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

DBRS, Inc. (DBRS) has today confirmed the Cumulative Preferred Shares rating of Canaccord Genuity Group Inc. (CF or the Company) at Pfd-3 (low). The trend remains Negative. The Company’s Support Assessment is SA3.

Underpinning the current rating is CF’s increasingly diverse franchise, which includes its capital markets and wealth management businesses, with strong positioning among middle-market clients in Canada and a growing presence internationally. DBRS views the franchise as resilient, having weathered a particularly challenging operating environment that significantly pressured earnings. The Company has taken the appropriate steps to become a leaner and more focused organization, which should contribute to improved bottom line results going forward. The rating also considers the Company’s sound risk profile, balanced by DBRS’s view that systems and processes need continued investment and enhancement. The balance sheet is generally highly liquid, while more illiquid or longer-term assets are funded via term funding or equity. Capitalization levels are solid, though capital generation through retained earnings has been limited.

In maintaining the Negative trend, DBRS recognizes that, despite the improving results in the most recent fiscal year, the Company still faces significant headwinds that have been driving weak results and low returns. While DBRS anticipates improving returns going forward, as increased capital markets activity should contribute to higher revenues and the completed restructuring has resulted in a lower expense base, the Negative trend reflects the Company’s inconsistent profitability to date. Furthermore, DBRS sees that CF may be challenged to increase its balance sheet with higher activity levels without increasing leverage. While the Company has maintained solid positioning amongst capital markets participants, DBRS will look for further indications that the Company is well positioned to leverage its franchise and benefit from an improving operating environment.

The Company’s increasing geographic diversity has made a greater contribution to overall results, with international results generally offsetting weaker results in its traditional Canadian market. CF has also developed into a more diverse institution in recent years by expanding Wealth Management in the United Kingdom and Europe to complement its traditional capital markets advisory businesses. The Global Wealth Management business is bringing a more stable source of fee-based revenue, contributing 32% of consolidated net revenues in 9M 2017.

CF reported a net income of $9 million in 9M 2017, a turnaround from a net loss of $358 million in FY2016 (net loss of $6 million excluding significant items, with the driver being a goodwill impairment) and a net loss of $11 million in FY 2015. (DBRS notes that CF has a March 31 year end.) While earnings have not rebounded to levels that align with the franchise potential, the Company is benefiting from a more constructive capital markets operating environment. The bottom line is also benefiting from a lower expense base.

Risk management processes are generally good, with appropriate credit and counterparty exposure monitoring. While DBRS sees that systems and processes can be enhanced further to prevent operational risk issues, this is already factored into the current rating level. CF is regularly exposed to underwriting commitments, and the risk is managed under established guidelines and approval procedures that limit the overall risk to the Company. CF is exposed to market risk through its principal trading activities, which are actively supervised. Credit risk is assumed through CF’s Wealth Management business, as the Company conducts trading activity on behalf of, and provides margin loans to, clients. Trading activities are subject to limits and other risk parameters, while margin lending is typically well collateralized. DBRS notes the risk in managing important relationships and, although the Company has procedures in place to manage its inventory positions, the Company does maintain aged positions resulting from certain activities undertaken to facilitate for clients that bring important business to CF. These positions have the potential to experience mark-to-market losses. Given the challenging operating environment, properly assessing counterparty risk, including a counterparty’s ability to meet margin calls, remains critically important.

Given the nature of the business and a relatively liquid balance sheet that includes cash and other liquid assets, liquidity is good. As of December 31, 2016, the Company had sufficient cash and liquid assets available to meet any short-term liability needs. Furthermore, CF generated positive cash flow in 9M 2017 of $42 million, following positive cash flow of $106 million in FY 2016. This has also contributed to an improved fixed charge coverage ratio.

Capitalization is satisfactory with a total assets/total common equity ratio of 5.2 times, which is down from FY2016 with lower asset levels and in line with historical levels. CF has most recently enhanced equity through a privately placed issuance of shares and warrants to its employees, as well as a convertible debenture that was privately placed with a strategic investor. Nonetheless, the ratio of debt plus preferred shares-to-capital has increased to 34% as of December 31, 2016. This ratio has been trending upward since FY2014 reflecting the sizable net losses that have reduced absolute capital levels. Importantly, regulatory net capital exceeds requirements at all of the regulated subsidiaries, and has been bolstered recently with the private placement and convertible debt issuances.

RATING DRIVERS
Signs of sustained earnings deterioration would likely add negative rating pressure, particularly if capital levels continue to be eroded. Increased pressure on the Company’s cash flows could also pressure the rating. Furthermore, any significant operational or reputational issues would likely pressure ratings.

On the other hand, further franchise diversification that contributes to sustained and improving earnings trends across businesses would provide support to the current rating level.

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

The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (July 2016). Other applicable methodologies include DBRS Criteria: Preferred Share and Hybrid Criteria for Corporate Issuers (December 2016) and DBRS Criteria: Support Assessments for Banks and Banking Organisations (March 2017), which can be found on www.dbrs.com under Methodologies.

The primary sources of information used for this rating include company documents and SNL Financial. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

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

Lead Analyst: Lisa Kwasnowski, Senior Vice President
Rating Committee Chair: Michael Driscoll, Managing Director
Initial Rating Date: June 6, 2011
Last Rating Date: April 8, 2016

The rated entity or its related entities did participate in the rating process. DBRS did have access to the accounts and other relevant internal documents of the rated entity or its related entities.