Equitable Group has just reported financial and operating results for the second quarter and first half of 2008. In contrast to the well known difficulties in housing-related sectors south of the border, Equitable’s results were solid. For the three months ended June 30, net income totaled $10.28 million, an increase of 37% from the second quarter of 2007. Earnings per share of $0.79 were 34% higher than the $0.59 reported in the comparable period a year ago. Annualized return on equity was 19.1% for the most recent three months and 18.9% for the first 6 months of the year. These results were considerably better than the Company’s target of 16% to 18% for 2008. Management also reaffirmed their confidence in meeting stated objectives for the full year, which were developed in anticipation of a challenging economic environment.

After examining the mortgage portfolio, we were pleased to see evidence of stable credit quality. Although $36,000 of loan losses were incurred in the quarter, this represented only a tiny fraction of the $2.9 billion of mortgage assets. Net impaired mortgages improved to 0.16% of total mortgage assets at the end of the second quarter from 0.29% at the end of the first quarter of 2008. It is apparent that Equitable did not employ the hazardous lending strategies and lax standards that led to the dramatic weakness in the US housing and credit markets.

Looking forward, the net interest margin, and therefore profitability, should expand in the coming quarters for two key reasons. First, the single-family mortgage division is the fastest growing segment of all the Company’s business lines. Remember that single-family mortgages are more profitable than commercial mortgages yet require only a third of the capital. Second, the prime rate is expected to stabilize and the mortgage spread over prime should increase due to more normalized credit pricing. In summary, fewer competitors in Equitable’s core market and tightening lending standards at the big banks are creating an opportunity for the Company to increase market share and profitably grow its business.

November 7, 2008

Given the trading in Equitable Group since September, investors can be forgiven for thinking that the end of niche mortgage lending has arrived. The shares have fallen from the recent secondary issue price of $21.50 to a low of $11.05 on November 3, a decline of almost 50%. Thankfully, the shares rebounded to $13.75, or almost 25%, by the end of the week.

Today Equitable released its financial and operating results for the third quarter of 2008, which should provide some reassurance to investors. Total assets reached $4.1 billion, total mortgages receivable were $3.0 billion and single-family dwelling mortgages surpassed $1 billion. Net income increased 22.3% to $10.8 million and diluted earnings per share were $0.74 compared to $0.67 a year ago. Return on equity was 16.7% in the quarter, within the Company’s target range of 16% to 18%.

A critical assessment of the results yields the following. First, we were impressed that the Company funded $976.9 million of mortgages in the third quarter, an increase of 25% over the third quarter of 2007. However, the Company benefited from turmoil in the credit markets, which allowed Equitable to securitize and sell $440 million of CMHC-insured mortgages. This level of securitization is unlikely to be sustainable over the long-run. Second, the credit quality was good, but demonstrated some deterioration in the quarter. Net impaired mortgages were 0.33% of total mortgage assets compared to 0.16% in the second quarter of 2008 and 0.08% in the third quarter of 2007. Due to “changes in economic conditions and real estate values in certain regions of Western Canada” management took a $1 million pre-tax charge to reflect potential losses in its multi-residential portfolio. Third, we saw some net interest margin compression in the quarter, as the prime rate declined while the rate on GICs remained relatively flat. Finally, capital ratios improved in the quarter, as the Company strengthened its total capital ratio to 13.3%, up from 11% in January. Overall, the results are on target, but some softening in the results was apparent and management’s tone was cautious.

However, we believe that the shares are pricing in a much greater deterioration in the Company’s business than is warranted. At current price levels, the shares are trading at 0.76 times book value and approximately 5 times 2008 earnings. Obviously, the market is looking for a massive decline in profitability going forward. After stress testing the financials, we believe that the current price is more reflective of fear and uncertainty than anything else. With a forecasted ROE in the mid-teens, we do not believe that the shares should trade below book value. Nonetheless, as economic data stabilizes and trading liquidity improves we expect the shares to recover nicely.

May 8, 2009

Nervous investors, fearing that Canadian home prices would decline in a similar fashion as American home prices, have punished shares of Equitable Group.  The stock declined from a high of approximately $35 in mid-2007 to reach a low of $8.66 in early December 2008.  As we discussed in our last update, management’s tone has been quite cautious for some time now.  However, economic data has been showing signs of stabilization and the shares have started to recover.

