Ann: Shareholders to vote on Humm Consumer Finance transaction, page-55

MYSTERIES OF HUMM

Update to my post of 16.52 on 13/5/22. I concur with most of what JetJunkie 19/5, Jin12345 20/5, Joda 20/5 and Icahn 9/5, among others, have posted.

Summary LFS offer for HCF much too low, and I disagree with Kroll. HUM share price: very cheap, but short term risk of falling (and very likely if deal is voted down); but long term good value.

Board attitude

There are oddities and flaws in the HUM Board’s support for the LFS offer. These are mainly matters of judgment, but I think that they have taken such a consistently negative view of their business as to be manifestly unreasonable.If they truly believe that the outlook for HUM’s current consumer strategy is so dire, they are tacitly admitting that their strategy for HUM- especially BNPL- over the last year or two has been seriously wrong. This is implicitly conceded by the $181m impairment to goodwill and software in the 1H accounts. It is not merely the “headwinds” of Covid and rising interest rates.The Board’s gushing enthusiasm for the LFS deal has, from the beginning, been painful and inexplicable.

There is another mystery. Even if you feel that the price offered by LFS for HCF is “fair and reasonable” - which I don’t - the implied value for Commercial, using today’s market price of HUM shares, is absurd - indeed negative under most sensible assumptions.

The tone of HUM Board’s commentary throughout the sale booklet, and previously, is remarkably gloomy about their own business. I’m surprised, and worried, that the very smart J Wylie concurs with this, both as a director of HUM and manager of Tanarra which owns 5.2% of HUM. It’s almost as if they hate the company and are anxious to get rid of it. Latitude hardly needs to make any advocacy in favour of its bid, as the HUM directors (except for AA) do such a hostile job on their own group.In 45 years of investing I have never read such a feeble (indeed, non-existent) defence of a target company, even when the target is in dire straits. That HCF is making good profits makes this even more bizarre. The negativity expressed by the HUM Board is what you would expect LFS to be expressing, to intimidate HUM shareholders into accepting its bid.The fact that LFS’s bid is so low-ball makes the Board’s lack of defence- indeed enthusiasm for the bid- even more unbalanced.

It’s true that the BNPL sector is out of favour- I think that sentiment has now overshot on the downside after the period when BNPL was ludicrously overhyped and overvalued. If HCF was solely a BNPL operation, that attitude might have some validity, but BNPL is only a very small part of HUM’s profit base: the card operations are stable and very profitable. The BNPL business is marginally profitable even after HUM has spent heavily on its overseas expansion. HUM argues that it needs to achieve scale in BNPL: that’s probably true but it doesn’t have to be overseas.The spending on developing the BNPL product (and obtaining market shares) would have been more productive if done within Aust and NZ. It’s probably true that only a company of at least LFS’s size can sustain the heavy spending to create scale in international markets- but that just means that HUM’s strategy of pursuing overseas BNPL expansion before getting its local business on a firm footing was wrong and wasteful.It’s not too late to stop the overseas cash drain. Again, even allowing for all this, BNPL is a small part of HCF. Even though the recent slowdown of the BNPL sector is doubtless a big disappointment for the Board, it’s extraordinary that they have little positive to say about HCF’s cards business, or to emphasise that HCF is much more than BNPL. A proper defence would have done so..

I agree with AA’s arguments for voting against the HCF sale, even if he slightly exaggerates them.(Of course, as others have said, I would have liked AA to put his money where his mouth is and maker a counter- offer).

