Taking Stock 24 September, 2020

Johnny Lee writes:

HEARTLAND Bank has reported its Full Year results to market, a month later than usual, ending speculation as to how the company has fared during what has clearly been a challenging environment for all. The share price, which had fallen in the lead up to the announcement, saw an immediate bounce. The period covered by the results was for the year ended June 30th – an important point considering subsequent developments.

Headline profit was slightly down, bad debt provisioning has risen, and the dividend has been temporarily reduced due to the restrictions applied by the Reserve Bank of New Zealand (RBNZ). The dividend of 2.5 cents per share will be paid on the 9th of October. The dividend was able to be paid due to the diverse geographic nature of the group, which includes the Reverse Mortgage business in Australia.

Fortunately, the rest of the news was more positive.

Heartland is forecasting a return to growth next year, barring any further adverse conditions. It also expects dividends to resume closer to previous levels following the easing of restrictions from the RBNZ, although there was no indication of the timeframe around this. One imagines the RBNZ will be conservative in its approach. Earnings per share actually rose 5%.

One example of the nimbleness afforded to smaller banks was Heartland's ability to connect with its customers very rapidly as the Covid crisis unfolded, reaching out to its customers to provide support and better understand their needs. A significant proportion accepted this support, but Heartland is already seeing some return to pre-Covid levels in repayments.

Heartland also noted that the increase in mortgage deferrals seen this year has led to some people choosing to increase repayments on costlier interest-bearing debt, such as consumer lending. Mortgage deferrals allow banks to effectively extend loan durations, yet paradoxically are perceived as ''generous'' on the part of banks. The winner from these longer-dated loans will be the bank, not the borrower.

Costs at Heartland have risen yet again, driven primarily by an increase in staff numbers and budgeted marketing expenditure. This marketing expense will largely be directed at increasing awareness of its Reverse Mortgage business. In New Zealand, Heartland is the overwhelming market leader in this product, albeit a large fish in a small pond.

Cost control will be aided by the push to digitise its offering, with usage of the Heartland ''app'' continuing to grow.

Across the Tasman Sea the Reverse Mortgage business, while not necessarily ''recession proof'', continues to surge. Reverse Mortgage lending, where cashflow is lent against an existing asset, is facing far less competition than traditional banking products, and faces a different set of risks.  Reverse Mortgage lending does not require employment – in fact, it is normally utilised by people without employment income – but it does require relatively stable asset prices. With interest rates continuing to fall, demand for Reverse Mortgages appears to be climbing, as the group of people with large assets but falling incomes continues to grow.

The other divisions within the bank were a mixed bag, with business lending continuing to perform, while livestock was adversely impacted by drought and motor vehicle finance struggled in the lockdown environment. Heartland is confident both factors are temporary in nature.

Multiple disclosures over the previous six months revealed that senior management had been buying shares in the company during the earlier lull in the share price. This was all appropriately disclosed and is not unusual – most investors would be pleased that those within the company wanted to own more shares – and clearly, those buying viewed the shares as undervalued.

The amount of Government support for this sector should not be underestimated. The Wage Subsidy Scheme, the Business Finance Guarantee Scheme and the proposed depositor protection scheme have all helped shape this result and the subsequent path forward.

As Heartland notes, its exposure to the tourism, hospitality and retail sectors is immaterial. The leap in unemployment among young people has yet to cause any undue impact on the bank.

The finance sector is one that is particularly exposed to increases in unemployment and decreases to economic activity. Heartland is not immune to this – but it has positioned itself as a niche bank with products that face a set of risks that have not yet felt the same degree of adversity as the other banks.

Kevin Gloag will be updating our research article on the Private Client Page shortly.

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IN TWENTY YEAR'S TIME, when the next generation of economists and market participants look back on this era during their university studies, one question that will almost certainly go through their minds will be ''What were they thinking?''.

With interest rates at such low levels, there is a very obvious movement from investors and savers along the risk continuum from bonds and term deposits, to the sharemarket.

The last five years has seen tremendous growth in share prices, with the S&P 500 up almost 75% in that time frame. Technology shares have been the core driver of this growth, particularly the largest technology companies, which have used their market power and access to seemingly limitless capital to reduce competition by acquisition. This has led to enormous increases in wealth for long-term shareholders. The proverbial monkey throwing darts has now made such profits it can buy as many bananas as it wishes.

Ten years ago, the largest listed companies in the world were almost exclusively petroleum companies – Exxon, PetroChina, PetroBras and Shell. Now, Apple, Microsoft, Alphabet, Amazon and Facebook dominate this metric.

Ten years ago, the largest automobile companies in the world, by market valuation, were Toyota, Volkswagen, Honda and Daimler. Today, Tesla outvalues all of those companies – combined.

However, signs are emerging that some of these valuations are prompting poor corporate behaviour, as new companies desperately try to take advantage of sky-high valuations.

The story of Nikola Corporation, an American-based company that purports to design and one day build hydrogen powered cars, is one such example.

Nikola listed only a few months ago, following the acquisition of an existing listed company. Within a week, the shares had doubled, valuing the company at $30 billion USD – about a third of the entire New Zealand stock exchange. Its chairman and one of its largest shareholders, in between spending hours on Twitter engaging with the public, announced plans to begin construction of hydrogen-powered trucks in 2020.

