First National Financial Corp

TSX:FN

Earnings Call Transcript 2017-Q4

[Operator]

Good day, and welcome to the First National Financial fourth quarter analyst conference call. As a reminder, this call is being recorded on February 28, 2018, for replay purposesAt this time, I would like to turn the conference over to Stephen Smith, Chairman and Chief Executive Office. Please go ahead, Mr. Smith.

[Stephen J. R. Smith, Co]

Thank you, operator. Good morning, everyone. Welcome to our call, and thank you for participating. I'm joined by Rob Inglis, our Chief Financial Officer; and Moray Tawse, Executive Vice President. I will 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. 2017 was a very positive year for the -- for First National and our shareholders. On the strength of growth in MUA, which reached an all-time high of $101 billion, the company generated $1.1 billion of revenue, a new record; $209.7 million of net income or $3.42 per share, also a record; and a 38% after-tax pre-fair market value return on shareholders' equity; demonstrating the efficiency of our business model. This performance provides support for record common share dividends of $3.08 per share, including a special paid in December. Cumulatively, since 2006, when First National went public, First National has paid about $18 per share of dividends in distributions to common shareholders who purchased ownership at the IPO for $10 per share. We are very pleased with these long-term and short-term results and the fact that earnings have produced a growing stream of dividends. In 2017, we increased common share dividends for the 11th time in 11 years. From a market perspective, 2007 (sic) [ 2017 ] featured a unique set of challenges. New policies introduced by various branches of government had the effect of reducing the size of the available market, particularly for insured mortgages. This led to higher competitive intensity among lenders through these mortgages and made the cost of portfolio insurance uneconomical in most cases. From a production perspective, it seemed early in the year that single-family originations would be down by 20%, but because of the hard work of our single-family team in serving our mortgage broker partners, volumes were stronger in the second half of the year, and we finished just below 10% -- just 10% below our 2016 numbers. We offset this decline by growing the other channels of our business. Single-family renewals were up 13%, commercial originations grew by 21% and commercial renewals increased by 16%. This was our commercial team's most successful year on record, so I would like to recognize their efforts as well. Stepping back, these results underscore 2 important facts about First National. First, the diversification of our mortgage lending activities is a strength. So while we're known as Canada's largest nonbank mortgage lender based on the size of our single-family book, First National is one of, if not the largest, commercial -- Canadian commercial mortgage lender. These are complementary businesses, and in 2017, we greatly benefited from the diversification of market opportunities they provided. Second, the ability to fully and quickly embrace the highest underwriting standards of Canada's largest financial institutions and then to efficiently and effectively comply by adjusting our [ revenue ] activities and capital allocations is a competitive advantage. These strengths will be tested in 2018 by the introduction of B-20 amendments and their dampening effect on the single family market. Moray will have more to say about this in his remarks. I'll conclude my thoughts with thanks to our customers, business partners and First National's 950 employees. The performance records established this year are the direct result of all that you do for our business. While we believe First National has used technology to effectively differentiate ourselves from our competitors, success really comes down to personal relationships, built on integrity, advice, service and execution. We will do our utmost to continue First National's legacy of performance going forward by investing time and energy in every relationship. Now here's Rob with his commentary.

[Robert A. Inglis, Chief Financial Officer]

