First National Financial Corp

TSX:FN

Earnings Call Transcript 2021-Q1

[Operator]

Good morning, ladies and gentlemen, and welcome to First National's First Quarter 2021 Analyst Call. [Operator Instructions] This call is being recorded for replay purposes on April 28, 2021, at 10:00 a.m. Eastern Standard Time.It is now my pleasure to turn the call over to Stephen Smith, Chairman and Chief Executive Officer of First National. Please proceed, Mr. Smith.

[Stephen J. R. Smith, Co]

Thank you, operator, and good morning, everyone. Welcome to our call, and thank you for participating. Also on the line are Rob Inglis, our Chief Financial Officer, who will provide quarterly performance highlights; and Jason Ellis, our President and Chief Operating Officer, who will discuss our outlook. Since the MD&A provides full details, our prepared remarks will be brief. Before we begin I'll remind you that our remarks and answers may contain forward-looking information about future events or the company's future performance. This information is subject to risks and uncertainties and should be considered in conjunction with the risk factors detailed in our MD&A. We are very pleased with First National's first quarter. In fact, growth in our earnings exceeded our expectations. For shareholders, strong profitability provided such good coverage for our common share dividend that the Board of Directors approved a further increase to our dividend rate starting on June 15. This 25% per share -- this $0.25 per share increase brings the dividend rate to $2.35 per share on an annualized basis. This represents the 15th consecutive year since our IPO in 2006 that we increased distributions to our shareholders, and that's possible because of the structural advantages of the First National business model. For the first quarter, the dividend payout ratio was in the low 60s and together with a positive trend in cash flow, the Board felt comfortable with this latest increase.Turning to operations, first quarter performance did not display the typical effects of market seasonality as borrowers continued to finance home purchases at a record pace to take advantage of the low interest rates. I think the fact that many Canadians also accumulated savings during the lockdown and deployed it into housing was another factor that played in favor of a very active first quarter market. Looking specifically at production, single-family originations increased 58%. Once again, double-digit growth was generated by every First National office across Canada. Commercial originations were lower than last year by 31%. In context we're comparing to a very strong quarter to start 2020, which included some very -- fairly large financings that landed in that particular period. Because 2020 was such an unusual year, I think a better basis of comparison for progress is 2019. If you recall, Q1 2019 commercial originations were $1.2 billion, and at the same time, we describe that performance as strong, which it was. This year, Q1 generated $1.8 billion of commercial originations. On a normalized basis, we think this is a good start to the year. On a consolidated basis, new mortgage origination was higher by 16% over last year. Our strong market share performance was supported by great service of all our teams. Speaking specifically to our employees, thank you for your dedicated efforts.I know there has been a lot of discussion on media and on Parliament Hill about measures to cool the housing market. Although OSFI has increased qualifying rates and the federal government in the recent budget introduced a nonresident forward buyer tax on vacant housing, I don't believe these measures will have much impact on demand. We are certainly of the view that lack of supply has and continues to be an ongoing issue, particularly in Vancouver and Toronto. The creation of additional housing stock is the real solution to the supply issue, and since First National finances both single-family and multi-unit apartments, including new construction, we look forward to being part of the solution for the long term.Now over to Rob.

[Robert A. Inglis, Chief Financial Officer]

Thanks, Stephen, and good morning, everyone. First quarter revenue increased 23% but was down 1% if we exclude the changes in the fair market value of First National's instrument related to interest rate movements between the quarters. The biggest drivers of revenue growth were a 26% increase in residential volume originated for institutions; the impact on per-unit placement fees from a proportionately a larger volume of residential business compared to commercial this quarter; and 37% growth in mortgage servicing income, which includes both our third-party underwriting and our administration businesses. The outlier, as in Q4, was mortgage investment income, which was 34% lower primarily due to lower interest rate environment compared to Q1 last year. As you may recall, we ended 2020 with virtually no borrowers on deferral. Despite adding no new borrowers to program since September 2020, our investment in deferred payments has not significantly decreased its peaks in the third quarter. Most borrowers returned to making their regularly -- regular monthly payments. Accordingly with that, this will only be repaid when those borrowers either renew for a new term with First National or pay up. We're encouraged that these investments were actually repaid and provide cash flow over the next 4 years.Expenses in the first quarter were generally higher, but for the right reasons. In Q1 brokerage expenses increased by 80% on a 93% increase in single-family originations made for institutional investors. Per unit broker fees were generally consistent between the years, but we did expect some of the costs of broker loyalty left over from 2020. Agent costs increased 24% as a result of growth in our workforce and some 2020 bonus costs which were spent in the first quarter. Other operating expenses increased 5%, but most of the increase related to higher agent costs. Excluding that, other expenses increased modestly to a cost to support the growth of the business, higher MUA and technology investment. Interest expense, much like investment incoming, decreased 42% due to the decline in short-term hedging rates.Now, over to Jason.

