Golden_Brown
The Toronto-Dominion Bank (NYSE:TD, TSX:TD:CA) and Royal Bank of Canada (NYSE:RY, TSX:RY:CA) both reported earnings this week. Royal Bank’s release showed modest 2% year-over-year growth in diluted EPS. TD’s release was even stronger, with 76% growth in earnings, or 5% on an adjusted basis.
Overall, it was a solid earnings season from Canada’s two biggest banks. Earnings grew, dividends increased, and investors were rewarded for holding.
The question is, what does the future hold? Canadian banks are performing well at the moment, but risks abound. One of the reasons why RY’s earnings only increased modestly, despite large increases in net interest income, is because its provisions for credit losses (“PCLs”) increased by 16 basis points. PCLs are basically reserves that banks set aside to cover loans that may go into default. When banks increase them, it takes a bite out of earnings. So, the modest growth in earnings seen in fiscal Q4 was largely due to perceived risk factors. Underlying interest growth was very strong, but the banks think that more defaults are coming.
As covered elsewhere, a lot of this has to do with the state of Canada’s housing market. Housing affordability has been deteriorating in Canada for many years now. For most of the past decade, that was down to rising prices. This year, prices fell, but unfortunately, interest rates increased more, so total cost once again went up. The Bank of Canada has been raising rates all year long, hoping to tame inflation. The effort has been partially successful: in October, the CPI increased 6.9%, which is high but down from the highest levels of the year. The price of goods is coming down, but the problem is, for goods that people typically have to borrow money for, the total cost is rising. So, banks are raising their PCLs, as they are expecting defaults.
The paragraph above covers the bear case on Canadian banks. The housing market is out of control and getting more expensive by the day. This thesis has been covered elsewhere on Seeking Alpha many times before, and I think there’s some logic to it. Canada does have a higher house price to income ratio than the U.S. does, so the idea that housing is a particular risk to Canadian banks is a valid one. In most credit models, a high loan to value ratio implies higher default risk, and the wider the spread of price over the down payment, the greater the percentage that must be borrowed.
However, the idea that Canadian banks are going to collapse any day now excessively zeroes in on this one risk factor and ignores the banks’ U.S. income, non-mortgage lending, and non-lending business operations. The Royal Bank and TD Bank both have heavy U.S. exposure, and both are involved in businesses other than lending. For this reason, we can expect decent performance from them, even if Canada’s housing affordability issues remain.
Recent Results
Both TD and Royal Bank put out solid earnings in their most recent quarters. Some selected metrics for TD included:
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Revenue: $15.5 billion, up 42%.
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GAAP earnings: $7.6 billion, up 67%.
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Adjusted earnings: $4.1 billion, up 5%.
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Total assets: $1.92 trillion, up 10.9%.
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$0.89 in dividends per share, up 12.6%.
The key metrics for RY were:
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Revenue: $12.56 billion, nearly unchanged.
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GAAP earnings: $3.9 billion, unchanged.
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Revenue: $12.56 billion, nearly unchanged.
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Diluted EPS: $2.75, up 2%.
Basically, RY’s earnings were flat, but buybacks helped trigger improvements on a per-share basis. So, we have TD with a solid earnings beat and RY with decent enough performance. Even RY’s earnings would have grown considerably had it not been for the reserve build. RY’s PCL ratio increased by 0.16% year-over-year in the quarter, reflecting increased risks. Partially this stems from the housing market issues mentioned earlier, partially from other miscellaneous macro risks. These risks are worth keeping in mind but, as I’ll demonstrate shortly, they can be overstated.
TD and Royal Bank Both Have Significant Business Interests Not Tied to Canadian Housing
One reason why the “Canadian housing bubble” never seems to put a dent in Canadian banks’ earnings is because Canadian banks do more than just mortgage lending. Both TD and RY have significant non-mortgage loan books, and both have significant U.S. operations.
We can start by looking at TD.
