Earnings Call: Q1 2014

May 7, 2014

Good morning, ladies and gentlemen, and welcome to the Equitable Group first quarter 2014 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 such 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 security laws. This call is being recorded for replay purposes. It's now my pleasure to turn the call over to Andrew Moor, President and CEO of Equitable Group and Equitable Bank. Please go ahead, Mr. Moor. Thank you, Genevieve. Good morning, everyone. Joining me is Tim Wilson, Chief Financial Officer of the bank and Equitable Group. Before getting started, I would like to advise that we added a slide deck to the webcast of our call. Equitable opened 2014 by setting new performance record in the first quarter. Operationally, the bank also executed very well on our growth and diversification strategies. On the lending side, we delivered record first quarter single-family originations, up 42% over the same period last year, and pushed through the CAD 4 billion threshold in mortgage principal for the first time in that business line. During a particularly cold start to the year that likely blunted some housing market activity, this was a real accomplishment that speaks to the ongoing efforts of our team in using service to attract new customers and to build long-term customer loyalty. We also opened our single-family operations of business in Quebec on March 31st, which means we now have a dedicated presence in seven provinces and all of Canada's largest cities. We continue to prepare to launch Equitable as a prime mortgage lender, an important strategic initiative that should help to augment our presence in the single-family market and create substantial value for the bank in future years. On the deposit side of our business, we continue to experience a steady increase in demand for our new Equitable Bank High Interest Savings Account, a complement to our GICs. It has attracted over CAD 120 million of funds as of this morning. Broadening our services to Canadian savers and our sources of cost-effective funding is a long-term priority, and was also aided just after the quarter through a successful CAD 150 million deposit note offering. We'll discuss each of these highlights in today's call. First, I'd like to summarize what our growth and development meant for shareholders in the first quarter. Compared to last year, diluted EPS increased 20% to a first-quarter record of CAD 1.56. This is an excellent outcome, but it should be noted that our earnings would have been even higher if not for additional non-interest expense related to the appreciation of Equitable's common stock price and to severance costs that we wouldn't expect to recur in normal quarters. ROE was 17.9%, up from 17.5%, and well in line with a consistently high average over the past five years. Book value per share increased 18% year over year and 4% during the quarter itself. These strong results and our positive outlook gave our board cause to once again raise our common share dividend at their meeting yesterday. We are very pleased to note that we will now pay beginning in July at a rate of $0.17 per quarter, up 13% from a year ago. This is our sixth increase in just over three years. Underlying our record first quarter results was solid growth in the bank's core lending businesses. Both single-family and commercial lending services, where mortgage principal is up 20% year over year. Leading the way in growth once again this quarter, and by design, was our single-family lending services business. On strong origination volumes and mortgage renewal success, single-family mortgage principal at March 31st was up 28%, or $875 million to $4 billion. Normalized to the securitization of $238 million of single-family mortgages over the past year, the growth rate of the portfolio was an even more impressive 35%. As a reminder, when mortgages in our core lending operations are securitized, we begin to report the balances in our securitization financing results, and the impact is a decrease in core lending assets. $4 billion in principal means that we've increased the size of this business by more than 466% since we made it a focal point of our expansion efforts in June 2009. Origination levels in the first quarter totaled $404 million, up 42% from a year ago to a new first quarter record. We expected a strong first quarter and were definitely not disappointed. This performance results from Equitable's continued efforts to deliver responsive service to the mortgage broker and provide housing finance to entrepreneurs and people newly establishing themselves in Canada. Although there continues to be a lot of debate about a soft landing in the market, we are now several weeks into the second quarter, and we continue to see good demand in the single-family business. The bank's commercial lending services mortgage principal expanded 10% to $2.4 billion. While originations of $126 million were below last year's first quarter, due primarily to lower commercial market activity, renewal activity was strong, and as a result, balances were down only marginally from Q4. Our growth has also continued to benefit from expanded partnerships in the commercial mortgage market. In securitization financing, mortgages under management remained at the same level of $5.8 billion, in line with our expectations. As in prior quarters, the need to use our CMB capacity to fund elevated levels of maturing mortgages did not leave much room to grow this business. Recently, our CMB capacity has been running at approximately the same level as our volume of maturities, and this situation is expected to prevail until the end of 2014. Generally, we've experienced strong demand for our