[Jason Ellis, President & COO]

Thanks, Rob, and good morning, everyone. The past year has been a busy one for the First National team with substantial growth in originations leading to record mortgages under administration in every quarter, this one included. Through a large part of last year, we also responded to a record number of requests for service and advice from our borrowers and their mortgage advisors, which is understandable given the unusual economic and market circumstances.Our scalable model has been critical to our success during this time. Operating leverage is not a concept often associated with mortgage lenders, but technology, including automation, has definitely provided that kind of leverage by allowing us to be productive as well as efficient as we put more business on the books. Stated simply, our originations platform had a fixed-cost component, so additional origination volume has a positive impact on the marginal costs of underwriting.At the same time, we still needed to add to our workforce. Over the past year, we've added 276 people, a 26% year-over-year increase. Investing in our workforce is a key strategic priority, and growing it is a sign of confidence in First National's future. Additional staff have been deployed in all areas, including third-party underwriting where our customers are also experiencing strong growth. We've put a great deal of effort into the successful recruiting, onboarding and training of new hires using virtual means. What's more difficult is to instill our culture in our new employees while we continue to work from home. Our collaborative and entrepreneurial spirit sets First National apart, and it's crucial to maintaining these volumes throughout the organization. We are very pleased with the extraordinary efforts of our employees who are to be credited for much of our success this quarter and over the long term. Thank you to everyone.Turning to our short-term outlook, it hasn't changed since our last call. We remain very positive. Since the first quarter of 2020, the housing market has been extraordinarily strong. We expect this trend to continue in support of our optimism for increased residential origination in 2021. We also expect success in growing commercial mortgage origination. As you heard from Stephen, commercial originations were down in the first quarter relative to an exceptional Q1 last year, but demand signals in the market remain positive.On the funding side, demand remains strong from institutional investors who have a substantial amount of liquidity available to deploy and know they can do so and earn an attractive risk-managed return in mortgages originated by First National. Securitization markets also continue to operate well after a brief period of disruption at the beginning of the pandemic. For the short and long term, we believe our strong relationships with mortgage brokers and our diverse funding sources will keep First National in a leadership position in the market. And of course, we take comfort from the fact that the company will continue to generate income and cash flow from our servicing portfolio and our mortgages pledged under securitization, which together amount to approximately $117 billion. And of course, we expect to continue to capture the value inherent in our single-family renewal book.This concludes our prepared remarks. We'll be pleased to take your questions now. Operator, please open the line for questions.

[Operator]

[Operator Instructions] And your first question comes from the line of Etienne Ricard with BMO Capital Markets.

[Etienne Ricard, Analyst]

First question on mortgage servicing income from your third-party underwriting arrangement. It continues to be strong. Could you help us understand how meaningful those partnerships could become over time from a top-line perspective?

[Jason Ellis, President & COO]

It's Jason, Etienne. Yes, the servicing line is a combination of third-party underwriting as well as our traditional mortgage administration activities. I would say that proportionately, the third-party underwriting fees have been growing, and we expect them to continue to form a meaningful part of that line of income going forward.

[Etienne Ricard, Analyst]

Okay. So I mean the vast majority is still the servicing income on your book. Got you.

[Jason Ellis, President & COO]

The vast majority of that line is related to the servicing revenue on the -- I don't know, Rob, what is it? Approximately $50 billion of mortgages that are serviced for third parties?

[Robert A. Inglis, Chief Financial Officer]

I think it's like $83 billion or something. Yes, like $35 billion is on our balance sheet kind of thing, and the $83 billion is the -- with institutions.

