Earnings Call: Q2 2016

Aug 12, 2016

Good morning, ladies and gentlemen. I'd like to welcome shareholders and analysts to Equitable's second quarter 2016 conference call. We would like to remind you that certain forward-looking statements may be made on this call, including statements regarding possible future business and growth prospects. You are cautioned that forward-looking statements involve risks and uncertainties detailed in the company's periodic filings with Canadian regulatory authorities. Many factors could cause actual results or performance to be different from those expressed by such forward-looking statements. Equitable does not undertake to update any forward-looking statements made by itself or on its behalf, except in accordance with applicable securities laws. This call is being recorded for replay purposes. It is now my pleasure to turn the call over to Andrew Moor, President and CEO of Equitable Bank. Please go ahead, Mr. Moor. Thank you, Michelle, and good morning, everyone. Joining me is Tim Wilson, Chief Financial Officer of Equitable. Our MD&A and the slide deck at eqbank.ca, the company's remarks, contain all the details of our Q2 results. To give deep insight into our strategies for building our franchise, and with that shareholder value, we're planning an Analyst Day for Wednesday, November 16. The second quarter was Equitable's best on record for franchise growth, as gains in market share and successful geographic and business line expansions drove total mortgage originations past the CAD 2 billion mark, 45% above last year's levels. Growth was achieved across the board. Single-family alternative led the way with originations of CAD 953 million, up 49% year over year. As this portfolio is the most critical driver of shareholder value at Equitable, continuous growth that has brought single-family alternative mortgage principal well above the CAD 7 billion mark is important. A pleasant surprise were our commercial lending originations, which grew by 62% to CAD 323 million, the best performance for this line of business in 17 quarters. We're working hard to make growth a consistent feature of our CAD 2.4 billion commercial portfolio and believe our prospects are very positive. On a 32% year-over-year increase in prime mortgage originations, which reached CAD 500 million, securitization financing mortgages under management stood at a record CAD 9.1 billion at June 30. These results reflect the tremendous work our teams are doing in executing on our long-standing approach of delivering exceptional customer service while maintaining high underwriting standards and operating efficiency. My sense is that our entire business is focused on doing the right things to build a better bank. In taking a corporate-level view, we continue to believe that how we allocate capital and price loans, as well as the efficiency of our branches' banking models, are critical elements in building shareholder value. Second quarter earnings amounted to CAD 2.05 per share, a strong showing that fell just a penny short of the quarterly record set last year when results included a per-share gain of CAD 0.10 related to a securities transaction. Also of note when making year-over-year comparisons is the fact that Equitable spent more in this most recent period on strategic initiatives, CAD 2.8 million more than in Q2 of 2015, or a cost to EPS of CAD 0.13. These initiatives, including the launch of EQ Bank, place us in a fantastic spot as the banking landscape evolves around us. EPS grew 20% in comparison to the first quarter, when we incurred $2.6 million or $0.12 a cost to support the successful launch of EQ Bank. This earnings increase reflected profitable asset growth, low losses, and sequentially lower levels of EQ Bank-related spending. All of this is good news. As a result of strong earnings, the bank produced a second quarter ROE of 17.1%, which is broadly in line with our long-term ROE track record, in spite of higher costs to support strategic initiatives, and was well above the average of the big banks for the period. Return on shareholders' capital is the financial metric that management considers to be of central importance in creating shareholder value. I would point you back to the shareholder's letter in this year's annual report that puts that in a broader context. The quarter's results show we are on track with our longer-term goals. On strong earnings and a positive outlook, our board declared a quarterly common share dividend of $0.21 for holders of record on September 15th, payable on October 3rd. This is an 11% increase over the dividend declared at this time last year. While growing our dividend, Equitable has continued to keep our earnings retention rate high and above the rates of the other banks, and our CET1 ratio strong. We believe retaining capital is the right decision for our shareholders while we still have good asset growth opportunities ahead of us. This quarter, we also executed a transaction that transferred the risks and reward of securitized prepayable mortgages to third parties and allowed us to de-recognize $253 million of assets from our balance sheet. This transaction helped the bank to maintain its leverage ratio above target levels. As I mentioned at the outset, alternative single-family lending originations were up 49% year-over-year. While data on the size of this market is hard to nail down with precision, we believe that approximately half of this growth was related to growth in the overall market, while the other