M&A announcement

Dec 3, 2018

Good morning, ladies and gentlemen. I'd like to welcome shareholders and analysts to this Equitable Group conference call and webcast. Management will open the call with some comments, and then we will conduct a Q&A with participating analysts on the call. Before we begin, and on behalf of our speakers today, I will refer webcast viewers to slide two of the presentations and our callers to the following information, which contains the company's caution regarding forward-looking statements. We remind you that certain forward-looking statements will be made today, including statements regarding possible future business and growth prospects of the company. You are cautioned that forward-looking statements involve risks and uncertainties detailed in the company's periodic filings with Canadian regulatory authorities. Certain material factors or assumptions were applied in making these forward-looking statements, and many factors could cause actual results or performance to differ materially from those conclusions, forecasts, or projections 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. Additional information on items of note, the company's reported results, and factors and assumptions related to forward-looking statements are available in Equitable's recent filings with securities regulators, including today's news release. This call is being recorded for replay purposes on December 3, 2018. It's now my pleasure to turn the call over to Andrew Moor, President and CEO of Equitable Bank. Please proceed, Mr. Moor. Thank you, Sharon. Good morning, everyone, and welcome. I'm joined by Tim Wilson, Senior Vice President and Chief Financial Officer of the bank. As you would have seen, this morning's press release, we're very pleased to announce a definitive agreement to acquire Bennington Financial Services Corp, a profitable and growing privately owned company serving the brokered equipment leasing market in Canada. For Equitable, this accretive acquisition is fully aligned with our position as Canada's challenger bank and our diversification objectives. The transaction gives us a presence in an attractive market where we can leverage our existing capabilities to create value and deploy shareholder capital to superior risk-managed returns. With this acquisition, Equitable takes another important step in growing beyond our deep roots in single-family and commercial mortgage lending, and does so on the shoulders of a proven, focused, and entrepreneurial business with a leasing portfolio of more than CAD 400 million. In this call, we'll take you through the rationale for the transaction, expected benefits, and some financial details. To start, we expect that the final price of the acquisition will be CAD 47 million. That figure is based on a book value of 1.3 times and a price/earnings multiple of 6.9 times. Based on the evident value of the transaction, we think the price is fair. For shareholders and analysts who own and follow Equitable, you know that organic growth has always been our preference and priority, and this will continue. What you may not know is that we regularly review acquisition opportunities and assess them with sophisticated gating criteria that reflect our value discipline. These factors made us highly selective, and other than some portfolio acquisitions, including most recently Maple Bank, this is the first operating opportunity that exceeds our thresholds. The benefits of this transaction are clear and compelling. For Equitable, Bennington allows us to assume strong positions in near-prime and non-prime equipment leasing markets we find attractive. It diversifies our revenues and assets. It provides us the opportunity to deploy our excess capital and improve our ROEs. It offers immediate per share accretion, excluding the impact of an IFRS 9 related provision that Tim Wilson will discuss later. And it adds specialist talent, knowledge, and relationships that we can use to expand in the broader equipment financing market. In this industry, specialization and experience is critical when it comes to underwriting, servicing, and recovery management. Bennington brings with it a proven approach to adjudication with emphasis on lease structure, security, and remarketability. For Bennington, we welcome all of its employees to the Equitable team. Joining our bank allows Bennington to become part of a larger investment-grade entity and its range of cost-effective funding sources. We believe that we're going to be able to reduce Bennington's funding cost by more than 100 basis points over the next few years. With Equitable providing capital, Bennington will now have support to increase its participation in high-quality credit segments, attract new clients, and grow its average ticket size. Not to be missed when looking at the benefits is that our two companies use the same go-to-market philosophy. Bennington originates all of its business through independent leasing brokers across Canada and has developed strong, trusting partnerships based on service excellence. This is similar to Equitable's mortgage brokerage distribution model that we use to great advantage in our other secured lending activities. By way of background, Bennington was founded in Oakville 22 years ago to serve the equipment leasing needs of commercial borrowers. It finances a wide range of assets with a focus on transportation, construction, and food service equipment, with average ticket sizes of approximately CAD 50,000. In its market