HGH - Heartland Group Holdings

[LoungeLizard]

LL FWIW Here's a comparison of HGH v OCA SP performance over the last 5 years.

Hardly inspiring for either company.

Nice graph there LF. The profile, as I said, is remarkably similar. And for the last 2 years they've both been in a relentless downtrend. Different companies with different stories of course, but if one is going to compare them, you at least need to use the same time period.

[Basil]

You'd have to be very brave to adopt those two unloved "puppies" at the same time.  Arguable though that both have never been better value so you never know, maybe both will be a rewarding experience....

[winner (n)]

Basil is one of a rare breed ......an acconomist ....one who specialises in both accounting and economics

[Shareguy]

Jardens latest note says

A potentially dilutive equity raise (~10cps at $200m raise) are likely to weigh on the stock until resolved.

[winner (n)]

How much capital does Heartland need when they make $200m in 2028

Say that's a ROE of 12% which implies something like $1.65 billion needed

Current shareholder funds are just over $1 billion ......so need another $600m at least in next few years

Profits F24 to F28 could total $700m and if current divie policy maintained they will retain about $200m of those earnings

The DRP could contribute another $50m or so

So we have $250m of the $600m that might be needed by 2028

That's $350m short and if Craig's are right on the $200m coming soon we'll still probably see another raise in a few years.

That's how I see it what a lot also depends on what equity ratio Heartland are happy with

[Basil]

All the signs are there they will do well in Australia, an entrenched dominant market share of 41% in the reverse home loan business is no easy thing to achieve by any means.  I'm happy to support them with their growth ambitions and agree with your comment above Winner, it's likely the next capital raise won't be the last.

Their expectation was that Challanger would lower their cost of funds there by 50-100 bps, midpoint 75 bps but the signs are very encouraging with 134 bps lower funding costs with the initial ~ $500m raised on term deposit there.  That's getting on toward doubling the cost savings they were expecting.  The other thing with having a dominant market share is you don't need to be the price leader so they should enjoy a really good NIM with their reverse mortgage book there.

I feel like we're on the cusp of something special here.  After so many decades of Australian owned banks dominating the N.Z. market, Challenger will dominate the reverse home loan market over there with nice juicy fat margins on this very low risk lending. 

[winner (n)]

$200m in 2028

Going from $110m to $200 seems big step.

A big chunk of it is going to come from a big decrease in CTI ...cost to income .....from around 44% now to <35% in 2028.

IT and more things being done on online .......ie less people .....doing heaps more with a little more ...good stuff

Rough sums see that building up and contributing about $50m in 2028...... that is expenses at 35% of income instead of 44%

So it's not all about lending more but doing it very efficiently

[snapiti]

trading x divi today but still the same closing SP as yesterday

[LoungeLizard]

Jardens latest note says

A potentially dilutive equity raise (~10cps at $200m raise) are likely to weigh on the stock until resolved.

If it's projected that the expansion will require further funds, they are probably better off getting on with it. Otherwise the cap raise overhang will keep the SP subdued for the foreseeable future, regardless of how the OZ expansion goes.

[winner (n)]

Jeff's next preso -

Australia is a vast expanse of opportunities. We already have 41% of the reverse mortgage market and growing fast in other segments. And soon Challenger Bank will be going gangbusters. I feel like we're on the cusp of something special here.

I have a dream. I dream if $200m profit in 2028

I have a dream. I dream of many shareholders who came along with and are now much richer.

[Fiordland Moose]

Thought I'd offer a few perspectives on the 1H results as there is the (increasingly) usual good, bad and ugly. A lot of good stuff has already been written here about how the current valuation metrics compare to its historical range, the ugly TA and chart, macro background and investor sentiment, so won't bother to comment on those as I don't have anything new to offer there.

Below I've mainly focused on credit risk and cashflow as I believe these by and large missed by the brokers and broader investment community.

The Good
Fantastic that Challenger has ramped up deposit raising (and at comparatively superior rates to HGH AU's wholesale rate) as I had been concerned that it could a long time for Heartland to raise deposits in Australia given it doesn't have any apparent brand recognition or pre-existing channel to raise deposits. Am heartened that there is a clear pathway to raising funds in quick order than can be used to refinance the Australian business at much better levels, although we don't know yet the marketing/customer acquisition costs associated with Challengers efforts. In theory the 134bps savings referenced could go straight to AU's NIM - in practice I reckon it'll be just a portion of that (maybe half to 2/3rds) as Heartland passes on its lower cost of funds to grow marketshare.

On the earnings call Jeff & co sounded reasonably wedded to HGH's dividend payout ratio, so for those who are primarily invested into HGH for yield that'll be of some comfort. I do acknowledge and concur with many of the points made around the irony of paying out dividends while raising capital, and more particularly how capital intensive its RM business is (more on that below).

Actual incurred credit losses (net of recoveries) were in-line with last year - likewise more on this below. A good result.

and finally I thought the business did an admirable job of managing its fixed costs, and retained aspirations of shrinking its cost to income ratio over time.

Impairment Expense and Credit Risk
It's worth recalling the impairment expense recorded in HGH's P&L is the aggregate of the actual incurred credit losses (eg write offs) during the period, recoveries of previously written off receivables, and the movement in provision for all future expected credit losses.  It's instructive to break them apart.

