Home Capital Group Inc

TSX:HCG

Earnings Call Transcript 2018-Q2

[Operator]

Good morning. My name is Jessa, and I will be your conference operator today. At this time, I would like to welcome everyone to the Home Capital Group Second Quarter Financial Results Conference Call. [Operator Instructions] Thank you. Ms. Laura Lepore, Investor Relations, you may begin your conference.

[Laura Lepore, Assistant Vice President of Investor Relations]

Thank you, operator, and good morning, everyone. Thank you for joining us today to hear about our financial results for the second quarter of 2018. I'm very pleased to introduce with me on the call today Yousry Bissada, President and Chief Executive Officer; and Brad Kotush, Chief Financial Officer. We also have members of our management team on the call this morning: David Cluff, our Chief Risk Officer; and Ed Karthaus, Executive Vice President of Sales.So before we begin, I'd like to caution listeners that this conference call may provide management the opportunity to discuss financial performance and conditions of Home Capital, and as such, comments may contain forward-looking information about strategies and expected financial results. Various factors, many difficult to project or control, could cause actual results to differ materially from the results projected in forward-looking statements. Accordingly, the audience is cautioned against undue reliance on these remarks. Finally, a link to the slides accompanying this live webcast is available on our website at homecapital.com.With that, I'll turn it over to Yousry.

[Yousry Bissada, President, CEO & Director]

