Basic Analysis: Heartland Group Holdings (HGH.NZX, HGH.ASX)
Annual Accounts to 30th June, 2022 (Two Years Analysis)
Note
All amounts are in NZ$ unless otherwise stated.
Data
The data set for this article can be found in PDF format here:
Date
27th January, 2023
Industry
Banking & finance
Current Prices
NZX: NZ$ 1.82; ASX: AU$ 1.675
Trading History
The company Heartland Group Holdings Limited (HGH) is listed on both the NZX and the ASX where it trades under the code HGH.
NZX:
Source: Direct Broking
ASX:
Source: Direct Broking
Overview
HGH is a New Zealand registered bank which also operates finance company activities such as vehicle financing and reverse mortgages financing.
In recent years it has grown strongly and in the last year it acquired StockCo Australia.
Note
This is the first financial institution analysed here and apologies are made for any errors and misunderstandings of the bank's financial statements. Bank financial statements are notoriously complicated. Analysis has been restricted to recasting the accounts.
Financial Highlights
Source: Page 7, HGH Heartland FY22 Results & NZ$ 200 Million Equity Raising
StockCo Australia
HGH acquired StockCo Holdings 2 Pty Ltd and StockCo Australia Management Pty Limited together called StockCo Australia on 31 May 2022.
StockCo Australia finances agricultural businesses.
Interest Income Capitalisation
The reverse mortgage business comes with the difficulty of interest income capitalisation.
Interest is added to the principal amounts and compounded until the loans are repaid usually by the owners leaving one way or the other and the properties being sold.
This presents cash flow issues which may reduce as the business reaches some maturity or saturation of the reverse mortgage market.
The average period for repayment in reverse mortgages for HGH is between seven and nine years although sometimes interest and principal are not repaid for as long as 20 years or more.
The methods of financing these advances are important. If the bank has to make payments on its own debt yet receives nothing from the borrowers then this can be a problem depending on the size and maturity of the reverse mortgage book compared to total assets.
In some businesses a borrower can legitimately capitalise interest costs to say a property development asset until the asset is completed. Interest payment may or may not be made during construction depending on the loan contract. Profit for the borrower is consequently higher.
In the case of HGH they are on the other side of the loan transaction as the lender. It runs the interest capitalised through its income statement which makes the profit, in this case, much higher.
The way it does this is not strictly one for one because of a complexity, namely the difficult IFRS 9 Financial Instruments.
The effective interest rate method is used to calculate the interest income over the period of the loans despite little or no interest actually being received.
It's beyond the scope of this article to go into detail on this method except to say that it’s a way of calculating interest, impairment and receivables’ balances for financial instruments.
This interest capitalisation is not something the company draws much attention to in its annual report.
In the indirect cash flow statement capitalised net interest income & fee income of $95.3m is deducted under non-cash items in the calculation of operating cash flow.
This gives a rough idea of how much of the stated profit is actually not received in a normal business cycle.
Oddly, the amount of $95.3m is slightly greater than the reported net profit of $95.1m.
There is no doubt that capitalised interest income is not of the same quality as regular interest income.
It is received far in the future and there are risks with that. However, one risk, that of negative equity on eventual sale of the secured property may be insured.
The trading banks don't do these kinds of loans and it seems the reason, at least in part is reputational risk.
Recast Revenue Statement
The interest revenue of HGH varies in quality. There are interest payments that are on a normal payment cycle and then there are the reverse mortgage interest payments which have no specified payment date only a conditional repayment.
Overall interest income was up 4.3% while EBIT increased 8.0%. Note that EBIT includes interest income but not interest expenses in the recast format.
Funding costs fell while the tax provision rose significantly.
Impairment expenses (on loans) are included above EBIT in the recast format because the cash has been paid out and the loss will most likely occur.
The fair value gain on derivatives which was an unrealised $16.7m saved the income statement from posting a YoY decline in total earnings which came in 9.3% higher at $95.1m.