Good morning, everyone. Stephen already addressed long-term performance, and I'll focus most of my remarks on the fourth quarter. MUA grew an annualized rate of 6% between December 30 and December 31. This was a faster pace than we saw early in the year and likely reflects a step-up in single-family borrower activity in advance of the introduction of the B-20 amendments. Fourth quarter single-family originations were higher year-over-year by 4%. Single-family renewals equal last year's performance, and on the commercial side, new originations and renewals together grew by 9%. All in all, total fourth quarter mortgage originations were 7% higher than last year. Once again, the financial results [ blurred ] by this growth were significantly impacted by interest rate changes, which affected both gains on financial instruments as well as placement fees. Fourth quarter revenues were 7% lower than in 2016 because in the comparative period last year, we recorded larger gains of financial instruments, totaling almost $38 million versus $3.6 million in Q4 2017. This change was almost entirely due to the pace of rising interest rates. While rates rose in both periods, the pace of the increase was much lower in 2017. In 2016, as you might recall, United States had a new president-elect, and the market expected pro-business policies to fuel growth. Due to the effect of these values, Q4 revenue was 5% higher year-over-year as rising interest rates had a favorable impact on the interest earned on securitized mortgages as well as on mortgage investment income, these revenues increased by 7% and 27% respectively. These increases more than offset an 8% decline in placement fees, which resulted from a shift in funding from institutional investors to the company's own securitization. For all of 2017, First National earned over $56 million in gains on financial instruments. All this revenue increased net income in 2017, it will be an obstinate economic impact in future earnings. This will be evidenced in tighter securitization spreads in our future transactions. The benefit, of course, the company has now earned the money as opposed to over the 5- and 10-year mortgage terms. If you exclude these gains, fourth quarter pre-fair market value EBITDA was the same as last year, demonstrating the consistency in our performance. As you know, this measure excludes gains and losses on financial instruments and is used by management as a proxy for core operating performance. Solid pre-fair market value of EBITDA through the year, including the fourth quarter, provided good support for our common share of dividend payments, including the special dividend paid in December. The 2017 payout ratio against pre-fair market value of EBITDA was 90%. Special dividend is the result of several years of [ humid ] earnings. By excluding it, the payout ratio would have been about 53%. Lastly, I note that we terminated the First National mortgage investment fund on December 19. The fund management made this decision as a result of decreasing fund capital, and maturity of these forward agreements was provided for a favorable tax treatment to the unitholders. This tax strategy, which was an integral part of this fund's structure, was disallowed by the federal government's 2013 budget. Together with a reduction in size and the funds of that asset, it was determined that the fund was no longer economically practical for unitholders. On December 15, the fund's units were delifted from the TSX. In total, between this offering in 2012 and the end of 2017, the fund paid distributions at a rate of 6% per annum. And now here's Moray with our closing comments.

[Moray Tawse, Co]

Good morning, everyone. Well, we're pleased with the results of 2017 even though we experienced somewhat slower residential market as a result of the change in the mortgage insurance rules enacted in October 2016. The combination of consistent revenue for both securitization, mortgage -- and mortgage servicing departments and the value inherent in the company's renewal opportunities continue to support earnings, which were just 2% lower than in 2016 when adjusted for the fair market value considerations. Looking forward, our industry is now adopting to more government regulations through the new mortgage qualification rules known as B-20. These amendments require conventional mortgage borrowers to qualify at interest rates higher than the actual rate offered by lenders. This means stress tests are now applied to both conventional and high ratio borrowers. As Rob said, we believe the January 1 implementation of these additional rules pushed some borrowers to accelerate their decision to purchase real estate into 2017, giving an uplift to our origination numbers in the fourth quarter. For 2018, we believe the B-20, along with the ongoing application of earlier policy interventions, will have a further dampening effect on single-family origination volumes. There is a significant degree of uncertainty about the ultimate impact, but our sense is that the potential for strong economic growth, population expansion and supply-side constraints in many cities will provide offsets. We also expect to see growth in single-family renewals and a stable commercial sector. But then again, rising interest rates and some increased competition may act to check this growth. From an earnings perspective, we will see an offsetting economic impact from the large gains on financial instruments recorded in 2017. This will be seen in tighter securitization margins as we issue NHA-MBS with higher coupons than when the mortgages were initially funded. The timing of this impact will depend how we elect to fund these mortgages but will be generally spread out over 5- or 10-year terms of the related MBS terms. Recall also that we put some temporary promotions in place last summer to fuel activity in the single-family market. When mortgages originate under those promotions funded the higher costs for capitalized against our securitized mortgages and during the amortization period going forward, net securitization margins will be reduced. Net-net we see both challenges and opportunities. The opportunities include a large renewal pipeline in the single-family business, which we have steadily built over the last 20 years. And while we're Canada's largest commercial mortgage lender, we estimate our share to be under 15%, so lots of room to grow in this segment. First National has always been prepared to respond to changing market dynamics by being nimble but without changing our core strategies, especially our customer service culture. We believe our positioning is strong, and we know from experience that our business model is efficient. When all is said and done, First National continue to generate income and cash flow from what is now a $27 billion portfolio of mortgages pledged under securitization and a $74 billion servicing portfolio. That critical mass, 3 decades in the making, give us a strong platform to start for 2018. That concludes our prepared remarks. Now we'll be pleased to take your questions. Operator, please open the line for questions.

[Operator]

[Operator Instructions] And we'll take our first question from Jaeme Gloyn with National Bank Financial.

[Jaeme Gloyn, Analyst]

Yes, my first question is around the breakdown of funding in this quarter. Obviously, an outsized number on the securitization side, and I just want some more color as to the decision-making process there, given what looks like a near all-time low mortgage spreads in Q4. Why such an outsized number on securitization versus placement?

[Stephen J. R. Smith, Co]

Well, I would say -- even at tighter spreads, securitization is always an attractive option.

