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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Ladies and gentlemen, good day, and welcome to the First National Financial Quarter 4 2018 Analyst Conference. As a reminder, this call is being recorded on February 26, 2018, for replay purposes. At this time, I would like to turn the conference over to Mr. Stephen Smith, Chairman and Chief Executive Officer. Please go ahead, Mr. Smith.
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 remind you that our remarks and answers may contain forward-looking information about future events or the company's future performance. This information is subject to risks and uncertainties and should be considered in conjunction with the risk factors detailed in our MD&A.We were pleased to report fourth quarter and annual results last night that featured steady growth and mortgages under administration, the source of the majority of the company's earnings. First half was solidly profitable in both 2018 and the fourth quarter of the year. Despite record origination volumes for the year, tighter mortgage spreads and additional securitization activity, which delays the earnings process, meant lower EPS. In context, this was the company's 30th consecutive year of profitable operations, a track record that demonstrates the strength and durability of our nonbank business model. This profitability is evidenced in our 5-year and 10-year returns on equity at 41% and 43%, calculated using a pre-fair market value EBITDA.As a result of annual performance, together with excess capital generated over several years, the company paid a special dividend in December of $1 per common share. We also increased the monthly dividend at the same time to an annualized rate of $1.90 per common share, another sign of confidence in the company's future.This is the 12th consecutive year of rising regular dividend payment since our IPO 12 years ago, and the First National has delivered $20.92 per share of dividends and distributions to those who purchased ownership at the IPO for $10 per unit. Combined with share price appreciation, we calculate that the total return to IPO investors through to December 31, 2018, was 419%.While increasing the dividend, we have ensured there is good coverage. Excluding the special dividend, the 2018 payout ratio was 68% or 70% if we also exclude gains on financial instruments. We don't consider this revenue to be available for dividend payments.Looking at market conditions, 2018 appears to have marked the turning point, of sorts, in house prices and activity levels brought on by the cumulative effect of several years of government interventions and 3 separate increases in the central bank rates. While adhering to new underwriting requirements, First National's single-family team worked hard to provide good service to broker partners and borrowers and was rewarded with strong growth in originations and even stronger renewals. Through the full year, new single-family mortgage originations increased 10% while single-family mortgage renewals growth was 17%. We have expected the renewal rates to improve as a result of government policy changes that make it more difficult for borrowers to switch financial institutions, but by the same token, we had sizable renewal opportunities to work with. In the fourth quarter single-family mortgage renewals were 18% higher than 1 year ago while single-family mortgage originations were unchanged at $2.8 billion, in our view, a strong finish to the year.Underlying this progress was a good contribution from our Excalibur program. As you will recall, we have reintroduced this alternative mortgage program last spring to meet demand of self-employed and other creditworthy borrowers who find them outside -- found themselves outside traditional lending guidelines. Although we have initially limited the Excalibur program to the Ontario market, 2018 volumes surpassed our expectations, and we find this very encouraging and a validation of this growth strategy, financially originated Excalibur for placement with our institutional funding partners and earn a onetime placement fee and servicing income over the mortgage terms. In our Prime business the Toronto and Montreal regions were the growth leaders in 2018.Our National commercial team also did a great job. For the year, commercial originations grew 8% while commercial renewals were up 19%. The trends through the end of the year were also positive with Q4 commercial segment originations up 12% and renewals more than doubling from 2017 levels. While First National benefited from strong commercial market activity, our opportunity pipeline also grew in 2018 as we developed deeper, more meaningful customer relationships and invested in our regional teams. As Canada's largest commercial mortgage lender, First National participates across a number of commercial asset classes, providing real estate financing at every project stage. The breadth of our offerings and ability to make the right underwriting decisions served us well.Overall, 2018 was a productive profitable year and a great way to mark the company's 30th anniversary. I sincerely thank our customers, business partners and First National's 987 employees for making it so. Speaking on behalf of the management team, I will say, we look forward to building on First National's strong foundation in 2019 for the benefit of all stakeholders. Rob will now walk us through the key financial metrics before Moray presents our outlook. Rob?
