Friday, February 29, 2008

TD Bank Q1 2008 Earnings

  
• TD Bank target price cut from C$81 to C$71 by CIBC, rating is Sector Perform
• TD Bank raised from Neutral to Outperform by Dundee Securities
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RBC Capital Markets, 29 February 2008

EPS close to our expectations

Q1/08 core cash EPS of $1.46 were close to our estimate of $1.47, which was in line with consensus, representing YoY growth of 6%.

• TD raised its quarterly dividend to $0.59 from $0.57; we had looked for $0.60.

• Domestic retail earnings were slightly below our expectations on higher reserves in the P&C insurance business and weaker margins.

• Wealth management net income was ahead on much stronger than expected revenues.

• TD Banknorth net income was slightly higher than expected as lower than expected revenues were offset by lower than expected expenses and loan losses.

• Wholesale earnings were weaker than we expected in spite of high securities gains. Trading revenues of $197 million were well down from year-ago levels ($330 million) on weaker credit and equity trading.

• Management reminded that its mid-term objective of 7-10% in EPS growth will be exceeded in good times, and challenging in tough times. The growth objective implies 2008 EPS of $6.15-6.35. Our estimate is $5.80.

Capitalization strong, but heading down

Basel II had a beneficial impact on the Tier 1 ratio, which was 10.9% versus 10.2% under Basel I.

• The closing of the acquisition of Commerce Bancorp is expected to bring the ratio down next quarter to about 9.5%.

• We expect capital ratios to build in H2/08 but then come down by 160 basis points to 8.9% in Q1/09 due to expected changes in capital calculations for investments in unconsolidated entities in which a bank has a substantial investment. The balance of TD's investment in TD Ameritrade was $4.6 billion in Q1/08; if half of that amount was deducted from Q1/08 Tier 1 capital, the Tier 1 ratio would come down by 160 basis points.

• We do not expect TD to be in a position to aggressively deploy capital in 2008 and 2009.

Credit relatively weaker, although weakness did not come from expected areas

Specific provisions for credit losses were $235 million versus our $190 million estimate, $165 million in Q4/07 and $153 million in Q1/07. Our full year estimate is for specific loan losses of $970 million, up 51% versus 2007, with a loss rate in line with historical averages.

• Surprisingly, loan losses declined sequentially in the U.S. We expect that trend to reverse in upcoming quarters given TD Banknorth's exposure to construction real estate and commercial estate (3% and 12% of assets at TD Banknorth, respectively).

• Wholesale banking losses of $56 million were well up from the $4 million reported in Q4/07 and $24 million in Q1/07. Those losses were the result of two impairments in the merchant banking portfolio; we expect losses to come down in Q2/08.

• Retail loan losses $172 million were up from $138 million in Q1/07, but down slightly versus Q4/07. We expect continued upward pressure on losses, driven by higher loss rates in the commercial and small business segments, and growth in personal lending.

The increase in gross impaired loans was more rapid than for peers but the increase was partly due to changes in reporting methodology.

• Gross impaired loans were $785 million; up from $569 million in Q4/07 and $511 million in Q1/07. Increases came from both Canada and the U.S.

• $124 million of the increase came from Canadian retail, with the majority being due to a change in the definition of gross impaired loans for insured residential mortgages from 360 days to 90 days past the contractual due date.

Wholesale profitability down, even with strong securities gains

We believe that TD Securities' earnings could be challenged in upcoming quarters, unless more unrealized gains are realized.

• We believe that the bank realized two very large gains in the quarter. Securities gains of $152 million were quite high compared to the average of $65 million in Q4/07 and Q1/07, in spite of taking write-downs in the bank's head office portfolio and realizing losses on the transfer of a security that was held in a sponsored mutual fund (we believe this relates to holdings that were held in money market funds managed by TD Asset Management USA).