Recast Balance Sheet
Finance companies usual have a higher risk profile than trading banks and this company sits somewhere in the middle as it's involved in both banking and finance company activities.
Its equity ratio declined to 11.4% and total assets were 24.9% higher at $7.09bn due to increased lending and the takeover of StockCo Australia.
Investments in the recast accounts include finance receivables.
Recast Movements in Shareholders’ Equity
This was quite a straight forward statement with little requiring change. Total shareholders’ funds increased 6.2% to $808.7m.
Recast Cash Flow Statement
HGH’s presentation of its cash flow which is common for lending institutions differs from the recast presentation.
The section in the operating cash flow that highlights the changes in operating assets and liabilities is excluded and these items are placed in financing and investing cash flow.
As usual, lease liabilities payments and dividends are placed in operating cash flow as per the recast method used.
Source: Heartland Group Holdings Annual Report 2022, page 90
Some $95.3m of capitalised net interest income and fee income has been deducted in the operating cash flow calculation in FY22.
Of note in the recast operating cash flow is the massive negative operating cash flow of $47.8m which is much worse than the preceding period.
In the recast statements dividends paid and lease liabilities are moved from other categories of cash flow to operating cash flow.
Additionally, shares in lieu of dividends and share based payments are now included in the recast operational cash flow and the corresponding amounts are then included under share issues.
While not strict cash transactions these items are part of the way that the company finances its operations and including them does not change the overall cash amounts for the year.
This recast presentation gives a better idea of what is actually going on.
The investing cash flow requirement of the company was a large $434.3m and it, along with the negative operating cash flow were financed by $17.3m of shares issues and a whopping $545.4m of interest bearing debt (borrowings).
Closing cash for FY22 was a large $310.8m.
Ratio Analysis
Funding costs cover was 2.4 times while NTA per share declined to $1.00.
EPS increased to 16.1 cents while the price earnings ratio at balance date declined to 11.8.
Segmental Analysis
The most profitable segment based on total assets employed appears to be motor lending at 4.9% and the least profitable based on total assets, personal lending at 1.9%.
StockCo Australia was only a subsiduary for a small part of the year.
Summary
On the face of it, HGH seems to be a lending institution going from strength to strength showing increasing total earnings and a rapidly expanding balance sheet of profitable loans.
But the whole profit amount is accounted for just in the reverse mortgage business net interest income treatment of capitalised interest, the cash from which is coming in slowly compared to the size of the loan book.
Complex calculations are used to arrive at figures for reverse mortgage income but the cash from the bulk of this income is often many years into the future.
The net operating cash flow, when recasted, shows what seems to be the heightening pressure of the reverse mortgage cash flow situation rather than the rosy situation portrayed in the published financial statements.
It must be said that the negative operating cash flow arises from our recasting methods which differ from the IFRS standards.
The company has done nothing technically wrong in its presentation.
The recasted accounts, however, show a much better picture of the company’s situation.
The extrememly large dividend amounts compared to profits also much be questioned for without them or the bulk of their amount, the company would have a positive operating cash flow.
Why pay such large dividends?
Looked up Stock co (SCo) via website and Elders an report. SCo lends 100% finance for livestock and gets security over stock. That is the very high risk end of agric lending. They need to charge high int rate to offset risk. 2021 ELD an report says SCo had $100m loan book, p103 says ELD 30% equity was $10.8m 2020 ELD share of net profit was $(1.3m), 2021 equity was $10.9m profit $0.09m. So high risk low profit acquisition. HGH has also recently purchased Challenger Bank.
Interesting analysis of complicated co I have never heard of. Just wondering how the reverse mortgage loan book will impact on debt and equity into the future. Reverse mortgages are a drain on cashflow and seem to increase debt at the expense of equity % so is this offset by a high margin? Also interested to know more about Stock Co (guess I can look it up myself). Aus agricultural lending can be very high risk, that would change the risk profile of HGH.