HGH - Heartland Group Holdings

[davflaws]

Kia ora Snoopy
I both understood and appreciated this post. Thank you.

[Snoopy]

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

I now want to take investors right back to the formation of Heartland and the goodwill that came onto the books as a result. The following is a quote from p12 of AR2012 page 54, immediately following the acquisition of Southern Cross Building Society, CBS Canterbury and Marac on 5th January 2011 (during FY2011).

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"Goodwill of $20.1 million has not been allocated to individual cash generating units, as the future economic benefit is attributable to all business units. The Group's management and board continue to monitor goodwill at a total level."

"Goodwill on acquisition of $20.1 million has arisen due to expected benefits of the newly formed financial services group. The Society has the benefits of scale and scope and is expected to be value enhancing for all shareholders and offers a better outcome than could be expected as standalone entities."

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At the end of FY2012 (the first full financial year after which Heartland acquired the three companies mentioned), the profit before income tax was $20.329m. That would have adjusted downwards to an operational net profit after tax of $20.329m x 0.72 = $14.637m (if Heartland had not had a tax refund that year).

Fast forward to the end of FY2017 (the last financial year to be reported on before the 'Camereon Partners Scheme Booklet' was published) and the Reverse Mortgage business amounted to $921m, almost exactly half of the 'household' loan book. Of that $516m was Australian Reverse Mortages and $405m was NZ Reverse Mortgages (from p11&12 Annual Result 2017 presentation).

$60.808m-0.72($0.628m) = $60.355m is my estimate of the normalised NPAT for Heartland over FY2017. We can do a quick and dirty and not so accurate estimation of the amount of profit generated via the whole of Heartland less the Australasian Reverse mortgage business by simply allocating profit in proportion to the size of the respective loan book. The total receivables at EOFY 2017 were $3.545.897m.

So $60.355m x [($3,546m - $921m)/$3,546m] = $45.419m

The question as an investor you should ask is: Has the realisation of combining the three founding acquisitions (Southern Cross Building Society, CBS Canterbury and Marac) -together with PGW Finance, which incredibly was able to be brought into the Heartland fold without any related goodwill being acquired- lived up to that early promise? At this point I could attempt some fancy calculation to prove this point, one way or the other. But comparing the profit of five years previously ($14.637m) to the same businesses units after five years of Heartland stewardship ($45.419m), tells you all you need to know. And the answer is "Hell yes".

The next question to ask youself is this. If all of the business, less home equity loans, was sold off to a third party now, would that $20.1 million of goodwill at acquisition time be recovered? My answer: "Hell yes, and then some". This then is the key point of this post. That $20.1m of intangible goodwill is bankable any time Heartland management so chooses. So it should be regarded as a 'hard asset' of the company, just as good as a 'net tangible asset' in my view.

SNOOPY

[Snoopy]

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
2014	$2.278m	$45.143m	$47.421m	Australian Seniors Finance

I now wish to look at the goodwill acquired as a result of the Seniors acquisition.

From p64 of AR2014 we learn that $25m in goodwill has come onto the books as a result of the REL business being acquired.

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Goodwill

Goodwill on acquisition of $25.0 million has arisen due to expected benefits of the newly acquired business. NSL is the largest HER mortgage provider in New Zealand, with approximately 80% market share. ASF is the largest non-bank HER mortgage provider in Australia, with approximately 20% of that market. Both the NSL and ASF portfolios are seasoned and diversified. This acquisition has given the Group the opportunity to fast-track entry into strong and established market positions.

The Group incurred acquisition-related costs of $1.2 million in the year to 30 June 2014 relating to external legal fees and due diligence costs. These costs are included in selling and administration expenses.
In the 3 months to 30 June 2014, NSL and ASF contributed net operating income of $2.5 million and estimated profit of $1.2 million.

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Annualizing that after tax profit means a NPAT of $4.8m for the FY2014 year. Fast forward three years and the annual net profit for this business unit can be estimated as:

So $60.355m x [$921m/$3,546m] = $15.676m

So we ask the relevant question. If Heartland were prepared to pay $25m in a goodwill payment three years previously and the profit for the business unit has since tripled, what chance do Heartland have of getting that $25m of goodwill back in hard cash, if they chose to sell? I think they would easily get it back. My conclusion is similar to Part 3. The $25m in 'Seniors goodwill' should be regarded as a 'hard asset' of the company, just as good as any 'net tangible asset' in my view.

