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MCAN Mortgage research and analysis

Contributed by eResearch

By Bob Weir

MCAN reported net income for Q3/11 of $7.6 million or $0.45 per share. On an adjusted basis, net income was $4.9 million or $0.29 per share versus an adjusted $6.2 million or $0.38 per share in the prior quarter and $8.6 million or $0.60 per share in the same period last year. Theseresults were about $0.08 per share below our expectations. The adjusted net income excludes income taxes of $2.2 million and a positive Fair Market Value (FMV) adjustment of $4.9 million. MCAN has declared its regular dividend of $0.27 per share payable January 3, 2012 with record date December 2, 2011.

This was the third reporting period for MCAN prepared in compliance with the International Financial Reporting Standards (“IFRS”). The impact of IFRS are worthy of repeating. The most significant impact relates to the accounting for the securitization of insured mortgages through its participation in the Canada Mortgage Bonds (“CMB”) program. Under IFRS, MCAN no longer accounts for these transactions as sales of mortgages and now records them as assets. This has increased the balance sheet quite considerably from $0.6 billion, as at the end of Q4/10, to $3.8 billion this quarter. The impact on MCAN’s income statement will, for the most part, increase volatility as interest rate swaps will be stated at FMV each quarter with no accounting offset even though there is an offset. It is basically the equivalent of valuing one side of the balance sheet at market and the other at historical cost. A more detailed analysis follows in the section IFRS Impact.

The quarter benefited from a 43% Y/Y increase in mortgage loans in the corporate asset portfolio offset by lower net interest spreads. On a sequential basis, mortgage volume grew by a more modest 4% which was well below our forecast. Net investment income from corporate assets in the quarter was $5.4 million, down 34% Y/Y and 13% sequentially. This quarter was lower than expected due to lower equity income from MCLP and lower net interest spreads on mortgages sequentially and Y/Y. Securitization income was lower by 44% Y/Y driven largely by a 20% decline in the average portfolio. Equity income from MCLP was $0.4 million in Q3/11 versus $1.2 million in the same period last year. Last year also benefited from a recovery of credit losses of $1.0 million.

For 2011, we have lowered our forecast adjusted EPS to $1.27 from $1.55 per share (excluding FMV adjustment and income tax recoveries). The earnings revision resulted from (i) lower volume growth than expected, (ii) a further lowering of net interest spreads, (iii) lower than forecast fee  income and equity income from MCLP. MCAN has a demonstrated record of loan loss recoveries such that actual losses have been virtually negligible at 10 bps (basis points) over that time period.

However, key to MCAN’s growth is its current excess lending capacity of some $177 million as at the end of the quarter which we expect will accommodate significant asset growth of 15% annually over the next 18 to 24 months. For 2012, we have lowered our estimated EPS to $1.35 from $1.75 per share driven by lower spread and loan growth assumptions.

We continue to expect dividend payout over the next 12 months to approximately $1.15 per share which assumes a regular quarterly dividend of $0.27 per share ($1.08 per share annually) plus an extra dividend in Q1/12 of $0.05 to $0.15 per share.

We recommend MCAN as a BUY. We have lowered our share price target to $14.50 from $16.50. We conclude that MCAN’s asset growth potential, when combined with its strong credit experience, positions it as an overlooked investment opportunity with a very attractive sustainable yield potential. MCAN will be ideal for pension and other tax deferred accounts such as RRSP and RIF accounts and particularly attractive for non-taxable TFSA accounts.

Valuation

Our one-year target price implies a 10.7 times multiple on our 2012 EPS estimate. This valuation is in line with the average P/E ratios of Home Capital and Firm Capital and is a discount of about 10% to the average of the six major Canadian chartered banks. Our valuation for MCAN also includes five key factors; namely, (i) earnings potential, (ii) risk profile, including overall leverage, (iii) expected profitability, including return on equity, (iv) share liquidity and (v) its long standing Board of Directors representing significant shareholdings.

Based on our dividend expectation for the next 12 months of $1.15, our target share price would imply a potential yield of about 7.90%. At this level, MCAN’s yield would imply about a 700 bps premium over the current one-year Government of Canada bond yield. When compared to a high yield corporate bond fund, such as MHY.UN (monthly payout with a current yield of 7.26%), MCAN would support about a 10% premium yield.

Other Quarterly Highlights

- MCAN reported net income of $7.6 million or $0.45 per share for Q3/11 versus $10.7 million or $0.74 per share. However, from an operating standpoint, excluding (i) fair market value adjustments of $4.9 million, and (ii) an income tax provision of $2.2 million, adjusted net income was $4.9 million or $0.29 per share versus $8.6 million or $0.60 per share in the same period last year. The decrease Y/Y was attributed to (i) lower volume growth, (ii) lower interest spreads, (iii) lower fee revenue and (iv) lower than expected equity income from MCLP. Adjusted net income decreased 21% sequentially driven by lower investment income and lower equity income from MCLP.

