HGH - Heartland Group Holdings

[Snoopy]

Using 'Heartland' as an example I have been through five bank-imposed hurdles that any finance company, that will give you your invested capital back, must jump through. However, I know that numbers make some readers glaze over. So I think it is worthwhile trying to explain the reasoning behind imposing each of these 'hurdle tests' in a 'number free' way.

H1/ 'Interest Cover Ratio' In order to pay out interest to debenture holders, a finance company must have someone feeding cash into the other end of the 'debenture paying machine'. That cash must be sufficient to cover all debenture interest, with a margin for safety.

H2/ 'Liquidity Buffer Ratio' Real cash is required to pay debenture interest. " I have earned the money but I will pay it to you later" is not an acceptable business practice. Matching payments with incoming money can only be achieved when there is some kind of connection between the term over which the money is used and the term the money is lent.

H3/ 'Gearing ratio' Underlying every finance company is a building, some staff and a few computers. 'The office' must be in sound financial shape itself to provide a firm foundation to the lending capital business that is built on top of it.

H4/ 'Single Customer Group Exposure' If a disproportionate amount of business is done with a single customer, however good that customer seems, the potential exists for the whole finance group to collapse because of an unexpected glitch in one customer arm.

H5/ 'Minimum Equity Contribution' Why don't you and I don't go out and start a finance company tomorrow? Because a certain buffer of shareholder funds to cover unexpected bad debts and to help massage any small mismatch between borrowers and lenders expectation in the timing of loans.

Once you understand the importance of these five hurdles you can see how unhelpful the information generally published in share tables on finance companies is. PE ratio? Yield? Asset backing? Profit trends? As an potential investor in the finance industry I won't be considering those statistics any more. Because whatever their value, unless the finance company under consideration can pass the five hurdle test then I don't think it can survive at all in the medium term.

SNOOPY

[percy]

Now you can understand why the team at HNZ spent so much time and effort wooing high nett worth depositors and kept so much money on hand to get through govt quarantee period.
At long last they have the building blocks in place and can start generating some real profits.

[Snoopy]

Once you understand the importance of these five hurdles you can see how unhelpful the information generally published in share tables on finance companies is. PE ratio? Yield? Asset backing? Profit trends? As an potential investor in the finance industry I won't be considering those statistics any more. Because whatever their value, unless the finance company under consideration can pass the five hurdle test then I don't think it can survive at all in the medium term.

I am now going to take Heartland shareholders on a little trip back in time to when PGGW Finance was an independent entity. As soon as PGGW Finance was sold to Heartland all the business financial reports were taken off the PGW website very quickly and not put back on the web under the Heartland brand. Changing names can be an effective way to whitewash the past. However those that do not learn from the past are often doomed to repeat past mistakes.

Unfortunately for Heartland management (but fortunately for you Heartland shareholders) I have retained this information. The aim of what I am going to present is this:

1/ Look at how PGW Finance stacked up hurdle wise before the PGGW cash issue bailout (at the end of FY2009).
2/ Look at how PGW Finance stacked up hurdle wise after the PGGW cash issue bailout (at the end of FY2010).
3/ See if any lessons can be learned from the exercise.

SNOOPY

[Snoopy]

Now you can understand why the team at HNZ spent so much time and effort wooing high nett worth depositors and kept so much money on hand to get through govt quarantee period.
At long last they have the building blocks in place and can start generating some real profits.

I would argue that from a conservative shareholder perspective that Heartland are still short of capital, when regarded as the finance company that they are. YMMV Percy.

SNOOPY

[percy]

I would argue that from a conservative shareholder perspective that Heartland are still short of capital, when regarded as the finance company that they are. YMMV Percy.

SNOOPY

You can argue all you like,but you are only argueing with your self.

[Snoopy]

1/ Look at how PGW Finance stacked up hurdle wise before the PGGW cash issue bailout (at the end of FY2009).

Here is how PGGW Finance stacked up as at 30th June 2009.

H1/ Interest Cover Ratio:

EBIT/(Interest Expense) = ($10.180m)/($37.758m)= 0.270 cf target figure of 1.2.
Result: Fail Test

H2/ Liquidity Buffer Ratio:

(Current Liabilities)/(Current Assets) = [$83.032m+($180.0-$71.5)]/$411.56m) = 0.465 cf target figure of 1.1.
Result Fail Test

H3/ Gearing ratio

(Non risk Share Liabilities)/(Non risk Tangible Assets)
= [508.659-83.032-(71.5+123.584+221.05)]/[575.475-559.659-1.163]= 9.493/14.653= 0.6479 = 65% cf 90%. Result: Fail Test

H4/ Single Customer Group Exposure

(Single Customer Loan Exposure)/(Shareholder Funds)
= ($20m)/($66.8m)= 30% cf 10% target
Result: Fail Test

(Note total Crafer farm debt is $200m so I am assuming PGW has 1/10th of this. This is a guess on my behalf)

H5/ Minimum Equity Contribution

(Shareholder Funds)/(Risk Share Lending)
= $66.8m/$559.659m= 11.9% cf target 20%
Result: Fail Test

(note all loans are assumed to be Tier 1, a conservative assumption)

The old PGGW Finance failed every banking hurdle test. It looks like it was a disaster waiting to happen despite all the bullish management comments of strong profitability and 80% debenture reinvestment rates plastering the media at the time. So did the subsequent capital injection after the PGW rights issue shore up the situation?