TD Bank has a vast and growing U.S. retail business, which includes a large investment in Charles Schwab (SCHW). Schwab is one of the many financials growing net interest income this year, and it’s contributing large sums of money to TD. In the third quarter, Schwab threw $310 million into TD’s pot. Organic results in U.S. retail were pretty good too: on an ex-SCHW basis, earnings jumped 9%.
Apart from the U.S. business, TD has a variety of non-mortgage business interests. It operates the Canadian brokerage TD Waterhouse, it has an insurance business, and it has some small presence in investment banking. The investment banking business will grow if TD closes the acquisition of Cowen Inc. (COWN), a U.S. investment bank.
It’s a similar story for RY.
RY also has U.S. operations that drive a significant percentage of earnings, mainly in wealth management and capital markets (i.e., investment banking). RY’s investment banking exposure is part of why it’s trailing TD’s earnings this year: investment banking fees are down 67% across the industry, thanks to market conditions being unfriendly to IPOs. That along with PCL build is holding back RY’s results. Nevertheless, the fact that the bank did $617 million in investment banking net income last quarter shows that the bank has many business activities unrelated to the Canadian housing market.
Now, you might be thinking, “the U.S. housing meltdown in 2008 caused contagion that eventually led to Lehman collapsing, couldn’t the same happen in Canada?” Certainly, it’s possible, but it’s not likely. The U.S. housing collapse was driven by subprime mortgages; i.e., high-interest mortgage loans to people with low credit scores. People couldn’t afford mortgages, they were given them anyway, and a wave of defaults ensued. That’s not exactly what’s happening in Canada today. In Canada, houses aren’t affordable, but the government is not responding by loosening lending requirements.
To this day, Canada has a strict mortgage stress test that banks are required by regulation to implement, where the hypothetical interest rate is raised higher than the real one, and the person’s income has to cover interest payments in the hypothetical scenario. If income doesn’t clear the interest payments, no mortgage is issued. These and other regulations help ensure that Canadian banks will make it through the housing correction without too much damage. Lower origination is possible, even likely; a collapse is not.
Modest Valuations
Another thing that TD and Royal Bank have going for them is modest valuations. At today’s prices, TD trades at:
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10.3 times adjusted earnings.
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10.81 times GAAP earnings.
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3.5 times sales.
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1.59 times book value.
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3 times operating cash flow.
For its part, RY trades at:
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11.5 times earnings.
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3.6 times sales.
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1.85 times book value.
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5.49 times operating cash flow.
Pretty cheap multiples overall. On a sector-specific basis, they’re not necessarily all that cheap: it’s quite common for banks to trade at single-digit P/E ratios. However, we’ve got Canadian banks with much lower P/E ratios than the NASDAQ, and TD is growing faster than many tech stocks. So, the comparative valuation, with the whole market as the investment universe, looks cheap.
TD and RY Both Have Upcoming Catalysts
A final factor worth mentioning is the fact that both TD and RY have catalysts on the horizon.
TD is in the process of buying First Horizon National (FHN). FHN is a U.S. regional bank with $80 billion in assets and $1 billion in annual net income; if the deal closes, it will increase TD’s earnings and assets substantially. This deal was initially criticized for offering too high a price for FHN: when the deal was announced, the implied earnings multiple was 14.5. Later, though, FHN put out an earnings release that showed 14% growth in net income and even higher growth in net interest income, putting the valuation fears to rest.
RY, too, has a big deal in the works. It’s buying out HSBC Holdings’ (HSBC) Canadian operations for C$13.5 billion ($10.1 billion), similar to the amount TD paid for FHN. The deal will add $134 billion in assets to RY’s balance sheet and is expected to boost 2024 earnings by 6%. Overall, the deal looks promising, but we won’t know the final impact until it closes.
The Bottom Line
The bottom line on The Toronto-Dominion Bank and Royal Bank of Canada is that both are modestly valued, growing financial services companies with futures that look better than their recent past. Already, TD is putting out all-time high earnings, yet its stock hasn’t even taken back the beginning of 2022 levels. RY’s results haven’t been quite as nice, but are still basically adequate. When you look at how these stocks have been valued in the past, and how they’re valued now, you get the impression that there is substantial upside. In my opinion, that apparent upside is very real.
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