- Total assets as at quarter end were $3.8 billion, down 2% Y/Y and basically flat sequentially. Corporate mortgage loans amounted to $540 million, up 29% Y/Y and higher by 4% sequentially. The corporate mortgage portfolio added an average of $100 million or 61% in single family mortgages on a Y/Y basis. Construction and uninsured single family mortgages increased by $20 million or 10% Y/Y. The uninsured portfolio increase was driven by two portfolio acquisitions during the first quarter. Securitized assets, reported on the balance sheet, declined 15% Y/Y and were flat sequentially at $3.1 billion.

- Average ROE for Q3/11 was 19.5% versus 34.3% in the same period last year and 19.9% in the prior quarter.

- Total net investment income, before the fair market value adjustment, was $6.5 million versus $10.1 million in the same period last year and $8.0 million last quarter. Of the total Y/Y decline, $1.8 million or about half was attributed to lower fees and equity income from MCLP.

- Corporate Asset net investment income was $5.4 million, down 34% from the same period last year and 13% sequentially. The decrease on a sequential basis was driven by lower income from the equity income MCLP and lower net interest spread.

- Net interest income on corporate assets (interest earned on loans less deposit cost) was reported at $5.6 million. The net interest income was helped by the increase in the corporate asset loan portfolio but partly offset by lower net interest spreads. The average yield on mortgage loans in the quarter decreased to 6.47% from 7.32% in the same period last year while the average cost of term deposits increased to 2.45% from 2.08%. Net interest spread decreased Y/Y by 1.22% to 4.02% from 5.24%. Sequentially, net interest spread declined 16 bps.

- Securitization Asset net investment income, before fair market adjustments, was $1.1 million versus $1.8 million in the same period last year, down by almost half. Average mortgage balances declined $389 million or almost 20% Y/Y. After fair market adjustments, net investment income was reported at a profit of $6.0 million. The difference between the latter and the $1.1 million clearly demonstrating the volatility of earnings due to IFRS accounting.

- Fee income was $333,000, down from $1.3 million last year. Fees consisted of fee income from a profit sharing arrangement relating to mortgage portfolios acquired by MCLP of $82,000 and other mortgage fees of $251,000 versus $883,000 and $438,000 in the same period last year respectively. Fee income was particularly strong last year.

- Equity income from MCLP was $0.4 million in Q3/11 versus $1.2 million in the same period last year driven by lower mortgage gainsand fee income.

- Impaired loans were $14 million as at the end of the period or 2.51% of total corporate mortgages (net of allowances) versus $15 million or 2.46% of total corporate mortgages as at the end of last quarter and $15 million or 3.40% of total corporate loans as at the same time last year.

- Provision for credit losses decreased to $80,000 from $257,000 last quarter but were up from a recovery last year of $1.0 million. This quarter reflected provisions of $95,000 less recoveries of $15,000.

- Total corporate mortgage arrears were $28 million as at the end of the quarter, up marginally from $26 million as at the end of last quarter.
Securitized mortgage arrears were $52 million, down from $61 million as at the end of the prior quarter.

- Tier 1 Capital Ratio (Basel II) was 27.4% versus 26.8% as at the end of last quarter. MCAN’s regulatory capital ratio was 4.63x versus 5.58x as at the end of last quarter.

Forecast For Year-Ended December 31, 2011

Mortgage loan growth is expected to slow over the balance of 2011 into 2012, particularly in residential home construction. However, the slowing is not expected to be material. We expect competition from the banking sector to continue stronger than expected. MCAN plans to diversify further in Canada which should help volume growth. We are forecasting corporate mortgage growth for the year of about 40% Y/Y. MCAN had about $177 million of unused lending capacity as at the end of the quarter. Securitization assets are expected to decline over the next 4 years with $1.1  billion maturing in each of 2012 and 2013.

Interest spreads on the loan portfolio have narrowed more than anticipated over the first nine months of 2011. We estimate that the corporate loan spread between the yield on mortgage loans and other loans and the cost of deposits to decrease to the 4.25% to 4.40% (previously 4.75%) level from 5.43% in fiscal 2010.

MCAN’s total net investment income is forecast to decrease by about 14% Y/Y, excluding FMV Adjustments. The lower net investment income is the result of the increase in the size of the mortgage portfolio offset, in part, by lower interest margins. In addition, fee and equity income from MCLP are expected to decline Y/Y by about 60%. Operating expenses are expected to be higher by about 7% Y/Y.