[Jaeme Gloyn, Analyst]

Okay. But relative to past quarters, securitization this quarter was, let's say, in and around 40% of funding. We haven't seen that kind of level since Q1 '15. I'm just wondering if there was anything other than just -- maybe just diversifying funding at this point. But maybe just a little bit more color on why more securitization this quarter?

[Robert A. Inglis, Chief Financial Officer]

Well, I think, generally, we have more capital to use, so that makes it easier for us to do our own securitization. And we -- there's only so much you can do with the CMHC, the allocation from the CMB, and we want to use all that up ourselves basically. So we did, and I think we have some new asset-backed most-favorite programs, which have been successful, so we're using that as well. But I think, just in general, we have more capital to invest in these programs. And so we're doing that. You make more money when you securitize.

[Stephen J. R. Smith, Co]

Yes, I actually don't remember having a conscious decision on the fourth quarter that we're shifting to securitization or not.

[Jaeme Gloyn, Analyst]

Okay, so part of that would've been the increased use of ABCP, and I guess that also explains why there was such an increase in capital to those programs in Q4 and, I guess, throughout 2017. Is ABCP just a lot more of an attractive product now? Or is there something different in those programs that makes it more attractive today than earlier in 2017?

[Stephen J. R. Smith, Co]

No, I don't think there's quite as much science in that. I -- thinking back to that period when we made those decisions, or when treasury would've made those decisions, I can't think of anything particularly driving the high degree of securitization relative to other assets.

[Jaeme Gloyn, Analyst]

Okay. And my next question is maybe a bit more industry-related. BMO, on their conference, they discussed pulling back from purchasing mortgages from third parties. Is there anything you can share with respect to relationships or conversations you're having with your key investment partners? And do you think that BMO's decision to sort of ease off the gas on third party mortgages as a signal that this is wider spread? Or may become wider spread amongst the Big 6 bank investors?

[Stephen J. R. Smith, Co]

I would think BMO's decision -- I mean, it's difficult to speculate. I would assume that's probably idiosyncratic to BMO. I'm not seeing an industry-wide move that way.

[Jaeme Gloyn, Analyst]

Okay. And last one for me just around the investments in technology. Can you give us a little bit more color as to what are those investments related to? Is it some maintenance? Or is it keeping up with competitors or disruptors? Or is it something that's innovative? And just a little bit of color as well around the timing of costs and expectations on that -- how long that will stretch for?

[Stephen J. R. Smith, Co]

Well, I would say we don't see it being a big expenditure. We've always been on the forefront of technology. So in 2017, for example, for brokers, we have had MERLIN updates. So 2001, 2002, we were the first application that allowed brokers to go directly into our database to track their loans. We launched a mobile application for that. We have our My Mortgage program, which allows our borrowers to come in and track their mortgage and make changes on their mortgage. So I think we're launching a new view or a new version of that. It's scheduled to come out in the middle of Q2. We don't have huge technology expenditures here. It tends to be more -- we're at a pretty high level, so it tends to be maintenance. We don't have any issues with disruptors in this space. And if anything, I would think [indiscernible] disruptor in that sense. So I don't think I have too much more to add to that.

[Operator]

[Operator Instructions] We'll take our next question from Graham Ryding of TD Securities.

[Graham Ryding, Research Analyst of Financial Services]

Maybe I could just start with B-20. Your message seems -- sounds like it -- do you think it is going to be dampening activity somewhat this year? Is there anything you've seen in January, February to date that you can maybe quantify? Or could you perhaps estimate what you think the effect could be in that to maintain...

[Stephen J. R. Smith, Co]

You know what? Let me give you be a better [indiscernible] with the mortgage market in last 3 months than I've seen in the last 30 years. A year ago this time, changes were made to the qualifying rates for insured mortgages. Roughly 40% to 50% of our mortgages are insured. So in many ways -- and those are the mortgages we tend to securitize. We tend to securitize and give us our higher margins. At the same time last year, with the capital changes to that OSFI put in for the insurers that made it more difficult for us to insure our conventional mortgages. I'd say at this time last year, we were looking at changes that were an awful lot more challenging than this year. If anything this year, these new stress tests don't affect our insured book because that's already happened, and in some ways that's going to come back a bit. So we're only looking at the stress on the conventional portion. In some ways we had to deal with the stress of not being able to -- funding those other mortgages a year ago, so we've had to deal with that. I think in -- also in other ways, we were -- we're now dealing that I think we're -- we were already using the stress test a year ago because we -- what mortgages we had we're insuring and our competitors at the [ Sched 1s ] didn't have to do that because they could still do the contract rate. So we're seeing -- from our point of view, we're seeing a lot of factors that are making us feel a little bit more confident about this year. So even though there's a pressure on the stress test, we think it's quite manageable. If I had to go, and I'll just go by our commitments for the first 2 months of this year compared to last year, they are up in the 10 -- I think January, the commitments were up about -- at the end of the month, were up about in excess of 20%. And I think February is looking like it is going to be up more than -- above 15%. So we're fairly -- we're feeling fairly confident that the stress test changes, while affecting the [ Sched 1s ], it might affect their volume, in the context of our business is something we can manage.