segment, Bennington is now the largest independent funder of commercial equipment in Canada. Its secured leasing portfolio of over CAD 400 million is split 75/25 between the near-prime and non-prime segments. Our intention is to focus more on the near-prime segments over time. Geographically, its portfolio is distributed across the country and in fact closely resembles the distribution of Equitable's own mortgage portfolio. Annual revenue is in the CAD 50 million range, and over the past five years, it has grown by an average of 10%. Bennington is profitable and generates return on equity in line with our existing business. Beyond strategic fit, alignment with our risk appetite, and financial impact, two of the very important gating criteria we use in evaluating acquisitions are management capability and capacity. Bennington scores highly on both fronts. Its founder is Larry Malinowski, who serves as the firm's CEO. Larry started his career over 45 years ago and is recognized as a leasing industry expert. Two years ago, as part of a succession plan, Larry recruited Troy Campbell as President and COO. Like Larry, Troy Campbell has deep expertise in the leasing industry and brings new skills to our business. Together with a team of 135, Larry and Troy Campbell have grown Bennington into a dynamic business with great long-term potential. To ensure full continuity, we will operate Bennington as a subsidiary of Equitable under Larry's direction. To us, Bennington represents a great way to enter a large and growing market. Today, total equipment finance in Canada is valued at CAD 18 billion, of which over CAD 2 billion is our target market. Bennington's current market share of that market is strong, but we have good reasons to believe that they can expand it over time by making more cost-effective capital available, maintaining 100% focus on serving the broker community, and expanding to higher value transactions further up the credit curve. I would like Tim to walk through the key financial details. Tim? Thanks, Andrew, and good morning, everyone. To begin, I will reiterate this is an accretive all cash transaction. In terms of Bennington's financial impact, we expect it to represent around 10% of Equitable's annual net revenue. That said, this investment exceeds our hurdle ROEs and will be immediately accretive to Equitable's EPS in the range of CAD 0.35-CAD 0.40 per share before the acquisition-related IFRS 9 provision that I will touch on momentarily. In terms of the impact on our key metrics, Bennington is a high ROE business, generating returns in line with Equitable's long-term average. As such, its addition will certainly complement Equitable's track record, which has been among the best in the Canadian banking industry over the past decade. The all-cash structure of the deal will result in an immediate uplift to our corporate ROE in the range of half a percentage point. Due to the nature of its lending activities, Bennington's NIMs are higher than in Equitable's core lending business, so it should provide a modest uplift to our overall corporate NIM. On the flip side, loan losses and arrears are also higher than Equitable's, so you should expect both of those metrics to increase post-acquisition. Even so, the business is highly profitable. By focusing the business on higher credit quality segments, as Andrew mentioned earlier, we expect to improve this credit performance over time. Similarly, Bennington has an efficiency ratio higher than Equitable, so at a corporate level, we may move out a bit beyond 40% post-acquisition. The reason that their efficiency ratio is higher is that the cost of underwriting and servicing each client is absorbed by smaller value leases, which is much different than the larger ticket mortgage business in which Equitable currently operates. Moving on to IFRS 9, accounting standards require the bank to record an unusual acquisition-related provision through our income statement in Q1 2019. This provision is not a market first. If you follow Scotiabank, you will know that they set up a similar provision of approximately CAD 400 million on some recent acquisitions. RISCO also did the same on the acquisition of a portfolio. IFRS 9 treats acquired financial assets just as it would assets originated directly by us. As such, we need to record an allowance equal to 12 months of expected losses on performing leases acquired immediately after they come on the bank's balance sheet. In order to set up this allowance on the balance sheet, we need to run a provision through the income statement that will occur on acquisition but not repeat after that. This provision may be up to CAD 9 million. We will provide further details on the size of the provision subsequent to the date of closing, and we expect closing to be on or about January 1st. Of course, it goes without saying that this accounting provision does not change our view on the quality of the business or the underlying lease portfolio acquired. With that, I'll now turn it back to Andrew. Thanks, Tim. I mentioned earlier that the acquisition will enable us to profitably deploy our excess common equity capital for high returns. Accordingly, we expect CET1 will decrease by approximately 70 basis points after the acquisition. As a result, it will remain within our operating range of 13%-14%. Equitable will continue to operate with capital ratios that exceed regulatory standards and the level of the other eight publicly listed Schedule I banks in Canada. In summary, the acquisition