Overall, credit quality is expected to remain extremely stable. PCL is forecast to increase to $0.8 million (but down from our prior forecast of $1.0 million) from the net reversal of $0.4 million in 2010. The higher losses are, for the most part, volume related.

Adjusted net income is forecast to increase to an estimated $20.7 million or about $1.27 per share, down from our prior estimate of $25.3 million or $1.55 per share. We expect MCAN’s regular dividend to be maintained at $1.08 per share in 2012 with an extra dividend payable in the first quarter of fiscal 2012 of $0.05 to $0.15 per share. This would imply a total payout in 2012 of approximately $1.15 per share.

IFRS Impact on MCAN of Fair Value Accounting

MCAN’s financial results are prepared and reported in compliance with IFRS. The most significant difference is the accounting for the securitization of insured mortgages through its participation in the CMB program. The impact on MCAN’s financial statements are summarized below:

- Balance Sheet: Under IFRS, MCAN no longer accounts for these securitization transactions as sales of mortgages and now records them as assets. This has increased the Balance Sheet quite considerably from $0.6 billion as at December 31, 2010 to $3.8 billion. Included are $1.7 billion of securitized mortgages and $1.1 billion of financial investments. MCAN participates in the economics of each CMB issuance in accordance with a pre-determined economic sharing percentage which dictates the upfront and ongoing cash flow rights and obligations of the participants. MCAN’s weighted average economic participation for outstanding CMB issurances as at June 30, 2011 was 28%.

- Income Statement: The impact on MCAN’s income statement will, for the most part, increase volatility as interest rate swaps will be stated at fair market value at the end of each quarter with no offset. Stated as simply as possible, MCAN enters into “pay floating rate,  receive fixed rate” interest rate swaps as part of the CMB program. The purpose of the interest rate swaps is to hedge interest rate risk on both securitized mortgages and other assets that have a floating interest rate, as substantially all interest payments on the securitization assets are fixed rate.

- Does IFRS Make Sense? Not really, as it is basically the equivalent of valuing one side of the balance sheet at market and the other at historical cost at the end of every quarter. The gain or loss is then added or subtracted from its earnings. In actual fact, fair value changes in the financial instruments are generally offset by changes in future expected income from securitized mortgages and other assets that have a floating rate. The latter has not been reflected in income. The important issue here is that MCAN intends to hold all these instruments to maturity so in actual fact, little or no gain or loss will ever be incurred over the life of the financial instruments.

- What IFRS Does Do! We expect that IFRS will make earnings more volatile on a quarterly basis. Therefore we will adjust earnings each quarter by excluding the fair market value adjustment on derivative financial instruments.

Review of MCAN’s Business Model

MCAN’s business model is designed to generate a steady and reliable stream of income by investing in a portfolio of mortgages (including single family residential, residential construction, non-residential construction and commercial loans), as well as other types of loans and investments, real estate and securitization investments.

MCAN employs leverage on its invested capital by issuing term deposits eligible for Canada Deposit Insurance Corporation (“CDIC”) deposit insurance. The term deposits are sourced through a network of independent financial agents. MCAN invests its own equity capital and the funds derived from the term deposits in eligible investments such as residential mortgages.

MCAN derives its income from fees as well as net interest revenue which is the difference or spread between revenue earned on assets and the cost of the term deposits issued. Consequently, the size of MCAN’s investment portfolio is important to its total earning capacity.

MCAN, like the Canadian chartered banks, is federally regulated by the Office of the Superintendent of Financial Institutions (“OSFI”). For regulatory purposes, OSFI has provided MCAN with a consolidated regulatory leverage maximum on capital employed which limits the amount of assets MCAN may acquire. However, in addition, MCAN, as a MIC, is also limited by the Income Tax Act (Canada) (“Tax Act”) which enforces a liabilities to capital ratio of 5:1 (or an assets to capital ratio of 6:1), based on MCAN’s non-consolidated balance sheet measured at its tax value. The maximum leverage permitted under the Tax Act is actually more constraining on the company than the regulatory assets to capital ratio mandated by OSFI. For this reason, MCAN manages its assets to a level of 5.75 times capital based on its non-consolidated balance sheet at its tax value to provide a prudent cushion between the maximum and total actual assets.

In actual fact, MCAN’s leverage ratio is very conservative when compared to the over 21:1 ratio currently supported by the major Canadian chartered banks. Furthermore, MCAN’s Tier 1 Ratio as defined by Basel II (international bank capital guidelines) is 27.4% compared to the Canadian bank average of 13.3% implying that MCAN has almost double the capital supporting its assets and liabilities.