HGH - Heartland Group Holdings

[winner69]

HGH are doing a good job of feeding the dividend hounds that like to eat and those that like to bury their bones for consumption later can elect the dividend reinvestment scheme.

What Snoopy was essentially saying that having a high payout ratio as well as raising new share capital (not counting the bonds) affects the value of the company on book value per share basis ....and therefore the share price

Heartlands Book Value (Net Assets) per share has increased from 99 cents in 2014 to $1.187 in 2019 - ie at a rate of 3.7% pa (in raw $ terms the increase is from $452m to $676m)

Of that increase in Book Value per share about 70% has come from New share capital and the other 30% from Retained Earnings

A lower payout ratio over the years would probably have seen a much higher share price than it is today (beause its Book Value would have been higher from higher level of retained earnings)

[BlackPeter]

...

What I am saying is that there is an underlying cash flow risk for the business going forwards. That risk can be fixed by shareholders putting their hands in their pockets and answering a rights issue call. I am saying that shareholders holding now should be prepared for a rights issue if capital market conditions change.

Fair enough, though you could say that about a lot of "growth" companies. Heartland is currently growing their REL portfolio, and yes, this will require additional capital - though not ad infinitum. I think the average duration of a REL is something like 8 to 10 years - i.e. give it another 6 years or so and they should get enough capital back through REL which they can recycle.

Obviously - they might find by then something else they want to grow :

Given that the HGH share price does not really price in growth (at a forward PE of 11.5 based on analyst forecasts) am I not concerned, if shareholders are paying for this extra growth through CR / DRP or similar. On top of that - their forward earnings CAGR is 6 (backwards 11.7), which makes them really cheap ...

Still - you are obviously right - there might be as well a time when HGH is too dear (as it used to be last year), and then it is a good time to sell, but in my view this is not now :

Referring to asset value: NTA was rising consistently from 86 cents in 2014 to $1.04 now. That's a CAGR of 4 - not too bad. On top of that they do have as well more shares on issue - i.e. I don't think that net assets / market cap did drop in average (but I admittedly didn't check the latter).

[Beagle]

What Snoopy was essentially saying that having a high payout ratio as well as raising new share capital (not counting the bonds) affects the value of the company on book value per share basis ....and therefore the share price

Heartlands Book Value (Net Assets) per share has increased from 99 cents in 2014 to $1.187 in 2019 - ie at a rate of 3.7% pa (in raw $ terms the increase is from $452m to $676m)

Of that increase in Book Value per share about 70% has come from New share capital and the other 30% from Retained Earnings

A lower payout ratio over the years would probably have seen a much higher share price than it is today (beause its Book Value would have been higher from higher level of retained earnings)

People who don't want the divvy can participate in the DRIP and grow their wealth that way.

[Snoopy]

Heartland is currently growing their REL portfolio, and yes, this will require additional capital - though not ad infinitum. I think the average duration of a REL is something like 8 to 10 years - i.e. give it another 6 years or so and they should get enough capital back through REL which they can recycle.

I have heard this 'recycling capital' for reverse mortgages argument before. My answer I have recycled below

I need to be quite precise with my language here. I believe that the Australian Reverse Mortgage Business is very profitable right now. But the profits are paper profits in the sense that they cannot be cashed up by Heartland until the loan is ultimately cashed in.

'Building scale' is all about growing the size of the reverse mortgage portfolio. Growing the REL portfolio means that HBL will always have poor cashflow, because as 100 loans are paid back in the future (say), Heartland will have to fund 200 new equivalent loans to keep the growth going. So I see no end to the cashflow issue, provided the REL portfolio keeps growing.

Of course if the REL portfolio stops growing, then, at some time in the future (say ten-fifteen years) the cash flow situation will resolve itself. If Heartland were to decide to wind down their reverse mortgage portfolio in the future it would then become a cash flow generating engine for the company, the exact opposite of the situation now. But if the REL growth is halted, the earnings multiple that investors are prepared to pay for Heartland will go down. At that means the share price will shrink. Therein lies the 'balancing act' and the dilemma.

Then Jantar tried to put me straight.

I think you may be treating this issue as too much of binary situation rather than as a variable scale. Inflation alone would mean that simply replacing 100 matured loans with 100 new ones that there would be growth in absolute terms, if not in real terms, However the cashflow would be the equivalent of the compounded interest over the period of those loans. Increasing the number or value of loans by an amount equal to say half of the cash generated would achieve both cashflow and growth.

i don't think I commented at the time because i am not sure I fully understood what Jantar was getting at. What Jantar is saying is that the compounding cashflow from the reverse mortgage interest is what is really driving the profits.

