FN.TO - First National Financial

[Grossbaum]

PDF with images and financials attached.

 

In $C

Price $36.40

Market Cap $2,180m

EBIT $245m

Net Income $180m

EPS $3.00

Earnings Yield 8.2%

Price/EBIT  8.9x

P/E 12.1x

ROE 40%

TTM Div Yield 6.7%

 

Summary

Well run company, that is the largest non bank lender in Canada and they are a large servicer of loans as well. Mortgages under administration are about $105b, of which 80% is residential and 20% commercial.

 

Revenue Sources

29% Institutional Placement  (Originates a mortgage and places it with a lender, takes a fee)

27% Net interest - Securitized mortgages (Earns the spread between the mortgage rates and the CMHC rates loans issued)

27% Mortgage Servicing - (get perhaps ~0.20% for servicing residential mortgages and less than that for commercial)

17% Investment income (owns mortgages for a short period between origination and securitization/placement)

 

Notes about the business:

• Non Capital intensive business that has high returns on equity, ($440m of common equity producing $180m in earnings)
  
• Essentially 85%+ payout ratio - FN can’t reinvest meaningful capital back into the business
  
• Two largest owners own about 71% of the Company
  
• Stephen Smith - Co founder CEO/Chairman (~$815m worth of stock, 22.4m shares)
  
• Also has purchased 20% of EQB on the open market in the last 5 years
  
• Moray Twase - Co founder EVP ($740m worth of stock, 20.4m shares)
  
• Smith & Twase sold 1.3m shares in a secondary in December ‘19 at ~$42/share
  
• IPO’d in 2006 and has produced a 730% cumulative gain since then, or 17% per year
  
• Has paid out over $21 per share in dividends since IPO
  
• Operating Income has grown at about 10% a year over the last decade
  
• 2018 was the Company’s 30th consecutive year of profitable operations
  
• Run very conservatively, financially - less than 0.5x debt to operating income
  
• The Company doesn’t have material underwriting/loss risk - they don’t own the mortgages once securitized
  
• A key advantage for FN is having a direct relationship with the borrower -
  
• The Company is considered by most of its borrowers as the “mortgage lender”
  
• Company can negotiate new transactions and pursue marketing initiatives directly with the customers
  
• Higher mortgage spreads increase profitability for FN, lower mortgage spreads decrease profitability - spreads got wide during the financial crisis and have compressed back down to normal levels since (see chart below)
  
• FN has the lowest cost funding levels because of its size and relationships which helps it be the most profitable non bank mortgage lender and securitizer
  
• Earnings increased dramatically in ‘09 / ‘10 as mortgage spreads widened
  

 

Technicals:

• 60m shares out; 17m float due to high insider ownership
  
• 85k/day avg volume, or about $3m $C trading per day
  
• FN can’t repurchase shares because of already limited float
  
• Has averaged ~10x BEst P/E ratio. Has never got a high multiple, although has compounded at a high rate from earnings growth and distributions.

 

Comps

FN ~5% market share - origination

• MCAP (private) ~4%
  
• Street Capital Group (SCB.CN) ~2% market share of total Canadian MUA - acquired 10/2019 by RFA Capital
  
• Paradigm Quest/Merix ~2%

 

Roughly C$1.6 trillion (USD $1t) of residential mortgage debt in Canada; so at $70b in residential mortgages serviced for FN, that would be servicing about 4.4% of total outstanding resi mortgage debt.

 

Overview of the industry

Mortgage finance companies have taken share from big 6, and First National has grown the fastest. My impression is the Big 6 Canadian banks have seen increased regulation which impedes them from being able to originate mortgages swiftly and efficiently. The Big 6 mortgage origination process has become bureaucratic due to the regulations. The non-bank lenders are more nimble and easier to work with so they have been gaining share of total residential mortgage originations. Non bank originators I believe have increased share of total origination in Canada from ~3% in 2005 to above 15% today. This is a similar dynamic seen in the US, with non bank lenders gaining share.

