First National Financial Corp

TSX:FN

Earnings Call Transcript 2019-Q4

[Operator]

Good morning, ladies and gentlemen, and welcome to First National's Fourth Quarter 2019 Analyst Call. [Operator Instructions] This call is being recorded for replay purposes on February 25, 2020, at 10:30 a.m. Eastern 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. 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 risk and uncertainties and should be considered in conjunction with the risk factors detailed in our MD&A.2019 was an extremely productive and profitable year for First National, featuring broad-based growth by mortgage type and across the country. Both of our business segments set new records for annual origination. Single-family originations grew by 11% to $13.5 billion, and commercial originations were up 19% to $7.4 billion.As you may recall, 2019 began with single-family originations down in all regions, so the results for the full year are very satisfying. In the final analysis, all First National offices reported growth, led by Ontario and the Maritimes, with a combined 17% increase in originations on the year.Mortgage renewals also had a big impact on our business, led by the commercial division where renewals amounted to $2 billion, a new record. In the single-family segment, we renewed $5.5 billion. This is a function of our 4-year term product we originated in 2014, such that in 2018 we had a double cohort of renewals to work with. Generally, retention rates year-over-year were profitable.Primary result of originations and retention of renewals, mortgages under administration grew 5% to $111.4 billion as of December 31. It's never possible to exactly pinpoint the reasons for market performance, but I would say that there were 2 driving forces this year. One, in most recent -- regions of the country, employment levels were positive; two, mortgage rates remained low, which in of itself drives activity. But in this case, low rates made it easier for borrowers to qualify for the same mortgage size that they did in 2018 prior to the implementation of the revised B-20 guidelines.First National capitalized on solid market conditions by leveraging our strengths. With our top 3 position in the mortgage broker channel and the continued development of our Excalibur program, we were able to record double-digit growth in residential origination. Given that we did $12.2 billion in 2018, this growth rate is truly exceptional.In commercial, demand for mortgage financing was strong, and First National's status as a market leader in providing access to capital resonated with borrowers across the country and supported the company's position as one of Canada's largest commercial mortgage lenders.Our third-party underwriting and fulfillment process -- processing business also had a good year, helping our long-standing bank customer increase its success in the mortgage broker channel. As you'll have noted from our press release released in December, Manulife Bank of Canada became the second bank to choose First National to provide credit adjudication services to the residential mortgage broker channel in Ontario and Atlantic Canada. We are very pleased by this appointment and look forward to leveraging our capabilities to help the bank further enhance its presence in the channel this year.Looking at profitability, both operating and net income were well ahead of last year on account of revenue growth, wider margin spreads and a shift in funding mix favoring institutional placements. Per share net income grew 6% to a record $2.90. This provided good support for the increase in the common share dividend the Board paid in December and the special dividend of $0.50 per share paid at the same time.We're proud to note that since listing on the TSX 13 years ago, First National has paid $1.4 billion to shareholders, and combined with share price appreciation, delivered a total return of 514% to the end of December 2019 with respect to the payout ratio of 66% in 2019, excluding the special dividend compared to 68% a year ago on the same basis.A couple of additional highlights. In the fourth quarter, as we announced by the way of a press release at the time, Moray and I sold some of our shares in First National. This was done in an orderly fashion through a bought deal with a syndicate of underwriters. Even with the sale, together, we still own over 71% of the outstanding common shares, and we are still very much aligned with public shareholders.We were also very pleased to announce that Jason Ellis added President to his existing title as Chief Operating Officer. Jason has become an integral part of the strategic development of First National and will continue to champion the entrepreneurial culture upon which the company was founded. Most of you know Jason, but for the record, he's been with First National for 16 years, leading our treasury and capital markets activities for much of that time. One of the great things about First National is that we have a very strong team at all levels, and it's gratifying to be able to promote from within.On that note, I would like to sincerely thank all employees of First National delivering great results for our shareholders in 2019 and focusing, as always, on helping our customers and partners succeed.Now here's Rob with a detailed look at our results for the fourth quarter. Rob?

