HGH - Heartland Group Holdings

[Snoopy]

In April 2017, Heartland had a subordinated capital note issue of $A20m. Approximately 72% of the face value of the Notes will be recognised as Tier 2 Capital by our banking regulators. So we must add the 'Tier 1 capital' (being shareholder equity) to 72% of the 'Tier 2 capital' to obtain the total recognised 'tier' capital for liquidity purposes

<snip>

I am not convinced that using 'only' 72% of the Tier 2 capital is justified (if 100% of Tier 2 capital was used the 17% pass figure would be achieved).

I got a sudden brain zonc during the day. Tax will be due on this subordinated capital note. The note lasts for ten years. So there will be quite a large tax bill to pay over the existence of the bond. And if Heartland were to get into capital strife, the IRD would likely get first dibs at recovering their money ahead of other creditors. The current NZ tax rate is 28%, which leaves 72% of what is left to be divvied up amongst other creditors. Could that be the reason that only 72% of this 'Tier 2' subordinated capital note issue may be counted as 'capital' for bank capital stability purposes?

SNOOPY

[Snoopy]

Updating for the full year result FY2016:

The EBIT figure is not in the financial statements. So I will use 'interest income' as an indicator for EBIT, once I have taken out the selling and administration costs

EBIT (high estimate) = $265.475m - $68.872m= $196.603m

Interest expense is listed as $118.815m.

So (EBIT)/(Interest Expense)= ($196.603m)/($118.815)= 1.65 > 1.20

Result: PASS TEST

The historical picture of this ratio is tabulated below. Despite the shakey start, the trend is very pleasing.

	FY2012	FY2013	FY2014	FY2015	FY2016	Target
EBIT/ Interest Expense	1.15	1.22	1.44	1.52	1.65	>1.2

Updating for the full year result FY2017:

The EBIT figure is not in the financial statements. So I will use 'interest income' as an indicator for EBIT, once I have taken out the selling and administration costs

EBIT (high estimate) = $278.279m - $71.684m= $206.595m

Interest expense is listed as $115.169m.

So (EBIT)/(Interest Expense)= ($206.595m)/($115.169m)= 1.79 > 1.20

Result: PASS TEST

The historical picture of this ratio is tabulated below. Despite the shakey start, the trend remains very pleasing.

	FY2012	FY2013	FY2014	FY2015	FY2016	FY2017	Target
EBIT/ Interest Expense	1.15	1.22	1.44	1.52	1.65	1.79	>1.2

SNOOPY

[Snoopy]

The underlying debt of the company (debentures and other loan supporting borrowings removed) is the first factor in an attempt to assess the underlying shareholder owned skeleton upon which all the recivables that are loaned ultimately sit.

According to the full year (FY2016) statement of financial position the debt excluding borrowings is:

$42.099m + $6.754m = $48.853m (1)

-----

To calculate the total underlying company assets we have to (at least) subtract the finance receivables from the total company assets. I would argue that you should also subtract the 'Investment Properties' (the rump of the problem property portfolio) and the unspecified 'Investments' (held on behalf of policy beneficiaries) from that total:

$3,571.181m - ($3,113.957m +$8.384mm + $236.435m) = $188.405m (2)

We are then asked to remove the intangible assets from the equation as well:

$188.405m - $57.755m = $130.650m

----


Now we have the information needed to calculate the 'underlying company debt' (skeletal picture) net of all Heartland's lending activities:

$48.853m/$130.650m= 37.4% < 90%

Result: PASS TEST

The historical picture of this ratio is tabulated below.

	FY2012	FY2013	FY2014	FY2015	FY2016	Target
Underlying Gearing Ratio	20.2%	14.7%	40.5%	58.4%	37.4%	< 90%

The underlying debt of the company (debentures and other loan supporting borrowings removed) is the first factor in an attempt to assess the underlying shareholder owned skeleton upon which all the receivables that are loaned ultimately sit.