multi-unit residential mortgage product and continue to see profitable opportunities for this business going forward. The bank's growth in returns have continued to be positively influenced by disciplined underwriting standards and credit practices, and by a generally positive economic backdrop. You may remember that we began reporting a metric that we referred to as our impairment provision last quarter. The metric represents our provision for credit losses on impaired mortgages and, in our opinion, is the best indicator of loss rates on our portfolio. In the first quarter, we had a net impairment recovery of $36,000. The recovery results from the restructuring of one large commercial loan and low loss expectations for newly impaired loans. I also want to point out that we added only CAD 500,000 to our collective allowance in the quarter, a much lower amount than has been our recent practice. Our overall allowance continues to bump at the top high end of our target range. I'll now ask Tim to provide his analysis to quarter before discussing our outlook. Thanks, Andrew. Total net interest income was up 21% year-over-year on 8% growth in assets under management and a very healthy 25 basis point increase in NIM, which stood at 1.67%. NIM also grew sequentially and is now sitting at its highest level in over three years. This reflects the continued shift in our asset mix towards our higher margin core lending businesses and wider spreads within core lending itself. In fact, core lending NIM increased 28 basis points year-over-year, due primarily to improvements in our single-family renewal pricing and more efficient management of our liquidity portfolio. Securitization financing NIM was down four basis points because of lower mortgage prepayment income and the fact that recent originations and renewals have been at lower spreads than our maturities. The maturing mortgages were originated mainly during 2009, when spreads were significantly higher than they are today. Looking ahead, our expectation for NIM performance in 2014 is unchanged from last we spoke. That's to say that we believe total NIM will increase during 2014 on the continuing shift in our asset mix. Although it may experience some fluctuations quarter to quarter due to inherently volatile mortgage prepayment charge income. With respect to other income, you'll notice that our gains from securitization were consistent with Q1 of last year, but down 52% from the prior quarter. We did use the majority of our CMB capacity in Q1, and the lower gains on sale are driven by the types of mortgages originated and securitized. Non-prepayable mortgages, the types that allow us to achieve de-recognition, represented 25% of assets securitized in Q1, in contrast to 53% in Q4. This change in mix was simply a function of current market demand. I'll also remind you that the gains will now flow through the income statement over time, and our net economic position is really unchanged. We're cautious about providing guidance on our securitization mix going forward, but based on current market activity, believe that our gains could fall anywhere in between the Q4 2013 and Q1 2014 levels in the future, a reduced expectation from past quarters. Shifting to cost, our non-interest expense growth was elevated by the 22% appreciation in our stock price during the first quarter, and some severance, which together represented CAD 600,000 of increased compensation costs compared to both Q1 and Q4 of last year. Expenses also increased in the quarter due to FTE growth and the associated office and equipment costs. Finally, we began to amortize our HELOC investments in Q1, which contributed CAD 300,000 of costs. Ahead of any revenue, I would add, since this product is just gaining some scale now. Accordingly, Equitable Bank's efficiency ratio was 31.9%, up 1.6 points from last year and 3.5 points higher than in Q4. You will note that we are now using the term efficiency ratio rather than productivity ratio in order to better align with industry practice. Looking forward, as a result of planned growth in the business and our strategic diversification initiatives, we expect the bank's efficiency ratio in 2014 to remain slightly higher than in 2013. Even so, Equitable will remain one of Canada's most cost-effective banks, reflecting the advantages of our branchless business model. Turning to our outlook for credit quality. Given the quality of mortgages we have added in recent periods, and assuming Canadian employment levels and interest rate trend as anticipated, we expect our single-family arrears rates and losses will remain low in 2014, although they will likely trend upwards from Q1 to levels more in line with historic norms. Arrears and losses in our commercial portfolio should also remain low. In terms of capital, all of Equitable Bank's ratios continued to surpass minimum regulatory standards and most competitive benchmarks. Our period-end capital ratios were all up slightly from the fourth quarter and from a year ago, mainly due to the organic growth of our equity. We also helped our capital ratios by portfolio insuring CAD 179 million of single-family mortgages during Q1. As a result, Equitable remains well-positioned to support continued growth and value creation. As Andrew mentioned, subsequent to Q1, we successfully completed a CAD 150 million deposit note offering, which adds depth and breadth to our cost-effective funding sources. We issued a three-year fixed rate deposit note at a 135 basis point spread to Government of Canada yields, and it has since traded in to a spread of 123 basis points. I am pleased to say that the offering was oversubscribed and attracted broad institutional investor demand. Since