Buffett Point 1/ FY2016: Top Three Position in Chosen Operating Markets
Scale is important for any business wanting to maintain a strong position in whatever market they operate in. If you don't have scale, you can carry on developing a business until the point that the 'big boys' notice you. If you continue to push ahead, those already dominating the market will act aggressively against you. This can severly limit any future growth and may end up being fatal for that part of the smaller expanding business. I am not saying that a small business can never match and get on equal terms with a bigger one. I am saying that when a small player starts to tread on the toes of a big player, then this introduces a significantly higher risk for those invested in the smaller player. if as an investor you can avoid such a risk, this is a good thing.
Heartland in their December 2016 presentation say that their mission statement is to:
"Pursue opportunities where they can provide innovative products in niche areas within the household, business and rural sectors, that are under-serviced by the major banks"
The Heartland mission statement is sensible, because the big four Aussie Banks are absolute gargantuans by Heartland standards. It wouldn't be too far of a stretch to say that to take on the big Aussie banks directly would be a suicide mission. But how secure is Heartland really in these market niches in which they choose to operate?
The specific target markets are listed below:
Millennials (People Reaching your Adulthood in the early 21st Century => Aged 25-35 today):
Provide a frictionless digital experience to the emerging millennial market, who value speed and ease.
e.g. Harmony joint venture, Motor Vehicle Loans, Online personal loans. Growing the consumer loan book has a lower ROE (because more capital is needed to support such loans) which needs to be balanced by a higher margin.
Current Gross Receivables: $844m, Average Loan Size $14k
Heartland vs Competitors (Motor Vehicle)
1/ Marac (Heartland Subsidiary): 12.95% to 19.95%: Finance and Insurance Loan Book $340m
2/ Motor Trade Finance: 13.75%: Finance Book $535m
3/ Turners Vehicle Finance 12.95%. Finance book $144m
Heartland vs Competitors (Consumer Peer to Peer)
1a/ Harmony (Heartland investment 10% equity): Loans from $1,000 to $35,000 (all unsecured). Interest rates depends on net assets, income and credit history. Loan Book Size : Up to $100m (approx)
2a/ Squirrel Money: target A and B grade borrowers (only approve 21% of land applications). Loans $3,000 to $30,000 (unsecured) OR $70,000 (secured). Interest rate - market base plus individual risk profile. Loan Book Size: $5m
Retired:
Provide a personalised service to the 65+ via reverse mortgages. This requires an accessible and friendly branch structure, as the retired like to be able to eyeball their bank manager. Nevertheless the information is there on line too. ( https://www.seniorsfinance.co.nz/ )
e.g. Seniors Finance (Australia and New Zealand). Growing the reverse mortgage business will result in higher ROE (lower Reserve Bank risk weighting for housing, less capital applied) but a more compressed margin.
Current Gross Receivables (NZ only): $374m, Average Loan Size (NZ Only) $94k
Heartland vs Competitors:
1/ Heartland Seniors current loan rate is 7.5%, compounding monthly, $10,000 minimum loan. 15% of house value available at age 60. 35% at age 80. 40% at age 85. maximum Loan amount $500,000
2/ SBS Bank ('Retirement Loan' floating rate of 6.74% (fixed rate no longer available). Total loan balance $61m (September 2013) Amount of loan offered from 5% of the value of your home at age 60, to 30% at age 80 (to a maximum of 50%).)
3/ ASB (closed down their HomePlus business to new customers on August 3rd 2015),
Small and Medium Enterprise:
To be a smart streamlined on-line lender in this neglected market, where 'big banks' prefer to deal with 'big companies.' Plant/Equipment and Working Capital Finance. The web portal for SMEs is https://openforbusiness.heartland.co.nz/
Current Gross Receivables: $942m, Average Loan Size $107k
Heartland vs Competitors:
1/ Heartland Business Funding rate 10%, Property and Business Services book: $405m
2/ ANZ Business Indicator rate 9.4% plus lending margin. Business and Property Services book: $14,275m
3/ ASB Business Lending fixed rate 10.15%. Property and Business Services: $7,439m
4/ Westpac Base rate of Interest + 'Customer margin.' (Indicative 13.95%) Property and Busines Services book: $2,284m
Rural:
Livestock Finance, Farm transition loans, Intermediate Finance with partner PGG Wrightson, Term loans to farmers in the sheep beef and dairy sectors whose debt needs are modest (my emphasis). The web portal for livestock loans is https://openforlivestock.co.nz. However farm equipment funding is only accessible by dealers. https://ofb.heartland.co.nz/ofadappl...application%2F
Current Gross Receivables: $619m, Average Loan Size $209k
Heartland vs Competitors:
1/ Heartland Livestock: 100% finance available (for sheep, cattle, deer) secured against livestock purchased (not other farm assets). On line approval up to $500,000.