[Robert A. Inglis, Chief Financial Officer]

Thanks, Stephen, and good morning, everyone. First National finished 2019 on a strong note. Q4 revenue increased 10% to just over $342 million. This was our most productive fourth quarter of record and our second best quarter of 2019, surpassed only by Q3 when revenue was almost $353 million. Revenue growth reflected the mortgage originations in the year and a funding mix that at least earlier in the year favored more placement with institutional investors rather than mortgage securitization.We talked about the change in mix last quarter, and as a reminder, by placing mortgages, the company accelerates the recognition of earnings. In Q4, this trend reversed as the company has unused NHA-MBS capacity and shifted the funding mix in favor of securitization. The impact of our funding decisions will be evident as we briefly walk through the components of revenue, starting with Q4 placement fees. These decreased 2% due to lower placement volumes on both newly originated and renewed single-family mortgages.Q4 mortgage servicing income increased 20% due in part to the benefit of higher MUAs and the earlier year decision to shift to institutional placements for securitization, which effectively moved revenues from net securitization margin to servicing income.This increase is also a result of higher revenue from our third-party underwriting business as, much like First National, our long-standing customer increased origination levels in a strong market. Q4 net interest revenue earned on securitized mortgages increased by 3% despite the ongoing variability related to accounting for financial instruments, which I've described in the past calls. Wider securitization spreads in 2019 made the portfolio more profitable.Moving on to Q4. Mortgage investment income decreased 13%, primarily due to lower mortgage interest rates. Q4 revenue from gains on deferred placement fees was off 3%, reflecting slightly lower volumes for these programs.Moving to Q4 earnings performance. The same drivers for all of 2019 prevailed. Strong mortgage origination, wider spreads and the benefits of the large MUA led to an 11% growth in pre-fair market value EBITDA. In Q4, common share payout ratio was 122%, if we include the special dividend paid or 60% if we exclude the special.A couple of other items of note. In November, the company issued $200 million of senior unsecured notes by way of an offering memorandum. The notes bear interest at 3.582% payable on equal semiannual amount starting in May this year. The net proceeds were used to temporarily repay a portion of the outstanding indebtedness on our bank and credit facility. Ultimately, we plan to redraw on our bank credit facility to repay our maturing $175 million 4.01% unsecured notes that mature in April of this year.We were very pleased that 38 investors participated in this offering, and we achieved a credit spread of 2.1% over the benchmark bond. This made the offering our most successful debt deal to date.Now here's Moray with our outlook.

[Moray Tawse, Co]

Thanks, Rob. Good morning, everyone. I'd like to echo Stephen's comments and add my thanks to our employees for their hard work over the past several years, which enabled First National to set the records we are discussing today. As well, I would like to take a moment to thank our business partners for their contribution to our success.Looking ahead, I would say the prevailing mood here is one of optimism, given a couple of leading indicators. First, single-family mortgage commitments have significantly outpaced the levels we saw at this time last year. As Stephen said, our originations in Q1 '19 was down across the board. Current conditions are much more favorable. Second, our commercial team anticipates a strong start to 2020 with borrowers continuing to have a good appetite for product, particularly in the apartment building sector. Based on Bank of Canada's January policy announcement, it appears as if low interest rates will be here for most of the year.Of course, we would always caution that one quarter does not a year make, and Q1 is typically the seasonal low point for market activity. We also have to keep our eyes on the economy and the ongoing potential for international trade disputes to spill over into Canada as they did last year.We'll continue to be faced with uncertain securitization margins as well. Mortgage spreads tightened towards the end of 2019, and as of yet, has not widened into 2020. The effect of pre-2018 fair market value accounting conventions will continue to have a negative impact on income in 2020, but at a slightly lower level than 2019.Trying to take this into account all the pluses or minuses, we are optimistic about 2020. As always, we'll continue to generate income and cash flow from our $32 billion portfolio of mortgages plus other securitization and our $77 billion servicing portfolio. We'll focus on realizing the value inherent in our single-family renewal book and nurturing and growing the third-party servicing business.Well, that concludes our prepared remarks. Now we will be pleased to take your questions. Operator, could you please open the line for questions.

[Operator]

[Operator Instructions] Our first question is from Jaeme Gloyn with National Bank Financial.

[Jaeme Gloyn, Analyst]

Yes. First question is just around -- and maybe it's a little bit unrelated, but I'm hoping you can provide a little bit more color, Stephen, just around First National's relationship with Duo Bank and with Fairstone. And given that, that transaction that just occurred or -- and is set to close there this year, is there a potential for an expanding relationship if there is one or a new relationship if there isn't?

