GMP research on Xceed Mortgage & Coventree

Further to our Coventree post of earlier today (see “Where’s the Bank of Canada on Coventree stumble?“, August 14-07), here is a good piece from GMP Securities regarding Xceed Mortgage Corp. (XMC:TSX) that also touches on sister corp. Coventree (COF:TSX):

Xceed Mortgage Corporation’s (XMC) securitization partner Coventree Capital (COF-TSX) announced on August 13, 2007 that due to “unfavourable market conditions” (related to negative sentiment towards U.S. sub-prime lending market), COF has been unable to place new asset-backed commercial paper (ABCP) to fund the repayment of previously issued ABCP which matured on August 13, 2007. Due to this market disruption, COF had to extend the term of extendible ABCP (E notes) totaling $250 million issued by all Coventree-sponsored ABCP conduits and issued a liquidity notice on A notes. COF management stated in its press release that they believe investors are reducing or eliminating their investments in the Canadian ABCP market as a result of the well-publicized problems in the U.S. sub-prime mortgage market. They believe that this negative sentiment combined with recent large initially caused widening spreads, and has now resulted in today’s disruption. In short, COF has been unable to find investors willing to accept the current risk/reward trade-offs.

Investors in ABCP are now demanding higher returns (resulting in wider spreads) in exchange for
assuming paper deemed to be materially more risky (following recent sub-prime lending developments).

We believe this ultimately means that no ABCP’s will be issued by COF in the near-term removing one of the main sources of liquidity for XMC.

We believe COF’s market disruption is a very negative development for XMC and only adds to the negative sentiment currently surrounding specialty lenders in Canada.

Two main takeaway points we want to highlight:

1. XMC has a robust mortgage origination platform that YTD has originated over $600 million in new mortgages which for the most part are securitized via the ABCP market. Currently, XMC has a bank facility in place to fund $350 million of mortgages on a short-term basis; we believe the bank facility will last no longer than a few months and will be insufficient to support medium-term funding. XMC has also access to a securitization vehicle Xceed Mortgage Trust (XMT) which is a longer-term funding solution developed by the company and has been utilized in the past extremely well. The COF ABCP conduits were the company’s medium-term funding solution.

2. Even if XMC can replace COF or if liquidity returns to COF in terms of ABCP, the spreads may not be economical for XMC to compete in the high LTV ratio mortgage market in Canada?

Below is a chart indicating the downward pressure on XMC’s gains from securitization, which have already occurred over the past several quarters (due to an increasingly competitive marketplace). You can see that gains have declined below the average of 4.7% for the last three consecutive quarters and we believe there is a very good probability that gains (if they occur) will continue to see downward pressure.

It is our view that XMC will have difficulty securitizing mortgages in the latter half of F07 and into F08, which will result in lower gains from securitization. As a reminder securitization gains have averaged 74.4% of total revenue for XMC in F07 and clearly any impact on gains will have a direct impact on EPS and cash flows (more likely to impact future dividends).

We believe these difficult market conditions will continue to persist until the current sentiment in the U.S. has a more positive bias, or ABCP spreads tighten as demand for ABCP increases. We do not foresee either of these scenarios occurring in the near-term.

Based on limited information available at this time we have assumed gains from securitization will drop to the 3.0% level from the current 4.1% (as of Q2/07), which is a level XMC has historically experienced at least twice in the past (in Q2/02 and Q2/03). This assumption assumes that XMC will be able to find a replacement funding source for COF.

As a result of widening spreads and the ABCP supply/demand imbalance, our F07 EPS estimate would fall to $0.76 from $0.86, and our F08 EPS estimate would also fall to $0.71 from $0.92. This assumes that XMC will continue to find liquidity in the ABCP market away from COF or that COF will be able to resume issuing ABCP in Canada but at wider spreads resulting in lower gains. It is not known at this time whether it is likely a replacement funding source will be found, however we expect management to comment on the situation very shortly.

In the scenario that no liquidity is found to replace COF, we would be lowering our estimates even further as XMC would not be able to do the same volume of business it is currently doing and originations would have to decline. We have highlighted this as a risk on XMC for numerous quarters and since we initiated coverage of the company.

VALUATION AND RECOMMENDATION

Due to the fact that XMC’s management has not made a public press release to provide investors with some sensitivity to the COF announcement, we find ourselves in a situation where worst case scenarios are often the basis of a recommendation.

What we know is that XMC’s book value per share at the end of Q2/07 was $3.75 per share. We also know that XMC has generated $0.40 per share in EPS to date in F07 and lastly we also know that the company has available to it now a $350 million bank-sponsored facility in place to finance originations the company is currently funding. It looks like XMC had drawn down nearly $45 million of this facility as of the end of Q2/07 leaving nearly $300 million available to be drawn (as of the end of Q2/07). It is not known at this time how long the current credit facility can support XMC’s business operations, but we suspect it to be no longer than a 3-4 months.

XMC has also originated $621.1 million in the first half of F07 (averaging over $300 million per quarter).

The Canadian specialty finance companies we cover (excluding XMC) trade at 2.5 times book value and 13.1 times and 11.4 times or F07 and F08 EPS estimates respectively. The U.S. equivalent is 1.5 times book and 14.9 times and 12.2 times F07 and F08 EPS estimates respectively.

Our previous 10.0 times P/E multiple at this point seems unreasonable and the question is: what is the appropriate multiple for XMC considering we have limited visibility of earnings and also limited visibility on liquidity.

If we chose to weigh equally a P/B and P/E approach to derive our target, using a 1.25 times P/B multiple which generates a value of $4.69 per share and a 7.0 times P/E on our best attempt F08 EPS estimate of $0.71 (assuming a new funding solution is found) to derive a $4.97 value, our combined value would be $4.85 per share (down from $8.60 previously).

However, as we have discussed above there are several risks surrounding XMC at this time including whether or not a replacement for COF will be found and if so, will the spreads be economical for XMC. Based on the limited information available at this time, we believe the risks/uncertainty surrounding XMC are high and we are skeptical about holding XMC shares at this time and are placing the shares UNDER REVIEW until more colour is provided by management; we expect a press release will be issued today to address the situation.

We remind investors that despite the inherent risks (which have increased materially), management is solid and has a long track record of knowledge of the mortgage markets as well as the mortgage brokerage market. It is this management team that we are relying on to provide investors with a plan and some guidance as to the impact on EPS and liquidity from the COF announcement.

MRM