2/ ANZ $19,787m on loan ( 32x larger than Heartland! ) Agri Current Account "7.60% + (Lending margin)"
3/ Westpac $8,432m, Base rate of Interest + 'Customer margin.' (Indicative 13.95%)
4/ BNZ $2,210m on loan (includes fishing and forestry) Farm First rate 9.2%, secured over farm OR stock OR farming assets
Conclusion: Yes (see neighbouring discussions for reasoning)
SNOOPY
PS Base borrowing rates for various lenders can be found here
http://www.interest.co.nz/print/69150
on a page that appears to be regularly updated.
Strong Market Position Discussion : FY2016
Quote:
Originally Posted by
Snoopy
Conclusion: Open (so far)
Posting this discussion before I make my conclusion.
Looking at Heartland's four target markets, my impression is that they are strong in two and not so strong in the other two.
Strong 1: Millennials
Of the specialised motor vehicle retailers, Heartland are on par 'size wise' with 'Motor Vehicle Finance' and 'Turners'. However both Turners and MTF (through affiliated dealers) also sell vehicles themselves. Heartland do not. So it looks to me like Heartland have an inherent distribution channel disadvantage in this market. From the pricing information I can find, Heartland are prepared to meet 'market best' loan rates of 12.95% for their best prospective customers. Heartland have a high interest margin with respect to other banks. But Heartland fail the bank 'duck' test. Their finance company competitors have even higher interest margins. From a market size perspective Heartland are in a strong position. But I am unclear how they can match the cost structures and convenience of the competition going forwards.
Peer to peer is obviously in its infancy. But by grabbing a 10% stake in the first moving and largest player (Harmoney), Heartland is in a good position to learn about this new market, then perhaps ramp up their presence later.
While I can see some competitive pressures going forwards, Heartland's strong position in the 'Millennials' market today is not open to question.
Strong 2: Retired
Apart from SBS, Heartland are the only game in town for those wanting a reverse mortgage in New Zealand. Being about six times the size of their only remaining competition (I couln't find any current estimate for SBSs presence in this market) , the market strength of Heartland in the 'Retired' market is unquestionable.
Weak 1: Small and Medium Enterprise
There is some ambiguity as to how this business category is treated in the 'concentration of funding' section in the various accounts of the 'Big Banks'. Often the cheapest source of funding for small business owners is to take out a mortgage against their homes. These 'home loans' would not appear on the bank books as 'business loans', even though this is exactly what they are. Home loans are of course the domain of the big banks. Heartland does not want to take on the big banks directly! For the purpose of this exercise then, I have chosen to look at the big bank's 'Business and Property Service' loan books. Even though these probably under-represent the SME loan book of the big banks, they all dwarf what Heartland is doing by at least a multiple. Heartland's main point of difference appears to be 'ease of access' (getting loans approved fast, on line) and a relatively cheap loan rate. If you are a relatively small player, you do need to be price competitive, and remember that Heartland has an interest margin better than the bigger banks. But my impression is that Heartland does not have a sustainable long term advantage in this market. They are a minnow player and if a price war did break out between the big banks they could easily be squashed.
Weak 2: Rural
Despite being known as a 'rural specialist lender', in gross terms, even the relative minnow of the big banks -BNZ- has a rural loan book four times larger. The BNZ also has a lower base interest rate than Heartland, and will make rural loans against livestock and equipment, not necessarily land holdings. Making rural loans against livestock and equipment was, I thought, a Heartland exclusive. But this is not so. Heartland took a risk this year financing their farmer customers through loans that a major bank might have called in. The resultant goodwill among farmer customers might come back to help Heartland in future years. A further good point is that Heartland has a good and well established marketing channel through PGG Wrightson (Heartland own PGG Wrightson Finance).
Neverthless the bare facts of the situation show that Heartland is a relatively small player in Rural Loans. Furthermore, the emboldened acknowledgement from my 'Buffet Point 1' post
(We make) "Term loans to farmers in the sheep beef and dairy sectors whose debt needs are modest (my emphasis)"
speaks volumes.
Bear in mind that this was written in December 2016, after the worst of the dairy crisis appeared to be over. Bear in mind that this comment was written in the climate of investors questioning Heartland's exposure to dairy sector loans some months earlier. Given this background, I can understand why Heartland made this comment. The problem I can see going forwards is that if Heartland only lend to farmers whose 'debt needs are modest', that is aiming for a collision course with the big bank lenders. I see the comment as an admission by Heartland that they really don't have any competitive underlying advantage in Rural Lending compared to the big banks. And that, to me, spells potential trouible for growing Heartland's rural lending book going forwards.
