Earnings Call: Q1 2015

May 13, 2015

Good morning, ladies and gentlemen, and welcome to the Equitable Group first quarter 2015 conference call. Before we begin, 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 such forward-looking statements involve a risk 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 Chief Executive Officer of Equitable Group and Equitable Bank. Please go ahead, Mr. Moor. Thank you, John, and good morning, everyone. Joining me is Tim Wilson, Chief Financial Officer of the bank. As always, we are webcasting our remarks with accompanying slides, and those slides are being posted to our website. As a reminder, we are hosting our annual meeting this afternoon in Toronto, and since we will be making a very detailed management presentation there, we've chosen to keep today's prepared remarks brief. As you saw in the press release, the bank produced great results for shareholders, including best-ever earnings, up 16% year-over-year and well ahead of last quarter. Owing to the bank's efficiency and effectiveness in capital deployment, ROE was strong at 17.9%, well in line with a five-year average of 17.5%. These results enable our board to add to Equitable's track record of rewarding shareholders with growing dividends. The announced dividend increase brings the annualized rate to CAD 0.76 per common share and 12% above last year and marks the sixth raise in four years. Our board and management team feel strongly about growing the dividend while retaining about 90% of what we earn so that it can be redeployed to generate the higher returns on equity we expect of our value creation process. This process allows us to consistently grow book value, which was up another 15% or more than CAD 5.50 per share year-over-year. After a call like this, and because it falls so quickly on the heels of our last call, it's very tempting to let the numbers speak for themselves, but let me try to add some color. Our results are fueled by strategy to grow and diversify the bank's products and services to Canadian consumers while leveraging our existing strengths and maintaining cost-effectiveness as well as discipline in pricing and risk management. We're concentrating on specific areas for expansion in both lending and savings, and all contribute to Equitable's record performance and potential. The first is the expansion of the bank's single-family lending business. We set out to make Equitable a leader in this market six years ago, and the results we've announced in recent periods, including the first quarter, show that we're fulfilling our mandate. As one of two major players in the alternative space, the bank's single-family originations reached CAD 568 million, a first quarter record and up 41% from a year ago. As a result, single-family mortgage principal climbed to CAD 5.7 billion, up 31% from last year. I would say there are two drivers of this growth. One, our relentless focus on service is being appreciated by mortgage brokers and borrowers. Understanding our customers' needs and being responsive does make a difference. Two, we successfully broadened our national lending footprint over the past 10 years, and in Eastern Canada over the past half year. This is creating more opportunities for us to serve new brokers and borrowers, as well as to earn national lender status with some of the major brokerage networks. All a boon to our origination volumes. This expansion has certainly helped us to more than offset conditions in Alberta, where origination volumes in the quarter were broadly flat to last year's levels as a result of our own tightened credit standards and market weakness. Enriching our offering to be a more complete single-family lender hasn't hurt either. The Equitable Bank HELOC, launched at the end of 2013, is gaining traction as we thought it would because it is a perfect solution for one of our key customer demographics, business-for-self borrowers. Like our overall single-family business, our HELOC provides a good runway for long-term growth. Plus, it allows us to grow our share of the wallet with customers while earning a more attractive margin than we would typically earn on a single-family mortgage. A win for both our customers and our shareholders. Staying with single family, our prime mortgage business, which is our most recent expansion initiative, is progressing on plan. Which is to say we are building our internal origination capabilities and, as mentioned in earlier quarters, supplementing that activity with mortgages originated through business partners. In the quarter, we closed CAD 191 million of prime mortgages. This is a decent start for business with a significant room for growth and development. We're setting a 3 to 5-year time horizon for our development and believe we've got a great team in place to lead the charge. We are now actively serving broker communities in the GTA, Calgary, and Edmonton. Like our other bank lines, we seek to differentiate Equitable as a prime mortgage provider through service excellence. We are making good progress, but our team has a realistic sense of the journey ahead, and we understand that we have much to do to develop our offering to match the most effective competitors in this part of the space. We see the positive impact of prime mortgage growth on securitization financing mortgages under management, which is up 16% year-over-year. I