Berkshire Hathaway's Recent Investment: Home Capital Group

Berkshire Hathaway sought value in Canada

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Jun 25, 2017
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The Toronto-based mortgage Home Capital lender recently made a deal with Buffett’s Berkshire Hathaway. This after it suffered heavy blowbacks coming from the country’s Ontario Securities Commission allegations since April of this year.

The allegations were a result of Ontario Securities Commission’s 18-month investigation of Home Capital’s previous dealings.

The allegations concluded that Home Capital made “materially misleading statements” to its shareholders, blaming the decline in its mortgage business to “external vagaries, such as seasonality and competitive markets.” In fact, it was internal fraud that was depleting Home Capital’s bottom line (Vice).

Marc Cohodes, a former hedge fund manager and a tough critic, has been betting for more than three years on the lender’s implosion.

All these troubles originated in 2014 and early 2015 when the lender’s brokers provided “fraudulent employment income documentation” on some of the home buyers.

Prior to the allegation, Home Capital fired its CEO followed by its founder about a month later, lost C$1 billion and more in deposits and has entered a dire situation after having existed for 40 years.

In May, several suitors including Apollo Global Management, Blackstone, Brookfield Asset Management, Fairfax Financial Holdings and Centerbridge Partners were reported to be interested in the troubled lender while its country’s lenders showed little interest.

This week Berkshire Hathaway made a deal through its subsidiary with Home Capital for a $2 billion credit line with 9% interest along with a C$400 million equity investment or 38% at about $10 per share, according to Bloomberg. Home Capital’s stock rocketed 27% on this announcement, on June 22 to C$19.

Recent quarter performance

Home Capital reported its first quarter 2017 results in May. The lender delivered 1.5% rise in its revenue to C$147.7 million and a contrasting 9.7% drop in profits year over year to C$58 million—leading to a profit margin of 39.3% vs. 44.2% in the same period last year.

As observed, the lender logged 324.6% increase in its credit loss provisions, C$5.92 million, and 11% higher operational expenses to C$64.5 million, therefore resulting in lower profitability.

“Home plays a very important role in the Canadian housing market, providing financing for thousands of deserving customers, including entrepreneurs and new Canadians, and we are committed to ensuring the sustainability of this key enterprise. We are taking the steps required to regain the full confidence of Home’s stakeholders, most notably by adding four outstanding new directors with considerable expertise in governance and business, and we will continue to look at every opportunity to strengthen Home as we move ahead.”

Brenda Eprile, Chairman, Home Capital

Valuations

Despite the recent run up in share price, Home Capital (OTC shares) is still undervalued compared to its peers. According to GuruFocus data, the company had a trailing P/E ratio of 5.12 times vs. the industry median of 14.53 times, P/B ratio of 0.72 times vs. industry’s 1.2 times, and P/S ratio of 2.1 times vs. the industry’s 3.42 times.

The company also had a trailing dividend yield of 5.32% with a 27% payout ratio.

Average 2017 sales and earnings per share expectations indicated forward multiples of 4.1 times and 19.6 times.

Total returns

Home Capital stock provided 5.24% total negative returns in the past five years and 38.9% total negative returns so far this year compared to the S&P 500 index’s 15.2% and 9.8% total positive returns, respectively (Morningstar).

Home Capital Group

According to filings, Home Capital Group Inc. or Home Capital operates 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.

In 2016, Home Capital had 84.1% or C$15.1 billion of its loans in Ontario, 5.8% in British Columbia, 4.3% in Alberta, 2.8% in Quebec, and others.

Home Capital’s management views its business as a single business with separately identified lending portfolios, deposits and other activities.

Home Capital’s key performance indicators (4)

1) Net interest margin (TEB)

According to filings, net interest margin is a measure of profitability of assets. Net interest margin (TEB) is calculated by taking net interest income, on a taxable equivalent basis, divided by the average total assets generating the interest income.

In the recent quarter, Home Capital delivered a margin of 2.44% compared to 2.38% in the first quarter of fiscal 2016.

In fiscal years 2014, 2015 and 2016, Home Capital had margins of 2.83%, 2.83% and 2.73%.

2) Return on shareholders’ equity

Return on equity is a profitability measure that presents the net income available to common shareholders as a percentage of the capital deployed to earn the income.

In the recent quarter, Home Capital recorded a return of 14.1% compared to 15.7% in the same period last year.

In fiscal years 2014, 2015 and 2016, Home Capital had returns of 23.8%, 18.7% and 15.3%.

3) Return on average assets

Return on assets is a profitability measure that presents the annualized net income as a percentage of the average total assets for the period deployed to earn the income.

In the recent quarter, the lender had a return on assets of 1.1% compared to 1.2% in the same period last year.