of Bennington is fully aligned with our focus on secured lending, diversifies our business, furthers our position as Canada's challenger bank, and allows us to participate in a growing market with a business platform that is expertly run for the benefit of customers and shareholders. I'd now like to open the lines to your questions. Sharon, if you open the lines. If you'd like to ask a question at this time, please press star one on your telephone keypad. If you'd like to withdraw your question, please press the pound key. Your first question comes from Marco Giurleo with CIBC. Your line is open. Morning, guys. Morning, Marco. My first question is on the credit loss experience for this portfolio. I am just wondering, what are the loss rates like through the cycle, and is there- You mentioned there is going to be a shift to more near-prime. Is there anything material in the way they are going to be adjudicating those loans? Are they going to be adjudicating these loans materially differently under Equitable? I will deal with the second part of that, Marco, and then I will hand the first part back to Tim. They are involved in both the near-prime, so under their Bodkin brand, and then the non-prime in Equirex. I think it is true to say that the Bodkin brand will be the one that we will see the faster growth. We wouldn't expect to have any change in underwriting standards, although I am sure, like us, they are constantly tinkering with the credit box to learn from prior experience. Tim, I wonder if you can talk to credit losses. Yeah, Marco, I think the credit losses in this portfolio are probably going to range between 1.5% and 2% over the cycle. Okay. It is substantially higher than what we would see in Equitable's current portfolio. But as I mentioned, even at those higher loss rates, this business is tremendously profitable. Okay. Do you have a target exposure to this space that you guys are envisioning, or? I think we would expect this to grow broadly speaking, the same pace as the rest of our business. So it won't grow particularly as a share, in share over time. Okay. Then on the synergies, Andrew, I believe you mentioned there was cost of fund synergies. How are those going to flow through? Do you get them immediately up front, or are there more synergies going to be realized in 2020 as some of the debt, I would imagine, runs off for the acquisition? Yeah, that's exactly right. We haven't yet spoken to the securitizers that currently provide the funding. We would expect that with our support, maybe some of the funding costs can come down with existing securitizers and keep those arrangements going. Alternatively, some parts of the portfolio can be funded through our own deposit GIC relationship. It will take time. These securitizations run up to about three years in length, so it'll take three years before we fully move to an efficient cost of to the lower cost of funds structure. Okay. Just lastly, on capital, you mentioned the CET1 ratio drops to 13.1%. It hasn't been at these levels for a few years now. Are you comfortable operating at these levels? You mentioned that you could build organically the CET1 back to, I guess, where you're at now. But we haven't really seen organic build over the years. I'm just wondering, given the capital intensive nature of the business and your growth outlook, your organic growth outlook, would you be all right operating at these levels at 13.1%? Yeah. We're fine at these levels. I think we've always indicated sort of this is definitely towards the lower end of the bound, but well within our comfort level. So we think that we're quite comfortable here. Don't forget, one of the things that's been moving the CET1 down a bit has been the tremendous performance we've been seeing in our commercial business. So we may, if we dial that back a little bit, then capital grows quite fast if the CET1 ratio grows quite fast. Okay. Does the growth you set out in your guidance last quarter, does that still hold with respect to volume growth? Yeah, we haven't changed our expectations for the existing business at all, Marco. Okay, perfect. Thanks a lot, guys. Your next question comes from Geoffrey Kwan with RBC Capital Markets. Your line is open. Good morning. We've seen a number of these types of sales of commercial and vendor finance assets in recent years. Typically smaller players than there have been bought by deposit-taking institutions. Any concerns about when you've been doing the due diligence and credit quality, given where we are in the cycle? And what, to your point, and Tim, you mentioned the average through the cycle losses, what were the actual peak losses and when was that? I'm assuming it was the global financial crisis. Yeah. I do not know that we have been back that far, actually. I think these losses have not been particularly volatile based on our reading of this book. It is tough to really say and to extrapolate forward, Jeff, partly because the composition of the portfolio is changing. The existing Bennington business has been moving up the credit curve over time, and we intend to take it further in that direction. I do not think the historic data would be particularly useful, to be honest. Okay. But if we were to try and adjust for it, when was that kind of peak that you would have seen, at least through your due diligence? What year would that have been? That would have been in the credit crisis period. Okay. But again, there hasn't been a particularly notable volatility in their numbers. Again, it's