According to the full year (FY2017) statement of financial position the debt excluding borrowings is:

$25.479m + $9.856m = $35.335m (1)

-----

To calculate the total underlying company assets we have to (at least) subtract the finance receivables from the total company assets. I would argue that you should also subtract the 'Investment Properties' (the rump of the problem property portfolio) and the unspecified 'Investments' (held on behalf of policy beneficiaries) from that total:

$4.034.671m - ($3,545.897m +$4.909m + $318.698m) = $165.167m (2)

We are then asked to remove the intangible assets from the equation as well:

$165.167m - $71.237m = $93.930m

----


Now we have the information needed to calculate the 'underlying company debt' (skeletal picture) net of all Heartland's lending activities:

$35.335m/$93.930m= 37.6% < 90%

Result: PASS TEST

The historical picture of this ratio is tabulated below.

	FY2012	FY2013	FY2014	FY2015	FY2016	FY2017	Target
Underlying Gearing Ratio	20.2%	14.7%	40.5%	58.4%	37.4%	37.6%	< 90%

SNOOPY

[Snoopy]

Updating this number for the full year FY2016. The equity ratio is an assessment of the balance sheet risk of the total company, with all finance receivables and the supporting borrowings (whether they be from debenture holders or parent supporting banks) included.

Equity Ratio = (Total Equity)/(Total Assets)

Using numbers from the Heartland AR2016

= $498.341m/ $3547.181m = 14.1%

The customer loan base has once again increased a little faster than the company equity. This means the balance sheet is being worked a little harder. This isn't a problem if the risk of loans becoming distressed is going down.

The significant increase in share capital over the year was therefore from (reference "Statement of Changes in Equity")

1/ Retained Earnings:	$49.108m - $37.690m = $11.418m
2/ Dividend Reinvestment Plan:	$7.300m
3/ Share Based Payments to staff:	$1.888m
4/ Treasury Shares Bought:	$2.390m
Total	$22.996m

This is a reduction in the new capital generated within the existing Heartland in FY2015 ($27.503m)


The historical picture of this ratio is tabulated below.

	FY2012	FY2013	FY2014	FY2015	FY2016	Target
Equity Ratio	16.0%	14.6%	15.0%	14.3%	14.1%	-

Updating this number for the full year FY2017. The equity ratio is an assessment of the balance sheet risk of the total company, with all finance receivables and the supporting borrowings (whether they be from debenture holders or parent supporting banks) included.

Equity Ratio = (Total Equity)/(Total Assets)

Using numbers from the Heartland AR2017

= $569.595m/ $4034.671m = 14.1%

The customer loan base year on year has once again increased a little faster than the company equity (+14.4%). This means the balance sheet is being worked a little harder. This isn't a problem if the risk of loans becoming distressed is going down.

The significant increase in share capital over the year was therefore from (reference "Statement of Changes in Equity")

1/ Retained Earnings:	$62.240m - $41.977m = $20.263m
2/ Dividend Reinvestment Plan:	$10.590m
3/ Share Based Payments to staff:	$1.053m
4/ Issue of Share Capital:	$40.003m - $0.655m = $39.348m
Total	$71.254m

This is a big increase on the 'new capital generated within the existing Heartland in FY2016' ($22.996m), with most of that increase accounted for in the capital raising undertaken over the year.

The historical picture of this ratio is tabulated below.

	FY2012	FY2013	FY2014	FY2015	FY2016	FY2017	Target
Equity Ratio	16.0%	14.6%	15.0%	14.3%	14.1%	14.1%	-

SNOOPY

[Snoopy]

I have spat out quite a few numbers over the last few days. Now I am going to try and 'bring it all together' with no numbers.