would point out the positive earnings power that we have generated by building this part of the bank. In fact, the prime SFR portfolio gives us the ability to recognize almost CAD 6 million in pre-tax earnings if we enter into transactions to hedge the cash flow uncertainty and derecognize the underlying mortgage principal. Commercial lending is another significant business for the bank. It does offer the opportunity to maintain a more diversified asset base. As we've said on past calls, the large commercial market has become more competitive as liquidity has moved into the space, resulting in reduced margin opportunities. Despite this overall market environment, we've been successful in the quarter in the commercial business, and our small business lending product is showing great success. Given the growth opportunities available in our lending markets, it's vitally important for the bank to have solid, secure, and cost-effective funding sources. We do. So we are expanding and diversifying these as well. Our expansion focuses heavily on developing the market for our brokered Equitable Bank High Interest Savings Account. I am pleased to note that these balances surpassed half a billion CAD in the quarter, and at the close of business yesterday, sit at CAD 551 million. As a result of being able to meet the needs of more Canadian savers with safe, secure, and high-return products, including GICs, our mainstay. Our savings business now has in excess of 7.6 billion CAD deposits, up 18% from last year and 3% during the quarter. We believe we can continue to advance the bank's position in the savings market. The next big catalyst in this regard will be the late-year launch of our digital banking capabilities. This is a very busy time for the bank's digital banking team, and work will continue through the summer on building and testing our systems to ensure they are robust enough to meet the needs of the consumer marketplace. We are very excited about the prospects for this offering. I am also pleased to note that in the first quarter, we closed our second deposit note offering as part of our funding diversification strategy. This brings me to some comments about the market overall and our credit performance and outlook. While growth has been strong in our mortgage book, we have remained disciplined in our underwriting credit practices in every region of the country, including Western Canada. A good way to measure this is our impairment provision. As a reminder, this is the portion of our total provision that reflects the level of losses anticipated on our impaired loans. In the first quarter, it amounted to just one basis point of our mortgage book on an annualized basis. I would also take this opportunity to point out that the remaining CAD 600,000 represents additions to our collective allowance. This is an important number because adding to our collectives in this quantity is a more conservative approach than that taken by most of our peers and had a 4 cent negative impact on EPS in the quarter. Continuing on credit quality, arrears rates also remain low. In Alberta and Saskatchewan, activity in the real estate market has contracted along with employment levels, but arrears rates in those provinces did not increase sequentially. We believe that they will rise in future quarters, but the timing and amount is uncertain. You heard on our last call that management has extensively stress-tested the bank's exposure to Alberta and Saskatchewan. It is reassuring to know that we continue to believe that the risk of incurring any significant credit losses in these provinces is low. Even accounting for conditions in the West, we believe that the bank will have a solid year in the single-family business while also managing risks effectively. In terms of our forward agenda, it is unchanged from our last call. Our objectives for diversification, expansion, earnings growth, and return on equity are very clearly understood internally. I can assure you that whether it is growing our lending business, our savings business, or preparing to launch our digital banking capabilities, we will work tirelessly to do things the Equitable way, which in the context of the bank's performance over many years and quarters, means the right way for our customers and shareholders. Always with an eye to offering exceptional service. Now I will ask Tim to provide his analysis. Tim? Thanks, Andrew. As this is the start of a new reporting year, we always look for ways to enhance our disclosures. We made a couple of changes that are intended to provide a clearer picture of our lending portfolios or better align us with market practice. There is a detailed discussion of these changes on page four of the MD&A. in Q1, net interest income grew 16% year-over-year. The drivers were 10% growth in average asset balances and a seven basis point expansion in NIM on the continued shift in favor of our higher margin core lending business. Core lending NIM itself increased a very healthy seven basis points on more efficient management of our lower margin liquidity assets and prepayment income levels. We also benefited from improvements in pricing on single-family renewals, the effect of which was offset by mix changes within the book. Securitization financing NIM was down 14 basis points over the year, primarily because of the maturity of large volumes of mortgages