Friday, January 27, 2006

RBC Capital Research on TD Bank

  
Event

TD Ameritrade deal closes and Ameritrade reports Q1/F06 result.

Investment Opinion

• TD Vends Waterhouse (TWE) for 32.5% of Ameritrade (AMTD). Concurrent with AMTD’s Q1 report and board meeting, TD’s Waterhouse becomes part of TD Ameritrade. Over the course of the next three years, TD will now aim to pick up another 7.4% of AMTD outstanding in the open market to raise its stake to targeted 39.9%.

• EPS Accretion in Target Range Despite Buy-Up & USD Challenges. Management estimates EPS accretion should range from 4-7¢ for ’06 and from 19-25¢ in ’07 – the range reflects the low/high ownership post-close ‘buy-up’ outcomes. The original deal accretion targets, set June’05, were 8¢ in ’06, and 25¢ in ’07, both assumed full 39.9% ownership by TD and a stronger USD at 1.25. Since, revised higher synergy benefits should offset the lower USD and lower average expected ownership in the early stages of the deal. We do expect TD will aim for at least 37.5% ownership toward the end of 2006, to secure its 5th board seat and retain maximum management involvement at AMTD.

• AMTD’s Q1/F06 Meets Consensus Comfortably. AMTD reported US$0.21 EPS, which excl. 1¢ derivative adjustments, was US$0.22. AMTD also absorbed 3¢ in pre-deal closing costs, so the pre-closing underlying EPS was above the reported level. Q2/F06 momentum in early January is strong – trades/day are tracking up ~30% at both AMTD and TWE from the prior quarter average. Leverage to earnings at AMTD is ~1:1 with changes in trade volume.

• Synergy Target Boosted 17%. Management raised its target revenue synergy by 50% to US$300MM, adding 17% to total integration benefit expected. Since deal announcement date in June, 6 central bank rate hikes have improved the free balance revenue opportunity.

• Attractive Valuation. Our price target of $70 is set at 14x our $5.00 estimate, roughly the mid-point of our 2006 and 2007 estimates of $4.68 and $5.30, respectively. We have rolled forward our estimate period to help reflect a full year of earnings from each recent acquisition (AMTD and HU). Our premium target P/E reflects TD’s leading domestic franchise, management that we rate as peerless and the unique structure for growth in the U.S., yet TD trades at a sector-neutral 13x our ’06 estimates. Our investment thesis is that consensus estimates are low and overly discount (i) organic growth, which we believe should be above 10%, and (ii) EPS accretion on the Ameritrade and Hudson United transactions, particularly for 2007 where we are $0.30 or 4% above the 10% consensus growth rate.

TD Closes Ameritrade Deal Amid Strong Fundamentals, Though Challenges Persist

TD Ameritrade fundamentals are improving rapidly as (i) higher interest rates boost the free balances revenue (up 50% since the March quarter) and (ii) trades/day activity regains momentum. Since the deal was announced in June 2005, Ameritrade’s run-rate revenue is up 19%. Management has also increased their estimate for anticipated revenue synergy by 50% from US$100 million to $300 million.

Mitigating these improving fundamentals are two factors; (i) the falling USD, and; (ii) TD’s uncertain ownership level. On the USD, management is now using a 1.15 USD/CAD assumption in their outlook, below our 1.20 assumed, and the original deal level of 1.25.

On the Ameritrade ownership front, TD's financial ability to buy additional Ameritrade stock in the open market and achieve its 37.5% ownership threshold by year-end is strong. With over 10% Tier 1 capital, even post-closing the BNK-HU and AMTD deals, and with TD generating in excess of CAD$2 billion in free capital per year, we do not anticipate any financial constraint. Timing is uncertain though, as this will likely depend on market pricing. The good news is that AMTD is a very liquid stock, recently for example, trading 10 million shares/day. TD is aiming to acquire 24 million shares in the open market and would need an estimated ~CAD$550-600 million to get to 37.5%.

EPS Sensitivity to Varying AMTD Ownership. In 2006, roughly $0.03 of total $0.07-$0.08 modeled accretion is lost if ownership stays at 32.5%, 7.4% below the intended 39.9% final ownership outcome. We see a mid-range outcome as probable for ’06 average, but compared to the bank’s overall EPS, expected to run in the $4.60-4.70 range, variability around this number is just not an overly material issue.