tough to compare apples to oranges with the changing composition of the portfolio. Okay. Just the second question I had is as you've kind of branched out into different loan classes outside your traditional on the mortgage side, and now a little bit more into the C&V. Are there other asset classes that you're looking to get into if you assume, for example, that the mortgage market is going to slow and you want to be able to still drive earnings growth? I think we've sort of planted the seeds for the ones we want to grow into as we speak. We talked earlier this year about reverse mortgages, and we're feeling pretty optimistic about where that's going. So generally in that whole kind of decumulation of assets business, which we're interested in expanding. I think this will put us in a This acquisition will clearly cause us to pause now in terms of kind of new asset classes and get really comfortable, get our feet under us with that one before we step into anything else. Okay, thank you. Thanks, Joe. Your next question comes from Graham Ryding with TD Securities. Your line is open. Hi, good morning. Good morning, Graham. Just, Jeff sort of alluded to it, but is it safe to assume that you're seeing a slowdown in residential opportunities and that's part of the reason why you're looking to expand into a different vertical, like equipment finance? What is attractive about this market, and why are you moving into it now? Yeah, I think it's fair to say coming into the year, we thought that was the case with B-20 hitting us and so on. As you saw from our last quarterly statements, that proven to be not the case. We're seeing good growth in our single-family business. Of course, developments like this is not something that we cooked up overnight. We've been working with the Bennington team since, I think, the early part of the summer. So this is very much part of trying to add another engine of growth or another silo of asset class that we could grow so that the bank can continue to grow at the sorts of speeds that we've become accustomed to over the last 10 years, which is around about 15% a year. So it's definitely part of that agenda. I don't think this acquisition or the announcement this morning say anything negative about our single family or even indeed our commercial businesses, both of which have been performing well as we last reported and continue to do so. Okay. That's helpful. When you say that you're going to organically build back up your CET1 ratio in 2019, do you have to reduce your commercial growth to do that? Or how should we think about your plans for commercial now that you've got this equipment finance portfolio? I think it's always the way we described it. We tend to have a kind of waterfall approach where we first allocate capital to our single-family business, and we'll now tier in equipment finance alongside commercial in terms of ROE thresholds and so on. That will result in probably a slightly slower growth in commercial for next year than would've been the case without this acquisition. Nonetheless, we'll continue to see growth there. Okay. That's helpful. Then just, there was a mention about Larry brought in Troy Campbell in terms of a part of a succession planning, I think a couple of years or a few years back. So what is the succession plan, or what is Larry's plan in terms of remaining with the business? Yeah, so we expect Larry to be with us for a few more years anyway, and over time, Troy will take a more important role in the organization. Do you have any sort of protection in place to incent key individuals to stay around? Or is that an important piece of this is the individuals within Bennington are the ones with the specialty and the experience around equipment finance. Is that a key part of this acquisition is keeping the right individuals around? Absolutely. We've met with all the key individuals, explained the merits of the transactions, make sure we've got appropriate contractual arrangements in place with all of them, and welcome them on our team. We've also got to work hard to earn their trust over the months and years ahead. We have done what any prudent management team would do buying a company with key expertise inside it. Okay. That's it for me. Thank you. Sure. Once again, if you would like to ask a question, please press star, then the number one on your telephone keypad. Your next question comes from Jeff Fenwick with Cormark Securities. Your line is open. Hi there. Good morning, everyone. Morning, Jeff. I just wanted to carry on maybe with some more of the specific metrics here. Can you give us a sense of the order of magnitude of what the blended top-line yield would be off that portfolio? I am guessing it is probably low double digits, like around 12, but is that a fair number to use? Yeah, I would say you should use a number, Jeff, that is probably just under 10%, call it in and around 9.5. On the SG&A basis, you gave us a little bit of guidance here on the efficiency ratio on a blended basis. Rough numbers here specific to Bennington, how much are we talking about in terms of SG&A? Where are they running at? Sorry, do you want the actual dollar amount? Just a number, like- That's not a number we're going to disclose. Okay. I can tell you, it would typically run at an efficiency ratio in the mid-60s. Okay. Based on current profitability. If we are able to lower cost of funds, as an example, we will then be able to improve that metric as well. Okay. That is great. That is helpful. Maybe you could