Morningstar DBRS Confirms Conexus Credit Union 2006's Short-Term Credit Ratings at R-1 (low), Stable Trends

DBRS Limited (Morningstar DBRS) confirmed Conexus Credit Union 2006's (Conexus or the Credit Union) Short-Term Issuer Rating and Short-Term Instruments credit rating at R-1 (low). The trend on all credit ratings is Stable. Conexus' Support Assessment is SA2, which reflects Morningstar DBRS' expectation of timely systemic external support from the Province of Saskatchewan (Saskatchewan or the Province; rated AA (low) with a Stable trend) through Credit Union Central of Saskatchewan (SaskCentral; rated R-1 (low) with a Stable trend), particularly in the form of liquidity. In addition, Conexus has been designated a Provincial Systemically Important Financial Institution (P-SIFI), which increases the likelihood that systemic external support would be forthcoming. At present, the SA2 designation does not result in any uplift for the credit ratings.

KEY CREDIT RATING CONSIDERATIONS
The credit ratings and Stable trends reflect Conexus' solid franchise within its operating area and the benefits of its membership in the well-established credit union system in Saskatchewan. Conexus generates good revenue, including solid levels of both net interest income (reflecting a net interest margin (NIM) higher than the peer average) and noninterest income. However, bottom-line results have been adversely affected by elevated expenses reflecting business investments and elevated loan loss provisioning costs. Morningstar DBRS expects core earnings will improve over time as credit costs moderate and expense growth levels off. Morningstar DBRS notes that the Credit Union is significantly exposed to commercial real estate (CRE) lending and automotive finance, which are sectors that can experience higher levels of delinquencies during periods of economic stress. Conexus also has a stable funding base, primarily composed of core member deposits, with solid liquidity and high capital levels.

CREDIT RATING DRIVERS
Over the longer term, Morningstar DBRS would upgrade its credit ratings if Conexus is able to strengthen its franchise through a sustained increase in membership resulting in a material and sustained improvement in earnings, while maintaining a similar risk profile.

Conversely, sustained weakness in financial performance or a significant deterioration in asset quality would lead to a credit ratings downgrade.

CREDIT RATING RATIONALE

Franchise Strength
Conexus is the second-largest credit union in the Province, with total assets of $7.0 billion as of June 30, 2024. The Credit Union provides a range of retail and business banking services to its members, who represent approximately 11.6% of Saskatchewan's population, through 30 branches in its footprint area. Conexus has consistently grown its membership base in recent years, in line with provincial population growth, reaching over 142,000 members at Q2 2024. Following several years of challenging loan growth, organic loans grew a solid 4% in 2023, which was further augmented by investment loans for total loan growth of 7.7%.

Earnings Power
Excluding the one-time $68.8 million dividend from SaskCentral's sale of Concentra Bank in 2022 (note all quoted year-over-year (YOY) changes in earnings metrics are adjusted to exclude this dividend), Conexus' net income attributable to members declined 28% YOY to $16.1 million in 2023, driven by lower noninterest income and higher operating expenses, partially offset by lower provision for credit losses (PCL). Noninterest income decreased by 25% YOY in 2023, compared with a stronger 2022 that saw unrealized and realized gains on investments, primarily related to the Credit Union's venture capital funds, and derivatives. As a result, noninterest income comprised about 21% of total revenue, down from 27% in the prior year. Operating expenses increased 3% YOY, largely reflecting additional costs related to the credit card rewards program, and personnel restructuring costs. The efficiency ratio deteriorated to 83.4% compared with 76.1% in 2022. Net interest income was largely stable, increasing less than 1% YOY, as loan growth more than offset a slight contraction in NIM. PCL once again fell 34% YOY in 2023 to $13.2 million, but still formed 40.6% of income before provisions and taxes, significantly higher than peers.

Risk Profile
Conexus has significant exposures to higher-risk automotive finance and CRE lending. Accordingly, Morningstar DBRS notes that the Credit Union's asset quality metrics are sensitive to concentration risk, particularly in the commercial segment where cyclical performance in Saskatchewan's key industries can result in asset quality deterioration. Impairments increased on an absolute basis YOY in 2023, declining slightly as a percentage of gross loans to 1.67%. Net write-offs, while still manageable and lower than the prior year, remain elevated at 0.30% of average gross loans, primarily related to the commercial segment. Both impairments and net write-offs are materially higher than credit union peers. Positively, both the consumer and agriculture portfolios have been resilient, and impairments remain low. Additionally, while Conexus' growth augmentation strategy of purchasing investment loans provides some geographic diversification, it also presents third-party risk, and includes Alt-A and second charge mortgages, which Morningstar DBRS views as higher risk.

Funding and Liquidity
Conexus is largely funded through stable retail and business member deposits, which comprised 93% of total funding in 2023. Morningstar DBRS views Conexus' funding structure as well aligned with its lending activities, and the stability of local deposits is supported by the unlimited deposit guarantee provided by the Credit Union Deposit Guarantee Corporation (CUDGC). The Credit Union also has access to wholesale funding in the form of brokered deposits (currently an immaterial amount outstanding) and securitized borrowings via the National Housing Act Mortgage Backed Securities (NHA MBS) program, the Canada Mortgage Bonds program, and auto loan securitizations. Beginning in 2022, Conexus began retaining certain amounts of its issued NHA MBS certificates for liquidity management purposes. In addition, Conexus has various sources of liquidity, including credit facilities with SaskCentral and Desjardins, and reported a solid liquidity coverage ratio of 157% in 2023, well above the regulatory minimum of 100%.

Capitalization
Conexus maintains good capitalization that is sufficient to absorb potentially higher levels of provisioning and loan losses. The CET1 capital ratio, which is based on Basel III requirements, was stable YOY at 16.0% in 2023, double the regulatory requirement of 8.0%. Capital levels further improved in 2024 as new regulatory requirements came into effect on January 1, 2024. In addition, the quality of Conexus' capital is strong, with 97% of total capital composed of Tier 1 capital. As a P-SIFI, the Credit Union is subject to stronger oversight by CUDGC, which requires a 1% capital conservation buffer that Morningstar DBRS also views positively.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE (ESG) CONSIDERATIONS
ESG Considerations had a relevant effect on the credit analysis.

Social (S) Factors
The following Social factor had a relevant effect on the credit analysis: Morningstar DBRS views the Social Impact of Products and Services ESG subfactor as credit positive for the credit ratings, but it does not affect the assigned credit ratings or trends. As a credit union, Conexus operates a membership-based community banking model where the social aspect of its activities strengthens its franchise. As a result, this factor is incorporated into the Credit Union's Franchise Strength grid grades.

There were no Environmental or Governance factors that had a significant or relevant effect on the credit analysis.

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings (August 13, 2024) at https://dbrs.morningstar.com/research/437781.

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

The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (June 4, 2024), https://dbrs.morningstar.com/research/433881. In addition, Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings (August 13, 2024), https://dbrs.morningstar.com/research/437781 in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://dbrs.morningstar.com/about/methodologies.

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found on the issuer page at https://dbrs.morningstar.com.

The credit rating was initiated at the request of the rated entity.

The rated entity or its related entities did participate in the credit rating process for this credit rating action.

Morningstar DBRS had access to the accounts, management, and other relevant internal documents of the rated entity or its related entities in connection with this credit rating action.

This is a solicited credit rating.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. Morningstar DBRS' outlooks and credit ratings are under regular surveillance.

For more information on this credit or on this industry, visit https://dbrs.morningstar.com.

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