Strategy

Banking: Branching out

Although TD has made inroads south of the border, there may be trouble ahead.

Toronto-Dominion Bank’s first-quarter results can only be described as impressive — a bright spot in an increasingly bleak financial services environment. All major business units reported solid earnings — including the U.S. banking division. However, a few details in the fine print, including the bank’s considerable exposure to the U.S. housing market, indicate TD’s Great American Adventure may yet hit speed bumps in 2009.

While larger U.S. counterparts such as Citigroup appear headed toward nationalization, TD reported profits of almost $8 million a day in Q1. The bank’s net income was $712 million, and diluted earnings were 82¢ per share — a dip from $970 million the year prior. But adjusted core earnings were $1.15 billion or $1.34 per share, beating Thomson Reuters’ analyst expectations of $1.27 a share.

Some of the growth, interestingly, was driven by TD’s acquisition of New Jersey–based Commerce Bancorp Inc., a deal that closed last March. (TD’s American commercial and personal banking profits rose to $240 million from $127 million.) And investors, so far, have remained cautiously optimistic: in early March the bank’s stock price (TSX: TD) was above $35. That’s eminently respectable in comparison to Citigroup’s US$1.03 a share, and comfortably above RBC’s $29.40 a share. But tellingly, it’s less than half its 52-week high of $72.11. Not even TD can dodge the global downturn for financial services.

TD also remains committed to its retail focus on both sides of the border. The bank will be opening 30 new branches in the U.S., and maintained its quarterly dividend at 61¢ per share.

What’s interesting for Canadian readers is the continuing gap between how much TD is willing to invest in its U.S. customers (for whom it has to compete with about 8,000 other banks) and how much it is willing to invest in customers up north.

TD announced its deal to buy Commerce Bancorp in 2007. That year, the U.S. bank reported its efficiency ratio — the amount of expenditures compared to net revenue — at a whopping 88%. TD spokesman Nick Petter put this down to Commerce’s “full growth mode.” It could also be attributed to the U.S. bank’s trademark commitment to customer service, which it calls the “Power of Wow!” This includes operating seven days a week, holding large “block parties” when a new branch opens, and, once, even giving out free rice cookers in New York’s Chinatown.

For Q1 2009, the U.S. bank’s efficiency ratio is down to 58.2%, according to Petter. The efficiency ratio for the Canadian network, by contrast, is a mere 51.8%. Clearly, bank brass is bringing down U.S. costs — while continuing to prioritize investments in U.S. customers.

More curious still is what’s happening to the US$7 billion worth of jumbo and Alt-A collateralized mortgage obligations in TD’s investment portfolio. Since TD completed the Commerce Bancorp acquisition 12 months ago, the bank has taken no further impairment charges on this portfolio. Yet U.S. home prices have continued to decline. Petter explains this is because at the time of the acquisition, TD aggressively marked down the value of that portfolio by slightly less than US$2 billion. At the same time, says Petter, TD valued the portfolio under the assumption that U.S. housing prices would decline by another 15%. Housing prices have declined about 7% since then. However, prices could drop more than the bank’s initial valuation — which could mean future impairment charges, Petter concedes. (He couldn’t give a timeline.)

While maintaining TD’s valuation as fair, Morningstar analyst Chris Blumas is particularly concerned about the housing exposure. “While we like TD’s retail focus,” Blumas concluded in a research note responding to the results, “we remain skeptical of the bank’s U.S. expansion, and think its U.S. operation will have a difficult time earning its cost of capital.” Unsafe as houses?