speak just a little bit about the existing mix there today. I have heard they have got a pretty sizable truck portfolio in the mix there. So how do you view the portfolio they have today, and any risks or opportunities there? Yeah, I think there is a pie chart somewhere in the deck around the equipment mix. Yeah, but certainly trucking has been historically one of the strengths of Bennington. Sorry, I didn't realize you had a deck out there, Al. Sorry. There's a deck there. So slide 5, you'll see that about 45% of the market is transportation long haul, about another 16% local. Okay. Maybe a comment on broker concentration and how much would the top three brokers represent of the volumes they do in a year? Yeah. There's definitely some risk there. I can't actually quote that top three, but the top one is just below 20% of origination volume. Okay. Well, I think that covers my set of questions there. I will re-queue. Thanks. Next question comes from Jaeme Gloyn, National Bank Financial, your line is open. Yeah, thank you. First one is around the breakdown of the funding today. Are you able to provide how much is securitized versus other sources? It is virtually all securitized other than to the extent there are warehoused lines to fund loans that get securitized. Okay, and maybe early right now, but what kind of goodwill and intangibles are you expecting to bring on with this transaction? It is under CAD 10 million in total goodwill and intangibles, Jaeme. We still need to wait to finalize the purchase price to get to that number, but work with something in and around the range of CAD 6 million. Okay. Thank you. In terms of the OpEx, and the, I guess it is 60% efficiency ratio. Is this a scalable platform? I mean, in terms of the growth, do you need to bring on more people to continue to grow it, or is this sort of geared up for some scalability? We think there is going to be positive operating leverage as we grow. They have just put in a new computer system, so they have got state-of-the-art underlying backbone that hopefully should, well, drive efficiency and clearly as you scale, we will get some positive operating leverage on the servicing side. Okay, maybe a little bit of operating leverage here ex any cost of fund savings. That is right. The cost of fund savings, of course, are quite large right off the hop. Yep. Okay. In terms of the allowance for credit losses, what kind of PD and LGD assumptions are you using to arrive, or at least to sort of get to that CAD 9 million estimate today? We are not going to specifically disclose those numbers, Jaeme. I would say it all rolls into that expected loss rate of 1.5%-2%. Okay. We won't go below that level. Right. Okay. Thank you. Last one for me, just around the book of business. Transportation, long haul, I'm assuming these are the 18-wheelers, but I guess who is the underlying counterparty in these leases in that book? Well, it'd be the transportation companies are leasing the equipment. Yeah. Are these large companies? Who are we looking at in terms of truck sizes, quantity, things like that? These will be typically the smaller companies, so 3-10 truck type output. The reason why I am asking is another company that is out there lent against a firm that was doing sort of walk-away leases. Is there any type of walk-away lease type truck involved in this portfolio, or are these all permanent leases? They are not related to owner/operator leases. These are all the corporates as the counterparty. That is right. There is always a real corporate or a real person on the other end of it. All right. Maybe I will just rephrase it. Are there any owner-operated trucks involved in this lease portfolio? Oh, yes. Well, some of them would be because if you have a three fleet truck, then some of those people are going to be owner-operators as well. They are going to be driving. Do they have any walk-away provisions? No. Okay. All right. In terms of that truck portfolio, have you done a deep scrub of the underlying valuations of that truck portfolio? I guess what I would want to know is there any potential risk that we could have declining values in those truck portfolios related to engine or manufacturer risk and wear and tear, things like that around that transportation portfolio? Certainly we have done a deep dive, and we do have some expertise in-house, as I have described on previous conference calls, around leasing as in our risk second line. We are pretty comfortable that nothing exists in the portfolio as we speak. Okay. We shouldn't expect to see any sort of MaxxForce engine exposure in that portfolio or let's say 2012, 2013, 2014 vintage trucks. These are all newer trucks and non-MaxxForce. Is that fair? I don't know what you mean by MaxxForce, to be honest, but my credit guys are telling me that the leases are good. Maybe I just want to key in on that one. Just in terms of the age of the trucks, do you have any details around the age of the trucks? Our credit teams do, for sure. But you're not able to share that at this point. Well, we can get back to you. We can take it offline. Particular question, so we can take it offline. Yep. That would work for me. All right. Thank you very much. At this time, I will turn the call over to Mr. Moore. Great. As there are no other questions, I'd like to take this opportunity to thank you for participating on short notice. Thanks, Joanna, for assistance, and wish you the best of the season. Goodbye for now. This concludes today's conference call. You may now disconnect.