half came from market share gains. We exercised discipline in our pricing and credit approaches to make sure we build a prosperous business. Our single-family alternative business has continued to see strong demand in the third quarter, which will continue to support continuing asset expansion. With much of the recent single-family asset growth coming towards the end of Q2, this bodes well for net interest income. Stealing the limelight this quarter is our commercial mortgage lending business, which recently went through a rebranding effort and refined its approach to market with a goal of deepening and broadening distribution partnerships. The results are very promising, as I discussed at the beginning of my remarks. There isn't as much data available on market share in commercial, so it's harder to have complete confidence in the market dynamics that are causing us to have success in building our book. I'm sure of one thing, however, that our teams are doing a great job of delivering the service our customers want and expect, and this is certainly an important factor in our success. The other significant driver of asset growth was securitization financing, where mortgages under management were up 34% year-over-year to $9.1 billion. Once again, performance was pushed higher by the ongoing development of our prime single-family mortgage business. During the quarter, we funded CAD 500 million of prime loans, 32% more than at this time last year. As a result, prime single-family mortgages under management stood at CAD 2.9 billion at quarter end, double the amount of a year ago. Internally sourced prime originations in the quarter were CAD 192 million, with the balance sourced through third parties. As expected, the growth of our internal business is taking time, but we are patient, and progress to date suggests we are on the right track. Active management of our credit risk profile and our workout efforts meant that Equitable's second quarter credit performance was once again best in class amongst Canada's Schedule I banks. Our provision for credit losses were less than one basis point of mortgage principal outstanding, down three basis points from the second quarter of last year. At an aggregate level, net impaired mortgages increased CAD 7.8 million year-over-year. That largely reflected one commercial loan of CAD 7.3 million that is now resolved. Given current economic forecasts, we expect arrears rates and credit loss provisions to remain low for the rest of 2016. In terms of our credit performance in Alberta and Saskatchewan, the MD&A sets out more details of our book in these provinces. We actually saw reductions in both early-stage delinquencies and impaired loans in these provinces compared to the end of Q1. Clearly, this is encouraging data, but we continue to be cautious in these regions that will continue to see rising unemployment and economic stress caused by low energy prices. I will return with closing comments in a few minutes, but first, Tim will provide his report on our margins and expenses. Thanks, Andrew. Second quarter unfolded as we expected, with strong growth in assets and net interest income. Net interest income was a record CAD 67 million, up 10% from a year ago on an increase in our average asset balances in both core lending and securitization financing. NII grew at a double-digit rate despite our net interest margin declining 17 basis points over the past year. Even though margins within our alternative single-family and commercial businesses have been relatively stable over the past year, overall NIM declined because of the continued shift in our asset mix towards our lower-margin securitization financing business. I want to stress this important point. Marginal spreads in the businesses that generate the vast majority of our earnings have been more or less consistent. Outside of the impact of this asset mix shift, NIM was affected to a lesser degree by other factors detailed in our MD&A, including net growth in high-rate EQ Bank deposits, low margins on prime single-family assets originated at certain points in the past year, and a decrease in prepayment income. Sequentially, net interest income was up by 5%, an increase that mirrored the 5% growth in our average mortgage assets. NIM slightly exceeded our expectations as prepayment income and core lending moved up quite substantially and NIM was only down by one basis point relative to Q1. Of note, the NIM in our securitization business was down by about eight basis points in the quarter. This result surprised us a bit, and as we dug into the issue, realized that the NIMs were being influenced downward by some nuances in our calculation methodology. Specifically, we used period beginning and end amounts to calculate average asset and liability balances, and those simple averages might not be reflective of the daily average balances, the ones that drive our reported income and expenses. This disconnect is particularly notable with a portfolio like securitization that involves a number of lumpy intra-period transactions, and as a result, our calculated NIMs have exhibited some surprising volatility. The spreads on the underlying assets were much more stable quarter to quarter than the calculated NIM, using our current methodology would lead you to believe. We will refine our NIM methodology going forward in order to present a more accurate picture of the portfolio's true economics. Looking to the remainder of 2016, our outlook for net interest income is unchanged from the view we