Seniors interest rate is 7.82%. It is variable but since we don't know how it will vary in the future I will keep it fixed for the purpose of this exercise. To keep the figures easy, Mr & Mrs Crusty will look to take out a $100,000 reverse mortgage loan.

	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10	Total
Interest Payable	$7,820	$8,432	$9,091	$9,802	$10,568	$11,395	$12,286	$13,247	$14,282	$15,399	$112,332
Time Discount Factor	Face Value	7.4%	7.4%^2	7,4%^3	7,4%^4	7.4%^5	7.4%^6	7.4%^7	7.4%^8	7.4%^9
Time Discounted Interest	$7,820	$7,851	$7,881	$7,912	$7,935	$7,974	$8,005	$8,037	$8,068	$8,099	$79,582

Here is a graphic demonstration of compound interest. Mr & Mrs Crusty end up paying back $112k interest on top of the $100k that they borrowed! Or put another way each dollar they spend in their ten years of retirement costs them $2.12.

Using the above model, Heartland could double their Seniors investment capital in dollar terms on each $100,000 loaned over ten years. (I note the Seniors interest rate has reduced a bit since I went through my above example.) So the corollary is that if Heartland retain all their 'reverse mortgage capital' inside their 'reverse mortgage business unit' then the size of the reverse mortgage portfolio can double in ten years. Doubling in ten years is equivalent to an annual compounding growth rate of:

$100,000 x (1+g)^10 = $200,000 => (1+g) = 2^0.1 => g=7.2%

On average if Heartland want to grow their reverse mortgage portfolio faster than this 7.2%, then they need more capital. But if they want to take money out of the reverse mortgage portfolio (to go towards paying a dividend for example) they will have to be content with a growth rate of rather less than 7.2%.

Over FY2018, Australian reverse mortgages in gross receivable terms, grew by 31% and the NZ reverse mortgages receivables grew by 12%. This was followed up by more compounding REL receivables growth of 24% for Australia and 11.4% for New Zealand over FY2019. So the Seniors portfolio is growing way faster than its own self funding underlying organic rate of around 7%. But how long will this growth continue? As at EOFY2019 the Australian Reverse Mortgage market share that Heartland has is 24% of all REL loans. Given no other major player is active in recruiting new business for lump sums in Australia, I think we could see Heartland's REL market share double to near 50% in Australia. At the underlying organic growth rate, that means Heartland will have to continue to raise new capital if they want to take less than ten years to reach that 50% market share target. Consequently I don't see any free cashflow coming out of the reverse mortgage business for many years. In fact I see a cash issue (or an Australian bond issue?) on the horizon as being the more likely way to speed up growth.

SNOOPY

[Snoopy]

Snoopy wrote:
"What I am saying is that there is an underlying cash flow risk for the business going forwards. That risk can be fixed by shareholders putting their hands in their pockets and answering a rights issue call. I am saying that shareholders holding now should be prepared for a rights issue if capital market conditions change"

Fair enough, though you could say that about a lot of "growth" companies.

I think the potential situation is rather worse than putting Heartland into the same growth bucket as other growth companies.

Let's say you have a property worth $1m and take out what ends up being a a ten year reverse mortgage for $100,000. The bill at the end of ten years is $200,000, with all the compounding interest rolled up. But as a long term property owner, you might be expecting your property might have appreciated to be worth $1.2m over ten years. So in headline dollar terms you still have your $1m nest egg intact to pass on to your children. You feel good, and your children can't feel hard done by, as your very generous nest egg to them is intact.

Now let's look at an alternative property market scenario where property prices flat line for ten years. In that case your nest egg drops to $800,000. The wider economy is much cooler under this scenario, so your children are not getting ahead as much. Such a scenario might make you think twice about taking out that reverse mortgage in the first place. Do you really need that world cruise? Why not hang onto your old car rather than upgrade to a new one? So demand for reverse mortgages could drop. But the value of the underlying asset on which the reverse mortgage is based also drops in relative terms. So the existing reverse mortgages become more risky.

What I am saying here is that in a recession the reverse mortgage gets a double whammy. The first hit being a drop in demand for new reverse mortgages. The second hit being a new capital risk to the existing REL portfolio. I don't think most growth companies would face a 'double hit' like that in a recession.

SNOOPY

[BlackPeter]

Hmm - but didn't you say before that the biggest risk for REL's might be in the unconstrained growth (creating cash flow issues for Heartland)?

If the problem is now that maybe some potential customers might be a bit more careful in drawing on REL's to prevent the nest egg to shrink, than this just means that the REL market might grow a bit slower mitigating the cash flow issues you predicted for Heartland.

Sound like a "double whammy" Heartland shareholders should find it easy to live with .