SNOOPY

[winner69]

Snoops ....back when Seniors was acquired and $25m of goodwill was created there were a few on this forum who suggested that Heartland had paid too much .....by paying $25m more than the assets they acquired.

Been a good acquisition hasn’t it?

[percy]

Snoops ....back when Seniors was acquired and $25m of goodwill was created there were a few on this forum who suggested that Heartland had paid too much .....by paying $25m more than the assets they acquired.

Been a good acquisition hasn’t it?

Fantastic acquisition.
What goodwill would Heartland receive if they sold Seniors?
1] Less than they paid.
2] The same as they paid.
3] A little more than they paid.
4] Ten times what they paid.
5] More than ten times.

[iceman]

Percy depends on when they’d sell it. If it was in a couple of years for example , I think your answer 5) would definitely apply.

Heartland over the years has been criticised on this forum for both paying too much for acquisitions and being too conservative. Probably means they’ve got it about right.

With Seniors, they got a bargain

[Snoopy]

The 'Meads Test' is way to find out if dear old Colin says a profitable finance company is 'solid as', whether that company will run out of cash when it comes time to repay your debenture. "Liquidity Buffer Ratio" sounds a bit pompous, so I have adopted the term 'Meads Test'. I think most investors will relate to that term better.

We are looking at the balance between monies borrowed and monies lent and matching up those maturity dates using a one year time horizon. The equation we are looking to satisfy is:

(Total Current Money to Draw On)/(Expected Net Current Loans Outstanding) > 10%

Heartland provides a nice projection of forward cashflows in note 14 of IRFY2017. But these are contracted cashflows. In practice depositors roll over their Heartland debentures. And when customers repay a Heartland loan, they often take out another loan. So what we as investors need to concentrate on is the expected behaviour of those that take out loans from Heartland and those that loan money to Heartland. Expected behaviour is not written in stone. But we can make an educated guess at this by looking at what happened in prior periods where both 'contracted' behaviour and 'expected' behaviour were tabulated. "Adjustment factors" in the table below:

HY2017 Loan Maturity (Financial Receivables)	Contracted	CE Factor	Expected
On Demand	$69.655m	1.000	$69.655m
0-6 months	$802.074m	1.32	$1,058.738m
6-12 months	$538.448m	1.32	$710.751m

HY2017 Deposit Maturity (Financial Liabilites)	Contracted	CE Factor	Expected
On Demand	$754.583m	0.0301	$22.713m
0-6 months	$1,047.186m	0.324	$339.288m
6-12 months	$889.191m	0.364	$323.666m

Now I have generated the expected cashflow data over the ensuing twelve months, I can proceeed to make some 'Meads Test' calculations.

The 'Meads Test' is way to find out if the late dear old Colin said a profitable finance company was 'solid as', whether that company would likely run out of cash when it came time to repay your debenture. "Liquidity Buffer Ratio" sounds a bit pompous, so I have adopted the term 'Meads Test'. I think most investors will relate to that term better.

We are looking at the balance between monies borrowed and monies lent and matching up those maturity dates using a one year time horizon. The equation we are looking to satisfy is:

(Total Current Money to Draw On)/(Expected Net Current Loans Outstanding) > 10%

Heartland provides a nice projection of forward cashflows in note 14 of IRFY2017. But these are contracted cashflows. In practice depositors roll over their Heartland debentures. And when customers repay a Heartland loan, they often take out another loan. So what we as investors need to concentrate on is the expected behaviour of those that take out loans from Heartland and those that loan money to Heartland. Expected behaviour is not written in stone. But we can make an educated guess at this by looking at what happened in prior periods where both 'contracted' behaviour and 'expected' behaviour were tabulated. "Adjustment factors" in the table below:

HY2017 Loan Maturity (Financial Receivables)	Contracted	CE Factor	Expected
On Demand	$117.316m	1.000	$117.316m
0-6 months	$856.795m	1.32	$1,130.969m
6-12 months	$497.296m	1.32	$656.431m

HY2017 Deposit Maturity (Financial Liabilites)	Contracted	CE Factor	Expected
On Demand	$852.165m	0.0301	$25.650m
0-6 months	$1,272.889m	0.324	$412.416m
6-12 months	$614.591m	0.364	$223.711m

Now I have generated the expected cashflow data over the ensuing twelve months, I can proceeed to make some 'Meads Test' calculations.