• Management confirmed our suspicions that it had marked down part of its $3.3 billion loan commitment exposure to the BCE transaction in Q3/07 and it took more markdowns in Q1/08 (which were booked as negative trading revenues). The amount of the markdowns was not disclosed but we have suggested that the total could amount to $165 million to $330 million (pre-tax) if we assume that TD loses 5 – 10%, in line with the reported weakening in leveraged loan pricing. The $500 million equity bridge could also result in losses but the value is difficult to determine. Fees payable at the closing of the transaction mitigate the impact of a write down. Further write-downs are likely to be dictated by the direction of leveraged loan pricing.

• Trading revenues of $197 million were well down from $330 million in Q1/07 but not far from Q4/07. We believe that trading revenues will continue to be challenged, while the underwriting and M&A outlooks are probably muted as well.

• TD Securities appears relatively well positioned to avoid large hits in its wholesale franchise, but the near term earnings growth outlook is not overly exciting.

Retail trends not as strong as in prior quarters; we still expect TD to outperform

Retail revenue growth of 7% and net income growth of 10% is likely to prove strong relative to peers but it represents slowing growth relative to peers.

• On a relative basis, we expect revenue growth to benefit from branch openings, the extension of opening hours, the increase in financial advisors, and an increase in net revenue growth in P&C insurance (Q1/08 was negatively impacted by a $30 million increase in reserves related to a recent Alberta court decision that removed limits on awards related to pain and suffering on minor injuries resulting from automobile accidents). We are forecasting 7% in top line growth for 2008.

• On an absolute basis, we expect revenue growth to slow on a likely slowdown in industry volumes and less aggressive growth in credit cards for TD, while the bottom line is likely to be negatively impacted by a more rapid increase in loan losses than revenues. Management also believes it will be tougher to meet its 3% annual revenue growth/expense growth gap. We are forecasting 10% in bottom line growth.

• TD's market share of personal deposits was down 60 basis points in the last year on 3% growth in balances. The bank has focused on checking accounts and we believe share losses in that area have not been as bad. Management appears to have had enough of the market share losses in other areas (term deposits and high yield savings accounts) and appears willing to increase deposit rates to protect market share. This may be a negative for net interest income margins.

Management sticking to 2008 profitability objectives in the U.S.

Management reiterated its net income objective from U.S. retail banking earnings of $700 million in 2008.

• This assumes a Canadian dollar trading at par against the U.S. dollar and a Commerce Bancorp closing by the end of March.

• We believe that the objective could be challenging; there is upside to our earnings estimates if management delivers.

• We expect continued pressure on deposit spreads, but lending spreads could improve, partly mitigating the impact.

• We believe that loan losses will likely worsen from current levels. We expect 6% of pro-forma assets in the U.S. will be in construction real estate loans, while 25% will be in commercial real estate loans.

• We believe that Commerce Bancorp's $4.7 billion securities portfolio backed by Alt-A loans will be valued down at closing, leading to the price to book multiple TD is paying for Commerce Bancorp to rise.

• Management appears keenly focused on expenses, with both compensation and advertising costs declining versus Q4/07.

Valuation

TD (Outperform, Average Risk): Our 12-month price target of $76 is a combination of our sum of the parts and price to book methodologies. It implies an approximate forward multiple of 11.8x earnings, compared to the 5-year average forward multiple of 12.3x given the less accommodative macro environment. Our P/B target of 2.0x in 12 months is at the low end of the bank sector given a lower ROE. Our sum of the parts target of 13.0x 2008E earnings is higher than our target industry average, reflecting a superior domestic retail franchise and lower exposure to low multiple wholesale businesses.

Price Target Impediment

Risks to our price target include the health of the overall economy, sustained deterioration in the capital markets environment and greater than anticipated impact from off-balance sheet commitments. Additional risks include an unexpected acquisition, integration risk with Commerce Bank, TD Ameritrade and TD Banknorth, pricing pressure in the discount brokerage industry, a rising Canadian dollar, litigation risk and a worse than expected impact from Enron-related litigation (although it appears that risk has declined, given a court ruling in another Enron trial).
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Scotia Capital, 29 February 2008

Q1/08 - Solid Results - Dividend Increased 4%

• TD reported solid Q1/08 results with operating earnings increasing 5% to $1.45 per share. Earnings were driven by strong earnings growth from wealth management and retail banking offsetting weak wholesale banking results.

