HGH - Heartland Group Holdings

[Snoopy]

Snoopy wrote:
"Thanks Winner. Now here is a question arising.

On p19 of the independent advisors report, we learn the RBNZ restricts Heartland's secured assets to 20% of total assets. Why does this restriction exist? Surely the more loans that Heartland makes on secured assets, the better?"

Snoops, maybe you shouldn’t be thinking about that solely from a lending perspective?

Just a thought without investigating

The real meat is on page 60.
That is page 19 of Cameron Partners report.
Section 3.3.2 RBNZ constraints on Heartland Australia growth.
Secured Asset Lending.
RBNZ restricts to 20%of total assets.Currently up to 18%/
85% of these secured assets are related to Australian reverse mortgage business,and 15% to NZ motor vehicle financing.
Post restructure the secured asset limited ratio will decrease to approx. 3%.
"This will remove the constraint to growth in the Australian business and create significant additional new headroom for secured asset funding within the Heartland Bank business."
So the last sentence is what we were looking for.Growth in Australia and more headroom for NZ Bank using existing capital..

Yes I did manage to read that bit, at least. I still can't make sense of it though. Winner suggested I should think of it 'not solely from a lending out perspective'. Is he suggesting that Heartland should keep at least 20% of their loan book as cash on hand to secure their loans? I don't think Heartland have ever had that much cash to back their loans!

Perhaps the answer is for Heartland to only lend on unsecured loans, to get around this secured loan restriction?

A still baffled.....

SNOOPY

[winner69]

Yes I did manage to read that bit, at least. I still can't make sense of it though. Winner suggested I should think of it 'not solely from a lending out perspective'. Is he suggesting that Heartland should keep at least 20% of their loan book as cash on hand to secure their loans? I don't think Heartland have ever had that much cash to back their loans!

Perhaps the answer is for Heartland to only lend on unsecured loans, to get around this secured loan restriction?

A still baffled.....

SNOOPY

Snoops ....still haven’t looked at closely but I think the restriction applies to how much borrowing they can do using some specific finance assets as security. The bit that percy posted points to what they have securitised doesn’t it (mainly reverse mortgages and motor vehicles)

Thinking of it this way less baffling?

Then again I might be completely wrong

[percy]

Snoops ....still haven’t looked at closely but I think the restriction applies to how much borrowing they can do using some specific finance assets as security. The bit that percy posted points to what they have securitised doesn’t it (mainly reverse mortgages and motor vehicles)

Thinking of it this way less baffling?

Then again I might be completely wrong

That is the way I read too.
20% of assets as [locked up] security.
Only 15% of the 20% was over motor vehicle lending,while 85% of the 20% was on RELs.
A lot of headroom once REL lending is separated out.

[Snoopy]

An update from last years equivalent reporting period, HY2016.

The underlying debt of the company according to the HY2017 statement of financial position is:

$39.138m + $5.986m = $45.116m

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 problem 'Investment Properties' and the unspecified 'Investments' from that total:

$3,820.147m - ($3,394.800m +$6.827m + $298.519m) = $119.991m

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

$119.991m - $65.584mm = $54.407m

Now we have the information needed to calculate the underlying company debt net of all their lending activities:

$45.116m/$54.407m= 82.9% < 90%

This compares unfavourably with the comparatuve half year period figure of 56.0%, and even less favourably with the more recent 37.4% figure from FY2016 date (30th June 2016). The rapid deterioration in this statistic means we shoudl keep watching it. But being comfotably within covenant boundaries, there is no casue for medium term concern.

Result: PASS TEST

An update from last years equivalent reporting period, HY2017.

The underlying debt of the company according to the HY2018 statement of financial position is:

$26.020m + $6.722m = $32.742m

(Note: there seems to have been some change in policy that has allowed Heartland to substantially understate these underlying liabilities in comparison with the previous half year comparative period).

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 problem 'Investment Properties' and the unspecified 'Investments' from that total:

$4,307.484m - ($3,783.091m +$1.724m + $294.297m) = $228.372m

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

$228.372m - $71.365mm = $157.007m

Now we have the information needed to calculate the underlying company debt net of all their lending activities:

$32.742m /$157.007m= 20.9% < 90%

This compares very favourably with the comparatuve half year period figure of 82.9%, and even favourably with the more recent very good 37.6% figure from FY2017 date (30th June 2017). If there was a hint of things going off the rails last comparable half year, it looks like it has all been brought back.

Result: PASS TEST

SNOOPY

[Snoopy]

Updating for the half year result HY2017. 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) = $135.789m-$35.966m= $99.823m

Interest expense is listed as $56.828m.

So (EBIT)/(Interest Expense)= ($99.823m)/($56.828m)= 1.79 > 1.20

Result: PASS TEST, an improvement from the HY2016 (1.55) position. And also an improvement on the full year position as of 6 months ago FY2016 (1.65)

Updating for the half year result HY2018. 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) = $152.471m-$40.248m= $112.223m

Interest expense is listed as $62.377m.