expressed on our last quarterly call. That is, we expect that it will increase at low to mid-teen rates as the bank continues to grow its assets. Core lending NIM in the second half of the year should remain around Q2 levels, while securitization financing NIM should expand slightly. With the portfolio mix skewing towards securitization financing due to the growth of our prime business and creating a negative mix shift, we would expect NIM in aggregate to continue coming down, potentially by up to five basis points. Moving on, current growth in the business, as well as investments in support of our key business strategies, led to significant increases in non-interest expenses compared to last year. These increases were planned and we believe create long-term value for our shareholders. Non-interest expenses, excluding the impact of strategic investments, increased 19% or CAD 3.9 million year over year and were 6% higher than in the first quarter. FTE were the primary driver of this growth. We have added about 100 people in the past year and 21 in the last quarter alone. These are increases that are necessary to sustain the high levels of service and the appropriate level of risk management as we grow. Non-interest expenses to support strategic initiatives amounted to CAD 3.4 million, 416% above last year's level, but down 40% from the first quarter when we incurred significant costs to support the launch of EQ Bank. Looking forward, outside of strategic initiatives, we expect non-interest expenses to continue increasing at year-over-year rates in line with the growth of the bank for at least the next two quarters. Higher spending will be mainly driven by hiring. With respect to strategic initiatives, costs will likely be CAD 0.5 million to CAD 1 million higher in Q3 and Q4 as compared with Q2, due to the launch of some new EQ Bank marketing campaigns and continued hiring. As a result of these investments, we expect our efficiency ratio will remain in the high 30s for the balance of 2016. Our capital ratios at quarter end all continued to surpass minimum regulatory standards and most industry comparables, and we expect to continue operating above those benchmarks as we grow. As Andrew Moor mentioned, we entered into a transaction in the second quarter to derecognize CAD 253 million of securitized prepayable mortgages. This was done expressly with a view to managing our leverage ratio, although we had the added benefit of booking a small gain on sale. We will continue to execute these transactions to the extent warranted by our asset growth and our leverage ratio position. Now, back to Andrew Moor. Thanks, Tim Wilson. 2016 will stand up as a transformative year for Equitable as a result of the launch of EQ Bank, and with it a brand-new platform to serve Canadians, differentiate our bank, and diversify our funding sources. Our belief was that there was a market for a born-in-the-mobile-world digital bank offering in Canada. We are delighted to say that EQ Bank not only found this niche, it has captured it at a pace that is well beyond our own expectations. EQ Bank Savings Plus account deposit balances grew 25% from Q1 and now stand at more than CAD 1 billion, even as we had to take steps to improve our service levels in the early going. Our call center is meeting our customers' demands, and we have been diligently working on improving the customer experience within the digital platform. While we still have much to do to give our customers the full digital experience that so many are looking for, we are definitely making progress. To summarize, this was a quarter which continued to demonstrate the value that we've built in our franchise with our dedication to customer service, capital allocation, strong risk management, and the depth of a commitment of our team. The financial results are strong indicators that the assumptions we lay out in our value creation model, most importantly, ROE and the ability to deploy retained capital, are right. Our strategic position as a leader in digital banking should give us all confidence that the bank is well positioned for future changes in the industry. That concludes our prepared remarks, and now we'd like to invite your questions. Michelle, can you please open the lines to our callers? Thank you. We will now open the lines to your questions. To ensure as many voices are heard as possible, please limit yourself to two questions per turn. To ask a question, please signal by pressing the star key followed by the digit one on your telephone keypad. If you are using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. If you have signaled for a question prior to hearing these instructions on today's call, please repeat the process now by pressing star one again to ensure our equipment has captured your signal. We will pause for just a moment to allow everyone the opportunity to signal for questions. Our first question comes from Jeff Kwan, RBC Capital Markets. Please go ahead. Hi. Good morning. The first question I had is, in your MD&A, you talk about, and I think you have had this for at least a couple of quarters, about the stress test in Alberta and Saskatchewan. In particular, the one where you talk about where there would be price declines of 30% and I think a spike of unemployment about two or three percentage points. How do you go about applying which of the mortgages wind up defaulting, presumably, given a higher unemployment rate? Well, we have models. It is a multi-factor stress test models, Jeff, that look at a whole