Conclusion
'On the one hand' BUT 'on the other hand'. Anyone got a comment to make to help stop me wavering? I think that am going to have to sleep on this!
SNOOPY
Risk Weighting on Mortgages, Small Business and Agriculture
Quote:
Originally Posted by
Snoopy
Retired:
Provide a personalised service to the 65+ via reverse mortgages. This requires an accessible and friendly branch structure, as the retired like to be able to eyeball their bank manager. Nevertheless the information is there on line too. (
https://www.seniorsfinance.co.nz/ )
e.g. Seniors Finance (Australia and New Zealand). Growing the reverse mortgage business will result in higher ROE (lower Reserve Bank risk weighting for housing, less capital applied) but a more compressed margin.
Banks are required to hold capital against each category of exposure according to the relative riskiness of that type of exposure. The minimum capital ratio is fixed at 8 percent of risk-weighted assets; so the amount of capital required to be held against each loan is determined by the risk weighting for that type of loan. For every additional dollar lent on an exposure with a 100 percent risk weighting, a bank will be required to hold an additional 8 cents of capital, whereas for a less risky loan with a risk weighting of 50 percent, only 4 cents of additional capital will be required.
On the subject of using Reverse Mortgages to improve the 'capital efficiency' of Heartland. The following information is from Resrve Bank paper RS2A on 'capital adequacy'.
BS2A-capital-adequacy-framework-standardised-approach-oct-2015.pdf, From page 45.
The following risk weightings apply to mortgages not past 90 days due.
Loan to Valuation Ratio |
Non-property investment Residential Mortgage Loan |
Property investment Residential Mortgage Loan |
Reverse Residential Mortgage Loan |
<60% |
35% |
40% |
50% |
>60% & <80% |
35% |
40% |
80% |
<80% |
35% |
40% |
Various |
>80% & <90% |
35% |
50% |
100% |
>90% & <100% |
50% |
75% |
100% |
>100% |
100% |
100% |
100% |
For comparison, a 0% risk weighting applies to:
1/ Notes and coins held on site
2/ Gold Bullion held in own Vaults
OTOH the risk weighting for equity holdings are 300% if they are publicly traded, and 400% if they are not.
Small and Medium business loans and Rural Loans are not mentioned specifically. The paper says that:
"A 100% risk weight applies for an asset not specifically provided for."
A conventional mortgage will generally have a lower risk weighting that a reverse mortagage. But Heartland IIRC have contracted out all of their conventional mortgage business to Kiwibank.
Given the four key markets that Heartland are targeting, it seems the only way to reduce risk weighting for Heartland is to do more reverse mortgages!
SNOOPY
Strong Market Position FY2016: Further Discussion and Conclusion
Quote:
Originally Posted by
Snoopy
Conclusion
'On the one hand' BUT 'on the other hand'. Anyone got a comment to make to help stop me wavering? I think that am going to have to sleep on this!
When you are looking at a complicated business across several 'growth' sectors, one approach is to look at the size of the sector loan book, make an estimate of future loan book growth, then add everything together.
Market Sector |
Loan Book Size (A) |
Growth Rating (B) |
(A) x (B) |
Millennials |
$844m |
10% |
$84.4m |
Retired |
$377m |
20% |
$75.4m |
Small & Medium Enterprises |
$942m |
-10% |
-$94.2m |
Rural |
$619m |
-10% |
-$61.9m |
Total |
|
|
+$3.7m |
While some sectors of the Heartland business show real growth potential, others face real threats. Naturally I need to add that the size of the loan book does not directly imply profitability. But I do believe there is a correlation between 'sector loan book size' and 'sector profitability'.
The above analysis shows that over the sectors that Heartland managment is concentrating on, growth will be marginal.
One counter-argument to the above is that my analysis of the 'Rural' and 'SME business' sector is too broad. Accounting standards require loans that Heartland make to farmers and small businesses to be categorised. But Heartland is taking a much smarter approach of 'cherry picking' within these broad loan categories. So it is not accurate to say that Heartland are going 'head on' against other 'Agricultural' and 'SME' lenders.
If we look to compare the loan book size over a longer period:
Year |
Category |
Gross Loan Book |
Increment |
Category |
Gross Loan Book |
Increment |
2016 |
Agriculture |
$628.202m |
(+25.7%) |
Property & Business Services |
$405.469m |
(+26.6%) |
2013 |
Agriculture |
$499.942m |
|
Property & Business Services |
$320.198m |
We can see that Heartland are growing the loan book areas they are targeting. I believe that watching what a company does is a better guide to valuation than listening to what a company says they will do. Heartland have made progress in their most risky targeted areas. So who am I to say that increasing profits do not follow?