We believe that the upwards momentum could continue given the solid first quarter results, released May 7, 2009.  Net income increased 23.3% to $11.9 million or $0.80 per fully diluted share compared to $9.7 million or $0.74 per fully diluted share a year ago.  Return on equity was an impressive 17.8% in the quarter and book value increased from $17.75 per share at year end to $18.90 per share.  Management’s tone was noticeably better on the quarterly conference call.

Admittedly, some may view the gains on securitization and sale of mortgages through the CMHC MBS and CMB Programs as unsustainable.  Over the past few quarters, the Company benefited from unusual credit market conditions and securitized these mortgages at wider spreads and volumes that were higher than historical levels.  However, on the earnings call, management suggested that volumes should remain firm in the near term but the gross margin would decline somewhat.  This should be mitigated in the second half of 2009 as spread compression related to rapidly falling interest rates dissipates.  The net interest margin is expected to improve as GIC’s roll over at lower rates, new and renewing mortgages are priced more favourably and interest rate floors are implemented on variable rate mortgages.

Finally, we need to examine the credit quality of the Company’s mortgage book.  Thankfully, the Company actually showed a sequential improvement in the quarter.  Net impaired mortgages were 0.94% of total mortgage assets at the end of the first quarter of 2009 compared to 1.21% at the end of the fourth quarter of 2008.  The improvement stemmed from successfully dealing with one problem borrower in Western Canada.  Management took over several key properties that were subsequently sold for losses of approximately $2.5 million, though the majority of the loan was recovered.  As they stated in the press release, “the level of defaults and losses that the Company has experienced in the last few quarters has been manageable and reflect management’s focus on protecting its portfolio”.

We believe that the solid financial results should give investors greater confidence.  In fact, Bay Street analysts were quick to upgrade their earnings estimates and price targets for the stock.  Annualizing the first quarter results, the shares are trading at only five times expected earnings.  We need to monitor the credit quality carefully, but it is safe to say that the Canadian home-owner is typically much more conservative than his or her American counterpart.  We therefore don’t expect to be surprised by a spike in defaults or loss losses.  As investors look past the worst case scenario and management continues to under-promise and over-deliver, the P/E multiple should continue to expand.

August 7, 2009

Equitable Group has, once again, reported a quarter that was ahead of “the Street’s” expectations.  On August 6, ETC reported a 15.5% increase in net income to $11.9 million from $10.3 million a year ago.  Diluted earnings per share increased slightly to $0.80 from $0.79 a year ago versus estimates of $0.73 per share.  Perhaps even more importantly, the press release contained the following statement, “Economic conditions appear to be improving relative to the past few quarters and, based on our increasing comfort with credit and real estate market dynamics, we have increased our sales efforts within the context of ongoing lending and risk management discipline”.  Given management’s conservative nature, this positive tone struck a real chord with investors, who pushed the shares up $1.40 to $19.90 or 7.6%.

The solid earnings performance stemmed from several factors.  First, the net interest margin increased to 1.9% from 1.6% in the first quarter in 2009.  Pricing strategies, such as converting floating to fixed rate mortgages and putting in interest rate floors on floating rate mortgages as they came due are working nicely.  Additionally, reduced competition for GIC sales meant that the cost of funding new mortgages declined.  The second main driver of the better-than-expected profitability was the securitization of $353.9 million of CMHC-insured mortgages that earned $5.8 million for the Company.  The implied rate on the securitization was 1.64%, double some forecaster’s expectations.

Finally, we like to examine the credit quality closely to ensure that the Company’s mortgage book remains solid.  Net impaired mortgages improved to 0.79% of total mortgage principal outstanding from 0.94% at the end of the first quarter of 2009.   Mortgages in arrears 90 days or more improved to 1.34% of total principal outstanding from 1.49% at the end of the first quarter of 2009.  Finally, in the most recently completed quarter, net realized loan losses related to workout activities amounted to $1 million, which is acceptable on a $3 billion book of mortgages.