Thanks, Stephen. Good morning, everyone. I'll focus my remarks today on Q4, although we encourage you to review First National's annual performance, which is the most meaningful measure of progress. Despite fourth quarter market seasonality, MUA grew 5% from September 30th to December 31st on good origination and renewal levels in both business segments. As a result of growth throughout the year, in the final quarter, MUA reached $106.2 billion at year-end, a new record and up 5% from 2017.Now turning to Q4 revenue, it was $312 million, 15% above Q4 of 2017. As our MD&A describes in depth, there were several changes in revenues during the year that, to a certain degree, also affected Q4, and these included the rising interest rate environment and the adoption of hedge accounting at the beginning of 2018. Looking at the various components of revenue, Q4 interest revenue on securitized mortgages increased 22%, as higher interest rate mortgages securitized in 2018 replaced lower coupon mortgages which matured in the year. Q4 placement fees increased 45% as the company placed $4.9 billion of new origination and renewals with institutional investors compared to just $3.1 billion in Q4 2017.Q4 revenue from gains on deferred placement fees was up 68% on account of higher volumes of multi-unit residential mortgages originated and sold institutional NHA-MBS issuers. Coupled with consistent spreads, Q4 mortgage-servicing income decreased 2% year-over-year as a result of the shift of MUA from third-party MUA for First National's own securitization programs. The company earns net interest margin on the securitization portfolio as opposed to servicing revenue from institutional investors. As the company has increased the amount of mortgages securitized in the last few years, there's been a shift from servicing income to net interest margin. Q4 mortgage and investment income increased 12% year-over-year due primarily to the increase in market interest rates. Notably, we earned higher interest rates on mortgages warehoused prior to securitization. Moving now to Q4 earnings performance. Tighter mortgage spreads and the trend towards increased securitization resulted in a year-over-year decline in net earnings of $0.22 a share. However, earnings available to common shareholders continued to exceed regular common share dividend payments with the Q4 payout ratio of 90% or 72% against pre-fair market value EBITDA. Pre-fair market value EBITDA for the quarter was 9% lower year-over-year due to tighter mortgage spreads and to some extent the outcome of shifting mortgages to securitization programs, which delays the earnings process, although one could argue that it is economically superior in the long run.A couple of final comments on our operations. First National continued to operate very efficiently and productively. For the year, salaries and benefits expense increased by just 2% while overall headcount was up 5% over 2017. Reinvestment in the business and in our technology in support of growth and to maintain service levels was disciplined and targeted. Now here's Moray with our outlook.
Thanks, Rob, and good morning, everyone. While as you've heard, we are pleased again with the results of 2018, which were delivered against the backdrop of changing dynamics in the residential mortgage market. To my mind, the company performs -- performance illustrates the advantage of having a large, diversified presence that includes the commercial mortgage market as well as the benefit of servicing all the new originations we secure. Borrower retention is a very important factor in our ongoing growth, and by providing good service to the initial term of every mortgage, we hope to earn the opportunity for a customer renewal. As we look ahead, I would describe our outlook as cautiously optimistic. Let me take these 2 words in order: caution comes from the fact the economic concerns arose in November that caused equity markets to sell off and credit spreads to widen. We've seen a rebound of sorts in equity market since then, but events like this can sometimes be a harbinger for volatility; that is a reason for caution. Our optimism comes from the fact in the short-term, the consequences of spread widening may be beneficial to First National. That's because we use government-sponsored funding programs, including NHA-MBS and CMB and we expect these sources of fundings to remain liquid and to outperform other debt instruments.In addition, while the yields on underlying mortgage government's bond benchmarks have fallen, mortgage lenders have shown discipline in the fact of an uncertain economy and as such, mortgage coupons have not fallen to the same extent. The consequences of wider spread between interest rates on the prime mortgages and the cost of CMHC-sponsored funding sources despite increased credit spreads. If they persist, these circumstances will generally provide the company with a greater securitization margin in 2019, than those recorded in 2018. This is a good reason for some optimism. In fairness, it's not clear how long this environment will last and whether competitive pressures will reduce these margins back to levels experienced in 2018, hence our cautious optimism.Overall, I would say, we are confident that First National's strong relationships with our mortgage brokers and our diverse funding sources will continue to set the company apart from the competition. And as we all are saying, including our prepared remarks and our outlook, we take confidence from the fact that we will continue to generate income and cash flow from our $30-billion portfolio of mortgages pledged under securitization and our $73-billion servicing portfolio. In 2019, we'll continue to focus on the value inherent in our significant single-family renewal book. In closing, 2018 was a positive year for First National, and we will continue to apply proven customer-focused strategies to deliver good results. This concludes our prepared remarks. Now Stephen, Rob and I will be pleased to take your questions. Operator, could you please open the line for questions?
[Operator Instructions] Our first question comes from Nik Priebe with BMO Capital Markets.
I wanted to start with a question on the funding mix. I noticed that the mix shifted somewhat considerably towards institutional placement versus securitization in the fourth quarter, which, as you alluded to, coincided with a period where spreads were widening, and thus, I would've thought increased the relative attractiveness of securitization versus institutional placement. Could you give us a little bit of insight on the funding mix there? Whether it's higher institutional demand in the period or because you might have been approaching the tier-pricing limit for government-sponsored securitization?