I do believe there are serious risks to growing the Heartland business from here. But given management's performance to date, we cannot assume that management will not be able to tackle those risks.
Accordingly to the question I posed on "Heartland having a top three market position in their chosen areas of operation', I have to answer 'yes'.
SNOOPY
Buffett Growth Model Screening (FY2016 perspective): Overall Conclusion
This is the summary for those millennials who are 'attention span challenged'. Warren Buffett's scanning of the 'growth potential' of a company can be summarized in four quick questions.
Q1/ Does Heartland Bank have a top three market position in the markets in which it chooses to operate? (Ref: my post 8523)
A1/ Yes
Q2/ Does Heartland Bank have a 'normalised profit' increasing 'earnings per share trend'? (Ref: my post 8493)
A2/ Yes
Q3/ Does Heartland Bank have a record of earning a superior ( >15% ) return on shareholder equity? (Ref: my post 8495)
A3/ No
Q4/ Does Heartland Bank have the capability of operating at increasing Net Profit margins? (Ref: my post 8510)
A4/ Yes
Overall Conclusion
Heartland is not able to satisfy all the requirements to apply Warren Buffett's compounding growth model. This does not mean that Heartland is necessarily a poor investment going forwards. It just means that Heartland must be analyzed in a different way.
SNOOPY
The growth failings of Heartland
Quote:
Originally Posted by
Snoopy
Q3/ Does Heartland Bank have a record of earning a superior ( >15% ) return on shareholder equity? (Ref: my post 8495)
A3/ No
To put this into perspective I want to quote from the Mary Buffett authoered 'Buffetology Workbook' p53
-----
"Warren has figured out that high returns on shareholder's equity can produce great wealth for shareholders. Thu, Warren seeks to invest in companies that consistently earn high returns on shareholders equity.
To fully understand why Warren is so interested in high returns on shareholders equity let us work through a hypothetical scenario.
Shareholders equity is defined as a company's total assets less the company's total liabilities. Kind of like equity in your house. Let's say you bought a house as a rental property and paid $200,000 for it. To close the deal you invested $50,000 of your own money and borrowed $150,000 from a bank. The $50,000 you invested in the house is your equity in the property.
When you rent out your house, the amount of money that you earn from the rent, after paying your expenses mortgage and taxes would be your 'return on equity'. If you rented your house out for $15,000 per year and had $10,000 in total expenditures then you would be earning $5,000 on your $50,000 equity. The return on your $50,000 would be the $5,000 you earned. This equates to a 10% return on equity. ( $5,000/ $50,000 = 10%).
<snip>
The average return on equity for an American Corporation over the 1960 to 2000 period (book was published in 2001) was 12%. This means that , as a whole, year after year, American business only earns 12% on its shareholder equity base. Anything above 12% is above average. Anything below 12% is below average. And below average is not what we are looking for.
What Warren is looking for in a business is consistently higher than average returns on shareholder equity. We are not talking about 12% or 13% but a rate of 15% and above - the higher the better.
-------
We have to consider here is that these are American figures. NZ, for so long a 'commodity based' market, may have had historical return on 'overall market equity' figures that are slightly lower than the USA. Nevertheless the Heartland return on equity figures are damning.
Financial Year |
Net Sustainable Profit (A) |
Shareholder Equity EOFY (B) |
ROE (A)/(B) |
2012 |
$26.606m + 0.72($5.642m + $3.900m) =$30.476m |
$374.798m |
8.1% |
2013 |
$6.912m + 0.72($22.527m+ $5.101m)= $26.804m |
$370.542m |
7.2% |
2014 |
$36.039m |
$452.622m |
8.0% |
2015 |
$48.163m - 0.72(0.588m) = $47.743m |
$480.125m |
9.9% |
2016 |
$54.164m - 0.72(1.136m) = $53.346m |
$498.341m |
10.7% |
Using ROE as a measure, Heartland is very definitely a below average business. I almost said 'well below average', but I knew that kind of talk would just upset 'the faithful' ;-P.
From my perspective as a potential 'growth' investor, this problem is serious. Part of the problem is regulatory. The reserve bank is requiring banks to back up their lending with more capital than has historically been required. Other banks address this hurdle by issuing such things as 'bank bonds', an alternative source of 'Tier 1' capital. Heartland has talked about doing this in the past, but so far has not issued "Heartland Bonds'. If they did, then return on shareholder equity could potentially be boosted. Yet with only a BBB credit rating, would there be enough corporate interest in Heartland Bank Bond to get an issue away?
If there is a case for investment in Heartland today, I feel as though it will be as a dividend play. So how does one fairly value Heartland from a dividend perspective?
SNOOPY