Home Capital shares drop after regulator’s allegations it misled shareholders

Home Capital Group Inc. shares plunged more than 20 per cent on Thursday after the Ontario Securities Commission accused the mortgage lender of misleading disclosure when the company uncovered falsified income information on some loan applications and cut ties with dozens of brokers in 2014.

The developments raised concerns about Home Capital’s future funding prospects and its reputation.

National Bank of Canada cut its price target on the stock on concerns that the OSC’s allegations — that the mortgage lender misled shareholders after discovering fraud in its broker channel — could cause “material damage” to its reputation.

The hit “could lead to S&P to downgrade Home Capital to noninvestment grade, weaker than expected deposit funding capabilities, weaker than expected mortgage loan growth, and impaired investor sentiment,” analyst Jaeme Gloyn said in a note to clients.

Gloyn cut Home Capital’s target price from $27 to $23 on the “reputational risk,” but held its rating at underperform.

On Wednesday, the securities regulator issued a statement of allegations and a notice of hearing against Home Capital, former president and chief executive officer Martin K. Reid, former president and chief executive officer and current director Gerald M. Soloway, and chief financial officer Robert Morton.

The OSC will hold a hearing on May 4. Potential sanctions on the named respondents include a ban on activities in capital markets, resignation from positions held, and financial sanctions of no more than $1 million for each respondent’s failure to comply, said Gloyn in the note.

“Notably, the above noted Statement of Allegations relate only to HCG’s continuous disclosure obligations and not the trading activities of several current and former directors and officers of the company, which could amplify any potential negative outcomes,” Gloyn added.

Additional information included in the OSC’s Statement of Allegations against Home Capital suggests further improvements in its business may be difficult to achieve, particularly because it may be challenged to obtain funding at a good price, according to Brenna Phelan at Raymond James.

As a result, the analyst downgraded Home Capital to market perform from outperform, cut her price target on the stock to $23 from $34, and reduced her EPS estimates for 2017 and 2018 by approximately 15 per cent.

This also reflects a forecasted decline of roughly seven per cent for Home Capital’s traditional mortgage portfolio in 2017.

“Our previously positive outlook on the stock was based on improving underlying business fundamentals, specifically in its non-prime mortgage business, and while recent data points point to improvement,” Phelan told clients.

The analyst noted that charges against current CFO Robert Morton, which may lead to his removal, could leave Home Capital without a CEO or CFO.

“The perception of heightened risk regarding the future leadership and operations of the company may lead to upward pressure on the rate Home Capital must pay on its GICs, the inability to access deposits through its own Oaken brand and/or potentially to the removal of its products from broker platforms,” she said.

Phelan also noted that Home Capital obtains about 70 per cent of its funding from the deposit broker network, five per cent from institutional deposit notes, and the rest from its own Oaken branded direct-to-consumer savings accounts and GICs.

The analyst bumped up her average deposit cost forecast by approximately 25 per cent to 2.50 per cent for 2017, and expects that number will decline to about 2.35 per cent in 2018.

“We note that that there are risks associated with these forecasts as the impact of reputational risk is difficult to quantify,” she added.

Home Capital said Wednesday that it has “always carefully considered its disclosure obligations.”

“The Company believes that its disclosure satisfied applicable disclosure requirements, and the allegations are without merit,” the company said in a statement on Wednesday evening. “The allegations will be vigorously defended.”

As well, Home Capital disclosed earlier this year that a proposed class action has been filed in the Ontario Superior Court of Justice, alleging “misrepresentations” in the company’s public disclosures in 2014 and 2015.

We note that that there are risks associated with these forecasts as the impact of reputational risk is difficult to quantify.