[Etienne Ricard, Analyst]

Okay. Great. Switching towards Excalibur, could you provide an update on how the rollout is progressing in British Columbia? And what impact on securitization market should we expect as Excalibur continues to grow?

[Jason Ellis, President & COO]

Well, we continue to roll the product out in British Columbia. I would say that we're not probably at full steam yet, but we're pleased with how that's going. As far as impact to the net interest margins on the securitized portion of the book, I think it'll be quite a small impact even as that program continues to grow given the relatively large denominator of prime mortgages through the -- both NHA-MBS and ABCP securitization program.

[Etienne Ricard, Analyst]

Okay. Makes sense. And it's great to see this additional dividend increase. And even after the increase, it seems that you may still be at the low -- or slightly below your 60% to 70% target range. And looking ahead, how should we think about First National favoring regular dividend increases relative to special increases?

[Stephen J. R. Smith, Co]

Yes. So that's a great question, Etienne, because I think we have that internal debate ourselves. We are torn between being prudent and cautious between following that market practice. Even with that $0.25 increase, the payout ratio is still quite low. So there's internal debates whether we should increase dividends further because we think there's room. I think the fact that we've had 4 years in a row of specials -- there's the argument inside, well, we've had 4 years of special, maybe we can afford to increase the dividend, particularly with the big jump in income last year and continuing. I would say that we certainly would have a policy that we want to increase dividends each year. And one could make an argument that maybe our target of 60% to 70%, which we have attempted to voice, is perhaps too conservative, that we could go for a higher payout ratio. But in the end, we're probably focused here to remain -- maintain the appropriate amount of capital yet still pay out a good dividend. So how should you think about it? Well, I think to the extent that we can, we'll continue to pay out dividends, and we'll continue to try to grow that as much as is prudently possible.

[Operator]

Your next question comes from the line Graham Ryding with TD Securities.

[Graham Ryding, Research Analyst of Financial Services]

Stephen, the 60% to 70% payout ratio target, is that just on the regular dividend, or does that including these specials?

[Stephen J. R. Smith, Co]

No. That doesn't include the specials. That would be the regular payout. So I think the way we've been running this, Graham, is we -- on a run rate basis, we -- the 60% to 70%, we've had that target for few years. And then when we get to the end of the year, we see -- we look at it as what capital do we need going forward, and then we do the special based on that. So last year, for example, was a great year but we did $0.50. And I remember when we put together the number, and one of the reasons there's so much room is I think we want to see visibility into 2021. So we had more room back last year because we announced that it would have been beginning in November. But actually, when we put it together and the numbers we sort of -- we basically did it on, I think if I go back on the end of August numbers, and we ended up having a very strong 4 months at the end of the year, so numbers came in a lot stronger. And then -- but at the beginning of last -- 2020, if you recall that there were substantial mark-to-market losses in the quarter, so that tended erode income, too. So that would be a factor. But to your point, the -- when we do -- when we think of payout ratio of 60% to 70%, that's on the run rate. And then the payout just adjust as to where we should be appropriately on capital basis.

[Graham Ryding, Research Analyst of Financial Services]

Okay. Understood. I appreciate your comments on the legislative policy, and we feel like this is a more of a supply issue, not necessarily a short-term solution. How are you feeling just about...

[Stephen J. R. Smith, Co]

