Home Capital Group: Business Model Confuses Market

| About: Home Capital (HMCBF)


Loan portfolio depletion normal for Home Capital.

Home Capital differs from traditional lenders.

Home Capital can grow again.

Home Capital Group's (OTC:HMCBF) second quarter performance indicates the company is stabilizing. The biggest fear among investors loan loss has subsided. I expect a flat year in 2016. Company's performance is likely to pick up in 2017. Two major problems are holding the stock back thus far: 1. high expense ratio 2. stagnant growth in loan portfolio. Expense ratio will come down once the revenue grows. Customer turnover rate caused a stir in the analyst community. I believe the high turnover rate is part of Home Capital's business model and will fix itself over time.

Business model

Home Capital Group's loan portfolio struggles to grow despite above 20% growth in originations last quarter. A lot of analysts are quick to complain the turnover rate is too high within HCG's loan book. But if you have better grasp HCG's business model, it is not that surprising at all.

Home Capital Group labels themselves as the alternative lender. Their business model differs from competition significantly. At a traditional bank, a mortgage typically has a 5-year term. The borrower has the choice between fixed rate and variable rate. Variable rate is marked to market. In the declining rate environment we have, it is not hard to imagine everyone prefers a variable rate mortgage. In addition, traditional lenders' risk management policy focuses on income. To illustrate, a borrower has to prove he or she has a stable income regardless how much down payment you have. Additionally, they have rules like each household can only buy two houses. The best part about these traditional players is that they offer very low mortgage rate at around 2%. However, due to all the policies placed around lending, these traditional institutional lenders locked out a lot of potential home buyers in Canada. Self-employed, a large group of Canadian population, often has hard time to secure a mortgage. Business owners tend to use their personal expenses to minimize their income and ultimately reduce their tax payments. In the eyes of traditional lenders, these business owners are unfit to own a house even though he may have very high real income. Another group is real estate investors. This group buys multiple properties and collects rent income every month. After your second home, traditional lenders will say "no" to your new application even if you have investable wealth.

After you get a "no" from your local bank and you still want to own a piece of real estate in Canada, you have to visit a broker. Home Capital is one of brokers' favorites. HCG's risk management policy focuses on your personal wealth rather than income. So it is required for the house buyer to contribute at least 25% to 35% down payment versus typical 10% at traditional banks. The trade-off for the borrower is higher mortgage rate in the neighborhood around 4%. That is 100% more expense than traditional banks! Also, Home Capital only has fixed rate mortgage. Remember today's borrowers prefer variable rate. Given these facts, a borrower would naturally gravitate towards borrowing at traditional lender if possible. Home Capital offers the option to have 1-year term mortgage which is their most popular product.

With good understanding of Home Capital's business model, we now know who is a typical Home Capital customer. A HCG customer is someone who has a fair amount of wealth and is locked out by traditional mortgage lenders. The customer knows that he pays above average mortgage rate and would love to get out their contract as soon as possible. They sign a one-year deal with HCG and hope they could get new mortgage from a traditional lender in the following year at a more favorable rate. Further, HCG sells through mortgage brokers. Mortgage brokers sell the cheapest mortgage to their customers and are not obligated to retain customers for HCG.

In recent quarterly earnings, analysts were irritated by high turnover ratio of customers and depletion in the loan portfolio. The reality is that this is part of HCG's business model. I am surprised that these analysts were so surprised.


Home Capital presents an interesting situation. The stock is heavily shorted, trading at 7x earnings and under 1.2x book value. The initial short thesis was based on a potential housing bubble in Toronto and Vancouver. That never materialized as loan loss is still extremely low. With that said, Home Capital is going through a cycle of its own business model in my opinion. Quick depletion in loan book is natural. Toronto and Vancouver housing markets continue to perform well. This puts a lot of pressure on individuals who are on the fence of purchasing a home. Home Capital is in a good position to capitalize the trend. Recent quarterly origination numbers have strong momentum and could get the company going again in the next few quarters. Also, if management could achieve any success in retaining customers as described on the call, that would be very positive.

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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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