[Stephen J. R. Smith, Co]

Well, of course, my activities with Duo are independent of activities here at First National. I'm a shareholder and Chairman at Duo. But I think both First National and Duo are always exploring activities to engage in mutually beneficial activities. And I think there are conversations going on between First National and Duo to engage activities that might be helpful to each other, but we have nothing to announce in that regard.

[Jaeme Gloyn, Analyst]

Okay. And then...

[Stephen J. R. Smith, Co]

Well, what were you thinking in, particularly, getting at, Jaeme?

[Jaeme Gloyn, Analyst]

Well, just that Duo is purchasing Fairstone. Fairstone has some mortgage and real estate secured assets and I'd like to...

[Stephen J. R. Smith, Co]

All right. Well, let me give you some color. I think Fairstone is very much a nonprime lender, and it's an installment business in the consumer finance. They do have mortgages, but it's $300 million. And those mortgages tend to be almost the nature of a consumer finance loan to impaired credits. I really don't see much overlap between -- in fact, no overlap between First National and Fairstone in that regard. We were just in 2 entirely different markets.

[Jaeme Gloyn, Analyst]

Okay. Great. Appreciate that extra color. As it relates to First National specifically then, looking at really strong single-family growth as well as multi-unit as well on the commercial side, but maybe just some thoughts around where you're seeing Q1 shape up? And do you expect a little bit of a -- maybe a slowdown here over the last few weeks of Q1 as homebuyers potentially delay purchases into April 6 on the new stress test for insured mortgages?

[Stephen J. R. Smith, Co]

Oh, no. We're seeing Q1 as exceptionally strong. I would say it's probably been reflected in the papers that housing activity in February is more like a housing activity we could see in March and April and May. It's been accelerated. I think there's an aspect of the market, particularly in Toronto, that would have characteristics similar to 2017, where there was a little bit of a FOMO type of effect taking place. I think, ultimately, it was a political move. But certainly, we would have supported the change in the stress test. If anything, the market doesn't need any stimulus. The issue with housing in Canada is not affordability, it's the lack of supply. And this is just going to inject more liquidity into the system. And in the long term, it's not going to be good for housing for Canadians. But the market is strong right now.

[Jaeme Gloyn, Analyst]

And so volumes are looking robust for 2020. Can we dive in a little bit on placement fee yields as well as brokerage fee expenses as the two sort of work in tandem? Both of those metrics were higher than -- in 2019, they were higher than 2018. Do you expect a similar evolution where placement fees may be pretty stable and broker loyalty programs are still active and so we should see brokerage fee expenses stay high? Can you just talk about those 2 drivers?

[Stephen J. R. Smith, Co]

Yes. I think this is the most common question I get from analysts because everyone wants to know the breakdown between placement fees and securitizations, so they can put it into their models to get a sense of what the income's going to be. I don't think I have visibility on that. Whether we do a placement fee or securitization tends to be very opportunistic, and it reflects margins, volumes, opportunities at the time. We don't -- I don't think I can give you guidance there. And you could see from Q2 and Q3 where we had a lot of placement activity, and then in Q4, it changed again. I don't think I can give you guidance there that would be reliable.

[Jaeme Gloyn, Analyst]

Maybe just specifically on broker loyalty programs or those programs that drove brokerage fee expenses higher in 2019 over 2018, are those still active? Should we expect similar levels of brokerage fee expenses?

[Stephen J. R. Smith, Co]

We haven't -- to my knowledge, we haven't changed our brokerage fee loyalty programs recently. The same one that we have in place now would be the one we have in 2019.

[Jaeme Gloyn, Analyst]

Okay. And then last one for me, just as we hear other players in the alternative mortgage space talk about RMBS and covered bonds developing as a source of funding, is that something that First National is also exploring as an alternative to selling the Excalibur program through to institutional investors? And how do you view those markets and the impacts it could have on the securitization performance?

[Stephen J. R. Smith, Co]

Yes. Well, I would think we are exploring those options. We're quite encouraged by the issuance of home capital last year. And of course, they're in on a, I guess, road show right now for their next issue. We feel that we should, during the course of this year, be able to do a public market securitization with an Alt-A product. So we're very encouraged. We think we can get further growth in our Alt-A business. We're going to be expanding to -- we're currently in Ontario now, and I think we originated about $1 billion last year in Alt-A. I think we're going to be going to Alberta and British Columbia with our Alt-A program. We have a whole range of securitization and whole-loan placement options for Alt-A. So we can see a lot of growth in that area.