In 2007, the 7% difference in ownership would generate a $0.06 EPS shortfall, from $0.25 to only $0.19. We view this latter ownership outcome at the low end of the range as unlikely, as we believe TD CEO Ed Clark is motivated to NOT lose TD its 5th board seat at Ameritrade, which would be triggered by a less-than-37.5% ownership level.

EPS Sensitivity to Trade Activity. A 30% lift in trade activity, given the industry’s and AMTD’s huge fixed cost leverage, would generate a similar 33% improvement in EPS, as we infer from management’s published sensitivity analysis, the latter well-supported by AMTD’s history as well as internal modeling capability. This would flow through to the $0.25 accretion bumping it to ~$0.33 (or works $0.19 EPS accretion, at lower ownership assumption, back up to $0.25).

Investment Thesis. We continue to believe the interesting aspect of the TD story lies in 2007, where our cash EPS estimate is $0.25 or ~5% above consensus.

In 2007, we do factor $0.25 EPS accretion from the Ameritrade position, assuming ~37.5% ownership. We also add another $0.10-0.12 from the Banknorth acquisition of Hudson United. Backing a range of $0.31 to $0.37 EPS accretion numbers out of consensus EPS, we see the consensus using 2-4% organic EPS growth compared to our 10% assumption. In our view, the difference is reflected in our 5% higher EPS estimate.

In summary, although the timing on realization of both the AMTD and HU deals has been pushed out into 2007, the fundamentals, particularly for AMTD, keep getting better. Trading at a sector-neutral multiple, we believe these circumstances constitute a good buying opportunity.

Hudson United Acquisition Closing

On January 11, 2006, shareholders of Banknorth and Hudson United (HU) approved the transaction with 99% and 98%, respectively, in favour. The deal has cleared all regulatory hurdles and is now slated for closing on January 31, 2006, with full systems conversion in May 2006. The deal was originally expected to be US$0.02 dilutive to EPS at the Banknorth consolidated level, but with the lag between closing and conversion, management now expects a further US$0.02 dilution for a total of US$0.04/share this year. At the TD level, the BNK-HU deal should be neutral to cash EPS in 2006, and $0.12 accretive in 2007.

Earnings Outlook

Our EPS estimates factor the following segmented earnings growth assumptions: (i) P&C at 15% in 2006, and 12% in 2007 (P&C earnings grew by 16-18% in each of the last three years); (ii) wholesale at 5% in each of 2006 and 2007 (in line with management’s aspirations, but in our view, somewhat beatable); (iii) wealth (excludes TD Ameritrade) at 20% in 2006, 15% in 2007 (earnings for this business includes retail mutual funds and brokerage, growing contribution at 20-30% in the last several quarters). For Banknorth, we are incorporating the estimates of our U.S. Bank Team (James Ackor) – factoring additive earnings from the Hudson United transaction, and for Ameritrade, roughly using mid-points of management projections.

Valuation

Our price target of $70 is set at 14x our $5.00 estimate, roughly the mid-point of our 2006 and 2007 estimates of $4.68 and $5.30, respectively. We have rolled forward our estimate period to help reflect a full year of earnings from each recent acquisition (AMTD and HU). Our premium target P/E reflects TD’s leading domestic franchise, management that we rate as peerless and the unique structure for growth in the U.S., yet TD trades at a sector-neutral 13x our ’06 estimates. Our investment thesis is that consensus estimates are low and overly discount (i) organic growth, which we believe should be above 10%, and (ii) EPS accretion on the Ameritrade and Hudson United transactions, particularly for 2007 where we are $0.30 or 4% above the 10% consensus growth rate. Risks to our outlook include (i) further USD weakness and (ii) deal integration disappointment.

Price Target Impediments

The primary risks to our price target are integration foul-ups and/or follow-on deal reinvestment risk. Potential for a unique earnings shortfall as distinct from normal systemic sector risk centres on (i) the BNK-Hudson United integration and (ii) TD Ameritrade deal risk. In our view, maintaining continuity of the BNK management team is also paramount to successful U.S. expansion, and this team has been together for fifteen years now. For its part, TD management has an excellent track record for major acquisitions, both with TD Canada Trust and previous trust deals, as well as numerous TD Waterhouse acquisitions (all cross-border).
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