Thank you, Laura, and good morning, everyone. Thank you for joining us today. Our goal has been to ensure we are consistently making the right long-term decisions to build a sustainable and highly profitable company that is built for growth. We strive to provide best-in-class service to all our clients and brokers, working to be a leader in the Alt-A mortgage sector and to continuously improve productivity. At the half year mark in 2018, we have taken significant steps to deliver on these objectives, but know we have more to do. While some of the performance measures in the quarter mutes the progress, we continue to strengthen our foundation each quarter to position Home over the coming years as a competitive, top-tier performer for the long term. I'm going to share with you 4 areas where we have made considerable progress. First, we are continuing to grow mortgage origination volumes and deliver profitable results against the backdrop of rising rates, slower housing market and an evolving regulatory operating environment. Our team has made strong progress growing volumes, while improving retention rates and maintaining our loan portfolio. Our second quarter marked the third quarter of increased residential origination volume, bringing our total originations in Q2 to $1.23 billion. Total residential loan originations in the quarter grew 9% to $949 million. In the first half of 2018, we prioritized growing mortgage origination volumes via the mortgage broker channel, first and foremost. This channel is the core foundation for the distribution of single-family residential mortgages, and we have enhanced the broker experience by investing in technology to help us improve service delivery. Our sales and underwriting teams are committed to providing excellent customer service and becoming recognized as service leaders in our industry. Home's model has always been to understand the borrowers full financial picture to offer the best solution to meet their needs within our risk appetite. This approach is embedded in our culture. We do this survey in more of their business and our strategy is working. We are also pleased with the growth in Commercial segment where loan balances increased to $1.96 billion, up almost 7% from Q1 2018. While we're pleased with the progress we've made in our plans to improve mortgage volumes and renewals during the quarter, the operating environment has been more challenging across our mortgage business due to rising interest rates, competition and the software Canadian housing market. In terms of B-20, we have observed that the market has largely adjusted to the rule changes that came into effect at the beginning of this year. We continue to experience an increase in higher credit quality customers and are maintaining strong pricing discipline around all products. We set rates according to the risks we are taking, while also taking into account the profile of qualitied, accessible borrowers. During the quarter, the average Beacon score on new Alt-A origination was 707 compared to an average Beacon of around 680 at the end of 2016. Average Beacon for our A mortgage was over 750, which also trended higher.Overall, while improving credit quality is one driver of reduced net interest margin, the second driver is the mortgage pricing increases have not kept pace with the increased cost of deposits in the current rising rate environment. Mortgage rate increases have lagged GIC and Bank of Canada rate increases, which have narrowed spreads on new and renewing loans. Over time, we expect margins to improve as we continually adjust rates to the normal mean reversion of the spread between mortgage rates and GIC to Bank of Canada rates. There is a lag due to competition that drives the timing difference between GIC and mortgage rate increases.Looking to the second half of this year, our priority remains to grow by adding quality assets and to do so at our targeted spreads. We are encouraged by the recent pickup in sales activity reported in the GTA and Ontario at the end of June and July. It's unclear that this is a short-term trend or it will continue for the remainder of the year. We are confident the fundamentals of the demand for our products in the medium and long term are favorable for our business model.A second area, which we have made progress is our funding diversification efforts and liquidity. Our direct-to-consumer channel, Oaken Financial, at the end of the second quarter, has [ rooms ] a record $2.4 billion in deposits, and [ we find ] increasing the amount of deposits in this channel over time. 92% of the deposits are in the form of GICs. We are constantly innovating within our Oaken platform. For example, during the quarter, Oaken went completely paperless, making information readily available to our clients where and when they want to access it. Oaken is more than a digital bank. We are sourced in Toronto, Calgary, Vancouver and Halifax, because we believe that in addition to digital banking capabilities, our store footprint gives Oaken a significant edge in attracting and retaining larger GIC values.In terms of liquidity, we have significantly reduced our reliance on demand deposits, which enable us to reduce our standby credit facility from $2 billion to $500 million. This was an important milestone and key objective for us. We now have a 3-year $500 million standby facility with BMO and RBC. This facility replace the $2 billion lines that matured at the end of June. We continue to strategically manage and maintain ample and stable liquidity to support our future business plans.A third area of progress is our digital strategy. We started on our plan to build digital and technology solutions that will attract and enhance the customer and broker experience. More specifically, our digital strategy is based on philosophy of providing our customers and brokers with choice. Our view is that the world is changing to allow for more choice and offering to consumers is a necessity in any business. We're also moving forward with initiatives that will provide deposit customers, mortgage brokers and borrowers the ability to choose multiple ways to connect with us. Customers will soon be able to choose whether they want to interact with us online, face-to-face, over the phone and have the mobile ability to check on their products.A fourth area I will highlight is our capital position. At the end of Q2, we continued to maintain a level of CET1 capital in our regulated entities at 23.21%, which provide us with an abundant layer of security. It is clear we must remain focused on our fundamentals and our core business to drive accretive growth. It is also clear that we must make the right long-term capital decision and find the right balance between maintaining prudent capital levels and generating accessible returns on equity for our shareholders. With this in mind, management and the Board of Directors are completely focused on moving as quickly as feasible to an efficient capital structure capital for Home Capital. We're developing a road map to bring this company to the efficient capital structure over the short and medium term. In closing, we are pleased with the strong progress we have made in terms of our originations, funding and liquidity profile and taking steps on our digital journey. We are focused on improving our key short-term metrics and long-term performance metrics, such as net interest margin, our efficient ratio and portfolio growth. With that, I'll turn it over to Brad.

[Bradley William Kotush, Executive VP & CFO]