I think you identified the answer. We looked at -- we ran into the tiered-pricing limit, so I think the tier is $9 billion. And once we get to that it starts to become more attractive to sell them institutionally. So that's why there was an increase in sales in institutions near the end of fourth quarter.
Okay, that's helpful. Just generally speaking, is there -- like do you see a higher level of demand for institutional placement in periods with higher credit spreads, just given the economics of those mortgages?
No, we don't see a correlation.
Okay, okay, and then just wanted to ask about the Excalibur product as well. You, kind of, alluded to the strong contribution that you've had since the relaunch this past year. Can you, kind of, quantify that for us? Like what proportion of maybe new single-family origination it might have represented in the fourth quarter?
I don't have fourth quarter number but for the year, we did about $650 million. And I don't know how much that was in the fourth quarter Excalibur plan.
Okay, that's helpful. And then -- and what about the timeline there on expansion of that product outside of Ontario? Is that something you will be undertaking early in the new year here?
No, I don't think so. I think we still think there is a lot of room in Ontario. What we -- I think we've been actually a little bit very pleasantly surprised that from a standing start in May that we're up to $650 million, and it's really played, I think, to the depth and strength of our broker relations and our distribution platform that we were able to arrange that platform. So I think what we're doing at this stage is we're just putting some more time into getting more investors. We have not been in the Alt-A program for quite a number of years, and we only wanted to get back in when we felt that there was enough liquidity. Know we're seeing quite a bit of liquidity coming in. So I don't think we will have a plan to go outside of Ontario at least in the first half of the year.
Our next question comes from Geoff Kwan with RBC Capital Markets.
First question I had was the renewal rate that you would've had, generally speaking, pre B-20, like what would that have looked like? And then as a result of B-20 last year, how much would that have probably increased?
Oh, I don't think -- I think this whole issue, generally, particularly, in the press, about borrowers not able to move, it's a little bit of a red herring at the margin. People won't [indiscernible] we would -- I don't know that we actually measure that there was a significant increase because they tend to bounce around for various reasons. So I don't know we can say -- doesn't go up 5 points or anything like that. And the other thing, just as a flip side, at the same time people aren't moving, that means you're not getting people coming in. So I think the whole thing is just a wash. I think the criticism with respect to people not being able to move, more is a reflection of probably originators feeling that it's affecting their business opportunities than a real problem.
Okay. On the commercial side, the increase year-over-year, how would you kind of dissect like what the driver is? Was it just the market was bigger and you participated in it? I know that you've been investing in it a little bit more, but maybe some color there. And also when you look out to 2019, like what is the strategy is? Is it kind of continuation of that investing, to do even more this year than you did last year?
Definitely, with the government being very encouraging of new rental projects, we're definitely seeing the biggest increase of new construction in rental projects in Canada probably we've seen in 30, 40 years. And with the cost of those -- the size of the mortgages that we're doing, the size of these projects are a lot larger than the typical mortgage size we would have seen over the last 5 years. So I think, just there's been so many new apartment construction right across the country, and also just a size of the loans because of the cost of building these days has really added to the market. We've been a leader in that apartment building lending market for years and years. So we're just sort of benefiting from all the work that we've put in over the last 5 or 10 years.
Another thing I'd add there, Geoff, is that we've invested heavily in terms of beefing up our teams in the West and in Québec and I think in terms of having invested in strong relationships with the borrowers and investors over the past decade. So I think we're seeing the benefit of that. So we're getting not only is the market good, we're also benefiting from the increase in market share.
I think on the profit side too, because the spread is simply based on the price of CMHC our markets stay pretty consistent and have been pretty consistent over the years.
And you were talking about a lot of that, Moray -- a lot of the growth -- or a significant chunk is coming from the new rental projects and your historical kind of strength there. Is that maybe also too like you're getting these -- in other words like from bank competition standpoint, how much are you seeing that? And how much might that impact your ability to grow this business in 2019?
Well, I would say that we are the leader in this business. I think we have close to 40% of market share for CMHC apartment buildings. And we should be one of the few companies that are really putting a lot of effort into understanding this, understanding affordable housing, working with CMHC, working with the government to help sort of grow this program. And we see this will be a big growth provider for First National in the next coming few years. Because construction cycle is usually about 3 years, so we are doing the construction financing on it and that will lead to the take up of financing 2, 3 years down the road.
Great, okay. And last question I had was, I think the MD&A gave the 2018 year-over-year -- or I guess the originations by your various offices. Are you able to give us what the Q4 year-over-year numbers would've been for those offices?