Actual net incurred credit losses (write offs less recoveries) was $7.8m vs $7.5m last year, and equated to 0.36% of average gross finance receivables (excl. reverse mortgages of which there were nil), the same as last year. This is well down from the 0.81% recorded in FY20 when it was doing P2P lending via Harmoney's p2p platform. Back in FY20 personal lending accounted for about 7.3% of all non-reverse mortgage lending, compared to 0.8% in 1H FY24, and carried a very high loss rate (but high NIM%), to the extent that HMY actually shut down that part of the business.

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Obviously NIM has come down over the period as high margin personal lending has been replaced with lower margin but higher quality lending. That said NIM has clearly been under pressure as the business declined the opportunity to pass on all its costs in the RM business and competitive pressures particularly with the car dealer market. The best way to get a view on the risk adjusted mix of the business is net lending margin, which is NIM less net incurred credit losses, which reinforces the above point. Worth bearing mind the point of the cycle we are currently in & how that could evolve in the future.

Provisions
On the other channel I have harped on about FY23 being under provisioned. It's interesting that in the FY23 result conference call mgmt said they expected FY24 to have a similar overall credit result, guidance was provided, & guidance was reiterated as late as November 2023 at the AGM, before being downgraded largely on account of additional provisioning just a month later in December, so its difficult to argue mgmt's credibility here hasn't been degraded. But what's the risk of additional large provisions and how does current provisioning compare to history?

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Provisions solely relate to non RM lending - RM's have never carried a provision for future expected credit losses - something I've written about before on the other channel and to keep it brief won't touch on the reasons why but I do remain broadly comfortable with this looking at their latest lending metrics. Provisions increased from 1.21% of gross non RM receivables to 1.66% at 31 Dec 2023. This is well down on the peak  of 2.02% at 30 June 2020, when the world looked like it was ending thanks to covid and personal lending was 7% of lending (vs 0.8% now). I think these are the only real sense checks available to see how well provisioned (or not) the group is - will leave others to decide for themselves. But say the group needed to move to its 2.02% peak provision rate - that would require an additional $15m increase in provisions.


Cashflow and Cash NIM

The RM business has fantastic long term tail winds and Heartland has a strong position the industry, but it is a capital intensive industry as interest is capitalised. By my estimates, that capitalisation accounted for half the increase in the RM book from 30 June 2023 to 31 December 2023, ie the RM book grew from $2.4bn to $2.64b, an increase of $237m, with net origination (origination less repayments) of $119m, implying $118m of growth through capitilised/compounded balances. That from one perspective is a marvelous financial thing as the receivables compound until the RM is retired (either through the borrower selling the house to downsize, move into a retirement village, or pass away), but it also has cashflow consequences that have to be funded.

The point above is evident to me in looking at HGH cash NIM (per the statement of CF) relative to its reported P&L NIM. Picking out the cash interest received and cash interest paid in the cashflow statement provides with with a cash NIM. Over previous 5 full financial years 'cash nim' to 'reported nim' has averaged 56.4%, and been as high as 65%. In 1H FY24, that number shrank to 28.1%. So from a quality of earnings perspective things have deteriorated. That cash will be received, but its further down into the future.

The fall in cash nim to reported nim probably due to two things: the increasing proportion of RM as a % of the total book, and a falling repayment rate within the RM book. In the last 3 years, the repayment rate in NZ averaged 14.6% vs 12.9% now, and in Australia 16.2% vs 13.8% now. The housing market plays a part of this based on comments made by mgmt in the past, with declined and modest house prices, and slower turnover of stock, reducing the number of voluntary house sales that would normally see people repay their reverse mortgage (ie want a high price before selling down to move into a retirement village, or just longer to sell).

Capital requirements
I've been banging on for a long time about the need to raise capital to acquire challenger and that hasn't changed.  But it's also worth remembering that Heartland Bank (NZ subsid.) has 4.5 years to reach the new capital adequacy rules. Total capital has to go from 14.07% to 16% by 1 July 2028, and core capital to 11.5%. The brokers all seem to forecast this will be met in the normal course of business but I haven't looked closely as the specifics of their modelling. Retained earnings, reinvested dividends, falling interest rates causing a positive revaluation of mark to market assets, additional subnote issues like the one they did last year could all be tailwinds to achieving the new requirements. If those didn't do the trick, a review of payout policies or equity capital would have to be on the table. I don't have a view on it, but worth mentioning.

There are a few other rats and mice within the result but I think the above points are the key issues. Apologies for the long post.

[LoungeLizard]

Great post there FM. A lot to digest. I'm impressed by your objectivity as I seem to recall you being very positive by the HGH metrics/vision at the time of the cap raise and you intended to participate. Us lesser mortals would have been embittered at being burnt to such a degree, but you are obviously made of sterner (and flame-proof) stuff.

[Basil]

Excellent post Fiordland Moose, many thanks indeed for drilling right down into the subjects you covered so well.  Will review in more detail later.
So, do you mind sharing whether you like the company at this price point given the record low forward metrics that I've been talking about, and have you been adding at these level's ?

[Shareguy]

Yes great post FM, very interesting indeed. Hopefully it won't be long to wait until we find out Challenger approval or otherwise. And most importantly funding. It seems that Heartland have no doubts on approval. I just don't no if they can be that confident.

[winner (n)]

As a matter of interest past cap raises by Hesrtland have been -

Feb 14 at 88 cents
Dec 16 at $1.46
Nov 17 at $1.70
Aug 22 at $1.80

Xxx 24 at $1.xx