TD Bank - A Big Uh-Oh!
Navigating Challenges: TD Bank’s Path Forward Amidst U.S. Regulatory Hurdles
TD Bank Group TD 0.00%↑ (TD) agreed to a plea deal with U.S. authorities to resolve multiple investigations into money laundering. As part of the deal, TD will pay $3.09 billion USD in penalties and face an asset cap on its U.S. retail banking operations. This asset cap limits the size of TD’s U.S. assets to about $434 billion USD (that is, approximately $595 billion CAD based on today’s exchange rate). The provisions for this were already accounted for by Q3 2024, and thus, were already reflected in the share price. However, any additional restrictions that may have arisen were still uncertain.
Management quote from Q3 2024 Earnings Call
“In our release, we noted that it is our expectation that a global resolution can be achieved by the end of the calendar year. The USD 2.6 billion provision we just announced, combined with the USD 450 million provision announced last quarter, represents our current estimate of the total fines to be paid related to these matters.”
This is where it gets worse. The imposition of an asset cap is a substantial action, usually taken in extreme situations, and it is set to affect TD’s expansion strategies in the U.S., which represents roughly a quarter of its revenue. The bank has acknowledged its shortcomings in preventing money laundering activities by drug cartels and other offenders, with officials characterizing TD’s setting as "convenient" for such illicit actors.
In 2017, Wells Fargo became entangled in a significant scandal when it came to light that employees had covertly established millions of unauthorized bank and credit card accounts without customer consent to fulfill aggressive sales targets. This led to substantial fines and penalties for the bank.
Consequently, in 2018, the Federal Reserve placed an asset cap on Wells Fargo, restricting the bank's total assets to $1.95 trillion USD. This measure aimed to compel Wells Fargo to rectify its risk management and compliance practices.
Currently, the asset cap is still in place. Its share price has finally recovered after seven years.
Here are the key insights from yesterday’s press conference:
Resolution Details: TD has reached a resolution with the OCC, FRB, FinCEN, and DoJ, including plea agreements with the DoJ, involving total payments of approximately $3.09 billion USD.
Asset Cap: The OCC Consent Order imposes an asset cap on TD’s two U.S. banking subsidiaries at around $434 billion USD (this represents the total assets as at September 30, 2024), with stringent approval processes for new products, services, markets, and stores in the U.S. The asset cap will stay in place until OCC says so.
AML Program Enhancements: TD has overhauled its anti-money laundering (AML) program, adding new leadership and over 700 AML specialists, and implementing new technology solutions for better detection and risk management.
Financial Impact: TD plans to reduce U.S. assets by about 10% in fiscal 2025 to comply with the asset cap, with expected one-time costs for asset reduction and investment portfolio repositioning of up to $1.5 billion USD after-tax.
TD’s Business Segments
TD comprises five distinct business segments. The hierarchy of their strength is as follows (above). The U.S. Retail segment warrants close scrutiny due to the significant impacts that are likely to influence this division predominantly going forward as of result of these issues.
U.S. retail revenue accounts for approximately one quarter of TD's total revenues, representing a significant segment of the business. Despite a decline in retail stores or branches since 2019, revenue continued to rise until 2024, when the AML issues emerged. Earnings before taxes (EBT) from these operations averaged about 30% of TD's total EBT, underscoring the substantial impact of U.S. operations on TD's financial performance.
TD Bank began its expansion into the United States in 2004 with the acquisition of Chase Bank's retail branches in New York, New Jersey, and Connecticut. This marked the beginning of TD Bank's growth in the U.S., and it continued to expand its presence through further acquisitions and organic growth over the years.
The business strategy detailed in the 2023 annual report has become unfeasible. It remains to be seen how they will adjust their U.S. Retail goals in the forthcoming annual report. Will they continue with their present level of engagement in the U.S. market, or will they consider withdrawing as they dedicate resources to a different market?
Asset Cap Imposed
Considering the U.S. Retail segment's share of assets, it accounted for about 30% of the bank's total assets. With the imposed asset cap of $595 billion CAD (~ $434 billion USD) and the intention to reduce this base by a further 10%, we can anticipate the asset size of this division to be around $504 billion CAD (~ $368 billion USD) in the very near term.