In fiscal years 2014, 2015 and 2016, Home Capital had returns of 1.6%, 1.4% and 1.2%.

4) Efficiency ratio (TEB)

According to filings, this ratio represents non-interest expenses as a percentage of total revenue, net of interest expense. The company also looks at the same ratio on a taxable equivalent basis and will include this adjustment in arriving at the efficiency ratio, on a taxable equivalent basis.

A lower ratio indicates better efficiency.

In the recent quarter, Home Capital recorded a ratio of 43.4% compared to 39.6% in the same period last year.

In fiscal years 2014, 2015 and 2016, Home Capital had efficiency ratios of 27.2%, 32.4% and 40.8%.

Financial condition measures (3)

1) Tier 1 capital ratio

Tier 1 capital consists of shareholders' equity and retained earnings. Tier 1 capital is intended to measure a bank's financial health and is used when a bank must absorb losses without ceasing business operations (Investopedia)

Under Basel III, the minimum Tier 1 capital ratio is 6%, which is calculated by dividing the bank's Tier 1 capital by its total risk-based assets.

In the recent quarter, Home Capital had a Tier 1 ratio of 16.34% compared to 18.28% in the same period last year.

In fiscal years 2014, 2015 and 2016, Home Capital had returns of 18.3%, 18.3% and 16.4%.

2) Net non-performing loans (NPL) as a percent of gross loans

According to filings, the NPL ratio is calculated as the total net non-performing loans divided by the gross on-balance sheet loans, which includes all on balance sheet loans except for loans held for sale.

In the recent quarter, Home Capital’s NPL% was 0.24% compared to 0.34% in the same period last year.

In fiscal years 2014, 2015 and 2016, Home Capital had returns of 0.3%, 0.28% and 0.3%.

3) Allowance as a percent of gross non-performing loans

In the recent quarter, Home Capital’s allowance as a percent of gross non-performing loans was 91.8% compared to 62.9% in the same period last year.

In fiscal years 2014, 2015 and 2016, Home Capital had returns of 64.4%, 74% and 73.4%.

Sales and profits

In the past three years, Home Capital had revenue growth average of 5.4%, profit decline average of 1.2%, and profit margin average of 48.15%.

Cash, debt and book value

As of March, Home Capital had C$1.25 billion in cash and cash equivalents and no senior debt. As observed, the lender had C$153.3 million in senior debt the same period last year and has eliminated it since.

Home Capital has negligible, 0.6%, blue sky (goodwill and intangible assets) in its assets while having grown its book value by 0.2% to C$1.67 billion year over year.

Cash flow

In the first quarter, Home Capital recorded 82% lower cash flow from operations year over year to C$67.2 million. In addition to lower profits, the lender had a good amount of cash outflow in relation to its loans at C$537.3 million, net of securitization and sales.

Cash flow from deposits increased C$204.6 million year over year as of March. This was prior to the billions of C$ being pulled out of the lender in May, which at one point accounted for 70% of its deposit base.

Capital expenditures were C$2.4 million leaving Home Capital with C$64.8 million in free cash flow compared to C$370.3 million the same period last year. The company also has allocated 35% of its free cash flow in dividends and share buybacks. On average, Home Capital allocated 30% of its free cash flow in shareholder payouts, dividends and share repurchases, in the past two fiscal years.

In the recent quarter, the lender allocated C$5.8 million in securities purchases and gathered C$9.05 million in proceeds from maturities.

Conclusion

Home Capital’s first-quarter results definitely did not reflect the aftermath post-allegations made by Canada’s Securities Commission. Nonetheless, an exit of the company’s CEO along with an even earlier claims by Marc Cohodes have certainly been warning signs worth noting.

As of March, Home Capital’s profitability did improve despite the critics. Nonetheless, certain metrics, especially allowances or provisions, have risen in the quarter in a year-over-year comparison.

In addition, the company did appear to be in solid footing until billions of dollars were withdrawn from in May. It certainly would be interesting to see the company’s balance sheet now that Berkshire is in the process of investing in it

Nonetheless, Home Capital recorded near flat book value growth and zero debt in the first quarter. The firm also has maintained a strong capital situation basing on internationally known standards, Basel III, while having provided steady dividend payouts and repurchases over the recent years.

Nine analysts had a 12-month price median target of C$17.75 per share — a 6.6% decline from today’s share price of C$18.61 a share. Asking 35% of Home Capital’s book value would indicate a value of C$16.9 a share.

With Berkshire’s equity stake averaging C$10 per Home Capital share and 9% interest in other arrangements, current investors do not have the same deal of what is being offered now in the current market.

In summary, Home Capital shares are a hold.

Disclosure: I have shares in Berkshire Hathaway Class B.