What Does AA Know?, page-120

It is complex. The notes info is provided in 2022 Annual report Note 17d. See also a helpful summary of the commercial terms of the notes on Slide 23 (page 34) of the RETAIL ENTITLEMENT OFFER BOOKLET for a FXL/Humm rights issue in November 2015, on Humm’s website.

The notes were issued by Flexigroup in FY16 as partial vendor finance when it bought Fisher and Paykel Finance. The face value of the notes was A$49.1m. They were interest free for the first 2 years: interest from March 2018 to March 2021 was capitalised so their face value rose to A$53.6m (see Note 17a). Since then interest has been paid in cash by Humm each year. NB the description of the first 2 columns in Note 17a is confusing: the heading is “# shares” but it means 49.129m notes. The notes do not convert into 49.1m Humm shares; if they convert at all, it would be into only 28.5m Humm shares. See Note 17d.

The conversion rights into ordinary shares are very limited. The note holder (which I assume is still a related co of Fisher and Paykel) has a right to convert (ie it may convert but does not have to) the notes into 28.5m HUM shares if and only if there’s a “change of control” of Humm. (That term is not defined but I assume the legal docs supporting the notes would have a precise definition- such clauses usually mean >50.001%). I don’t know if those words would apply if a new shareholder (not AA) acquired a smaller % ownership e.g. 35% - but that’s unlikely). The conversion price would be A$53.6m/28.5Humm shares: that’s an effective conversion price of A$1.88 per Humm share. As the current share price is about a quarter of that, the note holder would be crazy to convert at these levels. In any case, the only time it’s allowed to convert is if control of Humm changes.

In contrast, Humm(FXL) as the Issuer of the notes has NO conversion rights at all. The notes carry an increasing rate of interest (see the summary in the 2015 doc). The current rate of interest is not mentioned in the Annual Report but I interpret (from the 2015 doc) that it is now about 12% pa pre-tax and is increasing at 2% pa. At some point, Humm will decide that this cost is getting too expensive and want to repay. Humm has no right to convert the notes into shares: its sole right is to repay the notes for cash. In the early years, this was cheap funding- especially as it is subordinated to all creditors, but it’s becoming increasingly expensive.

As stated in Note 17d, the interest on the notes is treated as a dividend for accounting purposes (see P75 and Note 19); the note interest is NOT included in interest expense in the P&L account, nor in Hum’s results representations. Despite it being called a dividend for accounting purposes, I understand it is tax deducible. Hence its current after tax cost is about 8.4%. I assume that the accounting standards require the notes to be treated as part of the equity base as they’re perpetual and the holder has no right to demand repayment. From Humm’s aspect, the note really is (commercially) almost the same as- and nearly as permanent as- ordinary share capital. The after-tax cost of servicing this quasi-equity is now about 8.4% rising at 1.4% pa after tax. As it is subordinated to all creditors it is a useful form of capital for Humm. A rights issue of ordinary shares or similar to raise funds to repay the note would be very dilutive.

NB the holder can’t force Humm to repay the debt and it can’t even force Humm to pay interest. The holder’s only protection against Humm not paying interest in cash is a “dividend stopper” ie Humm would not be allowed to pay any ordinary divs until a note interest cash shortfall was rectified. The summary in the 2015 doc does not say if there are any events of default which the note holder could use to force a repayment from Humm, but my guess is that there aren’t.

Hence the only protections that the note holder has appear to be 1. It can (but doesn’t have to) convert into 28.5m shares, but only if there is a Humm change of control;

2. Until Humm chooses to repay the notes in full, the interest rate keeps rising every year withoutlimit- giving Humm a strong incentive to repay eventually. 3. If Humm does not pay interest in cash, Humm is not allowed to pay ordinary divs.

Against this, Humm has had very cheap vendor financing for years and has complete control over when and whether to repay the note. Alas, Humm cannot force the holder to convert the note into shares at A$1.88- and the holder would be mad to, at current prices, unless a very highly-priced takeover came along.

As a shareholder, I was until recently surprised that Humm has not repaid the note as it’s getting more expensive to service. However, given market talk about possible credit crunches, it makes sense for Humm to leave the note in place and hang on to this funding which has so few conditions attached to it. I don’t know if any of the securitisation facilities have conditions (like a gearing covenant) that require Humm NOT to repay the notes in order to be allowed to keep drawing on them- the annual reports and presentations contain very little info on the warehouse terms. NB also that the interest rate on the notes –even now- is probably similar to the borrowing cost of the (highest risk) mezzanine layer in the securitisation warehouses- so the note interest is even now not prohibitively expensive versus Humm’s marginal cost of debt, and is much less than cost of ordinary equity based on today’s share price.

However, the note interest cost at about 12% is much more than the interest Humm earns on its $100m unrestricted cash. That is a major opportunity cost: I assume that the Board tolerates this sacrifice as the price worth paying for retaining complete freedom how to deploy the $100m cash, especially in the current skittish markets. i.e. I guess that- in the current market- the Board would rather have $100m of free cash (and keep the expensive note) than have only $50m net cash.

With the share price so low, Humm can’t raise ordinary equity. It’s also unlikely that it could borrow more debt for corporate purposes, so its drawing flexibility is limited to the warehouse facilities. As Humm wants to keep expanding and drawing on the $1.1B”headroom” apparently still available in the warehouses, I expect Humm will NOT repay the notes for at least another year until most or all of the following have occurred: credit crunch jitters have settled down, we get a clearer picture of the Aust and NZ economies and bad debt write-offs, we see at least 6 months of clean results from Humm not muddied by large losses from BNPL, and a much higher share price.

The above analysis, opinions and assumptions are my own, but I am grateful for some info and clarifications from Humm’s Head of Investor Relations. This is not advice. DYOR