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Home Capital Group – Fallen Angel or Value Trap?

Our view has become more hopeful based on the terms obtained by Equitable Bank for its line of credit. Home Capital Group should be able to get better terms too. Current terms are onerous. Nonetheless, we remain sellers.
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It is fascinating to see the very public and humiliating unravelling of Home Capital Group (“HCG”), at a time when warnings surrounding a historically high Consumer-Debt/GDP ratio and stratospheric real estate prices across much of Canada abound. It seems almost surreal, that what originated as a problem related to falsified mortgage applications by 45 brokers, has brought Canada’s largest alternative lender to its knees in 2017. Regulators now allege securities law violations by the top executives as well.

Therefore, some of the largest equity investors have bailed, while the rest ponder their moves. Nonetheless, HCG’s mortgage book of $29 billion is a drop in the bucket, representing approximately 2.6% of all outstanding mortgages in Canada. Therefore, while a slowdown in some parts of Ontario could be the outcome if HCG continues to falter, overall the mortgage market has other far bigger issues to deal with.

We were, and still are, skeptical regarding prospects for equity investors of HCG, but information disclosed by Equitable Bank (“EQB”) at its earnings conference call gives us hope.

It is indeed disconcerting considering the data outlined in Table 1 below, that EQB, which is a competitor of HCG in the alternative lending segment with a similar business mandate, managed to arrange $2 billion in financing expeditiously, at extremely favourable terms compared to those secured by HCG.

Table 1: Why Such Onerous Terms for HCG?

Home Capital Group Equitable Bank
Tier 1 Capital 16.5% 15.0%
Total NIM 2.38% 1.66%
Demand Deposit (% of Total) 19% 23%
Delinquency Rate 0.30% 0.21%
Line of Credit $2 Billion $2 Billion
One time Guaranteed Fee $100 Million 0.75%
Interest Rate on drawn funds 10.00% 2.3%-2.5% (Estimate)
Interest Rate on undrawn Funds 2.50% 0.50%
Overcollateralization 2x 1.2x-1.3x (Estimate)
Size of Mortgage Book $28.9 Billion $22.9 Billion
Source: ANTYA Investments Inc., Home Capital Group & Equitable Bank

As outlined, EQB’s metrics are like those of HCG, except the regulatory reprimand served on HCG. While cognizant that regulatory rebuke can be onerous, and we do NOT take it lightly either, it still appears to us that either HCG recieved poor advice, or that there are more skeletons in the closet.

In absence of new problems, one could reasonably argue that HCG’s board failed the competence test in steering HCG in its hour of need. Clearly, the mortgage book of HCG is in no worse shape than that of any other participant in the industry, and while overall industry conditions are expected to normalise towards lower growth and declining volumes for all participants, not much is amiss from an operational standpoint at HCG.

While granting that ensuring liquidity at HCG is paramount, given HCG history on the street, it strikes us as odd that EQB should get a significantly better deal than HCG for accessing similar levels of liquidity in short order. In our view, given the depth and liquidity of Canadian capital market, $2.0 billion would have become available to HCG  quickly and at much better terms. If one believe that all hell broke loose on April 24, 2017, after HCG’s press release regarding deposit redemptions, then EQB’s success at arranging its credit facility at much friendlier and reasonable terms is startling. After all deposits are leaving EQB at $75 million per day as well.

Therefore, we deduce that although under duress, HCG should have shopped for its needs and negotiated better terms for its credit facility.

What can HCG do now?

  1. Immediately suspend the dividend to conserve approximately $65 million per year in cash.
  2. HCG should issue $2 billion in equity at $8/share, issuing 250 million shares.
  3. It should raise interest rate on its HSIA, and on its GICs, across the board by 25bps for one year, to entice current depositors to stay.
  4. HCG should offer customers a one-time bonus at the end-of the term of 25bps to create stickiness, and run this promotion for all new $100,000 deposits it can attract for the next 6-9 months.

On the current $15 billion deposit base, a 50bps increase in interest expense for an year or two, would cost a maximum of $150 million, bring new depositors in, and will bring stability to the funding side of the business. It appears higher deposit rates will cost as much as the facility from HOOP, but would be cheaper longer term than regaining lost depositors. HCG is committed to paying $100 million to HOOP, but from here onwards, it should increase compensation for its accounts, rather than paying 10% to HOOP for drawn credit, while maintain the flexibility of access to cash if needed.

Earnings Visibility Remains Poor

For 2017, if HCG withdraws the entire $1.0 billion from HOOP (which appears likely), it will cost the company $225 million (including one-time commitment fee and fee on unused amounts), ceteris paribus lowering net income to approximately $1.25/share. Our estimated decline of net-income for 2017, excludes any effects of business disruption working its way currently through operations increasing costs, and any lost opportunity in the marketplace to fund incremental mortgages.

Furthermore, industry participants expect compressed NIM in marketplace driven by new regulations and increased competition beginning Q2-17.Moreover, by 2018, if depositors do not come back and the entire $2 billion is drawn down at 10%, in absence of any mass lay-off, with top-line declining from 2017 levels due to a shrinking mortgage book (in absence of funding, the company cannot grow its mortgage book), earnings will also decline from already low 2017 levels.

Conclusion

Whether it is by chance, or due to poor decision making, the HOOP lifeline is a noose around HCG. HCG needs to immediately issue equity to soothe capital markets, and get better terms from somewhere else with another line of credit. Many in the media have already discussed conflict of interest and governance issues at HCG. If HCG wants to survive, it needs to issue equity right away to a group of deep-pocketed mutual funds and institutional investors. Even then, the road to an earnings recovery will be excruciatingly slow. We remain sellers, although if EQB can get good terms for a line of credit, we have become more hopeful for HCG as well.