[Graham Ryding, Research Analyst of Financial Services]

That's good color. And what do you think is driving your volumes being up so much? Is that a recovery in Alberta? And Quebec is part of that in the insured space? Or any color on...

[Stephen J. R. Smith, Co]

I think it was just that the first 2 -- the quarters -- the 2 quarters last year or the first 2 months last year, I don't think we had a competitive rate. I think there was a little of [ fish vats ]. I think there was a lot of pull-through on insured product to the -- to Q4 of 2016. There were a lot of those factors. We have a good competitive rate this year. So it's just a bunch of those factors.

[Graham Ryding, Research Analyst of Financial Services]

Got it. Maybe I can just jump to your outlook for...

[Stephen J. R. Smith, Co]

Graham, generally -- Yes, well, I find, just generally, it's very difficult to extrapolate on a given month a year-over-year number. Year-over-year that's indicative, a month-over-month number from one month to the -- compared to a month a year ago, either things can be very strong this year compared to a month ago last year, or last year could be weak or strong. So individual months, it's better if they're up than down, but you can't read too much into it.

[Graham Ryding, Research Analyst of Financial Services]

Okay, got it. Just the outlook for your securitization net interest margin, just wondering if we -- a little bit of color there. Seems like there's a few factors that could lead to some NIM compression, just wondering if you could give us any more color on to what extent we should be thinking about that planning out next year.

[Stephen J. R. Smith, Co]

Yes, I think that's not unfair, we've had pretty tight spreads. We -- I guess we have a couple of things. One is just[Audio Gap]margin compression but then there's total months. I would say another reason we feel fairly comfortable this year, we still see the commercial business being strong and that's a good sort of securitized business. The other issue would be our renewals are going to be stronger, so we hope to be doing more volumes. And spreads come and go. Right now, spreads are tight, they've been tight for a while, but they tend to come back.

[Moray Tawse, Co]

Graham, it's Moray. And also remember that a big portion of our -- a big part of our -- the commercial side, the spreads have not really changed because our product spread -- as our product is priced off the CMB, so our spreads, really, in that product have not changed at all. So for the securitization of the commercial, spreads are not tightening at all actually for our profit margins.

[Graham Ryding, Research Analyst of Financial Services]

Okay. And the $56 million of realized gains around hedging in 2017, how should we think about the offset there? I guess, what's the sort of -- you say between 5 and 10 years, so is it reasonable to think that, that offset happens over roughly 7.5 years?

[Stephen J. R. Smith, Co]

No, I think that's too long. Of that $56 million, Rob, what percent of the -- 80% or 90% would be 5 years?

[Robert A. Inglis, Chief Financial Officer]

Yes, I would think so. Because with the 10-year [stuff] it's smaller, much smaller. So I mean, 90% of it is 5-year product, which has a duration of 3.5 years.

[Stephen J. R. Smith, Co]

Yes, so if we had a 5-year -- let's say, a 5-year, we probably assume a duration of 3.5 years on that. And so if you -- the way we would think at a very macro level, let's say, there was $50 million in gain, divide that by 4, that's $12 million a year. That's how -- I think that's the way to look at it. So we take a gain of $50 million, we'll have a reduction in NIM by $12 million a year. So that's $12.5 million a year for the next 5 years.

[Robert A. Inglis, Chief Financial Officer]

I think, Graham, too, remember in the third quarter, there was like a $14 million to the adjustment we talked about in terms of placement fees. That $14 million of the $56 million has already been accounted for this year, 2017. That means there's $42 million to go, I guess, in the securitization book.

[Operator]

And Mr. Smith, there are no other questions, so back to you for any closing comments. And my apologies, actually, Jaeme has requeued. Would you like to take his question now?

[Stephen J. R. Smith, Co]

Sure. Yes, for sure.

[Jaeme Gloyn, Analyst]

Yes, can you guys hear me?

[Stephen J. R. Smith, Co]

Yes. Yes, go ahead, Jaeme.

