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Stock to Study

Banking On Success

Until fiscal 2001 (ending in October), TD had grown both its revenues and EPS at an accelerating rate for ten years. With such stocks, there is always the risk of a sharp drop in the multiple - and share price - arising from a surprising decline in either the company's Revenue or EPS growth, or, in the general stock market.

To minimize this risk, investors who might consider purchasing such stocks should consider the merits of using a series of modest purchases spread out over several months, quarters and even years - rather than a single large purchase.

Please note that "revenue" for the banking industry (reflected in this study of TD) is measured as net interest income (after provision for loan losses) + other income (e.g fees, service charges, investments and trading income). Editor

The Toronto-Dominion Bank ("TD") offers a full range of financial services (eg. personal and commercial banking, investment banking, self-directed brokerage and asset management) to over 13 million customers in Canada and around the world.

Historical & Future Growth Prospects

Over the longer term, a stock's price only goes up 'a lot' if the company's revenues and earnings go up 'a lot.' So let's start our study of the potential growth in TD's share price by understanding the reasons for its historical revenue growth and the prospects for that growth at least continuing over the next five years.

The Numbers

As indicated by the Revenue Profile in the accompanying Stock Study Guide, since 1992 revenue growth has averaged about 18% per year. During the last half of the study period, growth increased to almost 21%. However, for the first nine months of fiscal 2001, growth slowed to about 7% with estimated fiscal 2001 revenues at just over $10 billion.

Important Products

TD revenues are derived from four principle businesses: (1) TD Canada Trust; (2) TD Securities; (3) TD Waterhouse; and, (4) TD Asset Management.

TD Canada Trust (50% of estimated 2001 revenues vs 36% in 1996)

TD Retail Banking. Serving some 10 million customers through physical branches, automated banking machines, the Internet, the telephone, etc. Products include: banking accounts; loans & credit; mortgages; etc.

TD Commercial Banking.

Providing lending, financing, cash management, treasury and planning services to large and small businesses.

TD VISA;

TD Insurance (offering auto, term life, home, critical illness and travel insurance); and,

TD Waterhouse Bank (the largest electronic bank in the U.S.).

TD Securities (27% vs 56%) Corporations, governments and institutional clients (e.g. mutual funds, pension funds) use TD Securities for a variety of services including: investment and merchant banking services (e.g. mergers and acquisitions, underwritings, providing debt/equity capital, etc.); and, foreign exchange services.

TD Waterhouse (16% vs 0%) As the world's largest on-line financial services firm and second largest discount broker, TD Waterhouse provides `one-stop' access for buying securities and mutual funds and other financial products and service to over 3.3 million clients.

TD Asset Management (7% vs 8%) This business is the largest investment manager in Canada - over $117 billion in assets under management. Investment management services are provided to mutual funds, pension funds, corporations, institutions, endowments, foundations, high net worth individuals and retail customers (e.g. through TD Evergreen full-service investment advisors). TD Mutual Funds (the fourth largest mutual company in Canada) is a customer of this business and has about $30 billion of assets under management in more than 70 mutual funds and 30 managed portfolios.

Important Markets

Products are sold in the following regions: Canada (68% of revenues in 2001 vs 86% in 1996); United States (25% vs 10%) and, other International (7% vs 4%). The significant increase in U.S. revenues is due principally to the 1996 acquisition of Waterhouse Investor Services (an estimated 14% of 2001 revenue).

Important Competitors

TD's principal competitors are the other five large Canadian chartered banks (see Table 1 for a list of competitors sorted by fiscal 2000 revenues). The company also competes with foreign-based financial services companies such as MBNA (credit cards), Merrill Lynch (investing services), HSBC (banking), etc.

Important Influences on Future Revenue Growth

The company's revenue is measured as net interest income (e.g. interest earned on deposits from TD Canada Trust clients) and other income (e.g fees, service charges, investment income, brokerage commissions). Since 1996, "other income" for TD has grown from representing 43 % of total revenue to an estimated 61% in 2001.

TD expects that "other income" will continue to increase as a percentage of total revenue because of a combination of economic expansion, internal initiatives (e.g. more branches, new products/services) and external initiatives.

Economic Expansion

Over the next three to five years the financial services industry expects to continue benefitting from a low interest rate environment which inspires increased consumer banking activities such as borrowing to finance major purchases and lifestyles.

Internal Initiatives

Recently, TD reached an agreement with Wal-Mart that gives the bank the right to open banking outlets under the TD brand name in more than 2,000 (i.e. 75%) of Wal-Mart's U.S. stores that do not already have comparable arrangements with other financial institutions.

TD is committing significant resources to growing its e-commerce capabilities which are expected to revolutionize the accessibility of banking services. For example, the bank has already introduced fully-integrated wireless banking and brokerage services and, is the first bank to offer instant term insurance on-line.

In addition, TD Asset Management has launched mutual funds for sale in the U.S., U.K., Japan, Australia and Hong Kong with plans for further expansion internationally. Other initiatives include expanding its operations to include financial planning services at the retail banking level.

External Initiatives

In virtually all of its business segments, the bank recognizes that the Canadian market is not large enough to realize the economies of scale required to compete effectively with major foreign-based financial companies.

To address this situation, TD has completed a number of acquisitions during the last two years including: Canada Trust; Newcrest Holdings (improving the company's capability to provide investment banking services); YorkSHARE Limited and Dealwise Limited (making TD the number one self-directed broker in the U.K.); and, Harbour Capital Management (adding to TD's ability to act as investment managers to ultra high-net-worth private clients).

Other prospects for significant growth through acquisitions open up in 2002 when - subject to approval by the federal government banks may acquire other banks and insurance companies. It is expected that TD's future revenues will be significantly affected by such activities.

Capacity to Grow Revenues

Generally, a company's revenue growth is made possible by growth in its assets. Since 1992, TD's assets have grown from about $74 billion to an estimated $297 billion in 2001.

The vast majority (about $140 billion) of this asset expansion came from increases in client deposits. Another $70 billion of assets came from other liabilities which relate principally to TD's investment dealer business (e.g. derivatives, repurchase agreements and shares sold short). The company generated about $6 billion from a generally stable earnings retention rate (Chart 1), while some $7 billion came from increases in long-term debt and the sale of common and preferred equity.

Expanding assets with this financing mix has increased the company's reliance on debt from about $1,500 of assets for every $100 of equity in 1992 to an estimated $2,200 of assets for every $100 of equity in 2001 (see Chart 2). This very high use of debt is typical of deposit-taking institutions and reflects deposits from individuals, businesses, governments and other banks. These increases are in keeping with national and international guidelines that ensure adequate capital levels in relation to the nature of the bank's loans outstanding.

Chart 3 shows that TD's efficiency in generating revenues from the loans that results from the indicated deposit growth has remained steady at about $3 of revenues for each $100 of assets throughout the study period.

Projected Revenue Growth

Here, an illustrative A judgment was made to grow revenues at an average annual rate of about 15% to approximately $20.5 billion by 2006. This growth rate is supported by: (1) consistent, historical growth averaging about 18% since 1992; (2) current and future internal growth initiatives; and, (3) the expectation that, over the next three to five years, TD will participate in the pending bank and insurance company consolidations.