TD reportHome Capital Group Inc.
(HCG-T) C$40.84
Q3/07: Plain Sailing
Event
HCG reported Q3/07 EPS of $0.65, in line with our estimate and consensus,
up 35% year over year and 3% sequentially. In summary, strong results
driven by excellent origination growth (particularly commercial
originations), robust revenues, and efficiency improvements.
Impact
Positive. While we are maintaining our 2007 EPS estimate of $2.58 we are
increasing our 2008 EPS estimate to $3.12 (from $3.09), to reflect slightly
higher loan growth and efficiency improvements. We are also raising our
target price to $45.00 (from $42.00), but at current levels we are lowering
our recommendation to a HOLD (from a BUY).
Details
Loan and MUA growth was strong up 20% year over (see Exhibit 1).
• Originations were stellar rising $258 million or 48%, driven by HCG’s
expansion into the commercial mortgage arena (originating $178 million),
with residential mortgage originations accounting for the remainder, up
15% (including the purchase of a $28 million portfolio from another
lender). We continue to maintain our view that HCG has been
benefiting from recent unrest in the non-bank sponsored ABCP
market and from competition stepping back from the market.
• The EquityLine Visa also continued to grow with outstanding
receivables increasing 68% to $272 million.
• Outlook remains positive, although we note that management
anticipates commercial mortgage growth to be the key driver of
originations during 2008.
Revenues of $50 million were up a robust 23% year over year.
• Net interest income growth was the key driver, driven by margin
expansion and loan growth.
• Other income growth was also solid, up $2 million to $5 million, with
higher administration and servicing fees being the key driver.
• Higher securitization income (was in line with our estimates) and
reflected increased mortgages securitized and higher gains as a
percentage of mortgages securitized - 2.9%, versus 2.0% in Q3/06
(including derivative losses), or down from 3.5% ex derivative losses.
Expense control was excellent – with the efficiency ratio declining to 25.9% as revenues outpaced expenses
growth.
Credit quality was solid – while the PCL ratio increased to 0.23% (from a very low 0.11% during Q2/07), the
default ratio improved to 0.63% sequentially. We maintain our view that management is diligent regarding
credit, and that standards will not be sacrificed for volumes. We also note that management has a reputation
for very stringent collection procedures, a view reinforced by a wide variety of industry sources. Finally, we
remind that HCG is an equity lender (with an average portfolio LTV ratio of approximately 70%), and as such
we believe the company is more protected against any possible downturn in the housing market,
Finally, we believe management is targeting alternative growth opportunities, including the:
• Recently closed acquisition of PsiGate – which will allow HCG to offer payment-processing services to
internet based merchants. Management believes growth opportunities will exist to increase client
penetration when visa cards are required to be chip compliant.
• Establishment of Home Trust Asset Management, with the launch of a limited partnership fund focusing
on small cap financial services during Q4/07.
• Agreement allowing Unity Life to provide creditor life insurance to HCG’s clients (entered into during
October).
• Finally, management completed its first CMB securitization, diversifying funding sources, and we
believe lowering funding costs.
Valuation
The stock is currently trading at 12.9 times 2008 earnings, ahead of the banks (trading at 10.9 times 2008
earnings), and ETC which is trading at 10.0 times 2008 earnings. In our view, the stock should trade at a
premium multiple given: our expectations of 20% EPS growth in 2008; our belief that HCG is a preferred
lender with mortgage brokers; and that commercial mortgage operations will provide a growth opportunity for
the company. As such we have increased our target multiple to the higher end of our 14.0-14.5 times range.
Justification of Target Price
Our target price is derived by applying a P/E multiple of 14.0-14.5 times our 2008 EPS estimate of $3.12.
Key Risks to Target Price
The key risks to our target price include: sensitivity to rising interest rates; a downturn in the housing market;
reliance on gain on sale accounting; reliance on securitization for funding; increased competition; dependence
on several key senior managers and low liquidity and volatile earnings.
Investment Conclusion
Q3/07 was a strong quarter for HCG with impressive origination growth (particularly commercial
originations), strong revenues and efficiency improvements, and in our view, management must be
commended for delivering robust results, in what can only be described as a tumultuous quarter for
small cap sub prime lenders.
However, the stock is up roughly 25% since we upgraded it to a BUY, and while management is pursuing
growth opportunities including growth of its commercial lending operations, expansion into credit card
payment processing services to internet based merchants and the launch of its small cap financial services
fund, we believe growth from core residential mortgage lending is slowing. At current levels, we believe the
stock is fairly valued, and we are reducing our recommendation to a HOLD.