bunch of things that drive probability of default. So they would look at, for example, loan-to-value is actually an indicator of default. So the higher the LTV, you also get the higher probability of default. And of course, underlying unemployment levels is another important factor in that model. So our portfolio analytics team who run these stress tests look at those variables. There is a number of factors in that probability of default calculation. I could not precisely define how many of them there are, but we could certainly get back to you with that detail. Okay. Yeah, I am just, yeah, sorry. I am just trying to understand is when you assume unemployment goes up by X, it is not necessarily, I do not think there would be a correlation between the LTV and whether or not someone winds up losing their job. Because what I am getting at is That's right. That's exactly right. You take a macro review about where unemployment's going. We say, okay, unemployment goes up by 200 basis points or whatever the assumption in the model is. When we're looking across the portfolio, we're actually considering the probabilities on a mortgage-by-mortgage level to build up the total picture that we then give you. We would assume, well, the model would tell you that higher LTV mortgages have a higher propensity to default if you just consider changing that single factor, which is obviously logical if people's equity's been wiped away. They're less likely to be inclined to preserve and keep paying that mortgage. So high LTV is correlated with higher probability default. Across the entire portfolio, higher unemployment, of course, is correlated with higher propensity to default. I'm assuming the model also builds in, because in Alberta, if you have an uninsured mortgage at the time of origination, they have a greater ability, kind of a U.S.-style walk away as opposed to insured in Alberta where they can't. That's right. Geographic factors. I'm seeing the model. Yeah. The geographic factors Does the model adjust for that? The geographic factors would be one of the variables. Also, one of the factors is time to resolve. So you'd have a time to resolve. It'll be longer in certain geographies because of the legal factors. If it takes you six months to resolve the mortgage as it might in a western province, but it's going to be shorter in Alberta and shorter in Ontario, the model would factor that in. So the things like the cost of maintaining a property, the lost interest, the interest forgone would result in higher losses in those western provinces for an otherwise identical mortgage. Yeah. The reason I'm asking this question was I was just wondering if you've ever gone through the exercise of going through, I would call it probably your worst case scenario, Roberto. Let's say, what spike in unemployment that you get also happens to the loans that you have that would be the highest loan to values that suffer those price declines. If you've run a scenario like that and what that does to your losses. We certainly run it. I wouldn't have the numbers at my fingertips to be able to communicate back to you exactly what that looks like. But certainly if you wanted to come back and ask us a little bit more so we could get back to you with a bit more color on that. Okay. I can check in with Tim after on that. Yeah. Tim would have that. Yeah. Just one other question, if I can. The gain on sale percentage in the quarter seemed a little bit higher than in prior quarters. I know based on mix and whatnot and where the market is in terms of spreads, it can have an impact on that. Just wanted to get a sense from you as we look through the next few quarters, where you think that might play out. Actually, Jeff, we can talk about it offline if you want later. The gain on sale margin came down during the quarter, and it was influenced downwards by the larger transaction that we did to derecognize mortgages. Yep. Our gain on sale margin would be typically in the 80-100 basis point range, and it was 50 this quarter. It was really the result of the cost of doing that particular transaction. Okay. Yeah, we can talk about it offline then. Sure. Okay. Thank you. Thank you. Once again, ladies and gentlemen, if you do have a question, please press star one at this time. The next question comes from Graham Ryding, TD Securities. Please go ahead. Good morning. Good morning. Just wanted to touch again on the Alberta, Saskatchewan portfolio. The performance is obviously holding in very well. But you did indicate that you prepared for arrears to move higher. Are you seeing anything in particular that, is it seasonality or anything in particular that suggests it should move higher? Or are you just being cautious and realistic that the economy and whatnot is under pressure? I'd say it's more of the latter, Graham. In fact, I did take a quick look at the end of July arrears numbers, and they continue to look in great shape. Just talking to our people on the ground, we're not seeing anything that would There's nothing in the fact set that would say that arrears are going higher other than the things that you can read in the newspaper or whatever about rising unemployment. I think as a management team, I'm probably more optimistic about the likely outcome in those provinces. Having lived in Alberta for a few years and being connected to that market maybe just gives me a sort of sunnier optimism about the entrepreneurial spirit that drives that economy. But I think to be fair to investors, we need to be concerned as