As indicated earlier - I do see risks (as in any other business) and I could imagine that some of the more significant issues for them could be the potential reduction of the value of their securities through climate change issues.

However - any other bank lending money secured with mortgages is carrying exactly the same risk, so it is hard to avoid unless you remove banking from your portfolio.

The time frame and cash flow of REL's should not be an issues at all as long as Heartland makes sure they know how to use the death tables and there is enough headroom between maximum loan and security valuation for potential property slumps. So far I have not seen evidence for that not being the case.

In other parts of the world (e.g. Germany) it is quite usual for banks to give you e.g. mortgages with a 30 year time frame up to 60% of the property value, and while the banking industry used to have their issues over time, I never heard that any bank got into trouble because of this particular policy.

I think you are chasing a red herring .

[Snoopy]

Eagle eyed readers will note that I have revised some of my assumptions on what one off items are taxable or not.

Financial Year	Net Sustainable Profit (A)	Shares on Issue EOFY (B)	eps (A)/(B)
2014	$36.039m + $0.056m = $36.095m	463.266m	7.8c
2015	$48.163m - $0.588m - $0.098m = $47.477m	469.980m	10.1c
2016	$54.164m - $1.136m - $0.322m = $52.706m	476.469m	11.1c
2017	$60.808m - 0.72x$1.2m - $0.628m - $0m = $59.316m	516.684m	11.5c
2018	$67.513m + 0.72x$1.3m - ($4.8m + $0.6m) -$0.156m - $0m = $62.893m	560.587m	11.2c

Notes

1/ Property plant and equipment sale loss of $56k added back into FY2014 result.
2/ Profit of $588k from investment sale and $98k from Property Plant and Equipment sales removed from FY2015 result
3/ Profit of $1.136m from investment sale and $322k from Property Plant and Equipment sales removed from FY2016 result
4/ Profit of $0.628m from investment sale removed from FY2017 result. A $1.2m insurance write back that made the impaired asset expense for FY2017 unusually low and hence artificially inflated profits has been removed from the FY2017 result (refer FY2018 annual report).
5/ Profit of $0.156m from investment sale removed from FY2018 result. The after tax effect of $1.3m in 'one off costs' (system integration $0.5m, legacy system write off $0.3m and corporate restructure $0.5m) have been added to the FY2018 profit. Profits from the sale of the 'bank invoice finance business' of $0.6m and $4.8m recovered from a legacy MARAC property loan have been removed from the FY2018 profit.
6/ I have been unable to locate property plant and equipment sales profits/losses for FY2017 and FY2018.

Result: Pass Test

I am not going to go through a full Buffett review this year, because I know that Heartland will not pass the return on equity requirement. Notwithstanding this, that doesn't mean that Heartland is not a worthwhile investment according to other criteria. And it is always interesting to look at the trend of what I deem to be 'normalised profit'. See if you agree with the various adjustments I have made.

Financial Year	Net Sustainable Profit (A)	Shares on Issue EOFY (B)	eps (A)/(B)
2015	$48.163m - $0.588m - $0.098m = $47.477m	469.980m	10.1c
2016	$54.164m - $1.136m - $0.322m = $52.706m	476.469m	11.1c
2017	$60.808m - 0.72x$1.2m - $0.628m - $0m = $59.316m	516.684m	11.5c
2018	$67.513m + 0.72x$1.3m - ($4.8m + $0.6m) -$0.156m - $0m = $62.893m	560.587m	11.2c
2019	$73.617m + 0.72x($1.8m + $1.3m + $1.1m) -$1.936m -$0.173m - $0m = $74.532m	569.338m	13.1c

Notes

1/ Profit of $588k from investment sale and $98k from Property Plant and Equipment sales removed from FY2015 result
2/ Profit of $1.136m from investment sale and $322k from Property Plant and Equipment sales removed from FY2016 result
3/ Profit of $0.628m from investment sale removed from FY2017 result. A $1.2m insurance write back that made the impaired asset expense for FY2017 unusually low and hence artificially inflated profits has been removed from the FY2017 result (refer FY2018 annual report).
4/ Profit of $0.156m from investment sale removed from FY2018 result. The after tax effect of $1.3m in 'one off costs' (system integration $0.5m, legacy system write off $0.3m and corporate restructure $0.5m) have been added to the FY2018 profit. Profits from the sale of the 'bank invoice finance business' of $0.6m and $4.8m recovered from a legacy MARAC property loan have been removed from the FY2018 profit.
5/ Profit of $0.173m from investment sale removed from FY2019 result. The after tax effect of $4.2m in 'one off costs' (corporate and ASX listing $1.8m, one off currency costs of $1.3m and the Australian bond break fee of $1.1m) have been added back to the FY2019 profit. Lastly i have removed the $1.936m book gain on the fair valuation of an investment property.
6/ I have been unable to locate property plant and equipment sales profits/losses for FY2017 and FY2018 and FY2019.

