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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good morning, ladies and gentlemen, and welcome to First National's Third Quarter 2019 Analyst Call. [Operator Instructions] This call is being recorded for replay purposes on October 30, 2019, at 10 a.m. Eastern Time. It's now my pleasure to turn the call over to Stephen Smith, Chairman and Chief Executive Officer of First National. Please go ahead, Mr. Smith.
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. We're very pleased with third quarter results. Mortgages under administration, the source of most of the company's earnings, grow to a new record of $110.6 billion, a 4% annualized increase in the quarter itself and 5% higher than last year. Growth in single-family originations, wider mortgage spreads through most of the quarter and a shift in our funding mix produced record profitability. Taking a new high -- taking a high-level view of our markets. Demand in single-family was shielded by relatively strong economic conditions and lower mortgage rates. We saw good employment figures across Canada. And primarily because of issues set with the border, mortgage rates decreased by about 1% compared at the end of 2018. With its strong share of the mortgage broker market, First National was able to take advantage of these conditions to grow new single-family originations by about $300 million or almost 8% compared to Q3 last year. This growth was broad-based. Every First National office experienced higher volumes. This marks a turnaround -- this marks the turnaround activity in Alberta, a region that has experienced economic hardships over the past few years. Once again, the regional growth leaders in our business were Ontario and the Maritimes, with total origination volumes up about 10% over last year. In Ontario, we continue to benefit from the Excalibur program. It has been successful in meeting the needs of borrowers that are just outside the traditional parameters of our prime mortgages. Despite working under the pressures of summer seasonality, our single-family team continued to excel in service delivery, measured in part by response times. We very much appreciate their ongoing diligence. Looking at commercial originations, they were down by 2% compared to last year at $1.4 billion. Frankly, after a blistering pace of growth in the second quarter of 2019, pause and origination activity is natural in dollar trend. In fact, as Moray will tell us later. Our outlook for this business is positive, as our commercial team continues to bring their industry-leading services to more and more developers and commercial property owners across Canada. Factoring in total renewals of just over $2 billion in the quarter, overproduction was almost $7.7 billion, up about $200 million over last year. Based on the expansion of MUA, operating earnings measured by pre-fair market value EBITDA increased 28%. And $1 per share net income was a quarterly record, and $0.15 higher than Q3 of last year. This performance continued to provide a solid base for dividend payments. During the quarter, we paid $28.5 million in common share dividends, which represents an annualized rate of $1.90 per share, the payout ratio against the net income of 48% compared to 54% last year. I will just remind you that our payout ratio does fluctuate, and it's effective from time to time by the impact of fair value gains and losses on financial instruments. This quarter, those gains and losses did not have a significant impact on the payout ratio, such that it stood at 49% taking into account these revenues. You take note of fair value accounting when thinking about the payout ratio because it does create a timing issue from income recognition. [indiscernible] related news, as you saw from our release last night, the Board authorized an increase to the regular monthly dividend as well as the payment to the special. To take each in turn, the regular dividend will increase to the annualized equivalent of $1.95 per share effective with the dividend payable on December 16. This represents the fifth time in the past 5 years that the Board has increased the regular common share dividends. As for the special dividend, the Board authorized $0.50 per common share. This based on -- they based this decision on the excess capital that First National has generated this year and its view that the company can continue to fund its near to -- near-term growth opportunities from operations. The special dividend will be paid on December 16 to shareholders of record at the end of December. We're very pleased that First National continues to deliver this form of tangible value to shareholders.I'll now ask Rob to provide his analysis of the quarter before Moray comments on our outlook. Rob?