• TD increased its dividend by 4% to $2.36 per share from $2.28 per share.

• Reported earnings were $1.33 per share which included $0.03 per share gain from change in fair value of credit default swaps, $0.03 per share negative tax adjustment, $0.03 per share provision for insurance claims and $0.09 per share amortization of intangibles.

• Cash ROE was 19.7% versus 19.9% a year earlier. Return on risk-weighted assets was 2.92% versus 2.74% a year earlier.

• Wealth Management earnings increased 16% driven by TD Ameritrade with TDCT earnings growth of 10% offsetting the 17% decline in wholesale bank earnings.

Operating Leverage Solid

• TD’s operating leverage was solid in Q1 at 2.5%, with revenue growth of 0.8% and expenses declining 1.7%.

Canadian P&C Earnings Up 10%

• Canadian P&C earnings increased 10% to $598 million, primarily due to volume growth in real estate secured lending, credit cards, and deposits.

• Canadian retail net interest margin (NIM) declined 5 bp sequentially and year-over-year to 2.98%.

• Personal deposits and personal lending market share declined 60 bp and 30 bp respectively from a year earlier. Small business and other business loan market share increased 50 bp and 40 bp respectively YOY.

• Loan securitization revenue declined to $76 million versus $134 million a year earlier and was flat versus $80 million in the previous quarter. Insurance revenue declined to $186 million from $254 million a year earlier due to increased provisions for insurance claims relating to a recent court decision in Alberta. Card service revenue increased 9% YOY to $119 million.

• Operating leverage was solid at 4% with revenues increasing 7% and expenses increasing 3%.

• The efficiency ratio improved 80 bp to 51.0% sequentially.

• Loan loss provisions increased to $172 million from $138 million a year earlier but declined slightly from $176 million in Q4/07.

Total Wealth Management Earnings Up 16%

• Wealth Management earnings, including the bank’s equity share of TD Ameritrade, increased 16% to $216 million.

Canadian Wealth Management – Earnings Increase 5%

• Domestic Wealth Management earnings increased 5% to $128 million from $122 million a year earlier due to higher mutual fund fees from asset growth.

• Operating leverage was negative at 0.7%, with revenue increasing 3.4% and expenses increasing 4.1% to $570 million and $379 million respectively.

• Mutual fund revenue increased 10% to $220 million from $200 million a year earlier.

• Mutual fund assets under management (IFIC, includes PIC assets) increased 5% to $58.8 billion.

TD Ameritrade – Earnings Increase 38%

• TD Ameritrade contributed $88 million or $0.12 per share to earnings in the quarter versus $75 million or $0.10 per share in the previous quarter and $64 million or $0.09 per share a year earlier. TD Ameritrade’s contribution represented 8% of total bank earnings. TD Banknorth Earnings Flat Sequentially

• TD Banknorth earnings were $127 million or $0.18 per share representing 12% of TD earnings versus $124 million or $0.17 per share in Q4/07. This compares with an earnings contribution of $64 million or $0.09 per share a year earlier prior to the privatization of TD Banknorth.

• Net interest margin at TD Banknorth declined 12 bp from the previous quarter and 7 bp from a year earlier to 3.88% as the flat yield curve and strong competitive pressures continue to pressure the margin.

U.S. Platforms Combine to Represent 20% of Earnings

• TD Banknorth and TD Ameritrade contributed $215 million or $0.30 per share in the quarter, representing 20% of total bank earnings.

• The U.S. platforms contribution was negatively impacted by the 16% appreciation in the Canadian dollar which reduced earnings by $0.04 to $0.05 per share.

Wholesale Banking Earnings Decline 17%

• Wholesale banking earnings declined 17% to $163 million from $197 million a year earlier but increased 4% from $157 million in Q4/07.

• Revenues declined 4.3% to $608 million from a year earlier with expenses declining 3.3% to $321 million.

Capital Markets Revenue

• Capital markets revenue declined 6% to $359 million from $380 million a year earlier.

Trading Revenue Declines 10% Sequentially, 40% YOY

• Trading revenue declined to $197 million from $219 million in the previous quarter and from $330 million a year earlier.

