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Why TD Bank's Failed Acquisition of First Horizon Corp May Have Come at a Good Time - The Motley Fool

Canada-based Toronto-Dominion Bank (TD 1.53%) recently terminated its planned $13 billion acquisition of First Horizon Corp (FHN 1.55%) after deciding that it couldn't see a reasonable path toward receiving regulatory approval from the Federal Reserve.

TD announced the acquisition of First Horizon in February 2022. This February, it had to extend its merger agreement deadline until May but announced before May that it was unlikely to receive regulatory approval before that extension ran out.

While First Horizon is an attractive franchise and would have greatly bolstered TD's significant U.S. presence, I think the failed acquisition is also coming at a good time. Here's why.

People speaking in a board room.

Image source: Getty Images.

Things have changed -- a lot

To state the obvious, since TD first announced the acquisition in February 2022, everything has changed. The Fed has jacked interest rates up above 5%, credit quality on loans has started to deteriorate, and the U.S. economy is at risk of a recession. Plus, we can't forget about the high-profile failures of several banks in March that roiled much of the industry.

Although First Horizon is a promising franchise, the $13 billion acquisition would have significantly lowered TD's capital levels. At the end of the fiscal quarter ended April 30, TD Bank had a Common Equity Tier 1 (CET1) capital ratio -- which looks at a bank's core capital expressed as a percentage of its risk-weighted assets such as loans -- of 15.3%. That's incredibly strong. Had TD completed the purchase of First Horizon, its CET1 ratio would have dropped to somewhere in the 11% to 12% range. That isn't bad, but obviously it isn't nearly as strong.

In the current climate, banks with excess capital are much better positioned given the much more difficult environment -- namely, one where banks are fighting over deposits and preparing for credit deterioration, which is expected to eventually lead to higher loan losses. Regulators may also enact new changes that increase regulatory capital requirements, leading investors to carefully parse bank balance sheets. So the companies whose statements show enhanced liquidity and capital right now are in the best positions.

Deploying excess capital

Now, a big question is how will TD deploy some of its excess capital. On TD's recent earnings call, management said a good target for the bank's CET1 ratio is 12%, leaving it with roughly $19 billion of excess capital over its internal target, according to my calculations.

Investors are chomping at the bit for a large share repurchase. Along with its earnings report, TD announced that it plans to buy back roughly 1.6% of its common shares outstanding, but this doesn't seem to have excited the market too much. TD Chief Executive Officer Bharat Masrani said the bank would complete this repurchase and then reassess the capital return plans during the summer.

The other thing to consider is that TD could be saving itself a lot of capital by not purchasing First Horizon. When TD first announced the acquisition, it had planned to buy First Horizon for $25 per share. After the string of bank failures starting in March and the termination of the deal, First Horizon stock now trades below $11 per share. Now, I don't believe First Horizon faces any existential risks. It's more likely being painted with a broad brush right now as most of the sector. But banks do face a tougher outlook, and it's hard to justify paying such a huge premium over the current share price in a very different environment for the sector.

While TD's outlook for mergers and acquisitions in the U.S. is rather uncertain given the scrutiny the bank just received from the Fed, it is still able to invest in growth. In the U.S., Masrani said the bank is increasing new branch openings by 50% and doubling its hiring of wealth advisors. In Canada, Masrani said the bank is hiring more frontline and specialist advisors and increasing its investment in its digital and mobile capabilities.

A cushion and a potential war chest

The bad news from the failed deal is that TD wasted significant resources trying to complete the acquisition. Investors are also likely concerned about what issues regulators had with TD that prevented them from rubber-stamping the deal.

But now TD has a tremendous amount of excess capital. This gives it protection in a more uncertain environment and could allow the bank to return a lot of capital to shareholders once conditions stabilize, potentially later this year.

The U.S. banking system is also still expected to go through significant consolidation. If TD can navigate the regulatory environment in the U.S., it still has a war chest it could potentially use to make a big acquisition at some point -- and possibly at a better price, too. So while I don't think the First Horizon purchase would have necessarily been bad, because of everything that has transpired this year, terminating the deal seems to have come at a good time.

Bram Berkowitz has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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Why TD Bank's Failed Acquisition of First Horizon Corp May Have Come at a Good Time - The Motley Fool
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