Thanks, Stephen, and good morning, everyone. One of the key storylines so far this year is the change in our funding mix, positive demand. First National increased the amount of mortgages placed with institutional investors by about $1.6 billion in the third quarter compared to last year. Institutional placements increased from about $4.3 billion in the 2018 third quarter to $5.9 billion in 2019. A portion of this expansion was due to overall growth in origination, but majority represented a shift between funding sources. This shift has the effect of accelerating the recognition of our earnings, along with higher MUA and wider spreads, this was a driving force in third quarter performance. Turning now to Q3 revenue. The impact of this funding mix change and business growth is evidenced in several business activities. In particular, placement fees were very strong in the quarter and up 66% over last year. Most of this growth was related to an increase in the volume of mortgages we placed with our institutional investor and customers. Unlike securitization, the company recognizes most of the profit in the period of this transaction. Typically, the return from a securitization is recognized over a 5-year term and shown as net securitization margins. By moving the funding from securitization to placement transactions, First National has accelerated the earnings cycle when compared quarter-over-quarter. Placement transactions on both newly originated and renewed single-family mortgages and associated placement fees also benefited from a quickly changing interest rate environment, the fact that the company does not apply hedge accounting related to its interest rate risk program for our single-family mortgage commit pipeline. Accordingly, any gains or losses with the financial instruments used for this program are recorded in current period income. Any offsetting increase or decrease in the value of the mortgages that transformed to committed mortgages is recognized that the mortgages are either placed or securitized. First quarter 2019, bond yields dropped significantly, which created large losses on the financial instruments that we use to hedge our commitments. However, when these commitments transformed into funded mortgages, the interest rates were significantly higher on those mortgages than what was being currently offered. So in the third quarter, we were able to crystallize the value of those mortgages through these placement transactions. As a result, we effectively recouped some of the losses on financial instruments that we recorded in the first 2 quarters of the year in placement fee revenue this quarter. We estimate the value at approximately $3.6 million. Looking at other sources of revenue. Mortgage servicing income grew 3% year-over-year due to higher MUA. We also experienced 5% year-over-year growth and net interest revenue earned on securitized mortgages due to the growth in the securitization portfolio and the impact of wider securitization spreads should reverse the spread compression we have evidenced over the past 5 years. Revenue from gains on deferred placement fees increased 20% due to both higher volumes of mortgages originated and wider spreads. All told, Q3 revenue increased 13% over last year in spite of a 3% decline in mortgage investment income, which is due primarily to lower commercial segment mortgage loan investments held during the period. As expected, higher revenue meant higher operating costs, including costs related to our workforce. On a year-over-year basis, our total headcount increased 7%. With the higher FTE, our business model and our industry-leading technology allowed us to set -- to operate very efficiently, which is reflected in earnings performance and after-tax pre-fair market value and return on shareholders' equity. In summary, we're very pleased with Q3 growth and performance. Now here's Moray with our closing comments.
Thanks, Rob. Good morning, everyone. Before offering thoughts on our outlook, I'd just like to pick up on something Rob said about our workforce. Based on our growth over the past year, First National now employs over 1,000 Canadians across the country. This is an important milestone for us in our development as a business, and it speaks to our scale as a mortgage lender. And of course, as much we value our technology, it's the people of First National to make all the difference to our customers. Looking at fourth quarter and considering the various moving parts in our business and in the market overall, we remain optimistic for 2 very good reasons: one, single-family mortgage commitments continue to outpace commitments at the same time last year; two, our commercial team anticipates a strong finish to the year based on its current pipeline and origination forecast. As our outlook holds up, we execute well on the opportunity inherent in our single-family renewal book. Our MUA for both single-family and commercial will finish the year at record levels. Before we celebrate, I should note that we continue to face uncertainty with our securitization margins. As you may have noticed, mortgage spreads have been volatile in the past 12 months and in fact, tightened towards the end of the quarter compared to where they were at the start of the quarter. Looking beyond Q4, it's too early to provide a detailed outlook for 2020. But I would say that the fundamentals of our business remains strong. We have a leading position in the mortgage broker channel and excellent partnerships on the funding side with our commercial borrowers. These strengths add to our competitiveness as Canadian's largest nonbank mortgage lender and largest commercial mortgage lender. We also continue to enjoy the economic advantage of our scale, scale that now includes a $77 billion servicing portfolio and a $32 billion portfolio of mortgages pledged under securitization. We expect to continue to generate income and cash flow from both portfolios as we move forward. Well, that concludes our prepared remarks. Now we will be pleased to take your questions. Operator, please open the line for questions.