SNOOPY

[Snoopy]

2/ Look at how PGW Finance stacked up hurdle wise after the PGGW cash issue bailout (at the end of FY2010).

Here is how PGGW Finance stacked up as at 30th June 2010.

H1/ Interest Cover Ratio:

EBIT/(Interest Expense) = ($13.095m)/($30.357m)= 0.430 cf target figure of 1.2.
Result: Fail Test

H2/ Liquidity Buffer Ratio:

(Current Liabilities)/(Current Assets) = [$70.819m+($120.0-$21.0)]/$432.105m = 0.393 cf target figure of 1.1.
Result Fail Test

H3/ Gearing ratio

(Non risk Share Liabilities)/(Non risk Tangible Assets)
= [449.287-70.819-(21.0+99.658+247.58)]/[549.662-530.119-1.180]= 0.6479 = 56% cf 90%.
Result: Fail Test

H4/ Single Customer Group Exposure

(Single Customer Loan Exposure)/(Shareholder Funds)
= ($20m)/($100.375m)= 19.9% cf 10% target
Result: Fail Test

(Note total Crafer farm debt is $200m so I am assuming PGW has 1/10th of this. This is a guess on my behalf)

H5/ Minimum Equity Contribution

(Shareholder Funds)/(Risk Share Lending)
= $100.375m/$530.119= 18.9% cf target 20%
Result: Fail Test

(note all loans are assumed to be Tier 1, a conservative assumption)

A casual glance at those figures shows that PGGW Finance was in a poor situation, even after being bailed out by the shareholders!

SNOOPY

[percy]

SNOOPY.
Forget for a moment PGWF or PGGW F.
Some real fun would be to have a closer look at ANZ Bank,whose 6% equity ratio has to withstand,a falling Australian property market,struggling retailers,and fast going broke Australian manufacturers. 6% equity for that sort of concentration of risks must be of great concern to both shareholders and the Australian Reserve Bank.
HNZ is in a very strong position with spread of lending and avenues of funding,and has an equity ratio far superior to any Australian or NZ financial institution.
The outcome must be sell ANZ,buy HNZ.

[Snoopy]

A casual glance at those figures shows that PGGW Finance was in a poor situation, even after being bailed out by the shareholders!

OK time to assess what all of this means.

It is possible I have made some mistakes in my calculations. But I guess only those who have those old PGGW Finance annual reports will know!

Assuming I haven't made mistakes here is my explanation for PGGW Finances apparently desperate situation before it was acquired by Heartland.

1/ The interest cover figure probably represents a loan portfolio in transition. PGW is on record as saying that they were exiting a number of long term loans before the business was sold. Taking write downs or even just downsizing the investment portfolio before the supporting debentures were due would have reduced the earnings side while leaving the amount of interest due to debenture holders unchanged. This interest cover statistic is being distorted by the restructuring process.

2/ The liquidity buffer ratio was being influenced by the expiry of the government guarantee. A whole wall of debentures was maturing before the guarantee expired, thus spiking the 'current assets' total sharply higher than it would normally be post and pre guarantee. Due to this special situation, the liquidity buffer ratio is probably not a suitable test for FY2010 (or FY2009 for that matter).

3/ The gearing ratio largely depends on the asset allocation policy within PGW. Start thinking of PGW Finance as a separate company with its own administration structure and I think this fail would be fixed.

4/ Single Customer Group Exposure. As I stated by figure for the Crafers debt of $20m was a guess. If it was only $10m then things would look better.

5/ Shareholder funds are within cooee of the 20% level required by the banks.

In summary I don't think the picture of PGG Finance as I paint it on 30th June 2010 is quite as bad as those bare figures suggest. Heartland shareholders could take solace from the fact that some of the worst debts were retained within PGW when the finance business was sold.

SNOOPY

[Snoopy]

SNOOPY.
Forget for a moment PGWF or PGGW F.
Some real fun would be to have a closer look at ANZ Bank,whose 6% equity ratio has to withstand,a falling Australian property market,struggling retailers,and fast going broke Australian manufacturers. 6% equity for that sort of concentration of risks must be of great concern to both shareholders and the Australian Reserve Bank.

You are getting ahead of me Percy. Scrutinizing ANZ bank was going to be my next project!

SNOOPY