Corporate filings revealed the company had virtually no revenue throughout the year – beyond installing solar panels for its chairman – but shared a video of a seemingly functional prototype, boasted of its innovative internal designs and even saw motor vehicle giant General Motors acquire a large stake in the company, valued in the billions.

However, the share price has tumbled following revelations from research house Hindenburg Research, which claims Nikola, and its technology, is a fraud. It claims the prototype vehicle was simply rolling down a hill. The in-house proprietary components were purchased from existing manufacturers and had masking tape to hide logos identifying their origin. The General Motors deal, initially believed to be a sign of confidence in the company, was horribly one-sided to the benefit of GM. The ''billion dollar deal'' involved no actual payment of cash – just assurances around supply chains and technology sharing.

The company is now being investigated by the regulator. General Motors, seeing its own share price fall 10% in the aftermath, is defending itself from accusations that it failed to conduct proper due diligence. The Nikola chairman, after initially stating that he would rebut the claims made against his company, instead resigned, leaving him with little more than $3.1 billion worth of stock to his name. Shareholders, excited at the idea of a taking part in a new company of the future, are left with a share price heading downhill, and a product that only functions downhill.

''The next Tesla'', as it had been described, had seen a huge increase in interest from both retail and institutional share traders, no doubt including the various ''passive'' index funds. The tie up with a major, well-known competitor lent credibility that the product was real. It may one day be. But valuing a company at more than $30 billion, with revenues less than an average American coffee shop, was stretching that credibility.

Investing for future earnings is not in itself unusual. Speculating that a company's product will be successful and produce a profit is different from punts on unproven technology and an unseen product.

Any experienced investor knows that the proposition ''shares only ever go up'' is nonsense. Share prices are a function of supply and demand, themselves a function of thousands of individual factors.

Two of the hardest things to face as a share investor are selling a share at a loss and buying a share after the price has already taken off. But while waiting for a company to prove itself may forego the biggest potential gains, the shareholder who purchased Xero shares at $25 would still have quadrupled their money.

If, one day, we are to decrease our reliance on fossil fuels, innovation in our transport sector, indeed our technology sector, will play a huge role. The world wants this technology to succeed. But as investors, we must ensure valuations are borne of real revenue, real products and real profit.

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EROAD's CAPITAL RAISING of $50 million is now open, with $42 million already completed courtesy of a placement at $3.90 per share. The much smaller balance of $8 million will be available for retail shareholders. The shares will be priced at a maximum of $3.90.

Shareholders have been given nine days to respond to this offer. The steep discount is likely to attract some interest and given the roughly 50% gain in share price over the last three months, shareholders will likely be feeling positively towards the company. I expect scaling to reflect this.

The capital raised will be used to accelerate growth, both in terms of development and marketing. The current focus in terms of growth is Australia, where EROAD is making a renewed push to break into the market.

Earnings guidance was also provided in the accompanying presentation. EROAD has seen continued growth in all major markets and is forecasting this to continue. Retention rates – customers continuing to use its products long term – remain high. Ultimately, its success will be tied to its ability to find new customers and innovate new products to add more value to its proposition.

An article is available to view on our website for advisory clients only.

Clients wanting to discuss the capital raising are welcome to contact us. The offer closes next Friday.

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LAST WEEK'S GDP NUMBERS, showing the largest quarterly fall since records began, were entirely expected.

No one reading this would be surprised to learn that the June quarter was a huge challenge for virtually every sector – with the brunt of the decline seen by sectors including accommodation, tourism and retail. Construction also saw a large decline. The one sector that saw growth in the quarter was the Finance and Insurance sector – also not unexpected as people took steps to organise their financial affairs moving forward in an uncertain environment.

Spending plummeted, especially on transport, recreation, and restaurants and hotels. Lockdowns have this effect.

The value in this data is to measure the degree of these declines, and to measure their duration. Are we to see a short, sharp shock, before climbing back to historical levels, or a long, enduring slowdown?

Treasury estimates, courtesy of the pre-election fiscal update, were forecasting the latter. They made for sobering reading. Unemployment is to rise until 2022 before beginning the journey back towards the low levels we have enjoyed in recent history. Government debt will continue to climb for the foreseeable future. However, this is a highly uncertain situation. Already, we are seeing renewed Covid outbreaks throughout Europe as countries consider reinstituting lockdowns.

New Zealand, whether through luck or design, has fared remarkably well relative to our peers. Unfortunately, we rely on those peers to purchase our exports, stay at our motels and add to our GST take while touring our country. We will need to be patient, as the recovery from the health pandemic seems to be elusive.

These are unprecedented times and uncertainty reigns. The best companies are preparing their business models to cope with further outbreaks and further lockdowns, and making the structural changes needed to survive in this environment.

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TRAVEL 

David Colman will be in Lower Hutt on Wednesday 7 October.

Johnny will be in Christchurch on Wednesday 7 October.

Kevin will be in Christchurch on Wednesday 21 October.

We have now planned our final three seminars, entitled No Hiding From Risk.

Tauranga – September 29 – 11:30am - Tauranga Yacht Club

No restriction on numbers.

Please note: Due to restrictions on groups over 100 in Auckland, we cannot admit anyone who has not re-registered for our Takapuna or Mt Wellington seminars. Please do not assume that your previous registration has carried over.

Auckland – October 5 – 11am - Mt Richmond Conference Centre

North Shore – October 6 – 11am - Fairways Event Centre, Takapuna

Chris is available for client meetings after each seminar. Please contact our office to arrange a time.

Chris Lee and Partners