HCF valuation

The Kroll expert report is complex. Its valuation thesis is, in essence, that HCF’s maintainable after tax earnings (cash NPAT) are $26 to $28m pa. That expressly excludes any of the $65m pa pre-tax run rate of synergies that LFS expects to gain from the acquisition. Kroll justifies that (exclusion) by saying that the earnings multiple that it uses (10 or 11 PE) includes a “premium for control” of 43% to 57% which allows for those synergies, and that it would otherwise have applied a PE of only7x. (See the section “Trading Multiples Summary” on P80 of Kroll’s report). I concede that this is an over-simplification of Kroll’s argument and explanations, but it is the commercial substance and effect. I compared this against a different approach. Assume that the $65m pre-tax synergies are indeed achieved and spilt 50/50 between the buyer and seller. That is $65m pa x 70% after tax x 50% share = $22.75m. Add this to the $27m being Kroll’s midpoint of HCF’s standalone maintainable earnings. That gives $50m pa adjusted after-taxearnings for HCF. At $1.80 market price, LFS is paying 150m x $1.80 + $35m cash = $305m for HCF, which represents a multiple of only 6x my adjusted earnings. I think that is far too low.Allowing a fair split to paying for the ability to make these synergy benefits is the fundamental question for this whole deal. I say it should be spread 50/50: both parties must merge for there to be any benefit.LFS has been explicit (and probably understated) how large the synergies will be. There are over 100 references to synergies in the booklet- why else would LFS be buying?!

Implied value of Commercial

1		LFS share value	m cash	Per Humm share (a)	Surplus cash (b)	Total to return	Implied value/share of Commercial (c)
2	$1.00	7c	37.3c	16c	53.3c	+16.7c
3	$1.20	7c	43.4c	16c	59.4c	+10.6c
4	$1.40	7c	49.5c	16c	65.5c	+4.5c
5	$1.60	7c	55.6c	16c	71.6c	-1.6c
6	$1.80	7c	61.6c	16c	77.6c	-7.6c
7	$2.00	7c	67.6c	16c	83.7c	-13.7c

(a)ie 150m LFS/495m HUM =0.303 LFS + 7c cash

(b)($134.1m unrestricted cash- $55m to repay perpetual note, which is included in “equity”) /495m Hum shares = 16 c cash

(c)Using current 70c market price of HUM less total value to be received in previous column I.e. in the “Capital Return” from HCF sale and subsequent“capital management” of net surplus cash, either distributed to HUM shareholders by 31/12/22 or kept inside the corporate shell

Breakeven value of LFS shares on this analysis is $1.55. I.e. if you think that LFS are only worth $1.55, or sell them for that, when combined with the two cash elements, gives an implied value of Commercial (using today’s HUM market price of 70c) of zero.Ie at 70c share price, you are getting Commercial for nothing, if you can sell LFS shares for not less than $1.55. I believe (not advice!) that Commercial is comfortably worth 45c,and probably 60c+ per HUM share once the FY22 results in August demonstrate expected continuing strong profit growth.

Why is HUM shareprice so low?

I posted on this before.The only obvious reason would be if the market thinks that the LFS deal will fail, and that the share price would then collapse.Unless the deal is voted down (presumably because of AA’s opposition combined with low voter turnout- AA and Tanarra are the only substantial shareholders), I can’t see the risk.Fortunately, and very late in the day, the Board has- in the booklet- stated the main conditions precedent for the sale. All of these are standard. Of note, there is no condition that allows LFS to abort based on an adverse change in HUM’s performance, or market and macro conditions generally. The only price adjustment contemplated is (fairly) $ for $ based on actual accounting of NTA v proforma balance sheet at settlement.

Other

The Scheme of Arrangement seems to be only a legal convenience, to enable transfer of LFS shares to HUM shareholders. It’s there only to avoid delays for shareholders who don’t submit the Election Form, but not of any commercial significance.

The booklet makes no mention of HUM’s franking credits (other than the general, technical references in the tax section). I hope that all of HUM’s franking credits will still be available to HUM shareholders after the HCF sale.We do not know the ATO’s intended split between capital return and dividend for tax purposes within the “Capital Return” and may not know the final details until after the vote. The tax report correctly explains what happens if you make a capital gain from sale- but that’s amusing. In the last 5 years the HUM share price has only been this low for a few weeks when the whole market crashed in March 2021. At today’s price, you’d have to be very unlucky to make a capital gain!

The deal costs are high but they include (unusually) an amount for capitalised management time.

This is not advice.DYOR.

23/5/22