SNOOPY

[Snoopy]

HNZ LENDINGS vs HNZ DEBENTURES

Customers owe HNZ 'Finance Receivables' (Lendings) of $3,334,800,000. If we look at note 14 of IFR2017, we can derive the expected maturity profile of total finance receivables due over the next twelve months. (This is what I did in part 1 of this calculation.) Adding the totals for the ensuing twelve months gives:

	On Demand	0-6 Months	6-12 Months	Total
Expected Receivables Due	$69.655m	+ $1,058.738m	+ $710.751m	= $1,839.144m
less Expected Deposits for Repayment	$22.713m	+ $339.288m	+ $323.666m	= $685.667m
equals Net Expected Cash Into Business	$46.942m	$719.450m	$387.085m	$1,153.477m {B}

If more money is expected coming in from customer loans being repaid, than is having to be repaid to the debenture holders, then this is a good thing for liquidity and debenture holders being repaid. That is the case here: good news for debenture holders.

It is important to note that this calculation is based on the loan book position at balance date. New loans taken out since balance date are not included. Neither are brand new customer debentures invested with Heartland since balance date. So these figures are not a forecast of what will happen. But they are are forecast of what will happen if all customer loan and deposit activity ceased at last balance date. This means the figures are best suited for comparing with previous periods, rather than being forecasts of what will happen in their own right.

Compared to six months ago, the expected liquidity imbalance has improved overall. But the 0-6 month period has blown out, signalling a possible 'wall of cash' to be returned to Heartland between December 2016 and June 2017.

HNZ LENDINGS vs HNZ DEBENTURES

Customers owe HNZ 'Finance Receivables' (Lendings) of $3,783,091,000. If we look at note 14 of IFR2018, we can derive the expected maturity profile of total finance receivables due over the next twelve months. (This is what I did in part 1 of this calculation.) Adding the totals for the ensuing twelve months gives:

	On Demand	0-6 Months	6-12 Months	Total
Expected Receivables Due	$117.316m	+ $1,130.969m	+ $656.431m	= $1,904.716m
less Expected Deposits for Repayment	$25.650m	+ $412.416m	+ $223.711m	= $661.777m
equals Net Expected Cash Into Business	$91.666m	$718.553m	$432.730m	$1,242.939m {B}

If more money is expected coming in from customer loans being repaid, than is having to be repaid to the debenture holders, then this is a good thing for liquidity and debenture holders being repaid. That is the case here: good news for debenture holders.

It is important to note that this calculation is based on the loan book position at balance date. New loans taken out since balance date are not included. Neither are brand new customer debentures invested with Heartland since balance date. So these figures are not a forecast of what will happen. But they are are forecast of what will happen if all customer loan and deposit activity ceased at last balance date. This means the figures are best suited for comparing with previous periods, rather than being forecasts of what will happen in their own right.

Compared to six months ago, (net $884.340m due from FY2017 balance date) ) the expected liquidity imbalance has improved overall. Compared the pcp the expected cash to be returned has grown roughly in line with the loan book. This could indicate a 'seasonal effect' of net loan maturity, where more cash will become due in the ensuing twelve months when measuring from the December balance date.

SNOOPY

[Snoopy]

(Total Current Money to Draw On)/(Net Current Loans Outstanding) > 10%

In the numerator of the equation, we have borrowings.

HNZ BORROWINGS

1/ Term deposits lodged with Heartland.	$2,512.629m
2/ Bank Borrowings	$454.317m
3/ Securitized Borrowings total	$276.696m
4/ Subordinated Bonds	$3.379m
Total Borrowings of (see note 7, IRFY2017)	$3,247.021m

Note 7 does not contain a clear breakdown of current and longer-term borrowing amounts and their maturity dates.