[Operator Instructions] Our first question comes from Nik Priebe with BMO Capital Markets.
Okay. I just wanted to start with a question on the shift in the funding mix in the quarter towards institutional placement and away from securitization. If I look at the first 9 months of the year, I think the volume of mortgages placed with institutional partners is about 40% higher than it was a year ago. That's a pretty substantial increase in demand. I was wondering if you could just give us some insight on why that demand has improved so substantially relative to a year ago. Like, does that have to do with the funding environment and the improvement in credit spreads that make third-party mortgages more attractive to institutional buyers? Or is it more sentiment driven? Just any color on that would be helpful.
Well, I think we've had a little bit of a pop in the amount of mortgages we've originated. We're capped -- we're captive securitizing $9 billion a year on our own account. And if we have insured mortgages beyond that, we can't securitize. So we tend to sell them. I don't think there's any particular magic with that number. It's -- I think at a certain point, as we generate more mortgages, we're probably going to be selling more rather than securitizing.
Okay, okay. And then just switching gears. I also wanted to ask about the dividend announcement as well. I think, as you pointed out, this is the third consecutive year you've announced a special dividend. I was just hoping you could provide a bit of color there on the decision to pay out a special rather than opt for, say, a higher rate of growth for the regular dividend. And also, is this, I guess, now recurring special dividend? Is that something that we should think about as being largely sustainable on an annual basis just provided that the regular dividend payout ratio stays around its current level?
Yes. Well, Nik, I'm always reluctant to give predictions about what we're going to do in dividend policy going forward or promising other dividends. I would say that I think here, as management, we're just a little bit reluctant to increase the regular dividend beyond 70%. I think that's our sort of level that we feel comfortable with. You're quite right. Given that we did $1.25 2 years ago and $1 last year and $0.50 this year, you would think that we could increase the regular dividend. I think we want to err a little bit on the side of caution in terms of making sure we have a regular dividend that to the 70% -- 60% to 70% range and off to the specials rather than just increasing the regular dividend and be in a situation that, let's say, we have an opportunity to invest and we're [indiscernible] our dividends rather than have those funds or be in a situation if we had a tough year and we felt we had to reduce the dividend. So I think we're probably -- I think you're quite right, we're probably being just a little bit cautious in that regard, but I think we tend to be cautious with respect to capital management issues.
Our next question comes from Geoff Kwan with RBC Capital Markets.
My first question was just the relationship you've got with that bank you're doing the outsourcing for. I think it's been roughly now almost 5 years, I guess, since you started doing the work for them. Is there a contract kind of term that it lasts for? And is -- and how the renewal terms are and the potential for renegotiating in terms of that arrangement?
Well, I -- we do have a contract that outsourcing has been very successful. There is a term. And I think we would anticipate that when it matures that there'll be renegotiations that, that contract will be renewed.
Have you had to renew now? And if you haven't, is that coming up in the next little bit? Or is it a pretty long term, initial term?
Geoff, I don't know what we've disclosed. And I think I'm reluctant to say anything that would be out of line what we've disclosed in the actual deal.
Okay. My next question was on the Excalibur expansion. So you're just in Ontario right now. You've talked about maybe coming out to Western Canada. What are the factors that are driving the timing and how you expect the rollout? Is it based on having the institutional investor demand? Is it a view on market conditions? Is it a capacity issue, for example, having the right underwriters in place? Like, what's kind of playing into that thought process?
Well, I -- we're back in now for a year. I think there was one issue just getting comfortable with the underwriting in that. I think second issue would be the band, what we're -- I think what we've seen probably in the last year. We've seen quite a growth in demand for what we would describe as our near prime product. I think you could make a case near prime now was essentially prime about 6 to 7 years ago. So probably the limitation right now would be securing sources of funding that we know we could fund the extra origination that we would generate from [indiscernible] both.
Okay. And when -- and sorry, when you make the reference to assessing demand, was that from the institutional standpoint or just from market? Okay.
From the institutional.