Result: Pass Test

SNOOPY

[winner69]

I have read their annual report/review documents, and while they have obviously done a great deal of work on the Māori side of things, that doesn’t mean they are excluding other cultures. I have no doubt whatsoever that they employee people from many different cultures. They are thinking outside the square and aim to create a culturally diverse workforce/team, which they are to be commended for. I particularly like the fact that they employ many young people. Heartland seems to be a genuine and passionate employer and are doing much more than most businesses whose cultural inclusiveness is often nothing more than lip service.

There are two ways of thinking about inclusiveness and diversity, positive and negative.

The negative way is the “woke”, campus radical, activist, no-justice-no-peace sort of way that just leads to resentment, anger and a view it is really, really bad for business.

The positive way is that the more ideas and perspectives we have coming in from all over, the more likely we are to think of things nobody else has, walk down paths nobody else has trod. In other words it gives you a competitive advantage.

[Snoopy]

http://www.equity.co.nz/files/SKL_CMO_ABA_HGH.pdf

They say HGH really bad apparently...

If that is from Simply Wall Street,all I can say is their research remains really bad.

Rather than shoot the messenger, could I suggest looking at the message?

"HGH –OVER-PRICED! Tougher times ahead and NEGATIVE NET OPERATING CASHFLOWS OVER THE PAST 3 YEARS IS A CONCERN! Times could get tougher, making net negative operating cashflows a likely continuing trend,until such time as the NZ and Australian economies get back on a relatively strong growth trend. "

It is rather a shallow and rather odd analysis. A lot of the negative cashflows must be from the growth of the reverse mortgage business which requires cash to be shelled out up front, with repayment only at the end of the contract. The analysis then goes on to say fair value based on future cashflows is $1.54, based on 2018 results. So with the share price trading at around $1.60 after 2019 results, they would have to deem today's price fair. So what they are saying is that, despite trading at fair value, the 'shock risk' is too great.

The average duration of Heartland's REL book is 6.6 years in Australia and 7.5 years in New Zealand. Heartland fund this with two issues of NZ five year bonds, $125m maturing on 12th April 2024 and $150m maturing on 23rd September 2022. There is a two year $A50m Australian bond maturing on 8th March 2021. But all these funding arrangements are on average too short to match the average loan term. I wonder why the Australian bond was for such a short duration and for such a small amount? $A756.7m was the balance date size of the Australian REL portfolio at balance date. The balance date securitization arrangements that further support the Australian REL portfolio expire in just three years (30th September 2022).


Heartland admit their funding program is a work in progress

"Long term reverse mortgage-backed structure being developed."

We also learn of a change in the way the risk of a reverse mortgage is assessed:

-----

IFRS9 also introduced a change in the way Reverse Mortgages are valued.

o Under IFRS they are classified as ‘fair value through profit or loss’.
o Currently, it has been determined that fair value equals current carrying value. However, should consistent evidence of a market value emerge, this may result in a revaluation.

-------

Generally IFRS9 has resulted in a more conservative treatment of bad debts. But in the case of reverse mortgages, it would seem that all provisions for bad debts have been abolished until markets change. Yet when markets change it will be too late! What sort of new risk policy is this?

What will happen in three years time if market conditions change and the supporting bank arrangements that allow these reverse mortgages to continue are pulled back? How will Heartland continue in business? I think there is a real 'risk question' with serious consequences, albeit an unlikely 'risk question', to answer here.

SNOOPY

[percy]

Rather than shoot the messenger, could I suggest looking at the message?

"HGH –OVER-PRICED! Tougher times ahead and NEGATIVE NET OPERATING CASHFLOWS OVER THE PAST 3 YEARS IS A CONCERN! Times could get tougher, making net negative operating cashflows a likely continuing trend,until such time as the NZ and Australian economies get back on a relatively strong growth trend. "

It is rather a shallow and rather odd analysis. A lot of the negative cashflows must be from the growth of the reverse mortgage business which requires cash to be shelled out up front, with repayment only at the end of the contract. The analysis then goes on to say fair value based on future cashflows is $1.54, based on 2018 results. So with the share price trading at around $1.60 after 2019 results, they would have to deem today's price fair. So what they are saying is that, despite trading at fair value, the 'shock risk' is too great.

The average duration of Heartland's REL book is 6.6 years in Australia and 7.5 years in New Zealand. Heartland fund this with two issues of five year bonds, $125m maturing on 12th April 2014

As I correctly pointed out,really bad research.