Toronto-Dominion Bank, which has already bulked up its U.S. business, is said to be a logical buyer for RBS Citizens Bank, a massive franchise that would add considerable heft to its south-of-the-border foray.
Whether this will prove true — it is, after all, at the rumour and speculation stage — it prompts a couple of questions: One, is TD already too American for investors who like their Canadian banks to be Canadian? And, two, is eschewing TD on that basis actually a good idea for Canadian investors?
The answer to the first question is probably yes. The answer to the second is a little more complicated.
First, the facts. The recent headline-grabbing acquisition of Target Corp.’s credit-card business merely added to a U.S. business that tops $200-billion (U.S.) in assets and contributes more than a quarter of TD’s revenue.
A Citizens Bank deal would further dull TD’s Canadian content. Owned by the bailed-out Royal Bank of Scotland, Citizens Bank has $129-billion in assets and more than $100-billion in deposits; that would push TD’s U.S. operations to more than one-third of the bank.
Analyst Robert Sedran of CIBC World Markets notes that a combined TD/Citizens would rank fifth in the U.S. in deposits, behind only well-known names Bank of America Corp., Wells Fargo & Co., JPMorgan Chase & Co. and Citigroup Inc.
Does this make you uncomfortable? Analyst Peter Routledge of National Bank Financial suggests Canadians come to terms with the big banks’ path to profits outside Canada’s borders. In a report issued in May – well before the recent crop of TD/Citizens Bank rumours – he said the Big Six Canadian banks “will suffer from the impending completion of a near 15-year expansion in Canadian household leverage.”
I’m not going to spend time on either household-debt levels or the robust pricing in the housing market; if neither of these seem to be problems to you, then perhaps you can reject Mr. Routledge’s analysis.
If you’re willing to entertain it, however, note that the answer for the big Canadian banks comes from “viable, lower-risk growth platforms outside Canada” – and TD has one of the best, “a loan-light and deposit-rich U.S. balance sheet provides it with the lending capacity and low-cost funding advantage to outgrow its U.S. peers even in a softening economic environment.” That leads to Mr. Routledge’s “outperform” rating and $94 (Canadian) price target, well above Wednesday’s $81.01 close.
The calculus may change, however, if TD bites on Citizens. Mr. Sedran of CIBC, who calls TD a “sector outperformer” with an $88 target price, says that,while a deal would be “transformational” for TD, media reports peg any deal for Citizens Bank at $12-billion to $16-billion (U.S). Much of the consideration would likely need be in cash, owing to RBS’s status as U.K.-taxpayer-owned.
Importantly, Mr. Sedran argues, TD already has significant scale in most of the U.S. markets where it operates, and shareholders are less likely to embrace growth-driven transactions that don’t immediately add to earnings per share (EPS).
“Deals from here must be more financially attractive than they have been in the past … an EPS-neutral deal would not be good enough, in our view.”
Analyst Brad Smith of Toronto’s Stonecap Securities is a skeptic on the U.S. franchise, saying it’s already less profitable than the legacy Canadian business. Mr. Smith says TD’s U.S. operating bank subsidiary produced a return on equity of 3.7 per cent in the second quarter, an improvement on prior levels, but “well below management’s own estimated cost of capital in the 9 per cent to 10 per cent range.”
(Hint: businesses whose return on capital is consistently less than their cost of capital are unsuccessful.)
“While appreciating that time is required to fully energize transformational growth strategies like the one that TD embarked on seven years ago in 2005, the [ROE] underscores the major challenge facing management in its quest to achieve sustainable profit adequacy,” says Mr. Smith, who has an “underperform” rating and $70 target price.
This column has been almost universally positive on the prospect of investing in U.S. banks. That view has been based, however, on U.S. banks selling at historically low multiples of their book values, thanks to pessimism on the sector.
If TD can pick up Citizens Bank at a bargain price, and ride the rebound of the U.S. banking sector, shareholders should see quite a bit of benefit. But Canadians who prefer the safer, slower Canadian banks would be well-advised to consider whether TD fits in with their portfolios anymore, Citizens Bank deal or no.