[Operator]

[Operator Instructions] Your next question is from Graham Ryding with TD Securities.

[Graham Ryding, Research Analyst of Financial Services]

The -- I'll just start with the CMHC securitization side. I think there was a note in your MD&A just about increasing guarantee fees on those NHA-MBS pools. I just want to -- how do we think about that in terms of the impact on your NIM? Is it -- am I correct sort of estimating like a 1 -- an incremental 1 basis point a year maybe drag on your NIM assuming all else is unchanged?

[Stephen J. R. Smith, Co]

So Graham, we feel that the increase in the guarantee fees will be neutral. We feel that though that pricing can be passed through to the customers. The guarantee fees, I think there's a little bit of a different -- CMHC put those in, they're sort of pushed and pulled. Most of the D-SIBs take their insured mortgage book and use NHA-MBS so they can create high-quality liquid assets. I think the government, and I'd say the government at large that would be financed, and CMHC felt that there was an opportunity there to charge a higher fee because of the high value of the HQLA.From our point of view, for commercial borrowers, that can be passed through our competitors and ourselves. We'll just pass that through. Then on the single-family side, again, the single-family market tended to be at a lower price point than the conventional market. And I think for -- it would tend to be driven at the margin by execution in the CMB market, in the NHA-MBS market. So to the extent that the 5 basis points or 1 basis point a year, $0.10 to $0.05 tends to come through, that will be passed on to the customer, I believe. So I -- we don't think -- we haven't adjusted our budgets on that. It's just the additional cost.

[Graham Ryding, Research Analyst of Financial Services]

Okay. Understood. And generally, your outlook for securitization NIM in 2020, it sounds like you see some potential for margin pressure. Is that fair?

[Stephen J. R. Smith, Co]

Yes. Well, last year, where there were -- we've got much wider spreads, and you could see the benefits in some of our results. We've certainly said that spreads have tightened. Well, in the last 2 or 3 days, particularly yesterday, today and prior year, had big rallies. So spreads are quite good again. Probably a couple of days don't make a difference. But spreads have been tight for '18, a good part of '19, first part of '19, the last part of '19. We're certainly assuming spreads are going to be tight. But because I think of our -- because of our large volumes and big originations, it's -- we still think we're going to have good, we'll have a good year. It's -- if we happen to get a benefit where spreads widened out, then that will be a bit of a bonus to us.

[Graham Ryding, Research Analyst of Financial Services]

Okay. Understood. The mortgage underwriting agreement with Manulife, is there anything that you can provide in terms of potential impact? Is this a similar deal that you did with TD several years ago? Is it a reasonable level? Or is it smaller than that?

[Stephen J. R. Smith, Co]

Well, I would say it's a similar deal, and what we're doing for Manulife is very similar to the deal we're doing for TD. But Manulife is a smaller originator compared to the TD. So there's not going to be a material impact on our earnings. I think it's just -- I think it's another example of how we are viewed to those institutions who want to outsource, that's the gold standard with respect to mortgage origination, credit adjudication in Canada. And the fact we have another major financial institution that has come to us to do that, particularly when they've been with another provider, is a further testament to the -- to First National's qualifications and skills in that area.

[Graham Ryding, Research Analyst of Financial Services]

Great. And just my last question, just with you selling shares recently, yourself and Moray. Is this something that we should expect to be a regular event? Or is there any color on sort of the rationale beyond the decision to sell some shares?

[Stephen J. R. Smith, Co]

Well, I don't know. What do we -- what do I own in the shares, 22 million? What do you have, Moray, 21 million, 22 million? 21.5 million? We're pretty long shares, but I think we were at this call -- I think we were asked this call a couple -- previously when we were going to sell the shares. We have a state planning issues. We've been shareholders of First National for 32 years now. And we are probably getting to the end of our careers, so there's always an issue of the state planning. We have no plans to do anything currently, but who knows? There's always possibilities, but nothing planned right now.

[Operator]

All right. Mr. Smith, there are no further questions. Back to you for closing comments.

[Stephen J. R. Smith, Co]

Okay. Thanks, operator. That concludes today's event. We look forward to reporting our first quarter results on April 28 and hosting on Annual Meeting on May 5 in Toronto. Thanks for taking part on our call, and have a good day.

[Operator]

Ladies and gentlemen, this does conclude today's conference call. Thank you for your participation, and you may now disconnect.