DBRS Confirms Canaccord Preferred Shares at Pfd-3 (low), Trend Remains Negative

DBRS has today confirmed its rating of the Preferred Shares of Canaccord Financial Inc. (Canaccord or the Company) at Pfd-3 (low). The Negative trend, which was assigned in December 2011 following the announcement of the Company’s $400 million acquisition of Collins Stewart Hawkpoint plc (CSHP), is being maintained. Initially, the Negative trend was assigned to reflect the relatively large size of the Collins Stewart acquisition, financing uncertainty and integration risk, given the uncertain ambient market environment. The Company’s second issue of preferred shares in April 2012 ($100 million), combined with some excess working capital, allowed the Company to repay the $150 million short-term credit facility drawn to fund part of the $244 million cash portion of the acquisition cost, which addresses most of the financing concern. The integration appears to be proceeding smoothly, notwithstanding over $35 million in associated restructuring cost provisions, mitigated by good potential for realizing expense and revenue synergies in the Company’s U.K. and U.S. operations. The weak market environment nevertheless continues to be a source of concern for DBRS.

The current difficult economic and equity market environments continue to weigh on the Company’s business model, in terms of equity underwriting volumes, trading volumes and both institutional and retail commissions, and therefore also on its profitability and ability to generate free cash flow. While the original rating assignment recognized that the Company is especially vulnerable to equity market conditions, the weak market conditions were not expected to be as protracted as they have provento be. Under a severe stress scenario, independent broker dealers are potentially more vulnerable than bank-owned dealers, who enjoy broader market coverage, larger fixed-income operations and alternative sources of revenues, which may justify additional upstream support through difficult markets.

Profitability for the past six quarters has been weak or negative, as Canadian underwriting activity slumped by 50% in fiscal 2012 and continued weak into Q2 2013, with a 35% reduction in the first six months of fiscal 2013. This result is in line with the global decline in equity underwriting activity for the energy and mining industries, which account for over 50% of the Company’s normalized investment banking business volumes. Mitigating the weakness in Canadian underwriting activity has been relatively strong performance in advisory fees and in the Company’s expanding U.K. and U.S. dealer operations. The revenue contribution from these areas is a testament to the benefit of increasing diversification, which has been a conscious consistent theme of the Company’s strategy, starting with the 2010 acquisition of Genuity Capital Markets. DBRS believes that the CSHP acquisitions, as well as the November 2011 purchase of a 50% interest in Australian-based BGF Capital Group Pty Ltd (BGF), are also positive additions that enhance the Company’s diversification and scale efficiencies while providing a stronger global platform with which to meet the financial and investment needs of its corporate and institutional clients, respectively. The acquired U.K. wealth management businesses are relatively high-margin with 60% fee-based revenues, which are more stable than the Company’s transaction-oriented wealth management revenue stream in Canada.

In the difficult market environment of the past several years, the Company is bringing its costs into alignment with revenues through restructuring and rationalization initiatives. Correspondingly, employment costs as a share of total costs have fallen. The Canadian wealth management business has been especially targeted for rationalization, including the recently announced closing of 16 underperforming branches representing one-half of the Company’s local retail branches and offices, though just 16% of assets under administration (AUA). These expense-saving initiatives have come with one-time restructuring costs totalling close to $50 million over the past three years, including $13.5 million in Q2 2013 related to the downsizing or the branch network. Acquisition-related costs have totalled over $30 million over the same period as the Company pursues diversification strategies, both geographically and by line of business. While a large percentage of the Company’s costs are variable, given the rapid decline of core revenues and the growing operating platforms which have added headcount, it is not surprising that variable compensation has actually increased as a percentage of revenue. DBRS would expect this ratio to decline to traditional levels, with a recovery in revenues. DBRS believes that recent expense rationalization and the favourable contribution of the more stable wealth management operations acquired through CSHP should have a positive financial impact in the future.

As a result of the weak business environment, current cash flow as measured by EBITDA has fallen to levels close to the worst of the 2008-2009 financial crisis. Given the increase in preferred shares to $205 million during the interim period, financial leverage metrics have correspondingly deteriorated. The ratio of debt (including preferred shares) to EBITDA in the last twelve months (LTM) has increased to over 9.0 times in Q2 2013, with the corresponding fixed charge coverage ratio having fallen to just over 1.0 time for the last 12 months; these ratios are not representative of the run rate expected in a normal capital markets environment. At 22.5% of total capitalization, preferred shares plus debt, following the payment of the $150 million short-term acquisition credit facility, is consistent with the current rating assignment. DBRS believes that this level of financial leverage should be supported by a return to normal capital markets.

The Company’s limited regulatory capital and liquidity requirements are easily met. The capital markets business employs traditional short-term collateralized banking facilities required by the Company’s operating subsidiaries to operate as broker-dealers. The Company’s cash flow from operations is capable of supporting current operations, including a small dividend paid on its common shares. Proprietary trading operations are insignificant and therefore not a source of additional market risk.

The nature of the Company’s products and services, as well as the natural resource orientation of its client base, expose it to a great deal of revenue volatility related to economic and market cycles, including both capital and commodity markets. Normally, the adverse impact of such market exposures and associated revenue volatility on earnings and cash flow would be mitigated by the Company’s flexible cost base and the absence of operating leverage. Even though the Company has made strategic investments to diversify away from these market exposures while actively addressing its cost base, the current market environment is especially unfavourable for the broker-dealer industry, depressing earnings and cash flow below what DBRS believes should be sustainable in the long run. While DBRS applauds the strategic and expense initiatives taken by the Company to date, the level of uncertainty surrounding the Company’s industry makes it inappropriate to remove the Negative rating trend at this time.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link to the right under Related Research or by contacting us at info@dbrs.com.

The applicable methodology is Global Methodology for Rating Banks and Banking Organisations, June 29, 2012, adjusted for the Company’s absence of balance sheet leverage. In addition, reference is made to Preferred Share and Hybrid Criteria for Corporate Issuers (excluding Financial Institutions), November 5, 2012. Both can be found on our website under Methodologies.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.