Thank you, and good morning, everyone. We made some progress in the second quarter and delivered steady origination growth in our single-family residential portfolio. This helped offset discharges to maintain our mortgage loan balances. In addition, we're very pleased with the strong quality of our overall portfolio, which remains healthy and continue to report low losses with the exception of 1 commercial loan that moved to Stage 3 in the quarter.Turning to Slide 7 of our presentation. We reported net income of $29.6 million and diluted earnings per share of $0.37 compared to a significant loss for the same period last year as a result of the liquidity event experienced in that quarter. Sequentially, net income and EPS declined approximately 14% as higher deposit funding and noninterest expenses more than offset higher interest income earned during the quarter. Second quarter net interest income was $84.1 million compared to a net interest loss of $3.4 million last year. However, net interest income decreased $4 million or 4.5% from $88.1 million last quarter. Taking a closer look at income in the quarter compared to the first quarter of 2018, interest income increased $2 million or 1.3% to $157 million from total on-balance sheet nonsecuritized loans. On a total asset basis, interest income grew 3% to $187 million compared to $182 million in Q1. While we're pleased with our steady performance during the quarter, pricing improvements were outpaced by the growth in total interest expense as we are unable to pass on increased funding and deposit costs. This negatively impacted net interest margin, which declined 11 basis points to 1.91% from 2.02%. Year-over-year, net interest margin turned positive from the negative position last year, reflecting $100 million commitment fee related to the establishment of an emergency standby credit facility during Q2 2017 and elevated interest on subsequent draws on that facility during that quarter. We are pleased to have entered into a new standby credit facility of $500 million that replace the $2 million facility that matured at the end of June. This will translate to interest expense savings of over $15 million on an annualized basis resulting in an estimated 10 basis point positive impact on NIM. Over the long term, we would expect both net interest income and net interest margin to start to increase as we grow our book and place further emphasis on pricing improvements. However, we expect to see continued near-term pressure on NIM given the current competitive environment for mortgages and deposits. Noninterest expenses were $55.4 million, a significant reduction from the same period a year ago, but as expected noninterest expenses increased $4 million from Q1 reflecting higher salaries and benefits, partially as a result of adding new employees and net of a reversal of $1.8 million of estimated severance expenses. Turning to our assets. Loans under administration remained essentially unchanged from the end of Q1 at $22.5 billion. Lower origination levels and asset sales starting in the second quarter of 2017 accounted for a 13% decline in loans under administration on a year-over-year basis. Nonsecuritized single-family residential mortgage balances remained unchanged from Q1 at $10.2 billion reflecting increased originations and strong renewals that helped to offset increased discharges during the quarter. We are optimistic that we will see loan growth as we work towards building market share and improve retention.Looking at mortgage production, our third straight quarter of total origination growth was led by our traditional single-family residential business totaling $949 million compared to $870 million in Q1 2018 and $840 million in Q2 2017. Residential commercial mortgages contributed originations of $129 million, while nonresidential commercial mortgage originations, including store and apartment mortgages, contributed $151 million. We have been very pleased with the growth of our commercial loan portfolio, which stood at $1.96 billion, up 14% from the end of 2017 and up 6.6% of Q1 2018. We continue to take advantage of opportunities in the commercial business, which has seen increased demand. In terms of credit performance, PCL in Q2 as calculated under IFRS 9 totaled $6.5 million resulting primarily for 1 specific nonperforming commercial loan included in Stage 3. Total PCL as a percent of gross uninsured loans on an annualized basis was 22 basis points. Our residential mortgage portfolio continues to perform well and in line with historical levels. Overall, strong credit profiles combined with the growing level of higher credit quality originations and a stable loan-to-value ratio continue to support low delinquency rates. Net write-offs were $1.8 million and represented 5 basis points of gross loans compared to 3 basis points in Q1 2018 and 5 basis points in Q2 2017. Liquid assets increased $1.82 billion at the end of Q2 compared to $1.45 billion at the end of Q1 2018 and $1.65 billion at year-end 2017. Total deposits increased 3.4% to $12.5 billion compared to $12.08 billion at the end of last quarter and $12.17 billion at year-end 2017. Of the total $12.5 billion at the end of Q2 2018, demand deposits totaled $411 million and $12.09 billion of deposits were payable at fixed dates. Those included $300 million of deposit notes. Finally, looking at our capital. At the end of Q2 2018, our CET1 capital ratio decreased to 23.21% compared to 23.64% last quarter due to an increase in risk-weighted assets primarily from the growth in commercial loans. And as mentioned by Yousry, it is clear that we are currently running with capital levels well above the company's historical average CET1 capital range. Our capital planning and road map to a achieve more efficient capital structure is a top priority over the short to medium term. With that, I'll now turn it over to the operator.

[Operator]

[Operator Instructions] Your first question comes from the line of Nick Priebe from BMO Capital Markets.