 

https://www.bankofcanada.ca/wp-content/uploads/2016/12/fsr-december-2016-coletti.pdf

 

 

Valuation / Return Potential

I think even without multiple expansion the return potential at current prices can be attractive. If you combine the 8% earnings yield with 6% earnings growth you would get 14% annual growth in value, assuming no increase in multiple. The fact that First National can grow earnings meaningfully without retaining much of its earnings makes the return potential attractive. There is upside if the multiple rerates, which I believe it should given the quality of the business - although historic multiples have consistently been below market.

 

Risks

• Spreads may continue to be compressed, and FN may earn less net interest on securitized mortgages
  
• There may be increased scrutiny of non bank lenders - regulation may increase and erode the Company’s edge in providing superior services to customers
  
• Small float may keep multiples depressed, as larger institutions may not be able to own the stock
  

First_National_Financial_Notes.pdf

FN.TO_01_2020.pdf

[Grossbaum]

Just a quick update (financials attached):

 

2020 ended up being a strong year for FN. Adjusted operating income was up about 30% as total mortgage originations increased,  spreads widened (as other players retreated from the space due to the Covid disruption), and total Mortgages Under Administration continued its growth.

 

2021 should benefit from the increased spread in mortgages originated in 2020, that are now securitized and earning elevated net interest income.

 

The way I see it, most of the gains in the stock price over the last year has come from earnings improvement, and therefore the multiple of earnings that FN is trading at has not increased.

 

I believe at current valuations, First National is still an attractive investment.

 

In C$

Price $49.30

Market Cap $2,950m

EBIT $330m

Net Income $240m

EPS $3.95

Earnings Yield 8.1%

Price/EBIT 8.9x

P/E 12.3x

FN.TO_03_2021.pdf

[Uccmal]

Thanks Grossbaum, Nice summary.

 

I dont frequent the board as much, and have barely posted for several years. 

 

I have held First National for at least 8 years.  At the moment it probably makes up about 12% of my portfolio. 

 

I became an owner due to being a customer.  I am no longer a customer.  I needed a lender that could give me a big HELOC in the last refinance, and Scotiabank had slightly better rates than FN.  FN doesn't do HELOCs (so far). 

 

Their growth story is nothing short of amazing. 

 

Nearly all the business they write is 'prime' mortgages.  They chose to be selective, and leave the chaff for lesser lenders.  Consequently they have no trouble securitizing their mortgages with Institutions. 

 

They also do alot of business for TD.  And they are very slowly building out their commercial mortgages to prime customers, of course.  I also like the fact that they are a virtual company.  You cant walk into a First National outlet.  They have been in business since the start of the internet and have kept costs very low by not trying to be all things to the public. 

 

I especially like the special dividend that seems to appear every Christmas.  This has paid for my family to go south a few times. 

 

The way I work a company like FN is to buy it when there is some kind of crisis, or panic.  Last spring is the perfect example.  I was selling off part of my position during the rally ahead of the Pandemic last year.  Within weeks I bought back whatever I had sold, and some extra at half the price.  Right now I am very slowly selling it down to keep the position right sized. 

 

Eventually something will happen to bring the price back down again and I will load up.  And again, and again.  Tawse and Smith still seem very much in control.  As long as that is the case I am okay with it.  Last year, one or both of them took some money out, likely for diversification or estate planning purposes. 

 

I am wary of a couple of things:

 

- Tawse or Smith, or both deciding to retire.  But I honestly dont think they will.  It cant be that difficult to run this thing now that they have all the controls and culture in place.

- the growth runway: Every year I keep expecting them to hit a wall, but they seem to keep on pulling rabbits.  Should they hit a wall the stock will likely stabilize at a price that justifies the dividend.

- a major recession in housing.  As above, they are a careful lender, and cut their teeth during the financial crisis.  I am not sure they would even miss a beat since their customers are the least likely to suffer in a recession. 

 

Cheers, Al