the bank intends to become a regular deposit note issuer across a variety of terms, we are really pleased with market reaction to this inaugural offering. Now, back to Andrew for his outlook. Thanks, Tim. Looking ahead to the rest of 2014, our outlook is unchanged since our last call in February and is pretty well spelled out in our MD&A. We expect that our strategy, including our approach to capital allocation, will continue to deliver high returns on shareholders' equity throughout the year. From a mortgage origination standpoint, as we move into the spring and summer quarters, we look to take advantage of seasonally stronger real estate and mortgage market activity by maintaining the standards of service and responsiveness that made Equitable a favored choice for mortgage brokers and borrowers across Canada. The risk of slowing residential real estate activity has obviously not gone away, but capitalizing on the recent progress we have made in diversifying the bank's products and market reach should have a broad and positive impact on our prospects. With respect to diversification, I mentioned at the outset that we opened in Quebec single-family market right at quarter end. The focus for our team is on Montreal and Gatineau. While we've only been operating for a few weeks now, the deal flow is beginning, and we're building relationships with the local and national mortgage brokers operating in these vibrant markets. I'm also pleased to say that we've done the due diligence and are now ready to enter the prime single-family lending market. We recently hired Martin Beaudry, an experienced prime lender, to build this operation with Brian Leland, our VP of Residential Lending, and Ken Kuklewicz, VP Residential Sales, and others on the Equitable team. This is an exciting opportunity for the bank that will, over time, expand our reach within the mortgage broker channel and deepen our customer relationships. We intend to fund a majority of our prime mortgages through the MBS securitization program, which we have defined volumes allocated each quarter by CMHC. With access to low-cost funding and our current strategy, we believe we'll be able to originate between CAD 1 billion and CAD 2 billion of loans annually within 3 to 5-year time horizon. In 2014, as we ramp up our prime business, we're not expecting a material impact on EPS. Once we do reach critical mass, we'll have a foundation for significant long-term strategic and financial value creation. However, as you know, margins of prime lending will be governed by spreads between the MBS market and prevailing mortgage rates. So we expect earnings to be a bit more volatile for our prime business than our other businesses. 2014 will also be a growth year for our high interest savings account and our HELOC, and we're encouraged by our progress on both of these fronts so far. These products diversify our offering and extend our ability to deliver valuable financial service solutions to a broad range of customers. In summary, the bank opened in 2014 with record first quarter results and characteristically strong ROE. We set a new high water mark for single-family mortgage principal, and first quarter single-family origination volumes were up 42%. And we continue to grow as a trusted deposit-taking bank. Overall, our outlook for 2014 is positive. We have many opportunities to grow and a plan in place to ensure our ambitions are realized in a risk-managed and cost-effective manner. That concludes our prepared remarks, and now we'd like to invite your questions. Operator, can you please open the lines to our callers? Ladies and gentlemen, we will now conduct the question and answer session. If you have a question, please press the star followed by the one on your touchtone phone. You will hear a tone acknowledging your request. Your questions will be pulled in the order they are received. Please ensure you lift the handset if you are using a speakerphone before pressing any key. Your first question comes from Graham Ryding with TD Securities. Please go ahead. Thank you. Maybe I could start with your Quebec initiative. Can you flesh out how many people you have had to hire to get this sort of initiative off the ground, and what is your sort of initial plan to get business flowing? We have hired about five people in the province, so that includes mortgage officers, underwriters, a team lead, and a salesperson. Modest so far until we see the volumes growing. We are not expecting to be a material volume this year. If we can do somewhere in the sort of CAD 30 million-ish range, that would be good. Learn the market as we always do, make sure we do not make any credit mistakes in the early going, and then build from there in ongoing years. Could you give me an idea, like you gave some decent color around your single-family lending services initiative within 3-5 years. What about Quebec? Where do you see this potentially growing to within 3-5 years? Within three to five years, it will probably add a couple of hundred million CAD to origination volumes in the alternative space. Sorry, annually, CAD 200 million or- Annually. Yeah, annually. Okay, thanks. It's a bit hard for us to know, Graham. We don't have really good provincial data and so on, so we'll update you as we get a better sense for the market. Yep, okay. But that gives me some context. With the securitized assets that are coming up for renewal this year, is the CMB the only channel that you can securitize these renewals in? I guess you can't use the NHA MBS for this stuff. Is that correct? You could use the NHA MBS, but the way the pricing works in the multifamily mortgage market, effectively, there's no spread between MBS and the pricing on the