Description

Investment Thesis

First National Financial Corporation (“First National”) is Canada’s largest non-bank originator, underwriter and servicer of mortgages. First National has over C$90 billion of mortgages currently under administration – yet few institutional investors in Canada or the United States are familiar with the company and its unique business model. Significant insider ownership, a self-funding business model and the company’s small public float have led to limited institutional coverage from the “buy-side” and “sell-side” communities in Canada. As a result, many investors wrongly group First National with other alternative lenders – but the company is not a bank or lender in the traditional sense; rather, First National is an originator and servicer of mortgages with virtually no credit risk. Regardless, First National’s stock price has suffered from the negative sentiment associated with Canada’s mortgage finance industry in recent months. At today’s valuation, First National’s stock presents a compelling investment opportunity with material upside driven by both rising EPS and P/E multiple reflation. 

Background
First National was co-founded by Stephen Smith (current Chairman, President and CEO) and Moray Tawse (current Executive Vice President) and became a public entity in June of 2006. The company was originally listed as an Income Trust, but regulatory changes in Canada resulted in a conversion to a dividend paying corporation in January of 2011 (TSX: FN). Stephen Smith and Moray Tawse hold 24MM shares and 22MM shares, respectively, of the company’s 60MM outstanding shares – meaning they collectively own 77% of the total shares outstanding. The co-founders have been able to maintain significant insider interest because First National enjoys the benefit of a self-funding business model. The company has issued no shares from treasury since the January 2011 conversion to a corporation.

First National sources two different types of mortgages. Single family residential mortgages are sourced almost exclusively through independent mortgage brokers and from the company’s existing customer base. Multi-unit residential and commercial mortgages are sourced largely through First National’s experienced in-house mortgage underwriters who are employees. First National funds the mortgages it originates primarily through institutional placements as well as a diversified range of securitization alternatives. First National then earns a monthly servicing fee based on the value of its mortgages under administration, depending on the size and type of the mortgage. The value of First National’s mortgages under administration has grown from approximately $835MM in 1997 to $90.1BN as at June 30, 2015, representing a CAGR of approximately 30% over the past 18 years.

To properly frame the investment opportunity it is worthwhile to outline a number of potential misconceptions that market participants tend to have about First National and its business model.

Misconception #1: First National is like a bank or non-bank lender and its mortgages under administration (“MUA”) are susceptible to credit losses (e.g. TD Bank or Home Capital Group)

First National originates and underwrites mortgages like a bank, however, unlike a bank the company holds no residual credit risk. An excerpt from the 2014 AIF illustrates this point well: “Approximately 99% of First National’s mortgages under administration are funded through sources that result in no residual credit risk to First National.”

First National focuses predominantly on prime single-family and multi-unit residential mortgages, as well as commercial mortgages. When First National originates mortgages it typically sells the mortgages (as a pool) to institutional buyers such as pension funds and insurance companies – or securitizes the pool of mortgages itself via a Canadian Mortgage Bond (“CMB”), a National Housing Agency Mortgage Backed Security (“NHA MBS”) or other securitization vehicle. In either instance, First National is passing on all residual credit risk. It is also worth noting, First National predominantly originates mortgages that are fully insured by qualified mortgage insurers such as the Canadian Mortgage and Housing Corporation (“CMHC”). 

Misconception #2: First National’s earnings are highly dependent on home prices continuing to rise – so the company will be negatively impacted by the long-anticipated correction in Canada’s housing market.

Although rising home prices have certainly represented a tailwind to growth over the last decade, First National’s origination volumes are driven by a number of factors, including:

·          Home Prices: The average home sale price in Canada has risen at a ~5% CAGR over the last 35 years. The corrections in 1990 and 2008 each reflected ~5% declines.

·          Resale Volumes: Canada-wide, units transacted have increased at a ~4% CAGR over the last 35 years driven by steady population growth from net immigration. The largest corrections in 1990 and 2008 both experienced ~10-20% declines. However, in 2008 First National’s originations actually grew 9% due to increases in size of the overall broker channel as well as market share gains in the channel as smaller players exited the market.