I'd have to say this market -- this can't keep up. This reminds me -- and I will be dating myself here, this reminds me of 1988, '89. And I do remember the market in '89, too. In '89, it like stopped like in a week, all of a sudden, gone. And we were into a lot of monetary tightening. Rates were double digits back then, and we went into a period of monetary tightening for a number of years. And the early '90s were very, very tough. We would see here -- this is a lot different market, but it will change at some point. We're going to have -- the bid will come off and things will slow down. If I have a view on how I think things will go, I think it will be a case of things will slow down quite a bit. And I don't necessarily see prices dropping. They'll just probably go sideways for quite a while as income catches up. But the -- certainly the lack of supply is a big issue, and it's a big issue in Toronto in particular where provincial and municipal regulations conspire together to restrict supply and make it expensive. And we have a policy in Metro Toronto of intensification. Everyone supports intensification as long as it's not within a kilometer of their house. And we can see that along the Bloor subway where that's been there for 60, almost 70, years now. And yet it's a 1- to 2-storey buildings all the way along, and because local -- generally local people have opposed intensification. And so that's an over bragging issue. So -- and till we solve the supply issue, we're going to have demand. The other change that I would say, the big change in the last decade, and it would start after the crisis of what we said in '08 would be the introduction of B-20. And OSFI, particularly based on the experience in the United States, was very concerned about a real estate bubble. And mortgage loan is really a loan to an individual secured by real estate. And it's very easy at a certain point to just make that real estate. But OFSI, through B-20, has put more and more focus, and lenders, and supported by insurers, have made that mortgage is much more covenant loans. So they -- you're being lent to on the basis of your ability to repay through your income with collateral in the house. So like the number that I quote all the time would be in '07, '08 First National, we did 21%, 22% of our loan at FICOs under 680. Now it's maybe 3%, and certainly no insured loans under 680 any longer. So you've seen the insurers tighten up, all the leases have tightened up, the market has tightened up, so the quality of the book is very high. Another stat is: average FICO in '07, '08 was 705, now it's 775. So very, very high-quality book. So if I had a concern is we've -- at some point this market is going to slow down, and we will not be looking at these same originations. When that is? I don't know. It's like any market. It's like predicting a turn in the equity markets. At least some event or something will happen, don't know what that is. Certainly with all the stimulus the government is providing and all the savings on the sideline, you could see this running for a while. But those are my comments generally on the housing market and our book and the resiliency of it. So I feel lot more comfortable about the bookings. This gets back to like all-pay because we had an all-pay program, and I think it goes to the all-pay lenders where back in the day prior to B-20, I think all-pay was much more just real estate loans. In fact, even a number of the D-SIBs have -- had programs, they were willing to do 75% if your FICO was 720, no questions asked. And that's just all gone. So the support underlying the mortgage book in general is as strong as it's ever been.

[Operator]

Your next question comes from the line of Geoff Kwan with RBC Capital Markets.

[Geoffrey Kwan, Analyst]

You mentioned in the MD&A just the origination comparable to 2000. Just wanted to get clarification. Did you mean that kind of more for Q2, or I suspect you might have meant more for the 2021 on a full year basis?

[Jason Ellis, President & COO]

Sorry, Geoff, can you just repeat that one more time?

[Robert A. Inglis, Chief Financial Officer]

I think it was the outlook. I don't think what we said was the...

[Geoffrey Kwan, Analyst]

Yes. You had -- yes, the outlook that you're kind of talking about residential originations to be comparable to 2020. I was just asking whether or not that was in reference to Q2 or just still sticking to the kind of the full 2021 year?

[Stephen J. R. Smith, Co]

No, that would be for the year. And in fact -- yes, there's a couple of different factors there, I would say. We had a strong 2020, and we'd 2021 being as strong. One factor that's sort of the tailwinds on that is, certainly, we would see prices in the first Q1 up by about 30%. So if you had -- given those tailwinds, that would point to some fairly strong numbers. So it gets into an issue of to what extent one thinks the -- how strong the market is going to be for the rest of the year on a unit basis. So -- but those numbers apply to the full year, our forecast.

[Geoffrey Kwan, Analyst]

And then just what you're seeing right now? Obviously, the year-over-year comp should be easier for Q2 relative to last year, but just I guess maybe relative to recent quarters and obviously adjusting for seasonality, like how are you thinking -- how -- or what's the visibility around Q2 right now? But also, too, do you think that you're starting to see or are you seeing evidence of maybe people trying to get ahead of the OSFI likely increase in the stress test rate?

[Stephen J. R. Smith, Co]

We haven't seen any evidence of people trying to get ahead of the stress test. That's a 5% increase on the mortgage, less when you look at the mortgage including taxes changing and so on. So -- but we haven't seen any indication. I imagine that the margin, there'll be some, but that would only apply in certain markets. And at this point, it doesn't affect insured business. Although I think we expect -- we were surprised that the stress test wasn't increased in the budget. But as it stands now, it only affects conventional and noninsured markets.

[Geoffrey Kwan, Analyst]

Right. And just in general, Q2 how it's kind of shaping up, say, relative to, say, Q1 and Q4?