there's still risk there. When you think about your uninsured residential mortgages versus your uninsured commercial, do you see any higher risk with one bucket over the other? I think they're different kinds of risks, frankly. There's a little more systemic risk in the housing market in the sense that all assets are likely sort of correlated. Houses generally would fold in a particular region. I don't think they're correlated necessarily across the country. In the commercial space, it's different. You're thinking more about that asset by asset. So we've got great covenants behind some of these commercial assets, and it tends to be something about the project that's failed as opposed to the value of the underlying real estate that causes losses. So it's a different kind of risk. That's one of the reasons why we like being in both businesses, frankly. It does diversify our risk. We don't think that just because of a potential correction in the housing market, if it happened, that our commercial book would particularly suffer losses as a result. Got it. Can you remind what sort of loan to values do you have in your commercial book, and what are the types of commercial loans that are in that Alberta, Saskatchewan portfolio? The primary loan, in the Alberta, Saskatchewan market, I think we disclose our LTVs on average there. They'd be in the high 60s level. Mostly it'd be residential, so multi-family apartment buildings. There's a little bit of industrial in multi-tenant industrial. Mostly it's apartment buildings with a little bit of construction. But all looks like good assets. We reviewed the assets one by one, and we've got no concerns about any of them at this point. Okay, great. Just jumping to the capital side. You're still planning, I think, to shift to this AIRB model. Is there any indication at this point what sort of impact that could have on your overall CET1 ratio? Too early to say that. Clearly, there is a view that the risk weights would come down, but that doesn't necessarily mean that we would run at the same capital levels as we do today. The broader implications of that may. We don't have a really good feel on that. The big picture, though, is to improve and make more sophisticated as the bank continues to grow over the next decade or so, our capital allocation process, so that we will much more closely link what the regulators expect from capital with the true risk of the underlying assets. What we really believe that AIRB will allow us to do is to lend effectively on lower risk assets and get the capital relief that reflects that. The challenge we have today is if we lend to a fellow that develops an apartment building and then it stabilizes it, our risk weightings don't actually change as that asset matures and becomes less risky. As it becomes a great asset, then some of our larger competitors can underbid us and take that loan away. We'd really like to be able to offer a longer-term solution for our customers so that we can provide the term funding as that asset becomes less risky. An AIRB would allow us to do that by reflecting a lower capital risk weight as the asset becomes less risky. Okay, got it. Maybe just quickly on EQ Bank. How are you feeling about the service levels now relative to where you were last quarter? I am not sure if you disclosed it, but how many account holders do you have behind those deposits right now? We have got about 23,000 accounts represent the CAD 1 billion or so of liabilities for us, assets for our customers. I am feeling fantastic about the service. Give it a try. What we are hearing is that our call center is really standing up well. The great news about the effectiveness of the app is that people do not have to call because the thing works really well. People are using all of the features of the product, so they are depositing checks through the remote deposit check capture system. They are paying, which is a very important thing. We are the only bank in the country that allows you to make payments out of the high-interest savings account or the interest-bearing account. We were the first bank in the country to offer free Interac transfers as well. Particularly the fact that they come out of an interest-bearing account continues to be a recurring differentiator for us. If you go into RedFlagDeals and look at what the people are saying in the blogosphere about EQ Bank, you will see some really good things being said about the sort of people that really are interested in this kind of how banking is evolving. I am excited about where this can go for our institution, for sure. Great. Have you worked through the backlog? Yep. We did go to a queuing system, which allowed us to then sort of handle these customers that came on with more kid gloves rather than trying to deal with the surge in business. That queue has now been taken down, so anybody can open accounts as they feel and when they feel like. We are getting about 70 new accounts a day opening up today. Great. Thank you. Thanks, Graham. Thank you. Once again, ladies and gentlemen, if you do have a question, please press star one at this time. There are no further questions at this time. I will turn the conference back to Mr. Moor. Thanks, Michelle, and thanks to all of you for listening. We look forward to speaking to you in November following our third quarter report. In the meantime, I hope you enjoy the rest of the summer. Ladies and gentlemen, this does conclude the conference call for today. You may now disconnect your line, and have a great day.