Canada’s largest alternative mortgage provider saw its stock drop by more than 20% last week after the new mortgage insurance rules imposed by the federal government forced investors to reevaluate its stock.
Up until Finance Minister Bill Morneau brought in these changes, First National Corp.’s (TSX:FN) stock was flying along, up 43% year-to-date through September 30, the last trading day before the announced changes.
I’m a strong believer that markets typically overreact to important news—both on the upside and downside. Only time can help investors understand the true ramifications of a seemingly damaging piece of news. In the meantime, investors who don’t own its stock are faced with a potentially compelling opportunity to get in on the cheap.
There are definitely pros and cons to owning First National stock after its 20% haircut. I’ll tell you what they are and, more importantly, whether or not you should consider owning its stock at these prices.
Pros of owning First National stock
First National CEO Steven Smith suggests the company will see fiscal 2016 net income growth between 3% and 9% as a result of the changes compared with the previous forecast between 5% and 10%.
“We might not get the same growth of income, but I don’t see it declining,” Smith told Bloomberg by phone October 5. “Longer term, it’ll affect our margins, but it’s not like all of a sudden our income’s going to drop off.”
So, in the near-term in a worst-case scenario, First National expects to generate net income of at least $145 million in 2016 or $2.41 per share.
At current prices, we’re talking about a P/E ratio of 10.5—significantly lower than its multiple in 2015. Flip the P/E on its head and you see that First National has an earnings yield of 9.5%—350 basis points higher than the S&P/TSX.
In addition, although RBC Capital Markets analyst Geoffrey Kwan lowered his 12-month target to $27 from $31 last week, he still expects the company to generate $2.90 and $3.11 in earnings for fiscal 2017 and 2018, respectively.
Any way you slice it, First National’s stock is worth more than eight times 2018 earnings.
Cons of owning First National stock
Investors like certainty. These news rules provide anything but that for mortgage originators like First National, who’s been forced to find new sources of financing for about 25% of its $13 billion in annual residential mortgages.
In the past, these mortgages could be funded through the National Housing Act mortgage-backed securities markets. Those will now have to be funded through asset-back commercial paper, which is costlier.
Ultimately, First National’s margins will be hit as financing costs increase on a permanent basis. Coupled with this is the fact the new rules could seriously dampen the housing market, reducing the overall demand for mortgages and, by extension, its overall revenue.
Longer term, this is definitely going to hurt the company.
The big question for investors is whether the long-term damage is enough to take its stock down further, perhaps into the teens—a level it hasn’t traded at on a consistent basis since October 2013—or is this simply a bump in the road on the way to $40?
First National’s CEO feels the stock is oversold, calling the changes by the federal government “subtle” in nature. I would tend to agree with that assessment.
Two weeks ago, you would have paid well into the $30s to own First National stock. Today you can own its stock for $25. By the end of October, you might be able to own it for $20—perhaps less.
If you can handle some risk in your portfolio, I’d look at buying a half position today and saving the other half to see how this all shakes out.
Like Smith, I believe investors are making a mountain out of a molehill.
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Fool contributor Will Ashworth has no position in any stocks mentioned.