A Survey of Home Capital Group (HCG.TSE)
Market Price $ 17.10 CAD
Market Cap $ 1.37B CAD
AVG Volume 460,000
Please note all following dollar amounts are in CAD.
The Company:
Home Capital Group Inc. is a public company, traded on the Toronto Stock Exchange (HCG), operating through its principal subsidiary, Home Trust Company. Home Trust is a federally regulated trust company offering residential and non-residential mortgage lending, securitization of insured residential mortgage products, consumer lending and credit card services. In addition, Home Trust offers deposits via brokers and financial planners, and through its direct to consumer deposit brand, Oaken Financial. Home Trust also conducts business through its wholly owned subsidiary, Home Bank. Licensed to conduct business across Canada, Home Trust has branch offices in Ontario, Alberta, British Columbia, Nova Scotia, Quebec and Manitoba. 1
The Customer:
· Small business owners who cannot prove enough income to qualify with a major bank
· New immigrants to Canada who do not have a credit history
· Homeowners who have built up equity in their property but do not meet income requirements of the major banks
· Canadians with former credit difficulties that have since been resolved, including discharged bankrupts. 10
Valuation:
Possible intrinsic value range based on $200mi free cash flow / $1.5bi cash on hand and your evaluation / optimism / math / discount rate:
$4,000 mi CAD – $50 per share
$1,500 mi CAD – $19 per share
1. Background
Founded in 1977 and floated on the TSE in 1996 HCG grew to be Canada’s largest alternative mortgage lender until a series of executive missteps nearly derailed it.
JUN2014 - Home Capital Group "became aware of irregularities" associated with certain mortgage applications and launches an investigation in August, the OSC says. 2
FEB2015 - HCG files annual financial statements for 2014 and blames a decline in mortgage originations on "external vagaries such as macroeconomics, seasonality and competitive markets," according to the OSC. 2
FEB-JUL 2015 - HCG "knew it had terminated certain brokers because it had discovered fraud in HCG's broker channels," but didn't disclose its findings to shareholders, according to the OSC. 2
JUN2015 - HCG's chair of the audit committee receives a "Whistleblower memorandum" from a vice-president of HCG concerning the failure to disclose the findings of fraud. 2
JUN2015 - HCG for the first time publicly announces an internal review of its business partners led to the termination of relationships with certain brokers, which caused the drop in originations. HCG shares fall 19 per cent the next day. 2
FEB 2016 - HCG announces that co-founder and CEO Gerald Soloway plans to retire. 2
MAR2017 - HCG discloses that the OSC served several current and former executives with enforcement notices concerning disclosure. 2
19MAR 2017 - OSC files disclosure allegations against HCG, Gerald Soloway, CFO Robert Morton and Martin Reid. 2
27MAR2017 - HCG terminates CEO Martin Reid. 2
MAR-JUN 2017 HCG faces a run on the bank by its depositors and is bailed out by HOOPP with a $2bn CAD line of credit. 3
22 JUN2017 Berkshire Hathaway Inc.(BRK) said it has agreed to indirectly acquire a 38.39% (Approx. 19% was left up to a shareholder vote in SEP2017) stake in troubled Canadian mortgage lender Home Capital Group Inc. as part of a rescue package that includes a 2 billion Canadian dollars ($1.5 billion) loan. 4
12SEP2017 Shareholders representing more than 88% of the shares (which excluded the shares held by Berkshire) voted against the second 19% acquisition by BRK; resulting in no further dilution of shares. 5
2. Thesis
After the tumultuous events of the last two years HCG is now in a position to return to doing what it does well; generating cash.
3. Health of the Company
Income Statement: Since 2007 net income has increased at a good pace from 90mi – 2007 to a high of 313mi – 2014 and as late as 247mi - 2016. Although this looks good we must attribute some of this fast increase in 2012-2014 to the aforementioned substandard underwriting based on fraudulent submissions by brokers originating loans for HCG. 11
Long Term View: To err on the side of caution I would recommend a conservative estimate of 200mi in free cash flow within 1-2 years and a follow on growth rate of 10% with a flattening of growth at around 1.5% after 5 years; based on these assumptions the current intrinsic value falls between $1,500mi to $4,000mi or around $19 to $50 a share.