Okay. Just my last question is, you and Moray own, I think, it's roughly 74% of the stock. You guys are collecting, I guess, roughly about $3.5 million thereabouts a month in dividends, excluding special dividends. But from a valuation perspective, stock's trading roughly, call it, 12.5x PE, but you've got an almost, call it, 40% or 40-ish percent ROE.
Right.
The share of liquidity is low. Just wondering like how you think about the ownership level that you guys have in First National and its impact on the valuation multiple as to what investors both currently and have historically put on the shares.
Well, Geoff, what I would say that anyone -- as you will remember, because you covered this when we went public, I think we bought First National at $10 in income trust in 2006 and took in all the dividends. I think it might be one with better performing financial services stocks onto TSC. I think Moray and I have always been long-term investors. I think there's always an issue of -- we're operators, we understand the business well. We're pretty comfortable with our investment. And we happy because we -- I guess, in 13 years, we've sold very limited amount. That being said, I think there's always we've been both been [indiscernible] for 30 years. So to a certain point, there's always the issue whether we have to consider some type of diversification. But that's an ongoing conversation, I think, we've had for 13 years. And we had that conversation 2006, how much should we sell, and we have that conversations at various points. But it's certainly -- we like the model here. We like the fact that vast majority mortgages are insured. There's a limit of credit exposure, and it provides steady ongoing [ continued ] reliable sources of dividends. As you say, 3 -- we're almost $2 a share that we get in dividends, and we've both having just to say $3.5 million a year, plus we've got specials. Not too many investments that give you that type of cash a month -- I'm sorry, $3.5 million a month.
[Operator Instructions] Our next question comes from Graham Ryding with TD Securities.
Just going back to the special dividend. Do you measure excess capital? Like, are you looking at your balance sheet and the position? Or are you looking more at sort of in-year earnings when you're deciding whether to pay out a special or not?
I think what we tend to do is we tend to look at the capital we required to do the business. And I think for the last 3 years, you'll probably see a year-end number and that tends to be in excess of 5. I think last year, it was 5, 25, 30. I think that was the same in '17 and '18. And based on our forecast, we'll probably be in that range. So that was the number we plan to. And then we use the -- relatively speaking, we're fairly under-levered compared to -- I know if you look at the overall balance sheet and it seems quite levered, but in fact, those are all pass-throughs. So if you look at our net debt, which the way we look at is you take our mortgages and inventory, which is essentially cash. This will be sold within 30 to 60 days, and you net out our bank line against that. We sort of look at that as net debt. And relative to our equity, that's usually quite low. So we don't want to over deploy capital into the business. I think what's unique about First National, we -- Moray and I maybe the executives in the business, but we also think like shareholders. So we have no comfortable saying we make 40% ROE. That generates an awful lot of equities. We have a lot of room going forward that if we have any opportunities to either borrow or we could use capital. But if we don't, we don't. We give it back to the shareholders, and the shareholders can do nothing. And I think that's the policy we followed since 2006 of [indiscernible] good dividend policy, and also we pay specials where there's the opportunity.
Okay. All right. That's helpful. And that 60% to 70% payout ratio for the regular dividend, that's based on pre-fair market value EBITDA, is that correct?
Yes, that's right.
Yes. Okay. Your comment on the mix, the funding mix and capacity for $9 billion, I think, is the number you said for securitization. You're trending -- your run rate is below that. Do you always strive to hit that? Like, should we then interpret that Q4, you're probably going to ramp up securitization activity because you have not done as much year-to-date?
I would think that would be fair. And that other comment is, we've raised payout ratio pre-fair market value EBITDA after tax.
After tax, yes. Got it. Okay. Perfect. And then just lastly, the growth in your single-family, what sort of growth are you seeing from your Excalibur product versus the growth from your prime business? I look at that, I think you're up 8% year-over-year in originations. Is Excalibur above that or in line with that?
I think they're both the same. What we're seeing now is we're seeing a very strong -- we're continuing to see a very strong fourth quarter. There's been a bit of a rebound in the -- all the markets in the last 2 or 3 months, in particular, in terms of sales. And those sales are going to be reflected in closings in October and November and December. We're -- I think we're fairly bullish.
Our next question comes from Jaeme Gloyn with National Bank Financial.
