Home Capital has lots of cash, underpinning hopes for dividends, buybacks

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For all the upbeat numbers in Home Capital Group Inc.’s second-quarter financial results on Friday, one detail stood out: The alternative mortgage lender’s pile of cash has grown to eye-popping levels, raising questions about whether dividends, buybacks and another jump in the share price might be coming.

According to Jaeme Gloyn, an analyst at National Bank Financial, Home Capital’s excess capital – above and beyond what the banking regulator requires to absorb a financial shock – now stands at $11.47 a share.

That accounts for nearly a third of the company’s book value.

To be sure, Home Capital is not alone here. Other Canadian lenders also have been building impressive levels of excess capital since the Office of the Superintendent of Financial Institutions, or OSFI, halted dividend increases and buybacks in early 2020, in response to the economic uncertainty posed by the pandemic.

Canadian banks now have excess capital of about $37-billion, enticing investors with the prospect of dividend hikes when OSFI gives the green light, perhaps later this year.

But Home Capital, which underwrites mortgages for prospective homeowners who don’t qualify for loans from major banks, stands out.

Excess capital has driven the company’s common equity tier 1 ratio, or CET1 – a measure of the amount of capital that can absorb losses during bad times – to 22.3 per cent. By comparison, Toronto-Dominion Bank’s CET1 ratio is 14.2 per cent, and that’s the highest ratio among the Big Six banks.

How should investors approach Home Capital and its bounty of savings?

Right now, the excess capital is a drag on profitability. In the second quarter, the company reported that its return on equity was 16.9 per cent. While that looks good, profitability could have been much higher with a CET1 ratio in line with the company’s target of 14 per cent to 15 per cent.

Brad Kotush, Home Capital’s chief financial officer, said in a call with analysts that with a CET1 ratio of 15 per cent in the second quarter, the company’s ROE would have been more than 25 per cent.

That’s hypothetical, of course. But it’s reasonable to bet OSFI will relax its restrictions as the economy heals and the pandemic recedes – arguably leaving Home Capital with the most to gain from a return to normal, at a time when its business is thriving with a strong housing market.

Net income rose 118.5 per cent in the second quarter, year-over-year. Provisions for credit losses – money set aside earlier in the pandemic to cover bad loans – are now being released as concerns over mortgage defaults subside.

Single-family mortgage originations increased 63 per cent in the second quarter over the same period last year, as the company backed off from risk-aversion in its underwriting processes as the economic backdrop improved.

“By the end of July, all of the restrictions were removed from both residential and commercial underwriting. This means that all of our businesses will have returned to normal risk appetites for most of the third quarter,” Yousry Bissada, Home Capital’s chief executive officer, said during a call with analysts.

He said the decline in home sales in June and July was “a healthy moderation” from frenetic activity in February and March. As well, he said, the housing market is supported by low interest rates and robust consumer savings, along with rising trends in immigration and employment.

Little wonder, then, that Home Capital is openly discussing what to do with its excess capital.

Share buybacks are the top priority. Even though the share price has risen more than 33 per cent since the start of this year, management said the stock is still cheap relative to its intrinsic value.

Since buybacks leave fewer shares outstanding, earnings per share will rise, potentially driving the share price higher.

“But we will also, at the appropriate time, consider dividends as well,” Mr. Kotush said.

Home Capital hasn’t paid a dividend since 2017, when the lender cut its payout after a run on its deposits left it in need of a financial lifeline. Remarkably, the company now has too much money, giving investors a compelling reason to stay put.

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