Should You Buy First National Financial And Its 6.2%-Yielding Dividend?

Summary

• First National Financial is expected to continue to grow its mortgage originations.
• The company is expected to face margin compression due to its securitization strategies.
• The company pays an attractive dividend but its shares are trading at a valuation above its peers.

Investment Thesis

First National Financial (OTCPK:FNLIF) (TSX:FN) is Canada’s largest non-bank originator and underwriter of residential mortgages. The company is expected to continue to grow its mortgage origination volumes thanks to the new B-20 Guideline in Canada and its launch of Alt-A product. However, the company may continue to face near-term net interest margin compression due to its securitization strategies. While it pays an attractive dividend, its shares are trading at a valuation below its peers.

Source: Company Website

What we like about First National Financial

Mortgage origination growth continues

First National Financial has grown its mortgage originations by a compound annual growth rate of 4% since 2012 (see chart below). Although First National Financial’s mortgage origination volumes declined slightly in 2017, it is returning to positive growth in 2018. Its total new single-family residential mortgage origination was C$3.4 billion in Q2 2018. This was a growth rate of 5%. Its commercial mortgage origination increased by 17% year over year to C$1.7 billion. Overall, its new origination increased by 9%. This growth rate was much better than the larger Canadian banks whose growth rates were in the 5% range in the second quarter.

Source: Investor Presentation

Re-launching of its Alt-A product

Although the introductory of B-20 Guideline in Canada has resulted in a slowdown in mortgage originations, there are definitely opportunities for alternative mortgage companies. In response to this, the company has re-launched its Alt-A product this past quarter. Alt-A product is considered riskier than prime product but less risky than subprime product. The last time First National Financial had this product was back in 2007. The company at that time originated more than C$700 million. The product was discontinued during the financial crisis. Management now sees an opportunity after B-20 Guideline tightening as there will be many borrowers who have good credits but for some reason did not qualify a mortgage. The company believe that its Alt-A product could result in about C$700 million to C$1 billion in the next two years.

Consistent dividend increase

First National Financial currently pays a monthly dividend of C$0.154167 per share. This is equivalent to a dividend yield of 6.2%. The company has consistently increased its dividend since 2012. The last time First National Financial raised its dividend was back in March/April of 2017. Prior to that, its monthly dividend was C$0.141667 per share. The company has a healthy dividend payout ratio of 62% in 2017 (based on its EPS).

Margin compression is a concern

Unlike traditional banks, First National Financial’s gross interest earned on the mortgages is dependent both on the size of the portfolio of mortgages pledged under securitization as well as mortgage rates. The company has employed securitization strategies. This means that its net interest margins are typically locked in for five and ten year terms. During the financial crisis in 2008, its margins were wide because financial institutions maintained mortgage rates despite a significant drop in the cost of funds. However, the margins have steadily declined with competitive pressures and new securitizations are at much tighter spreads. This means that the company’s profitability has decreased considerably. This can be seen from its quarterly pre-FMV EBITDA in the past few years in the table below. As can be seen, its EBITDA continued to decline to C$56 million in Q2 2018 from C$68.3 million in Q2 2017. This is a decline of 18%. Looking forward to Q3, we expect its margin to continue to compress due to tight interest rate spread.

Source: Q2 2018 Financial Report

Valuation

First National Financial is currently trading at a trailing 12-month and forward P/E ratio of 9.7x and 11.0x respectively (see chart below). As can be seen from the chart, the company’s current valuation is slightly below its historical average (about 10.5x).

Source: YCharts

Compare with its peers, First National Financial’s P/E ratio of 9.7x is also much higher than Genworth MI Canada’s 7.7x and Equitable Group’s 6.9x.

Source: YCharts

Investor Takeaway

First National Financial should continue to grow its mortgage origination volume in the next few quarters as it re-launched its Alt-A product. However, its interest margin is expected to continue to compress in the next few quarters. The company pays an attractive and sustainable dividend with a dividend yield of 6.2%. However, its shares are trading at a valuation higher than its peers. We believe investors may want to look for other opportunities or wait for a pullback.

Note: This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.

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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.