[Nikolaus Priebe, Analyst]

Could you talk a bit about progress on service levels in the quarter and some of the initiatives that you discussed to improve borrower retention? It looks like originations continue to demonstrate a bit of improvement and the books certainly becomes stickier as opposed to large part B-20 revision. But do you feel you are now where you need to be on those fronts? Or do you think there some further in-roads to make there?

[Yousry Bissada, President, CEO & Director]

It's Yousry speaking here. First, to answer the last part of your question it's a journey. We will continuously improve our service. But in terms of what we've done, it's a lot of training, a lot of organizing the process. The sales team has gone out and also trained brokers about what is the kind of deals that we will do, we're very much focused on the broker, the brokers sending us the highest quality deal, one that has the highest probability of being approved, and we have seen the metrics. The ratio of mortgages we see to funding has been going up. And we also survey brokers all the time and it's going up. But as I say, it's a journey. We expect next quarter to be better than this quarter and so on and so on.

[Nikolaus Priebe, Analyst]

Okay. And then one second question from me. I just want to touch on the higher average cost to deposits in the quarter. Given that demand deposits are expected to remain low as a proportion of the overall funding mix. Do you have some visibility on the directionality of the weighted average cost of deposit through the balance of the year? And then as a second question, how would alternative single-family rates respond to that? Do you think there might be a bit of an offset?

[Yousry Bissada, President, CEO & Director]

I'll answer first, and then I don't know Brad may add a little bit. As I think, you're aware, GIC deposit rates are set by Government of Canada rates. So if Government of Canada rates stay relatively steady and GIC rates will stay relatively steady. There is competition within the GIC world of all the people that use deposit agents and bank boards to gain and grow their balance sheet. So if GIC rates move then mortgage rates move. But as I said in my comments, they don't move always sequentially. But as interest rates are going up, the GIC rates tend to move first and then the mortgage rates go down. As Bank of Canada rates go down, the reverse happens. GIC rates go down and mortgages lag, and we get -- we all will get a bigger NIM better in this business. So looking at the next 6 months, we've got ample deposits right now, and we don't have as large a need in the second half of the year as we do in the first half of the year. So I think it will be very steady, but I can't speak to market condition.

[Operator]

Your next question comes from the line of Dylan Steuart from Industrial Alliance.

[Dylan Steuart, Equity Research Analyst]

Just want to prefer a bit more color you guys, specifically single -- the 1 commercial mortgage that went into Stage 3. Just want to prefer a bit more color on the specifics of that?

[Yousry Bissada, President, CEO & Director]

Sure. We had a mortgage that became delinquent, and we've taken additional provisions moved into Stage 3 and have written it down to what we think is our estimate of the net realizable value of that loan.

[Dylan Steuart, Equity Research Analyst]

Okay. And looks like the risk parameters within the commercial mortgages bucket, there was quite a bit of provisioning added to that. Was that specifically related to this loan? Or was there a general view of, I guess, the market commercial mortgages that changed your...

[Bradley William Kotush, Executive VP & CFO]

Nearly, all that was related to the -- sorry, nearly, all that was related to the 1 loan. I'm sorry, I cut you off, I apologize.

[Dylan Steuart, Equity Research Analyst]

No, no worries. And just on the credit side of things. A bit of an uptake in Stage 3 single-family loans quarter-over-quarter. Any specific area that might have led to the increase our just a general uptick?

[Bradley William Kotush, Executive VP & CFO]

It's a general uptick. We are not -- we're very comfortable with our residential portfolios.

[Operator]

Your next question comes from the line of Marco Giurleo from CIBC.

[Marco Giurleo, Associate]

So my first question is with respect to Brad's commentary on NIM. If I heard you correctly, Brad, did you say you expect to see continued NIM pressures throughout the remainder of the year?

[Bradley William Kotush, Executive VP & CFO]

Yes.

[Marco Giurleo, Associate]

Okay. So is that going to be -- what is that going to be driven by primarily?