So (EBIT)/(Interest Expense)= ($112.223m)/($62.377m)= 1.80 > 1.20

Result: PASS TEST, near identical to the HY2017 (1.79) position. And also almost identical the full year position as of 6 months ago FY2017 (1.79). Has HBL found its own 'sweet spot' with this statistic?

SNOOPY

[Snoopy]

Snoops ....still haven’t looked at closely but I think the restriction applies to how much borrowing they can do using some specific finance assets as security. The bit that percy posted points to what they have securitised doesn’t it (mainly reverse mortgages and motor vehicles)

Thinking of it this way less baffling?

Then again I might be completely wrong

That is the way I read too.
20% of assets as [locked up] security.
Only 15% of the 20% was over motor vehicle lending,while 85% of the 20% was on RELs.
A lot of headroom once REL lending is separated out.

Just to bring other readers up to speed with what on earth we are talking about....

A 'Securitzed Loan' is when a bunch of 'similar' loans are bundled up together and sold, usually to a 'parent bank', as a 'package'. The 'parent bank' then gets to manage this collective packaged loan itself, collecting the interest due directly from the end customer. However, the seller of these loans (Heartland) does not get to remove these loans from their books, if Heartland is left with some residual guarantee on these loans if they go wrong. In the case of Heartland's REL portfolio in Australia, the 'parent bank' (see note 24 in AR2017 on Structured Entities). is the Commonwealth Bank of Australia (CBA) (see note 13 in AR2017 on Borrowings). However, in the case of Seniors Finance in Australia, I am not sure if the precise arrangements of any guarantee that Heartland have supplied have ever been disclosed.

Suffice to say that the amount of any guarantee, if called upon, could be substantial. Perhaps that is the reason that the Reserve Bank of New Zealand has placed a limit on the percentage of securitized loans (if that is what the Heartland restructuring report is referring to) made as part of a total loan portfolio? [assuming my explanation is relevant at all of course!].

Unfortunately the glossary of document in which Heartland is asking for your vote does not explain exactly what is meant by the phrase 'Secured Loan' :-(

SNOOPY

[Snoopy]

Updating this number for the half year HY2017

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

Using numbers from the Heartland HYR2017

= $528.002m/$3,820.147m = 13.8%

This is a decrease on the HY2016 position (14.5%), and also an decrease on the FY2016 position of 6 months ago (14.1%). This decrease is despite $20m in new capital being raised from institutions during the half year. So Heartland are driving their loan book forwards, and making full use of that new capital.

Updating this number for the half year HY2018

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

Using numbers from the Heartland HYR2018

= $641.339m/$4,307.484m = 14.9%

This is an increase on the HY2017 position (13.8%), and also an increase on the FY2017 position of 6 months ago (14.1%). These relative increases are largely attributable to the 40.215m new shares being issued over FY2017 and 34.838m new shares issued during HY2018 (on 14th December 2017) as part of a pro-rata rights issue. In addition to this, the dividend reinvestment plan has paid a smaller yet still important part in shoring up the company's equity position.,

SNOOPY

[Snoopy]

Note that in comparison to last year, I have revised my standard so that Heartland should carry 17% of sharehiolder equity in relation to the value of its loan book. This change of standard is in recognition of Heartland now being able to be thought of as a 'middle tier' finance player, instead the smaller rather more risky player that it started out as.

Tier 1 or Tier 2 capital adequacy is noted under section 19A (Capital Ratios) in the Heartland HY2017 report.

$3,334.800m of loans are outstanding. 17% of that figure is:

0.17 x $3,334.800m = $575.4m

Heartland has total equity of $528.002m. But from note 18A, only $457.631m is Tier 1 capital. The difference is because intangible assets, deferred tax assets, hedging reserve effects and defined benefit superannuation fund assets on the books must be adjusted for.

On top of the Tier 1 assets, there is Tier 2 Capital: a subordinated bond of $0.970m, offset by a $2.095m 'Foreign Currency Translation Reserve' adjustment. Somewhat bizarrely, this results in a negative Tier 2 equity balance of $1,125m being declared on the books.

Nevertheless, however the total tier capital is added together, it is still below my "17% of loan" target no matter what the tier classification of capital buffering any potential problems with the loans.

Result: FAIL TEST

Note: Post balance date, Heartland has raised an additional $20m capital from shareholders which will go some way to fixing this issue. If the loan book has not enlarged further since balance date, this would result in a loan book to total equity ratio of:

($528.002m + $20m) / $3,334.800m =16.4%

This brings the 'Total Tier Capital' to loan book ratio back to the level it was at FY2016 balance date (30/06/2016). If this is the level of capital that Heartland are comfortable with and the loan book continues to grow, then logic would suggest further capital raising initiatives could be required by Heartland in the near future.