No one wants to invest in a financial institution that isn't sound. The Reserve Bank of New Zealand set their own standards that any financial institution operating in New Zealand must have to keep to. In particular the amount of equity that must be held 'on the books' to stand behind the loan portfolio is specified. However, as an investor, I do not consider the reserve bank capital adequacy requirements for second tier financial institutions to be good enough. To me a much more worthwhile standard is what a top tier bank would require to loan to a second tier finance institution (i.e. a lending organization with 'skin in the game'). The top tier banks don't widely publicise what this figure might be. Suffice to say it is well above reserve bank minimum requirements though.

Irrespective of all this, investors can see that Heartland management hold their own Total Tier Capital/ Loan Book relatively steady, and well above reserve bank minimum requirements.

Not all loans are equally profitable. One measure of 'underlying loan profitability' is to compare the institutions cash incomings with interest payment outgoings. If there wasn't a decent amount of net positive cash headroom between these two cash streams, then the profitability of the whole operation would come into question, no matter how adequate the capital base of the company appears to be at any snapshot in time.

The next risk for the unsuspecting investor is the 'house of cards' finance company. This is something that appears at face value to have sufficient capital on hand and has a good profit margin. But much of the underlying source of funds has come from a third source, like company debenture holders. If the debenture holders timing for return of their cash does not match the cash repayment profile of the loans those debentures support then the financial institution could run out of cash. A innate financial strength independent of the loan book is needed to minimise this possibility.

Finally the 'equity ratio' is normally closely related to measuring the robustness of the loan book. But it encompasses all other borrowing arrangements, that contribute to the capital structure of the financial group.

To summarize, in my assessment, the fundamental underlying strength of Heartland has never been sounder, to the extent that I could even see myself on the share register at some point in the future (!). My stumbling point right now remains price. Where the share trades on the market today, I judge it to be at the upper end of full valuation. Granted it is probably no more overvalued than half the shares on the NZX main index. But I have never done well by buying overvalued assets, and truth be told I am not stocking up on those other NZX main index companies either.

SNOOPY

[Valuegrowth]

We find some valuable information here. Thank you. We have to study why some financial institutions had to bail out or went into receiverships in the past? I myself had some bad experience in the sector. Some financial institutions went into receivership mainly as a result of overexposure to the property sector. By going by their business model, HBL doesn't look like a failed institution.

[winner69]

Maybe I’m the zonc but I don’t get this bit at all — I got a sudden brain zonc during the day. Tax will be due on this subordinated capital note.

[percy]

Maybe I’m the zonc but I don’t get this bit at all — I got a sudden brain zonc during the day. Tax will be due on this subordinated capital note.

Please note I have not entered this conversation...Zonc'd too.!!!!.....lol.
I will leave it to you W69, to explain the fact of life on companies deducting interest payments on loans as an expense,and having to repay loans in full,otherwise people will think I am picking on him.!!

[Snow Leopard]

For I have trod the lands of Qomolangma.
I have bowed in awe at the departing red of the last glorious sunset,
and been reborn with the arrival of the cold crystal light of the first sunrise.
The sleeping Paper Tiger awoke renewed as the Snow Leopard.
I became one with the magnificence and beauty of life.
I hear the Om.

But all such fades into the deepest of shadows cast by a transformation such as this:

....To summarize, in my assessment, the fundamental underlying strength of Heartland has never been sounder, to the extent that I could even see myself on the share register at some point in the future (!)....

To have achieved the ultimate state of brain zonc after so many years of dedicated study!

Like Wow!

[RupertBear]

For I have trod the lands of Qomolangma.
I have bowed in awe at the departing red of the last glorious sunset,
and been reborn with the arrival of the cold crystal light of the first sunrise.
The sleeping Paper Tiger awoke renewed as the Snow Leopard.
I became one with the magnificence and beauty of life.
I hear the Om.

But all such fades into the deepest of shadows cast by a transformation such as this:



To have achieved the ultimate state of brain zonc after so many years of dedicated study!

Like Wow!

Welcome Snow Leopard I have often wondered what happened to the eclectic Paper Tiger. It sounds like you have been on an interesting journey and I look forward to reading your enlightened posts.