[Jaeme Gloyn, Analyst]

Okay, great. Just wanted to touch on leverage for a quick second. While not being higher, excess of it is elevated relative to the recent history. Is this the level we should think of going forward? Or is there a specific target in mind for what is "True leverage?"

[Stephen J. R. Smith, Co]

Yes, well, we think a lot about true leverage. And if you want to get a sense of true leverage, you really take our bank, our warehouse loans and deduct that from the mortgages held for sale, and that gives our true leverage. I think generally here, we look at ourselves as being underlevered. We have a lot of excess capital, both for regulatory reasons for our issuance program and just generally to support our assets. I think that's one of the reasons through -- one of the reasons that we had the special dividend last year. We thought we were quite overcapitalized. We're -- this business, we make almost 40% a year on our capital. So it's a big cash generator, so there's lots of excess capital. So I wouldn't -- I would say I don't see us taking on any more leverage, probably do some mezzanine business that we're doing with excess capital. But relatively speaking, that's not a particularly efficient use of capital, and probably the best -- a lot of the use would be dividending it out to shareholders.

[Jaeme Gloyn, Analyst]

Okay. And last one for me. Just around the IFRS 9. There was a comment, either in the MD&A or the financials about the -- opening up more hedging strategies for First National. Can you just talk about what those strategies are? And how they may impact net income and/or cash flow?

[Robert A. Inglis, Chief Financial Officer]

Yes, Jaeme, it's Rob. We're having the same strategies we've always had in treasury, but what will happen is they will now qualify for hedge accounting. And we figure that perhaps half of the volatility we've seen the last few years in fair market value of instruments gains and losses will disappear because we can take those gains or losses, defer them on the balance sheet, and amortize it back of the income over the terms of securitization. So there will be a lot sort of the volatility and pre-fair market value will disappear a little bit. So I...

[Jaeme Gloyn, Analyst]

So in an instance where IFRS 9 reduces volatility. Good.

[Robert A. Inglis, Chief Financial Officer]

Yes, absolutely.

[Operator]

And we have a follow-up question from Graham Ryding with TD Securities.

[Graham Ryding, Research Analyst of Financial Services]

Just wanted to follow-up on the funding mix. You securitized, I think, $8.2 billion this year. What's your capacity for -- is that a reasonable level to expect going forward? And then my second part of that question is, the asset-back commercial paper portion of that, is it funding at similar volumes as in the past? Or is it providing higher capacity for you? How do we think about that specific channel?

[Stephen J. R. Smith, Co]

Now Rob, is the [ 8-2 ] is -- that includes ABCP? Or is that just NHA-MBS?

[Robert A. Inglis, Chief Financial Officer]

That includes both. Maybe there is a [ billion ] or so in their ABCP. I'd say too that our ABCP program in the past had a lot of insured stuff. It's had terms of 6-months, 1-year kind of stuff. We kind of threw in some short-term renewals. That stuff rolls off very quickly. So you know we had some new origination going in there. The overall limits in that program have already grown over the course of the year.

[Stephen J. R. Smith, Co]

Yes. So I would think our -- that big number would generally be combination of CMB and NHA-MBS. And we would try, in a given year, to use as much as we can of that, unless we have an -- unless there's somebody else who's willing to -- we do have bidders who often -- who may want to issue themselves, and we sell them our allocation. But in general, we'll tend to use that number. I guess on the -- and my inclination say, yes, that's probably not a bad number to go forward with as where we would be because I think the allocations we get from CMHC are going to be fairly consistent going forward.

[Graham Ryding, Research Analyst of Financial Services]

Okay, that's helpful. And then what did you say about the asset-backed commercial paper? Is that channel still alive for you? Or has it been run off?

[Stephen J. R. Smith, Co]

I would say that a number of years ago, if you -- where the government prohibited us from putting in insured mortgages into ABCP. So what we have to do is, we convert them into NHA-MBS and then put them in. Or what we can do is we can use, certainly, to do a bit of funding on our NHA-MBS. We'll maybe use repo lines and then use the standby facilities at the ABCP as a backstop for that. We tend to put conventional mortgages into ABCP, we'll probably continue to do that.

[Operator]

And again, Mr. Smith, there are no questions at this time. So back to you for any closing comments.

[Stephen J. R. Smith, Co]

Thanks, operator. That concludes today's event. We look forward to reporting our first quarter results in May and to hosting our Annual General Meeting on May 7 at the TSX Gallery in Toronto beginning at 9 a.m. Eastern. Thanks for taking part in our call, and have a good day.

[Operator]

This concludes today's conference. Thank you for your participation. You may now disconnect.