that we originated back when spreads were extraordinarily high following the financial crisis. Those mortgages have now largely matured, and we expect less compression in future quarters. Sequentially, net interest income was also up as a result of asset growth and in spite of lower mortgage prepayment income and lower income on our equity securities portfolio. Andrew discussed our growth outlook earlier, and those expectations should support low double-digit growth in net interest income on a year-over-year basis for the remainder of 2015. Relative to quarter one, though, we expect NIM will decrease slightly as we move through the year. This reflects a combination of factors that were discussed in more detail in Q4, including the high relative growth of the single-family portfolio, which is lower spread but generates a higher ROE and a convergence of growth rates in our core lending and securitization financing portfolios, which means that we will benefit to a lesser extent than in prior periods from a shift in mix towards the high margin core lending business. One last note on revenue is that securitization gains were up sequentially and compared to last year, reflecting higher derecognized volumes and a higher gain on sale rate. The rate of gain is up due to changes in the underlying cash flow discount rates. In simple terms, the gains really represent the NPV of the future spread on derecognized loans. In Q1, the discount rates that we apply in these NPV calculations decreased along with the benchmark rates, as you would expect. Because we were using a lower rate to discount the future spread, the NPV was higher. Really, just Finance 101. We expect these gains to be higher than in 2014 and somewhat volatile going forward as interest rates continue to move and as we originate more prime single-family mortgages. Our intention is to sell the IO strips on these prime mortgages, and when we do so, we will recognize a gain on sale. The decision to sell the strips will be based on the economics of each individual pool, however, so the volume derecognized may not be consistent quarter to quarter. Turning to non-interest expenses, they increased CAD 3.3 million over last year. 27% of the higher costs reflected the growth of our existing franchise, and the remainder was for what we refer to as investments in our future. Most of our expenses relate to our existing business. Things like hiring great people to support our higher levels of origination and investing in our risk function to make sure that we prudently manage our growth. Examples of investments in our future are FTE and marketing CAD in support of key strategic initiatives. We believe it's important to spend in both categories in support of the bank's growth, service excellence, and performance. But of note, because of our non-branch cost advantage, the bank's efficiency ratio for the quarter remained well ahead of the big banks and our regional peers at 32.4%. As expected, our efficiency ratio was also markedly improved from quarter four when we accelerated our initiative investments. We expect our efficiency ratio to remain around current levels for another quarter before moving up in the second half on higher marketing spend to support consumer brand awareness. Our capital ratios continue to surpass minimum regulatory standards and most industry benchmarks. We expect to continue operating above these key benchmarks as we grow, including the new Basel III leverage ratio, which we began to report in Q1. This ratio replaces the ACM framework, as you're probably aware. At quarter end, our leverage ratio was 5.5%. I realize this doesn't mean as much without an associated minimum regulatory standard, but that standard is set by OSFI for each and every bank individually and is kept confidential. What I can say is that we are fully compliant. To sum up our prepared remarks today, it was a record quarter fueled by solid performance in our core lending business and the successful application of our diversification and growth strategies. Our credit performance was outstanding, and we expect this will continue as a result of our risk management discipline. And we expect more growth and high ROE to be the order of the day at Equitable as we move through all of 2015. That concludes our prepared remarks, and now we'd like to invite your questions. John, can you please open the lines to our callers? Thank you. We will now conduct a question-and-answer session. If you wish to ask a question, please press the star followed by the number 1 on your touchtone phone. If you're using a speakerphone today, please lift the handset before pressing the keys. To ensure that as many voices are heard as possible, please limit yourself to two questions per turn. Once again, ladies and gentlemen, if you have any questions at this time, please press star 1. Your first question today will come from Shubha Khan with National Bank Financial. Please go ahead. Hi, good morning. Hi, Shubha. Yeah. I have a couple of questions with respect to the accounting change related to, I think it was mortgage broker compensation or origination costs generally. My first question in that regard is just trying to understand the nature of the transition. Was all compensation to brokers fully expensed in each quarter in the past? Or was there a portion of broker compensation that was maybe captured in the