[Bradley William Kotush, Executive VP & CFO]

It's the competitive environment. I think we -- our ability to raise rates on mortgages is one where we're making maintaining our pricing discipline. There are some new market -- there is a significant new market entrant that has made its presence felt. We can still compete. As Yousry said earlier, we're investing in training, and we'll make some future investments in technology to improve service to our borrowers and mortgage brokers, so that we can also compete on service as well as on price. So that's going to take a while, one reason why we described it as near term, more confident in our ability to raise deposits. We had probably more liquid assets than we would prefer at quarter-end and that was a deliberate choice that we made. You may recall that we had a large inflow of GICs closer to the end of Q2 and through Q3 as we are trying to rebuild our deposit book after the liquidity events, and we funded out in anticipation that we might have had some leakage of GIC deposits, that didn't happen. So we have been less aggressive in some of our pricing on GICs. So that may slightly offset any competitive pressure on mortgage rates. The other thing -- and I'm giving you really long answers, so hopefully, it provides enough component. Yousry spoke earlier that there is a lag. So we may see that our competitors and ourselves have clearly advised us to raise our rates and it may be that others look at the same way and see what the market is able to absorb in terms of price increases.

[Marco Giurleo, Associate]

All right. So bunch of moving parts there. But directionally, you still expect it to be lower in the coming quarters. Is that correct?

[Bradley William Kotush, Executive VP & CFO]

No. I think it's going to be under pressure. So we're -- we would hope that we could maintain it at its current level and to the extent that we're now spending less on our standby facility, we would hope to -- if we're losing anything due to competitive pressure, we think we'll get some back from the lower interest we're paying on the standby facility.

[Marco Giurleo, Associate]

Okay. So that -- yes, that's -- that was going to be my next point. So these competitive pressures should erode the benefit of that -- of the lower standby facility?

[Bradley William Kotush, Executive VP & CFO]

They may.

[Marco Giurleo, Associate]

Okay.

[Bradley William Kotush, Executive VP & CFO]

They may.

[Marco Giurleo, Associate]

All right. And just one quick second question. If I could just touch on the Stage 3 loss rates in the quarter. Is the second quarter now where we see a loss rate on total gross loans in the mid-teen range, that -- which is up from about 7 basis point run rate in 2017 on average. So is this a new normal level for PCLs? Or do you anticipate it to take a step down? I know you called out 1 loan -- 1 commercial loan this quarter. Was it 1 commercial loan last quarter as well?

[Bradley William Kotush, Executive VP & CFO]

That's correct.

[Marco Giurleo, Associate]

Okay. So maybe a bit of color on just your outlook for Stage 3 provisions?

[Bradley William Kotush, Executive VP & CFO]

We don't believe that we have any significant further provisions based on what we know today. There may be some things that happened during the quarter, but our outlook is generally positive on credit. And we have not -- at today's date on this call, we're not aware of any other significant exposures that we're concerned of.

[Marco Giurleo, Associate]

Okay. And sorry, just if I could sneak in one last one. I noticed that the credit card and line of credit accounts were up pretty materially the last 2 quarters, 35% sequentially this quarter. Maybe you could talk about what you're doing with those products and the strategy there?

[Bradley William Kotush, Executive VP & CFO]

We had big influx of applications in relation to our preferred Visa that was featured in a number of credit card blogs because of one of its features which was foreign currency conversion at a lower rate. And we spoke in a couple of -- over the past few quarters, about increased expenditures related to processing that large influx of credit cards. So generally, we had -- most of those applicants had generally higher Beacon scores, and we're comfortable with our exposure there and are quite pleased that we've been able to grow that portfolio. And we have actually had some service issues because of that large volume flow, and we think we've handled that challenge now.

[Operator]

[Operator Instructions] Your next question comes from the line of Graham Ryding from TD Securities.

[Graham Ryding, Research Analyst of Financial Services]

Just the NIM dynamic that we saw this quarter, is it fair to say that there is a few factors involved? You had slightly higher liquidity than you normally would want, you're seeing a competitive market and then you're also seeing some higher credit quality overall. Are these sort of the key factors behind the NIM compression?