Short Term View: There is a fair chance HCG will turn a small profit for 2017 (not bad for a company that nearly went under 6 months ago…)
Balance Sheet – As of 30SEP2017 we find a refreshingly healthy sheet with no long term debt and the $ 2bi BRK line of credit undrawn. Asset sales have pushed usable cash to $1.5 billion and the company itself notes its book value at $22.20 a share; with a market price of $16.04 it appears we have our margin of safety. 1
Cash Flow Statements – Show no questionable behavior (i.e. paying dividends with freshly issued debt etc.) and indicate a trend towards building shareholder equity even with dividends paid out. Shareholder Equity increased from 2007 to 2017 from $348mil to $1782mil. 11
Management – Recently hired CEO and CFO have significant mortgage lending backgrounds. 6
Insider Activity – SEDI shows 79,000 shares (1.2mil) purchased by insiders in NOV17. 13
Labor – Morale is a touch low due to the last year, but management believes it is on an upswing. 1
4. Risks:
Loss of income to competition – Unlikely; HCG occupies the niche alternative mortgage market in Canada and faces competition primarily from Equitable Group (MktCap:1.17B). Ratios below show HCG seems to have a stronger financial position and therefore the operational advantage. Do note that HCGs current efficiency ratio is at 114.5% due to the liquidity event expenses, which management says will subside in the coming year. 1,9
HCG ‘16 Efficiency Ratio ~38% / Total Capital Ratio: 22% / Leverage Ratios: 8%/ LTV:54%
EQB ‘16 Efficiency Ratio ~38% / Total Capital Ratio: 17% / Leverage Ratios: 5%/ LTV:61%
Loss of income to creative destruction – Very unlikely; Nothing significant appears on the horizon and loan applications can be made via HCGs website placing them firmly in the 21st Century.
Loss of income due to shrinking customer base – Very unlikely; Folks who meet their customer profile will search out the bank since they are unable to qualify for loans through normal mortgage lenders. The company points to the federal annual 300,000 person target for new permanent residents as a positive trend.1
Further Share Dilutions – Very unlikely; enough cash and a line of credit are in place.
Drop in income due to fall in interest rates – Very unlikely; current government efforts point towards a raise in interest rates; even if the rate was lowered it would have a minor impact based on the company estimate that a 100 basis point cut would result in (9,190)mil loss to income over the next year.1
Market Price collapse due to future delinquencies – Very unlikely; even thou much of the scandal over the last 2 years revolved around undisclosed poor underwriting the delinquency rate for HCG currently sits at 0.31% 1
Collapse due to a Canadian Housing Crisis – Very unlikely; current low interest rates reduce the chance of a significant correction; although a correction may occur due to the many factors that have been listed on this forum ad nauseam a collapse similar to 2008 seems unlikely. Canadian regulators are aggressively reigning in speculation and stand a good chance to succeed with their current measures. If a correction does occur HCG has cash on hand, a credit line, and could easily issue senior debt; its LTV average of 53.7% gives it a fair margin of safety when it comes to recovering value; furthermore 2.82bi of its 13.28bi portfolio is federally insured. HCG also possesses a good Total Capital Ratio / Tier 1 Capital Ratio of 21.25% and a leverage ratio of 7.89% all of which allow for room when it comes to meeting regulatory standards. 1
New Regulations reduce income – Very unlikely; Stricter lending practices that began on 01JAN2018 may reduce the amounts HCG is able to lend to renewing or new borrowers. Management has stated that it is tough to estimate the effects on the overall current business, but that new business will be created as some lenders are unable to lend to previous or new customers. This would level out the risk and may even increase income.1,7
Buy Out – Even Chance; BRK did try to acquire 40% of shares at one time; the $200-400 million dollar deal seemed out of line for Mr. Buffett’s “elephant” gun – perhaps it is due to the future intrinsic value of the company being more along the lines of $2-5bi and it was just too hard to turn down a dollar for a quarter. As a long term investor I would like to retain this yielding asset and not lose a big earner early on.
Loss due to a tender offer at a lower market price then current price – Very unlikely. A market correction could allow for a market price at a level where BRK could offer a tender for all remaining shares, which may result in a loss at this entry point. Given that they would still pay a premium on market price and need shareholder approval this seems unlikely.
Catastrophic event permanently affecting the greater Ontario area – Nearly Impossible; 83.2% of HCGs loans are secured by Ontario property. Current volcanic activity is not considered dangerous and earthquake activity has only caused minor damage in the last 100 years.12 The three nuclear power plants in operation continue to maintain excellent safety records. Canada’s international stance greatly reduces the possibility of an already unlikely large scale nuclear attack by a state actor / terrorist group; the nearest major US cities are Chicago – 436 miles, NYC– 342 miles, Detroit – 240miles.
I am a shareholder in HCG.
References
1. www.homecapital.com/quarterly_reports/2017/HCG%20Q3%202017%20MDA.pdf
2. theglobeandmail.com
3. bloomberg.com
4. wsj.com
5.http://www.homecapital.com/press_releases/2017/Home%20Capital%20News%20Release%20final%20voting%20results.pdf
6. homecapital.com
7. osfi-bsif.gc.ca
8. bnn.ca
9. eqbank.investorroom.com
10. hometrust.ca
11. homecapital.com
12. chis.nrcan.gc.ca
12. theglobeandmail.com
13. sedi.ca
Catalysts
-Spring 2017 Liquidity Event
-Berkshire Hathaway Investment
-Revision to Guideline B-20 Residential Mortgage Underwriting Practices and Procedures effective 01 January 2018 |