Banking facilities are provided by CBA Australia but for both Australia and New Zealand. These facilities are in relation to the reverse mortgage portfolio. These banking facilities are secured over the homes on which the reverse mortgages have been taken out. These loans have a maturity date of 30th September 2019. That means they are classed as ‘long term’ for accounting purposes. Heartland can’t rely on CBA Australia as a source of short-term funds.

The information given in note 7 on the securitized borrowing facilities is as follows:

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	Total HY2017	Total FY2016	Facility Maturity Date HY2017
Securitized bank facilities total all in relation to the Heartland ABCP Trust 1	$350.000m	$350.000m	3rd August 2017 (*)
less Current level of drawings against this facility	$276.696m	$284.429m
equals Borrowing Headroom	$73.304m {A}	$65.571m

(*) I do not expect any problem in rolling this facility over for another year.

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Summing up:

(Total Current Money to Draw On)/(Expected Current Net Loan Maturity Outstanding)
= {A}/{B (from post Liquidity Buffer Ratio HY2017 (Part 2) }
= $73.304m / $1,153.477m
= 6.4% < 10%

=> Fail Short term liquidity test

	HY2017	FY2016
Amount lent to Customers (Receivables)	$3,334.800m (+7.1%)	$3,113.957m
Total Borrowings	$3,247.021m (+8.2%)	$2,999.987m
Amount borrowed from Customers (Debentures and Deposits)	$2,512.679m (+10.1%)	$2,282.876m

a/ Securitized borrowing facilities are $7.773m lower over the six month comparative period.
b/ External Bank borrowings have increased by $25.013m.
c/ $20m has been raised in part one of a cash issue.

Heartland have reduced their current period liquidity risk profile by:

1/ Increasing the debentures and parent bank borrowings at a faster rate than the receivables.
2/ Increasing the borrowed funds from Heartland bank customers, at a faster rate than the increase of all borrowings.

(Total Current Money to Draw On)/(Net Current Loans Outstanding) > 10%

In the numerator of the equation, we have borrowings.

HNZ BORROWINGS

1/ Term deposits lodged with Heartland.	$2,703.234m
2/ Bank Borrowings	$637.572m
3/ Securitized Borrowings total	$115.059m
4/ Subordinated Bonds	$3.379m
5/ Subordinated Notes	$22.277m
6/ Unsubordinated Notes	$151.902m
Total Borrowings of (see note 7, IRFY2018)	$3,633.423m

Note 7 does not contain a clear breakdown of current and longer-term borrowing amounts and their maturity dates.

Banking facilities are provided by CBA Australia but for both Australia and New Zealand. These facilities are in relation to the reverse mortgage portfolio. These banking facilities are secured over the homes on which the reverse mortgages have been taken out. These loans have a maturity date of 30th September 2019. That means they are classed as ‘long term’ for accounting purposes. Heartland can’t rely on CBA Australia as a source of short-term funds.

The information given in note 7 on the securitized borrowing facilities is as follows:

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	Total HY2018	Total FY2017	Facility Maturity Date HY2018
Securitized bank facilities total all in relation to the Heartland ABCP Trust 1	$175.000m	$300.000m	28th February 2018 (*)
less Current level of drawings against this facility	$115.059m	$214.365m
equals Borrowing Headroom	$59.941m {A}	$85.635m

(*) I do not expect any problem in rolling this facility over for another year.

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Summing up:

(Total Current Money to Draw On)/(Expected Current Net Loan Maturity Outstanding)
= {A}/{B (from post Liquidity Buffer Ratio HY2018 (Part 2) }
= $59.941m / $1,242.939m
= 4.8% < 10%

=> Fail Short term liquidity test

	HY2018	FY2017
Amount lent to Customers (Receivables)	$3,783.091m (+6.7%)	$3,545.897m
Total Borrowings	$3,683.423m (+7.6%)	$3,421.749m
Amount borrowed from Customers (Debentures and Deposits)	$2,703.234m (+5.0%)	$2,573.980m

a/ Securitized borrowing facilities utilized are $99.306m lower over the six month comparative period.
b/ External Bank borrowings have increased by $20.734m over the six month comparative period.
c/ $59.225m m has been raised in part one of a pro rata rights offer.