I think Geoff -- it's Rob, I think most of them, in a quarter as for the year, I mean, the calendar year is flattish to low. [ Vancouver ] has had some issues, whereas Montreal [ was strong ] the entire year. So I think those are the same percentages in growth or decline are the same [indiscernible].
[Operator Instructions] Our next question comes from Graham Ryding with TD Securities.
Maybe I could just start on the single-family side of the market where we're seeing some softness out in BC, Alberta and then also the new single-family space in Ontario has been weak for new houses. Where are you sort of more cautious with your lending going in 2019?
Yes, I would [indiscernible] seen new homes going down, but we would think that we would have -- we'd look at being the originations on the single-family side as being flat for the year, maybe up slightly because of Excalibur. But we're not seeing big drop-offs. It's -- although -- sort of to your point, it's not like you're looking out there and you are thinking a huge degree of softness in the market going forward. But we feel comfortable that the originations will be comparable or a little bit higher than last year.
Okay, and on that Excalibur product, it sounds like the traction you've got year-to-date, which has been pretty strong, is that you're leveraging your relationships with the brokers and that you now offer more than just Prime products? Is that the big driver here? Or are you -- is there any sort of difference between your turnaround time, your underwriting, your rates, your broker fees? Is there any sort of competitive dynamics that are giving you advantage on that front?
We would try to be -- we're competitive. I don't believe we're below the market. I think we're at the market. I think what we do benefit from here is we just have a high level of service that we've tended to bring to the broker market; people like dealing with us for that reason. So to the extent that you have -- we have, let's say, rewards programs that we give to brokers, to the extent that they can send us a transaction, if they're a prime broker and they also have occasional Alt-A deals, small Alt-A deals, that's a little bit of an attraction to get you that benefit of the First National level of service. I think all those reasons have helped us achieve some degree of success in that market.
Okay, great. Jumping to your net interest margin, there is a little bit of compression this year. My model suggests you're sort of running in the high 40 basis point range. Is that a reasonable run rate do you think looking out of the next year or so? And then the new mortgage spreads have seemed to have widened out. What sort of margins are you adding to your securitization book year-to-date?
So I guess what we would feel about margins going ahead with credit widening and we -- I guess, we tend to look at the price setters in the marketplace tend to be [indiscernible]. And when they look at what their marginal costs of funds are, their senior deposit notes or bail-in notes tend to be the determining factor in determining those spreads. Those have widened out quite a bit and they have widened up quite a bit wider than NHA-MBS widened them. So we feel that we are getting wider spreads. So although we have had spread compression for a couple of years, we feel that spreads will start to widen out or they have -- certainly, at this point, they've widened out by about 20 to 30 basis points. Now could they compress again, I suppose they could. It's a competitive market out there, but we're certainly much more encouraged about spreads than let's say we were this time last year and maybe 2 years ago. So we would think -- we're cautiously optimistic that we would think NIMs on new business that we put on will be 20 to 30 basis points wider. And of course, that's over 4- or 5-year period. So it will start to have an impact on our NIMs for this year and then years going out.
Okay, that's helpful. My one last question, just mortgage investment income. There is a portion that is related to interest income that you earn out from warehoused mortgages and then there's a portion that I believe comes from your commercial mortgages on your balance sheet. Can you give us an idea of what that split is?
Off top of my head, no. I would say, the bridge loan, I would just say more is an earned on average in terms of coupon.
Are you just talking about sort of what percentage are commercial or what are single-family residential? You're talking about spreads?
Mortgage investment income line is driven by a couple of pieces. You've got on balance sheet mezzanine commercial mortgages. And then you've also got interest income that you earn from your mortgages that you warehoused before you [indiscernible]. So I'm just trying to get a feel for what's the bigger driver there? I'm assuming it's the latter, but to what extent?
Well [indiscernible] the commercial mortgages everyone that goes on there is done at a fairly good spread. The single-family mortgages are not the same sort of spreads because we're funding over short-term cost of funds.
I think to your question, Graham, I think, nobody here at the table knows what that number is because it's not -- we tend to look at as the line and we tend to look at it as an item so we couldn't -- I don't know that we can give you the breakdown [indiscernible]. We could offline.
[indiscernible]
Mr. Smith, at this time, there are no other questions. So back to you for closing comments.
Thank you, operator. That concludes today's event. We look forward to reporting our first quarter results in late April and hosting our Annual Shareholders meeting on May 8 in Toronto. Thanks for taking part in our call and have a great day.
Ladies and gentlemen, that concludes this morning's presentation. You may disconnect your phone lines and thank you for joining us this morning.