·          Broker Channel Market Growth: First National originates mortgages through the broker channel (as opposed to Banks who originate mortgages via their branch network). In 1999, the broker channel accounted for only ~14% of all mortgages originated in the country. By 2012 that number was approaching ~40% and continues to grow.

·          Market Share Gains in Broker Channel: First National is the second largest mortgage originator in the broker channel and the largest independent originator. First National has seen experienced material market share gains over the past decade. Independent data from D&H indicates First National currently has ~12.8% nationwide market share – second only to Scotiabank at 17.4% market share (both figures as of June 30, 2015).

On the recent Q2 2015 earnings call, in response to a question regarding the company’s susceptibility to drop in housing activity, Chairman, President and CEO Stephen Smith outlined that a 20% drop in originations would “result in a 5% drop in our EBITDA before we make any adjustments to the staff or expenses.” Given the underlying factors that drive origination levels in Canada and the magnitude of historical housing corrections, we would characterize a greater than 20% drop in originations to be a relatively low probability event. Back in 2008 when housing prices and mortgage volumes were off materially, First National’s originations grew 9% and EBITDA grew 48%. Conversely, in 2013 when housing prices and mortgage volumes were up modestly, First National’s originations were flat and EBITDA grew 29%. Simply explained, the company’s operating model is much more stable and defensible than the share price implies.

EBITDA and earnings growth are possible because First National’s mortgages under administration continue to grow as long as originations and renewals outpace the portfolio run off. In 2014, originations were $16.2BN, renewals were $4.7BN and runoff was $10.6BN. First National has a large and growing pool of mortgages ($90BN and counting) to drive renewal volumes – renewals also offer superior unit economics given there are no broker fees to pay.

First National’s renewal opportunities are positioned to increase materially in 2016 and 2017 because strong origination volumes in 2011 and 2012 are coming due for renewal (5-year term average). We do not believe the market understands or appreciates the inherent protection these renewals provide from a potential decline in new originations if/when the housing market corrects.

Importantly, less than ~20% of all origination volumes are from Western Canada with less than ~15% of origination volumes from Alberta. As such, First National is not materially exposed to the challenges the Western Canadian housing market may experience given current oil prices.  

Misconception #3: First National has exposure to “shady” mortgage brokers and the company is highly susceptible to fraudulent practices (e.g. false statements of income).

First National addressed this issue on the Q2 2015 earnings call (July 28, 2015) by outlining a number of relevant facts: i) First National partners only with “A brokers” which are of the highest quality in the industry – a practice which has led to a record of industry-lowest arrears rates, ii) First National maintains what they believe to be the industry’s tightest practices with regards to quality assurance on underwriting processes and audits, iii) First National has never done any business with the broker population which Home Capital Group disclosed challenges with; and iv) First National announced (and is rolling out) a partnership with TD Bank to underwrite and service mortgages for all TD Bank’s non-bank originated volume. This contract is a testament to First National’s market leading platform for efficiency and quality assurance (not to mention earnings growth).

Misconception #4: Shares are currently yielding over 7%, so the dividend must be at risk.

First National has increased the dividend in each of the past 3 years. The current YTD payout ratio represents a conservative ratio of ~75% on earnings before changes in hedging instruments. We would expect a dividend increase is very likely in the next 6 months – irrespective of what happens with the broader Canadian housing sector.

The excerpt which best summarizes the company’s cash flow profile and flexibility to increase the dividend is on page 17 of the recent Q2 2015 MD&A: “Based on cash flow received in the second quarter of 2015, the Company will receive approximately $90 million of cash, annually, from its servicing operations and $137 million of annually cash flow from securitization transaction spread and deferred placement fees receivables. Together, on an after-tax basis, this $167 million of annual cash flow would be more than sufficient to support the annual dividends of $90 million on the common shares and the $4.65 million on the preference shares. Although this is a simplified analysis, it does highlight the sustainability of the Company’s business model through periods of economic weakness.” The $167 million in annual cash flow equates to a ~14% cash flow yield based on the recent share price of $20.00.