net interest margin and therefore more amortized over the course of the life of the mortgages, and only additional incentive compensation would flow through non-interest expense? That's definitely a question for Tim. Hi, Shubha. Your latter statement was the right one. The majority of our broker-related commissions and expenses flowed through net interest income before this quarter. There was a residual amount related to certain incentive payments for brokers exceeding certain volume thresholds that flowed through our marketing expense line. In the past, that was a relatively insignificant amount, but it started to grow in significance along with our originations. Because it was growing, because our practice, I think, is inconsistent with general market standards and also with the way we treat regular broker commissions, we decided to change the treatment in Q1. Okay. But if you were to take just the dollar amount paid to brokers, has that increased in line with the origination growth, or would it have been at a faster pace? We haven't changed the basic structure of our commission. The amount's really grown in line with originations. There's no reason to believe that these costs are becoming more significant because competitive conditions have tightened, and so you need to compensate brokers more to maintain market share or anything like that. It really just reflects our success in the single-family market and growing origination. That's probably more my kind of question. Absolutely. We obviously like working with our broker partners and making sure they're being properly rewarded, but we have not been trying to increase broker comps to increase volumes. Okay. That's perfect. Last question is on a separate topic. Credit quality, obviously very strong. Just, if I have to split hairs here, there was an uptick in early-stage delinquencies to 84 basis points, I think from 60. Is that entirely attributable to seasonal factors, or was there some weakness in specific markets? I'm thinking particularly of Alberta. As I mentioned in my remarks, there's no sequential increase or no material sequential increase in Alberta and Saskatchewan. It's more broadly across the book. There are two or three larger single-family loans, for example, that were in that early-stage bucket. The team is still looking at them. I believe one or two of them may have cured. It's something we're keeping an eye on for sure. We'll see how that rolls out in Q2. At this point, we've got no evidence of general deterioration in the book but that's the type of thing to kind of keep looking at. Okay. Perfect. Just to build on that, Shubha, we have looked at this over a long period, and that early arrears number does tend to be volatile. So you will see movement up or down quarter to quarter. Broadly speaking, the rate we are at now is within the normal historical range. Okay. Sounds great. Thank you. Thank you. Ladies and gentlemen, if you have any additional questions at this time, please press the star followed by the one on your touchtone phone. Once again, ladies and gentlemen, if you have any additional questions, please press the star followed by the number one on your touchtone phone. To ensure that as many voices are heard as possible, please limit yourself to two questions per turn. Your next question will come from Graham Ryding with TD Securities. Please go ahead. Good morning, gentlemen. I was just wondering if I could focus on Alberta and Saskatchewan. Perhaps I can get some color around your origination volumes. Sounds like they were flat year-over-year in Alberta. Perhaps maybe on a percentage basis, looking at 2014 and year to date, relative to your overall origination volumes in those markets, would it be comparable to how your overall portfolio plays out 9% of your uninsured book and 16% overall? Sorry. In terms of the volumes in the quarter, consistent with the overall. Because the volumes in the quarter, I'm still not sure what quite. Yeah. I'll try to be clear. The distribution of your origination volumes from Alberta and Saskatchewan, is that comparable to the distribution of your overall portfolio? I.e., are you originating roughly 9% and 16% of your mortgages from those markets in line with your overall book, or is your origination volumes from those markets slightly higher? No. I wouldn't like to guess a more tangible question like that, and I'm sure Tim can get back to you with that answer. Certainly in the quarter, we saw a decreased share of our overall volumes originated in the quarter. The share attributable to Alberta and Saskatchewan was lower, and we expect it to be lower again in this current quarter. I can give you some sort of color on this. We changed our lending criteria back in December. Well, actually, there was a little bit of tightening in November, then we tightened again in December. And of course, we had a pipeline of loans lined up then that closed in the quarter that we're currently discussing. So in the early part of the quarter, we didn't see the impact of our tightened credit standards. We do expect volumes in Alberta in this current month to be down about 30% over the year or so. Which again, is a reflection, I think, of the tightened credit standards then and the uncertainty in the market. So the two things together. And you should see LTVs on the originations start dropping meaningfully in