With an average revenue-to-asset ratio of 2%, a decline in revenue projections can be anticipated due to the diminishing proportion of the U.S. Retail segment in total revenues. This trend is expected to persist until TD adopts a new strategic approach in other global markets.
Valuation
As a holder of TD shares, among the first stocks I acquired on my investment journey, I am contemplating selling a portion of them soon. In fact, I have already sold half of my holdings in the past week. The returns have been satisfactory (~10% annualized return, ~25% total return); yet, the future growth trajectory now appears to be very bearish.
Following TD's fiscal year 2023 earnings report, I conducted a discounted cash flow (DCF) valuation using a risk-weighted asset (RWA) approach12. Considering its average growth, along with expected CET1 ratio and ROE targets at the time, TD seemed fairly valued for future growth. However, my assessment now needs to be revisited.
Risk-weighted assets (RWA) measure the risk exposure of a bank's assets. Each asset class (like loans, mortgages, or investments) is assigned a risk weight based on its riskiness. The total RWA is the sum of these weighted assets. Banks use RWA to determine the minimum capital they need to hold to cover potential losses and ensure financial stability.
Examining the U.S. Retail segment's RWA’s, it becomes apparent that a significant portion of TD's risk, approximately 45%, originated from this sector. Interestingly, the actualized risk also emerged from this segment. The recent news event might suggest a potential reduction in TD's risk exposure moving forward. However, it will also significantly constrain growth prospects in the U.S. market, which was replete with opportunities.
For these reasons, a more conservative approach is necessary. The impacts on the growth of RWA, the targeted Return on Equity (ROE), and the exit multiple (P/E) must be delved into. The latter two are crucial in this type of analysis. With TD previously targeting a 16% ROE, this goal has become unrealistic in the short-term. A more probable target would be between 10-12%, still decent as the ROE in the Canadian Retail segment is significantly stronger for TD, given its extensive presence across Canada, as opposed to the highly competitive U.S. market. In light of the anticipated weaker earnings, it may be prudent to also adjust the P/E ratio downward to reflect more conservative future expectations.
From this perspective, the significant impact on the stock's potential is evident. The stock's sharp decline in just two days following the official announcement is justified. Nonetheless, the situation is not irredeemable. The company's swift recovery and effective implementation of a new strategy could realign it with success, as it remains a fundamentally sound business. Additionally, placating shareholders through share buybacks could temporarily boost the stock price. While the current outlook may seem bleak, the larger intrinsic value is likely to manifest in the long term. The pertinent question remains: is the investment worth your time?
Conclusion
Ultimately, the U.S. market served as TD's avenue for growth, but this has been curtailed due to management's failure to oversee unethical practices. Now, TD must identify a new direction for growth, whether by increasing its market share in Canada or embarking on new ventures in regions like the Caribbean or South America. The Royal Bank of Canada has found success in the former, whereas the Bank of Nova Scotia has recently withdrawn from South America owing to unsatisfactory returns.
TD is facing short-term challenges that could continue if restrictions remain in place. These restrictions are not easily lifted. In contrast to Wells Fargo, which conducted most of its business (~95%) within the U.S. at the time of its cap restriction, TD has only a quarter of its business affected. Nonetheless, recognizing the effects of the cap on TD's affected segment is beneficial.
It is anticipated that operational costs will surge as the bank endeavors to rectify these issues and implement more robust controls. Consequently, this is likely to constrain earnings growth. However, it is worth noting that TD possesses other business divisions that remain valuable with high-performing assets and are not impacted by this incident. The concern now is whether the existing TD customers, as well as potential new clients, will opt to transfer their funds elsewhere. This aspect contributes to the problem and appears to be lacking in discourse. Rebuilding culture and trust is not an overnight process.
The dividends should remain intact for those who appreciate them, yet it is challenging to consider this bank at present. Over the past five years, it has been one of the slower-growing banks. Despite the higher premium, other options like Royal Bank and National Bank are difficult to overlook in favor of a constrained bank like TD. Additionally, the potential of an impending recession must be considered, which could further delay any hopes of a robust recovery, especially when other banks are better equipped to weather a downturn.
For those who still possess shares, as I do, you have the option to retain them for the long term or to redistribute your investments. As previously stated, I have achieved a respectable return, which may indicate it's an opportune moment to explore other opportunities.