Financial Profile

First National generates revenues primarily from three sources: (i) one-time placement fees from the sale of mortgage pools to institutional investors, (ii) on-going interest margin on mortgages First National has securitized, and (iii) on-going fees for servicing mortgages.

Mortgage placements with institutional investors have a number of positive characteristics including:

·          institutional investors acquire the obligations and entitlements of the mortgages at the time of the commitment and assume any interest rate risk associated with the commitment period (being the exposure to changes in interest rates between the commitment date and funding date on fixed rate mortgages);

·          all of the income earned from institutional placements, other than future servicing fees, is received in cash at the time of placement;

·          placement fees received tend to be consistent over a range of capital markets conditions; and

·          institutional investors generally have substantial ongoing demand for residential mortgages and First National has strategically cultivated mutually beneficial relationships with a select number of institutional investors for the placement of mortgages.

Securitization involves selling mortgages to into a securitization vehicle, which buy the pool of mortgages and then issue interest bearing mortgage backed notes or ownership certificates. First National retains the entirety of the mortgage spread on each transaction, which is collected on a monthly basis over the life of the instrument. Currently, First National participates in four securitization programs: NHA-MBS, CMB, ABCP and CMBS.

First National then services virtually all mortgages generated through its own mortgage origination activities and also earns revenue based on a percentage of the mortgages it services for third parties.

First National also uses short Government of Canada bonds (together with repurchase agreements to create forward interest rate contracts) to hedge the interest rate risk associated with fixed rate mortgages originated for its own securitization programs.  These gains or losses are recorded in the period in which the bond yields change; however, the offsetting economic gains or losses are not recorded in the same period. As such, it is more accurate to assess First National’s EBITDA and earnings on a pre-fair market value or “core” basis which eliminates the impact of gains and losses on these financial instruments which can swing materially between gains and losses quarter to quarter.

Key expense items include fees paid to the brokers based on the volumes they originate for First National, internal salaries, and interest expense on the interim credit facilities used to warehouse a portion of the mortgages it originates prior to settlement with the ultimate investor (institution or securitization vehicle).

Importantly, in a given quarter First National’s management has the flexibility to either place a mortgage with an institution or securitize the mortgage, depending on which alternative provides better unit economics as determined by current market conditions. Management has historically placed a majority of mortgages with institutional buyers, but more recently has taken advantage of a favorable funding environment to securitize a greater portion of originations. Between 2008 and 2013, management placed ~68% of all originations (on average) with institutions, however, in 2014 the company only placed ~57% of all originations with institutions. This purposeful decision lowered earnings and margins in 2014 given First National received less upfront fee revenue generated from placements to institutions – but no offsetting reduction in brokerage fees paid. The obvious “flipside” of this decision is increasing earnings in future years generated from interest margin on the larger portfolio of securitized mortgages. This dynamic, combined with the continued tightening of net interest margins, led core EPS to decline by ~7% in 2014, despite mortgages under administration growing by 14%. The market’s misinterpretation of this conscious decision is puzzling – but clearly reflects a lack of understanding of the business model. In simple terms, First National made a conscious decision to securitize more mortgages because market conditions would result (ultimately) in superior long-term earnings visibility and cash flow – yet the near term reduction in earnings weighed on the stock.

Key Forecasts & Assumptions

Originations: First National’s originations grew at an 11% CAGR between 2011 and 2014 and are up 8% YTD through June 30^th, 2015. MLS data for July suggests a 3% increase in volumes and 6% increase in prices (year-over-year). Despite the market’s apparent resilience to the recent decline in oil prices and slower economic growth, we are conservatively forecasting that market activity slows in the second half of 2015 and then exhibits a meaningful decline in 2016 and 2017. The result of this outlook equates to origination declines of 10% in 2016 and 5% in 2017, before beginning to recover in 2018. We are also forecasting that the percentage of originations that management chooses to securitize falls back towards the long term average of 30%. Under this base case scenario, MUA growth slows to 8% in 2016 and 6% in 2017; notably, this lower level of originations paired with renewal volumes continues to outpace runoff.