Q2. Okay. That gives you some context around Well, we'll get back to you with that precise number. No, that'd be great. I'm just trying to get a feel for what percentage of your origination volumes come from those markets. Secondly, I guess, you provided some good color around you do think there's potential for arrears in those markets to increase, but you're comfortable with your stress testing, that credit losses should be minimal. How should we think about how you would provision if that were the case? If you were to start to see some price pressure and some employment weakness, does your general provisioning increase to reflect that, or do you just provision based on what you actually see in potential losses? I think that I don't want to speak ahead of Tim looking up. I will speak ahead of Tim talking about it from a family perspective. But we provide at the rate of about 57.5 basis points on our collective allowance for our builder, our builder loan portfolio. Our experience of life of loan loss over the many years at the five-year period. So 60 months into the life of the loan, we have about a 12% historical loss 12 basis point historical loss experience over a 60-month period. So we believe our collective allowance more than reflects what's required to make sure we have adequate reserves in that bucket for cycles through the market. Unless we saw something really extreme happen, which would suggest that losses were going to be above 57 basis points, which seems like a very extreme and difficult scenario that we don't see playing out at this point, that you would simply see it flowing through as specific provisions in each period under consideration. Okay, great. Thank you. Thank you. Ladies and gentlemen, if you have any additional questions at this time, please press the star followed by the one on your touchtone phone. Your next question will come from Graham Ryding with TD Securities. Please go ahead. I'll throw a couple more in, if I could. The CAD 191 million of single-family insured that you originated in the quarter, did I read it right that CAD 56 million of that you originated in-house, and the remainder you sourced through partners? That's right. My second question, just on the capital front, with the leverage ratio. It sounds like you're considering moving to a different methodology for your risk-weighted assets through the end of the year, perhaps. If that does end up freeing up some capital, do you still anticipate having enough capacity with your leverage ratio if that were the case? Well, certainly I think you're reading there about the AIRB program that we would move to more advanced approaches to risk-weighting assets. That's a multi-year project. It's certainly not something that'll get done this year. You see a number of standardized banks. So what I term the sort of the mid four, the Canadian Western Bank, National, ourselves, Manulife, that second group of banks. Many of us are thinking about using more sophisticated approaches to measuring risk, and that would then lead you to advanced approaches that would have different approaches to risk-weighting assets. I don't think you see the primary benefit of that, or even a benefit of that is freeing up capital, per se, but it would allow us to compete across a broader range of asset classes and measure risk in a more refined and accurate kind of way. I don't think you should have any expectations that there's anything more than that's probably a 3-year type project to give you some sort of context for AIRB. There's a bunch of conversations going on at the Basel level around risk-weighting in banks, which get very technical, but that could change that whole picture in any event. This is a bit of a watch and see kind of period. The bottom line on the leverage ratio is we've got plenty of room right now on the newly reported leverage ratio. Clearly, we're within the compliance levels set by OSFI. As Tim talked about in his part of the script, the ability to derecognize some of the insured mortgages does have the impact of giving us more room on that leverage ratio. We feel pretty comfortable with the position we've got in that area at this point. Okay, great. We shouldn't necessarily think about you having less capital requirements going forward, if not it would be the same or higher, kind of in line with the industry? I think that we're pretty comfortable that the levels we're at, maybe the total capital ratio is a little bit high, but certainly from a CET1 and Tier 1 level, I wouldn't expect to see some meaningful changes over the next little while. Great. Thank you. Thanks, Graham. Well, thank you. Ladies and gentlemen, if you have any additional questions at this time, please press the star followed by the one on your touchtone phone. Mr. Moor, there are no further questions at this time. Back to you, sir. Well, thanks, John. As there are no other questions, we hope to see you at our shareholders meeting, which begins at 4:15 P.M. Eastern Time today at the TSX Broadcast Center here in Toronto. If you can't make the meeting, it will be broadcast at equitablebank.ca. Otherwise, we look forward to reporting our second quarter results in August. Thanks for listening. Goodbye for now. Ladies and gentlemen, that does conclude our conference call for today. We thank you for your participation. You may now disconnect your lines, and have a great day.