Weakness in the Canadian economy threatens to derail a housing boom that has pumped up bank profits for the past six years. It has been a great ride, but investors are now wondering if they should still hold positions in the Big Five.
The concerns about the sector aren’t new. In fact, shares of Toronto-Dominion Bank (TSX:TD)(NYSE:TD) are down about 5% over the past month and have been pretty much flat since this time last year.
The big green cash flow machine is often the defacto number one pick for bank investors, so let’s take a look at the current situation to see if the recent weakness is an opportunity to buy.
1. Restructuring
TD announced an after-tax restructuring charge of $228 million when it reported its Q2 2015 results. The company is undergoing a comprehensive review process that aims to improve operating efficiency across the business.
Management has been warning the market for more than a year that the banking industry is facing headwinds as it struggles against low interest rates and a competitive lending environment.
TD says the restructuring is primarily focused on the U.S. retail operations, but some areas of the Canadian business will also be impacted.
Investors should see the announcement as a positive sign that management is on the ball and making the necessary changes to ensure earnings continue to improve.
2. Earnings stability
TD continues to deliver strong results across its various business units. In the second quarter, TD’s Canadian retail operations enjoyed year-over-year adjusted net income growth of 6%. TD’s U.S. retail operations had solid loan and deposit growth compared with the second quarter in 2014, and adjusted net income improved a modest 1%.
Net income from wholesale banking improved by 19% as the trading and corporate lending units had strong performances.
3. Strong capital position
TD finished the second quarter with a Basel III Tier 1 capital ratio of 9.9%. This is important because it indicates the company’s ability to survive a strong economic shock.
The company also has a liquidity coverage ratio of 122%, well above the minimum requirement of 100%.
4. Dividend growth
TD increased its dividend by 9% earlier this year. This should be see as a strong signal to investors that management is comfortable with the earnings outlook for the rest of the year and into 2016.
TD pays an annualized dividend of $2.04 per share that yields about 3.8%.
Risks?
Concerns about the Canadian housing market continue to hover over the banks. TD finished the second quarter with $236 billion in gross loans connected to Canadian mortgages. About 60% of the portfolio is insured and the loan-to-value ratio on the rest is 60%.
A sharp meltdown in the Canadian economy or a sudden bursting of the housing bubble would affect all the banks. The more likely scenario is a gradual slowdown, which TD is easily capable of handling.
TD finished Q2 with just $3.8 billion in exposure to the oil and gas sector, representing just 1% of total loans. On the conference call, the company’s Chief Risk Officer Mark Chauvin said the oil and gas book is performing within the company’s expectations and TD is “not seeing any significant deterioration in consumer credit quality in the impacted provinces.”
The company is also well aware of the challenges it faces regarding the ways new technology can threaten its operations. CEO Bharat Masrani said, “Speed and innovation matter, and we will continue to make significant investments in digital technologies.”
Should you buy TD?
TD trades at just 11 times forward earnings and a reasonable 1.7 times book value. Long-term investors should be comfortable buying the stock at current levels, although there could be an opportunity in the coming months to pick up the stock a bit cheaper. Having said that, two bucks per share on a 20-year investment isn’t going to make much difference.