In fact, a new offer of approximately A$15m of Tier 2 regulatory capital to wholesale investors in Australia, has already been signalled in p13 of the half year results presentation.

As a middle tier finance industry player, I deem that Heartland should carry 17% of sharehiolder equity in relation to the value of its loan book. Note this is a higher standard than Reserve Bank requirements, because I am more worried about losing capital than the Reserve Bank is!

Tier 1 or Tier 2 capital adequacy is noted under section 18A (Capital Ratios) in the Heartland HY2018 report.

$3,783.091m of loans are outstanding. 17% of that figure is:

0.17 x $3,783.091m = $643.14m

Heartland has total equity of $641.339m. But from note 18A, only $562.786m is Tier 1 capital. The difference is because intangible assets, deferred tax assets, hedging reserve effects and defined benefit superannuation fund assets on the books must be adjusted for.

On top of the Tier 1 assets, there is Tier 2 Capital: subordinated bonds totalling $16.314m, plus a $1.455m 'Foreign Currency Translation Reserve' adjustment. This results in a posittive Tier 2 equity balance of $17.769m being declared on the books.

Nevertheless, if the total 'tier capital' is added together - which comes to $580.555m - it is still below my "17% of loan" target no matter what the tier classification of capital buffering any potential problems with the loans. However, as with the full year result, I am going to add back in the intangible assets of $71.365m. These intangible assets represent (amongst other things) money spent on the latest up to date computer systems and premiums paid for successful business acquisitions in the past. IMO these premiums could be remonetised into cash if required.

$580.555m + $71.365m = $651.920m > $643.14m

Result: PASS TEST

But the demand for new capital to 'feed the Heartland hunger' looks set to continue into the future.

SNOOPY

[Snoopy]

Nevertheless, if the total 'tier capital' is added together - which comes to $580.555m - it is still below my "17% of loan" target no matter what the tier classification of capital buffering any potential problems with the loans. However, as with the full year result, I am going to add back in the intangible assets of $71.365m. These intangible assets represent (amongst other things) money spent on the latest up to date computer systems and premiums paid for successful business acquisitions in the past. IMO these premiums could be remonetised into cash if required.

$580.555m + $71.365m = $651.920m > $643.14m

Result: PASS TEST

I am deviating from what is normal accounting practice by recognising intangible assets as part of Heartland's 'backing security'. I am sure there will be some (like trained accountants) who will disagree with this approach. Yet in the case of Heartland, I feel that leaving out all the intangible assets as 'unrealisable' is too harsh. As a start I would like to remind shareholders where all their goodwill, and the rest of the intangible assets, came from.

Financial Year	Net Carrying Amount of Computer Software {A}	Net Carrying Amount of Acquisition Goodwill {B}	Total Intangible Assets {A}+{B}	Major Acquisition(s) Incrementing Goodwill
2011	$1.415m	$20.187m	$21.602m	Southern Cross Building Society, CBS Canterbury and Marac
2012	$2.710m	$20.287m	$22.997m
2013	$2.844m	$20.159m	$23.003m
2014	$2.278m	$45.143m	$47.421m	Australian Seniors Finance
2015	$5.976m	$45.143m	$51.119m
2016	$12.612m	$45.143m	$57.755m
2017	$26.094m	$45.143m	$72.237m

More and more of the intangible assets (36% at EOFY2017) have come from computer software.

SNOOPY

[Snoopy]

More and more of the intangible assets (36% at EOFY2017) have come from computer software.

I think it likely that if Heartland fell over tomorrow, then the $26.074m of software assets on the books would have little value to a rescuing organization. The rescuer would no doubt have their own computer systems not compatible with what Heartland was doing. Thus would begin the long process of migrating Heartland's computer image of their own business on to the acquisitors computer platform. The legacy Heartland software would be left worthless. But this apparently sound argument in favour of not counting Heartland's software on the books as equity that could be monetised in an emergency has one key flaw.

"If Heartland fell over tomorrow" is the clue phrase. The very purpose of having a bang up to date computer system is to keep tab on the loan portfolio to make sure Heartland doesn't fall over. The superficial accountant might see a present value of $26.094m for software on the books and think:

"$26.094m is a lot of money. If Heartland had not spent the money and updated their software, there would be $26.094m more money available for creditors if things went bad. So from an accounting perspective, it would be best if Heartland saved money and didn't update their software."

The problem with this approach is that not spending the money updating software might contribute to accelerating a potential demise of Heartland. It would be a false economy to not understand what is going on inside the Heartland business. Thus my argument is that although the value of the software on the books is probably not recoverable, not including it as a 'backing asset' sends the wrong signal to potential investors. The Banking business is an 'information game'. IMO a Heartland with a bang up to date software system that is working well is the better bet than a Heartland that has not made that software investment. By recognising the software as an asset that should be counted, we investors can make better comparative investment decision as to whether Heartland is a good investment or not.

SNOOPY