurance, investment banking, and a variety of other consumer and commercial banking products and services. Bigger scale, powerful distribution networks, a multitude of products, and diversification of business lines lead to economies of scope in addition to the economies of scale already achieved.

We believe a more protective and efficient regulatory system also leads to cost advantages, primarily through risk reduction. Less fragmented and well-integrated banking systems, like the Canadian system, tend to be more stable, reducing risk. Also, Canadian regulators must monitor and develop relationships with only the big six Canadian banks, which is much easier than trying to monitor the thousands of banks in the U.S., for example. This leads to more collaboration and cooperation between regulators and banks, as well as greater institutional memory and more coordinated and easily implemented responses if strains begin to appear in the system. Regulators help control pricing in the market at times, such as on mortgage products, helping reduce the potential for pricing wars to gain market share at the expense of underwriting standards. Canadian regulation also makes it more difficult for bad credit to be issued, including mandatory insurance and standards on riskier mortgage loans, not having a government-sponsored enterprise, like a government-subsidized mortgage securitization market, and forcing banks to hold more of the risk on their own balance sheets. These factors help contribute to better absolute risk reduction in the system, as well as regulatory economies of scale.

The Canadian banks are more geographically diversified on average than, for example, most U.S. regional banks, which often have concentrations in individual states or local economies. This diversifies credit risk, lowering the overall risk for each individual bank. Canada’s system of higher taxes, more social safety nets, and undoubtedly other complex factors have also led to a more robust and stable middle class, which contributes to economic and political stability, further reducing systemic risk.

Combine all of these factors, along with explicit government subsidies on deposit insurance and mortgage insurance, as well as the implicit subsidy of being too big to fail domestically (all big six Canadian banks are labeled as domestic systemically important banks), and we believe excess returns for banks are almost certain within Canada.

Wide

Economic Moat

Toronto-Dominion Bank

The Toronto-Dominion Bank engages in the provision of financial products and services. It operates through the following segments: Canadian Retail, U.S. Retail, and Wholesale Banking. The Canadian Retail segment offers various financial products and services, as well as telephone, Internet, and mobile banking services. The U.S. Retail segment provides retail and commercial banking services, as well as wealth management services in the United States. The Wholesale Banking segment provides capital markets, investment banking, corporate banking products, and investment needs to companies, governments, and institutions in financial markets. The company was founded on February 1, 1955 and is headquartered in Toronto, Canada.

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The Toronto-Dominion Bank engages in the provision of financial products and services. It operates through the following segments: Canadian Personal and Commercial Banking, U.S. Retail, Wealth Management and Insurance, Wholesale Banking, Corporate segment. The Canadian Personal and Commercial Banking segment is involved in the provision of deposit, saving, payment, and lending products and advice. It also offers customized products and services to help business owners meet financing, investment, cash management, international trade, and day-to-day banking needs through its network of commercial branches and specialized customer centers. The U.S. Retail segment focuses on personal, business banking, and wealth management operations in the U.S. The Wealth Management and Insurance segment offers wealth and asset management products and advice to retail clients in Canada through the direct investing, advice-based, and asset management businesses. The Wholesale Banking segment serves corporate, government, and institutional clients in key financial markets around the world. The Corporate segment consists of service and control groups, including technology solutions, shared services, treasury and balance sheet management, marketing, human resources, finance, risk management, compliance, anti-money laundering, legal, real estate, and others. The company was founded on February 1, 1955 and is headquartered in Toronto, Canada.

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