Heartland have reduced their current period liquidity risk profile by raising yet more new capital via the rights issue. The total borrowings (from the parent banks and short term debenture holders combined) have increased by 6.6%, closely matching the rise in short term receivables of 6.7%. The increase in equity was timely, because it looks like short term expected liquidity (from existing borrowing and lending arrangements) has dropped to an all time low.

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

Summing up:

(Total Current Money to Draw On)/(Expected Current Net Loan Maturity Outstanding)
= {A}/{B (from post Liquidity Buffer Ratio HY2018 (Part 2) }
= $59.941m / $1,242.939m
= 4.8% < 10%

=> Fail Short term liquidity test

Heartland have reduced their current period liquidity risk profile by raising yet more new capital via the rights issue. The total borrowings (from the parent banks and short term debenture holders combined) have increased by 6.6%, closely matching the rise in short term receivables of 6.7%. The increase in equity was timely, because it looks like short term expected liquidity (from existing borrowing and lending arrangements) has dropped to an all time low.

Some of you may be wondering why I am so concerned with Heartland's half year results to 31st December 2017, when the full year results to 30th June 2018 have already been released. The answer is that these were the last full results available when the "Independent Adviser’s Report Prepared in Relation to the Proposed Restructure of Heartland Bank Limited" was commissioned. Actually a partial set of more up to date accounts (p36 of the Independent advisors report) dated 31st March 2018 was handed over by management. However the information released was just a balance sheet. It contained insufficient information to allow the fuller analysis that the more comprehensive half year results allowed. I also noted that the 31st March 2018 capital position was not sufficiently different from the 31st December 2017 capital position to cause my conclusions to be revised.

The two posts quoted above sum up the divergent prospects of Heartland's capital and cash position. On the one hand, there seems to be sufficient capital within Heartland to support a loan book of the current size. On the other hand, the buffer of cash available to pay out debenture holders could be questionable in a downturn. My calculations show that Heartland has access to only half of the cash buffer they might reasonably expect to need. Of course, if I include the cash supplied as part of the pro-rata rights issue which coudl be assumed to be as yet unallocated then the picture changes:

(Total Current Money to Draw On)/(Expected Current Net Loan Maturity Outstanding)
= ($59.225m + $59.941m) / $1,242.939m
= 9.6% < 10% but within the realms of rounding close enough to 10% for it not to matter.

Heartland will have no problem with cashflows, providing they continue to maintain the support of their shareholders, who have added nearly $100m in new capital to the balance sheet just from rights issues over the last two years. The other option of getting more cash in from new debenture holders may not be possible in the climate of an economic downturn. If Heartland can raise wholesale debt funding in Australia to fund the REL portfolio 'over there', that will all help too. But what happens if capital markets suddenly become more difficult? Can Heartland guarantee that they will be able to fund their growing REL portfolio in Australia with shorter term wholesale funding? IMO there are significant near term cashflow risks on the horizon for Heartland. If I were a shareholdler I would be comforted by the Reserve Bank of New Zealand oversight of 'Heartland Bank'. But with those potentially cashflow problematic loans planned to move outside of the Heartland bank structure, the oversight of some of the most vulnerable loans will be lost.

Heartland can double the size of their Australian operation 'right now' without going outside RBNZ guidelines (33% of Heartlands business is allowed to be 'overseas'), without growing the NZ loan book. It seems to me that given this, the proposed restructure is premature. If I was a shareholder, and given the turbulent political times that are upcoming in Australia, I would feel much happier if the RBNZ kept the reins on the whole Heartland operation a bit longer. My recommendation for Heartland shareholders is that they should REJECT the Heartland restructuring proposal. Maybe in a couple of years revisit this proposed restructuring. But I think very little opportunity will go begging between then and now. It looks to me to be precisely the wrong time to take away that RBNZ oversight of the Australian operations. Don't do it!

SNOOPY