• The extremely weak trading revenue was due to a loss in interest rate and credit trading and a decline in equity trading revenue. Interest rate and credit trading revenue was a loss of $37 million versus a gain of $105 million a year earlier and a loss of $69 million in the previous quarter. The credit losses are likely related to write-down's on the banks unfunded loan commitment to BCE. Equity and other trading revenue declined to $71 million from $152 million a year earlier. On the positive side, foreign exchange products trading revenue improved to $163 million from $73 million a year earlier.

Securitization Activity Moderate

• During the quarter, TD securitized $1.2 billion in assets versus $1.6 billion in Q4 and $3.4 billion a year earlier. At quarter-end, TD had $27.9 billion in securitized assets outstanding.

• The economic impact before tax of securitization this quarter was a gain of $5 million versus $4 million in the previous quarter and $13 million a year earlier.

Security Gains High

• Security gains were high at $152 million or $0.14 per share versus $60 million or $0.05 per share in the previous quarter and $70 million or $0.06 per share a year earlier. The earnings impact of the higher security gains was offset by variable compensation (gain on merchant banking position - Equalogic sale to Dell) and higher loan loss provisions in wholesale related to merchant banking portfolio.

Unrealized Surplus - $901 million

• Unrealized surplus declined to $901 million from $1,236 million in the previous quarter and from $990 million a year earlier. The bank currently has six quarters of security gains remaining in its securities portfolio based on the level of gains recognized this quarter.

Loan Loss Provisions

• Specific loan loss provisions (LLPs) increased to $255 million or 0.53% of loans versus $163 million or 0.38% of loans a year earlier.

• We are increasing our 2008 LLP estimate to $900 million or 0.45% of loans from $850 million. Our 2009 LLP estimate remains unchanged at $1 billion or 0.50% of loans.

Loan Formations Increase

• Gross impaired loan formations increased to $626 million from $387 million in the previous quarter and from $369 million a year earlier. The increase in impaired loans is mainly due to the bank now classifying insured mortgages as non-performing after 90 days in arrears versus 360 days. Loss experience on this portfolio is expected to remain at negligible levels.

• Net impaired loan formations increased to $429 million from $199 million in the previous quarter and increased from $243 million a year earlier.

Tier 1 Capital - 10.9%

• Tier 1 ratio was 10.9% under the new Basel II capital framework and 10.2% under Basel I. Tier 1 ratio was 10.3% in the previous quarter and 11.9% a year earlier. Basel II is expected to reduce the Tier 1 by an estimated 150 bp related to TD Ameritrade effective November 1, 2008.

• Risk-weighted assets declined 2% from a year earlier to $145.9 billion, with market at risk increasing 14% to $4.1 billion.

Recommendation

• We are trimming our 2008 earnings estimate to $5.95 per share from $6.00 per share and our 2009 earnings estimate to $6.70 per share from $7.00 per share based on expected slowing growth in the retail operations.

• Our 12-month share price target remains unchanged at $100, representing 16.8x our 2008 earnings estimate and 14.9x our 2009 earnings estimate.

• We reiterate our 1-Sector Outperform rating of shares of TD based on strong high-quality earnings, high relative profitability, growth potential from TD Banknorth and TD Ameritrade (including M&A potential) and attractive valuation.
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Financial Post, Grant Surridge, 29 February 2008

The unexpectedly high credit provisioning put in place by TD Bank yesterday has prompted Blackmont Capital analyst Brad Smith to lower his target price on the stock.

"Credit conditions are likely to deteriorate further, especially in the U.S.," said an excerpt of a note Mr. Smith wrote to clients on Friday morning.

The surprise credit provisioning caused TD's first-quarter results to miss Mr. Smith's expectations, and the announced dividend increase was about half of what he had predicted.

Excluding the provisioning, however, the results more or less jived with what Mr. Smith had called for, and he noted steady performances in the bank's Canadian retail and wealth management businesses.

Mr. Smith lowered noth his 2008 and 2009 earnings estimates and his target price to $63 from $68 previously.
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