[Stephen J. R. Smith, Co]

I think in general, the markets tends to be strong. I would say the best indication for -- to get a feeling how a quarter is just take the CREA numbers when they come out. So we wouldn't have April -- we obviously don't have April CREA numbers, but they will come out and they'll tell you. But certainly, there's house sales certainly for March for all records and that starts to tend to be in February. So sales in February and March tend to close in April, May, June, so they tend to be strong. Q2 tends to look strong with respect to originations.

[Geoffrey Kwan, Analyst]

Okay. Just my last question was on the multi-unit residential commercial side of your business. You mentioned the mortgage market being a little bit more competitive there in Q1. Just curious, I'm guessing it's a probably with the banks, but if -- any sort of insight as to what had changed? Was it certain parts of that market that were more competitive than others or were there other factors at play?

[Jason Ellis, President & COO]

Geoff, it’s Jason. I would say that we've definitely noticed other participants re-entering that space a little bit more aggressively. And you're right, it would be the banks and it would be life insurance companies. And what we've often observed is some of those participants, those big balance sheet participants who aren't necessarily leveraging securitization in that market the way we do, tend to come out at the beginning of the year with large budgets to originate, and they tend to fill those very quickly. So our hope would be that if history is any indicator, some of those competitive pressures might fill their piece for the year and step aside. But structurally, we're still seeing a very active multi-family market. So we do have confidence going forward in our ability to continue to grow that book.

[Operator]

[Operator Instructions] Your next question comes from the line of Jaeme Gloyn with National Bank Financial.

[Jaeme Gloyn, Analyst]

I just want to dig in on the expense side a little bit. In terms of the brokerage fee expenses in this quarter, they kind of picked up from last quarter, and they seem to be higher than recent years. So can you give us a little color as to what's driving that? And are these higher brokerage fees as a percentage of the mortgages originated and sold to institutional investors? Is this something that's sustainable at these levels, or should it come back down to what we saw in 2019 and 2018 levels?

[Robert A. Inglis, Chief Financial Officer]

Jaeme, it's Rob. I think per unit, it's basically the same. In 2020, we had a gangbuster year. And at the end of the year, we had a lot of broker incentives that we accrue for various people. But as always, there's more money that we have to award. We can't really figure out by the end of December. So we kind of project with you. So a little bit of the money for 2020 came into our expenses in 2021, and that's pretty well done. So I think it should be same old, same old. It’s not like it’s going up a lot. But definitely, when you do record volume in 2020, there's more loyalty incentives that click in and we have to sort of pay for that.

[Stephen J. R. Smith, Co]

There's been no change in the compensation programs to our brokers.

[Jaeme Gloyn, Analyst]

Okay. That was going to be my follow-up there. Elsewhere in the expenses, the increase in the headcount, pretty substantial. Is that a permanent increase, you think? Or is that something that's a bit more temporary just given the huge uptick in volumes here?

[Jason Ellis, President & COO]

Yes. At this point, there's no reason to think of it as anything but permanent. We've hired across the organization, underwriting, residential administration, commercial. We've just seen incredible growth in origination volumes in all aspects of the business. So at this stage, those are permanent increases, and we continue to hire. So feel free to send your resume in.

[Stephen J. R. Smith, Co]

I don't know that he'd qualify. Jaeme, no, the other 2 -- a couple of things that have happened is big hires there is that our third-party underwriting has been a big success. If you recall, we put that contract out. Our first one was with the TD, and that was launched in 2015. And that had a 5-year term that was renewed last year. And they have had substantial growth. So they've had substantial growth along -- substantial growth and along with an increase in the market, there's been an awful lot of hiring there. And of course, we brought on another regulated FI, I think, 1.5 years ago. And we've been hiring for them, too. They've been growing as well. So that higher -- that employment hire comes from, I'd say, 3 different areas: one, our own growth, our growth and also our growth for our third-party underwriters. So combined now, if you looked at what we -- in the broker channel, we would underwrite around 1/3 of all the mortgage underwritten in the channel. So that's -- it tends to be a lot of people.

[Operator]

Mr. Smith, there are no further questions. Back to you for closing remarks.

[Stephen J. R. Smith, Co]

Okay. Thank you, everybody. As there are no further questions, we look forward to holding our virtual annual meeting of our shareholders on May 6, which I guess is next week, and full details are available in our management information circular. We look forward to seeing everyone there. And thanks for taking part on the call today.

[Operator]

This concludes today's conference call. You may now disconnect.