[Yousry Bissada, President, CEO & Director]

No. That's -- it's Yousry. Yes, that's pretty accurate.

[Graham Ryding, Research Analyst of Financial Services]

And did I -- just to be clear, I got your message correctly. So after we adjust for the lower backstop facility, you see potential for some further NIM compression? Or are you expecting NIM to remain at this compressed level?

[Yousry Bissada, President, CEO & Director]

At this compressed level is our expectation.

[Graham Ryding, Research Analyst of Financial Services]

Got it. And then could you maybe just talk about renewals. How are you feeling about your -- you talked about sort of making some changes and try to sort of improve your execution on that front. Can you give us maybe a little color there? And then are you seeing any impact on the renewals from B-20 this year?

[Yousry Bissada, President, CEO & Director]

Yes. It's Yousry speaking. Our renewals have steadily continued to increase. Over the last year, measuring year-over-year, our renewals are up 10%, which is very good. We have done some deep dive to try to understand the impact of B-20 on that. And we make about half of the increase, so about 5% is relating to B-20, but it's a very high-level analysis because we don't -- we underwrite. If the client is in good standing, we will renew them. And if we were to underwrite, we don't know the situation if the client has changed. Somebody maybe earning more income. They may not have qualified a year ago under the B-20 guidelines that may have not been qualified because they have got more income or the situation's changed or what have you. So we don't have that deep information behind us. But the way we get that 5% that I just mentioned is we look at our annual rates and what we were steadily getting and then a bit of a bump came in the second quarter. So we're seeing approximately 5% relates to B-20, but not with great certainty. Does that help?

[Graham Ryding, Research Analyst of Financial Services]

Yes. That does. That's great. And then if I could ask one more. Just your comments on capital. How are you going to -- you're looking closely at planning your capital, both for the medium and long term. Can you sort of give us, I guess, a little more color on what does that mean? Like, in terms of what would your capital plan sort of factor in over the short to medium term versus the long term? What are you considering?

[Bradley William Kotush, Executive VP & CFO]

Well, we're considering factors such as potential loan growth, the category of loan growth as you're probably aware, different loans, classes of loans have different risk weighting in terms of capital. So if we place an emphasis on growing commercial, that's 100% risk weighted as opposed to a residential mortgage at 35%. So we have said that we're actively looking to grow -- we sold $1 billion of commercial that closed in Q3 last year. We love to replace that. And so we what we want to do is be forthright in our planning and making sure that we're adequately capitalized for growing our loan book to the extent that, that doesn't happen over the sort of the next few months, then we may make some other decisions. But obviously, as we've said, our plan is to grow our loan book, and in that case, we would require some of those capital. There'd also presumably be some that'd be available to return to shareholders either in the form of share buybacks or dividends, and we're looking that as well.

[Graham Ryding, Research Analyst of Financial Services]

And so that short-term time line is of sort of end of the year that you would -- you'll make a near-term decision? Or how should we interpret that?

[Bradley William Kotush, Executive VP & CFO]

I think we'll take a number that's -- maybe with our Q4 results, it'll be February where we'll be able to make some positive announcement, more definitive announcement in our capital plans. And maybe slightly earlier than that and maybe later than that. And again, that's going to relate to the trend we see in the ability to grow our mortgage portfolio. So it's a little bit of a moving target, but we want to emphasize that we understand that it's -- in some respect it's a nice problem to have. But we know what -- it gives us a really great foundation to grow our business, but it's also something that we understand that we need to move to a more efficient capital structure, and we need to do that with some degree of urgency.

[Operator]

[Operator Instructions] There are no further questions at this time. Ms. Lepore, you may begin your closing remarks.

[Laura Lepore, Assistant Vice President of Investor Relations]

Thanks, again, everyone, for joining us, and we look forward to talking to you again in Q3.

[Operator]

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