Considering management’s optimism, the improving profitability and the solid credit quality, we were quite pleased with Equitable Group’s most recent quarter.  Despite the move in the stock today, we still believe that the shares are cheap.  The stock should trade above the current book value of $19.94 per share given the profitability and outlook of this Company.

November 6, 2009

Equitable Group has once again released a solid earnings report on the back of net interest margin expansion and improving credit metrics.  The Company reported a 12% increase in net income to $12.0 million in the third quarter of 2009 compared to $10.8 million a year ago.  Diluted earnings per share grew 9.5% to $0.81 versus $0.74 a year ago.  Book value now totals $20.86 per share, up 16% on a year over year basis.

The Company’s net interest margin, the key driver of profitability, improved from 1.7% a year ago and 1.9% in the second quarter of 2009 to 2.2% in the third quarter of 2009. The net interest margin is expected to continue to improve as the Bank of Canada holds the benchmark rate stable.  Equitable’s pricing and product mix strategies should lead to higher average interest revenue while a lower cost of financing, as relatively expensive sources of funds (raising during the credit crisis) roll over, should lead to a lower average interest expense.  Netting out higher average interest revenue with lower average interest expenses obviously results in a better net interest margin.

Despite rising unemployment, Equitable’s credit quality actually improved in the most recently completed quarter with mortgages in arrears 90 days or more dropping to 0.88% of total principal outstanding from 1.34% in the second quarter of 2009.  Excluding one mortgage that was categorized as impaired but is actually current on its payments, net impaired mortgages amounted to 0.57% of total mortgage assets from 0.79% at the end of the second quarter of 2009.  Management suggested that they have avoided unreasonable losses due to the relative health of the Company’s mortgage portfolio and a general recovery in various real estate markets.

From a capital perspective, the Company issued $50 million of preferred shares and redeemed $2.5 million of sub-debt in the third quarter.  Equitable’s total capital position was 17.5%, well ahead of the Company’s internal target of 13%, and will be used to grow the mortgage book in coming quarters.  As Andrew Moor, President and CEO, stated, “We are confident in our business approach and current strength of demand for mortgage financing will translate into strong performance for Equitable going forward”.

Despite the solid results, Equitable currently trades just slightly above book value of $20.86 and less than seven times 2009 expected earnings.  With a nine-month trailing return on equity of 16.7%, the stock should trade at a more significant premium to book value.  This discrepancy is particularly puzzling when we examine Home Capital Group (HCG).  We acknowledge that Home Capital has a larger market capitalization and a higher return on equity.  However, with HCG trading at 2.6 times book value and ten times 2009 expected earnings, we believe that Equitable Group is simply a bargain in the alternative-lending sector.

April 16, 2010

Equitable has continued its impressive operating and financial performance.  Since reporting its fourth quarter and fiscal 2009 results, the stock has rallied approximately 20%.  Investors were appreciative of the improvement of almost every single operating and financial metric on a year over year basis.

In fiscal 2009, net income grew 33.2% to $51.4 million or $3.36 per share from $$38.6 million or $2.78 per share a year ago.  This implied a return on equity of 17.0% compared to 16.6% in 2008.  Note that the earnings growth did not compromise the balance sheet, as the total capital ratio improved to 17.6% versus 13.5% a year ago.  Book value per share grew 23% to $21.83 from $17.75 at the end of fiscal 2008.  Importantly, these impressive results were generated without relaxing underwriting standards, evidenced by the improvement in mortgages in arrears 90 days or more to 0.64% of total principal outstanding from 1.57% at December 31, 2008.

Based on analysis of the results and the Company’s outlook, we believe that that Equitable Group should trade at a greater premium to its book value than the current multiple of 1.16 times.  From regression analysis of several financial service companies, we believe that 1.5 to 1.6 times book value would not be an unrealistic expectation as the path to economic recovery becomes clearer.  As Andrew Moor, President and CEO, stated, “Given our well-capitalized balance sheet, quality mortgage portfolio and focused risk management processes, we are confident in Equitable’s ability to translate opportunity into value in 2010 for our shareholders”. 

We are extremely heartened by these comments by the CEO, Andrew Moor.  As a result, we remain very comfortable continuing to hold Equitable Group as we patiently await its true valuation to be recognized by the marketplace.