Net Interest Margins (NIMs): The net interest margin (NIM) on the securitized mortgage portfolio is a key determinant of earnings for First National. The NIM represents the spread First National captures between the interest they collect on securitized mortgages and the cost of funding the securitization vehicle. A proxy for the NIM spread is the difference between the average posted 5-year mortgage rate and the yield on a similar term Government of Canada bond. During the credit crisis of 2008, this spread ballooned to as high as 3.46%, but has since steadily declined to pre-crisis levels in the range of 1.5% to 2.0% (while this remains a useful proxy, more precise spread data can be pulled from CMHC databases). The combination of higher spread mortgages rolling-off and the addition of mortgages at relatively tighter spreads has led to First National’s NIMs declining from 82bps in 2011 to 58bps in 2014. This compression of spreads has reversed in the recent quarter, reflecting an end to the roll off of high margin mortgages. Despite this recent expansion, we conservatively forecast that NIM spreads finish 2015 lower at 51bps and decline further to 49bps in 2017, before recovering by 1bps per year thereafter.

Placement & Servicing Fee Revenue: In 2014, placement fees received from institutional buyers as a percentage of originations placed and servicing fees as a percentage institutional MUA both declined due to changes in unit pricing and product mix. In 2015, both have increased closer to historical levels. We conservatively forecast these items will again contract in 2016, with servicing fee tightening offset by the new third-party servicing agreement with TD bank to provide underwriting and fulfillment processing.

Valuation

First National’s share price trades on a multiple of its EPS as core earnings are a fairly accurate measure of cash flow and the basis for the dividend. The shares have historically traded in a fairly tight band between 8.5x and 10.5x NTM core EPS, or an average of 9.6x. Shares are currently trading below historical levels, due to i) a decrease in forward earnings expectations as competition and regulatory change drives a tighter NIM environment and ii) strong negative sentiment towards the broader Canadian housing market, which has pulled down the multiples of “alternative” lenders to all-time lows, who many view as comparable companies to First National.

At the September 2^nd closing price of $20.00, First National’s shares are trading at 8.6x NTM consensus analyst core EPS. If we assume that the multiple does not reflate, and that 2016 core EPS is in-line with the consensus analyst estimate of $2.74, the shares would trade to ~$22.00 by the summer of 2016. Including the 7.5% dividend yield, this equates to a 1-year total return of ~20%.  Assuming a more favourable scenario, where NIMs remain at YTD 2015 levels and origination volumes remain flat, 2017 core EPS would be ~$3.00; if the multiple moves in-line with the long term average of 9.6x NTM, the shares would trade above $26.00, equating to a 1-year total return of ~40%.

Risks and Considerations

First National has a number of risks (and mitigating strategies) to be taken into consideration:

·          Reliance on short term funding (to warehouse mortgages before sale to the ultimate investor) and long term funding (the array of securitization vehicles) top the list. Importantly, the proper functioning of capital markets, the demand for mortgage backed securities and the regulatory environment will determine the supply and price of funding sources. Management has shown a remarkable ability to adapt to the prevailing market environment and secure appropriate sources of financing.

·          A high concentration of institutional buyers is another risk – with the largest buyer representing 37% of all placed originations in 2014. However, management views these relationships as long-term strategic partnerships.

·          Susceptibility to changes in the interest rate environment, specifically Government of Canada bond yields and mortgage rates which drive the NIM that First National captures on its securitization portfolio.

·          Limited public float and resulting low liquidity make it difficult to move into and out of sizeable share positions.

·       Housing market activity and pricing levels, which are at elevated levels in a number of First Nationals core markets, are susceptible to a correction which would impact origination levels and the resulting growth rate of MUA

·          Investor sentiment towards the Canadian housing market generally, as well as troubles with specific mortgage lenders, could continue weigh on the P/E multiples of all publically listed mortgage companies

Catalyst

The catalyst is the market's recognition of First Nationals ability to generate double digit core EPS growth in 2016 and 2017, even under a scenario of "challenging" market conditions.  This forecast EPS growth will also allow management to increase the dividend early next year, signaling to the market their belief that earnings are sustainable.  As investors distinguish between the alternative lenders and First National, the currently depressed P/E multiple could also rise, leading to a re-rating in the share price.