First question is going back to capital. I just want to get a sense as to what is the bare minimum level of capital to operate this business. If I think about securitization requiring a certain amount of regulatory capital for CMHC and then, of course, some equity on hand to back warehouse mortgages, mortgage loan investments, things of that nature. So what would be the bare minimum?
I don't know that we've ever -- yes, we haven't done the numbers in that sense. We don't sit there what the bare minimum is. I guess the first number would be 2% of outstandings. But then we -- I don't know. I couldn't address that what the bare minimum of the business would be to operate. To some extent, we have -- we do some mezzanine lendings, so that could fluctuate. So I don't know there's a concept of the bare minimum. It's not like a regulated business. You have Tier 1 capital and you have a mandate. It's sort of a concept of -- actually, now that I'm thinking about it is you could probably run it more or less capital. And then depending whether you run more or less capital, you get a different credit rating. So we could run this leaner, for example, but that maybe the -- if that were the case, the credit rating would probably get dropped on investment grade. We could put more capital in, maybe we'd be upgraded to a BBB higher or a single label. So I don't know per se there's a concept of a bare minimum.
Right. Maybe thinking about it a little bit differently. Given where the capital is today, how much more capital would you need? Like, what are the growth initiatives that are going to require a significant amount of capital that you're going to want to retain some of those -- some of that earnings stream? If I look back to the payout ratios on pre-fair market value EBITDA in 2017 and 2018, they were about 100%. Meaning, you didn't really need to retain any of that earnings stream to fund the business. So in 2019, it kind of looks like we're around sort of the 80% plus level for -- on that metric. I just want to get a sense as to like what could be the big initiatives that's going to suck up capital in 2020 and 2021?
I don't -- I have to say we are going to do some more near prime business that we're going to securitize that produce some capital. But actually, we have a very significant debt capacity. I think that a lot of the initiatives could be funded through debt. So I -- to your point, not too many. One of the reasons that we can -- we tend to be a little bit straight when we look at the -- I think we can look at right now when our thinking has been for the last 3 years, we tend to look at that 5. $500 million number is the type of number we want to maintain. And I don't know that there's a lot of magic in that. Maybe we just gotten used to it. So we're comfortable with that number. And to get more, we tend to -- but if we had to, we'd leave the money in. I think what we tend to do, to some extent, if we have some FMV, or fair market value, losses, we tend to not to pay that out. So we tend to -- and then we tend to do, we look at the absolute number. And however, numbers work out, that's the number we have. We tend to look at is whether we pay out. But we don't see big initiatives that are going to create a lot of capital over the next year.
Right. And that $500 million, you're looking at sort of total equity on the balance sheet?
Yes.
That's right. Yes, right.
Yes. I think the number right now would be, what was it?
I think it's like $560 million before the special. So down about $530 million [indiscernible].
So $530 million. I think it would be $530 million at the end of the year.
Right. One more for me then, just around the other operating expenses, obviously helped out significantly by inverted yield curve or flat yield curve at this stage. Do you have like a little bit of a rule of thumb perhaps that we can think about as the impacts on operating expenses? So let's say, like yield curve is even 10 basis points or 50 basis points, whatever number it is that you're going to have an increase or decrease in other operating expenses as a result?
You guys are a lot more sophisticated than we are. No, we don't. We -- I think treasury -- it's sort of -- it ends up -- treasury comes as case good. Cost of carry isn't so much, and that's a bit of the tailwind. So we don't tend to take our cost of carry for -- because the inverted yield curve is not a cost. So we translate that into a percentage of operating earnings. We don't do anything in that.
At same time, Jaeme, we've lost on the carry between a mortgage coupon and the money we pay the bank inventory [indiscernible] for us. So that's a smaller margin, so you're losing sort of in that and then gaining back on the hedge expense.
At this time, I'm showing there are no more questions. I'll now turn the call back over to Stephen Smith.
Okay. Thank you, operator. That concludes today's event, everyone. We look forward to reporting our fourth quarter results next February. Thanks for joining us and taking part on our call today, and have a good day.
This concludes today's conference call. You may now disconnect.