mortgages. So there's no profit in it to do that, so effectively you have to use CMB capacity if you want to be making money in that business. So that becomes the practical constraint. Got it. Your ACM multiple ticked up, and I guess you provided guidance that you expect it to tick up further. Do you have the ability to manage around this with potentially selling some mortgages through the interest-only strips to bring this down? Or how are you looking at managing this multiple going forward? Well, first of all, we believe we've got lots of room on our current ACM, so we don't feel at all constrained or concerned about that at this point. I'll let Tim address the issue about where we stand with the sale of strips. That's certainly something that we believe will become open to us. The other complexity that we need to worry about around ACM is that starting in January of next year, we'll actually be moving to the Basel III leverage ratios. So the ACM that we currently report won't be the relevant metric. We're not expecting that that's going to change the permitted leverage, and that's sort of what OSFI is indicating to all institutions is expect your leverage ratio to continue to allow the same kind of asset growth as you have today. But it'll be measured off a different basis, so it'll be measured off CET1 rather than total capital. So there is a little bit of complexity around leverage that we have to keep an eye on over the next 12 months or so. Tim, I don't know if you'd make some comments about the sale of strips. Yeah. On the IO strip question, Graham, we continue to be active in the market, meeting with investors, talking about potential structures, and also discussing those structures with CMHC. As you're aware, we need their approval for any structures to proceed with them and get due recognition. As Andrew mentioned, we're not constrained by our ACM right now, so we're not rushing this process. We're trying to figure out the best structure for the long term, and not rush into something that'll compromise our business. Sorry, Graham, I do realize I misspoke. It was not CET1, it's Tier 1 that the leverage ratio is going to be based on. When do you expect to get some guidance on that Tier 1 leverage ratio? I think it is going to be late summer, early fall is my sense. I know there is a lot of work going on OSFI in that regard at this point. Okay, I will jump back in if I have more. Thanks. Thanks, Graham. Your next question comes from Jeff Kwan with RBC Capital Markets. Go ahead. Hi, good morning. First question I had was, how was activity so far in Q2? Q1 was clearly a weaker quarter for, it seems like the industry with the winter weather. But when you adjust for that and just say, okay, if the weather wasn't necessarily that bad, how is Q2 kind of shaping up? How would you generally characterize it so far? I'd characterize it as a bit regional. I would say the West is stronger than the East. It's strong. We're busy. But it does feel like a bit of a delayed spring market, perhaps. So busy but not run off our feet, I would describe it as we speak today or as it's been for the last couple of weeks. This is the time of the year that we would hope to get run off our feet. Now, I'm hoping that will still emerge over the next three to four weeks, which would really start to be the peak of the seasonality, but it does seem a little bit delayed. Okay. The second question I had was, have you done any sort of initial work with the broker community around the launch on the Prime side, and how's the feedback been so far? Yeah, we've gone out to a limited number of brokers to talk to them about a number of options that we've been contemplating, and it seems to be well received. I would say that we still haven't landed on some of the decisions we have to make yet, and it'll still take a month or two to do that. We don't expect to be in market, to be clear, with the Prime offering until the end of July. So we've still got a few decisions to make there. But I think we feel that we've got an offering that's going to provide value to that broker community. And it's going to be a little bit of a targeted approach in terms of the key broker partners that you're working with and then eventually expand, or would you keep it open to any broker that wants to submit an application? Well, our approach generally is to treat everybody equally and offer excellent service to every broker that chooses to want to come and try and do business with us. But we would obviously go out and seek and have more detailed conversations with those brokers we have the closest relationships with. So I would expect the volume to be coming from a fairly small number of brokers, but we certainly never close the door on anybody that chooses to do business with us. Okay, great. Thank you. Thanks, Jeff. Ladies and gentlemen, if there are any additional questions at this time, please press the star followed by the one. As a reminder, if you are using a speakerphone, please lift the handset before pressing any keys. Mr. Moor, there are no further questions at this time. Please continue. Great. As there are no other questions, I would like to thank you all for joining us and remind you that our annual meeting of shareholders is next week on May the 14th at 4:15 P.M. Eastern on the TMX Broadcast Centre. We hope to see you there, and an opportunity to meet some of our new members of the board. If we do not see you there, we look forward to reporting our second quarter results on August 13th with a call on August the 14th. Thanks for your interest and goodbye for now. Ladies and gentlemen, this concludes the conference call for today. Thank you for participating. Please disconnect your lines.