tamz- belated thanks for your posts.I was going to write about...

tamz- belated thanks for your posts.

I was going to write about HUM’s covenants but I decidedfirst to find out what else Morningstar had said about HUM. Apologies for avery long note here: it is difficult to critique the MS analysis succinctly,other than to question the few forecasts that they provide, because they don’tprovide workings (or assumptions) to support their contentions.

I’ve read the analyst note and looked at what I think areall the other tabs of figures and analysis in the MS material on HUM. MS give a table of forecasts but there appearto be no detailed workings (either figures or text) given to justify these forecasts.My distant memory was that 10+ years ago MS gave a lot of figures to supportand explain its forecasts, but that memory may be faulty. Have I missedsomething on the MS site, as the table of forecasts appears to be completely unsubstantiated? Also there are inconsistencies both withinthe forecasts and between the forecasts and text (see below).

The most alarming comment by MSis that they “incorporate an equity raise of approx $140m to support compliancewith covenants in FY26”. They provide nothing to substantiate this. I believeit is alarmist and fundamentally wrong. I believe that no equity raisingis necessary, especially since HUM had $157m of unrestricted cash at31/12/23 (see later). MS forecast a huge negative free cash flow in FY24of nearly $150m but don’t say why. Iwonder if that is a mistake or typo. I don’t know MS’s definition of free cashflow but note that HUM had a net increasein cash of $54.3m in 1H24, so MS are implicitly forecasting an enormous cashoutflow in 2H24

MS says “We believe the market is fixated on Humm's consumerfinancing operations while overlooking its growing exposure to commercial financing,which has a better earnings outlook”. I can agree with a lot of the commentaryin his note, but the analyst has fallen into the same trap. He briefly mentionsCommercial but does not discuss it much. Commercial is doing extremely well andhas been doing so for at least 5 years. HUM’s problems are all in Consumer. Theanalyst seems obsessed with BNPL in particular: he may well be right about his commentson HUM missing the boat with BNPL and other changes to the consumer finance landscape,but BNPL or PosPP is now a tiny part of HUM’s business. My main concern with Consumeris not so much its prospective bad debt levels (although these are worse thanin Commercial) but that its cost/income ratio is terrible. This is a major reasonwhy the normalised return on equity of Commercial in FY23 was very high (aboutmid twenties) but in Consumer was lousy- about 3 %. It’s good that the Boardhas asked Rob Wright, who did a great job improving Commercial, to get involvedwith Consumer.

I hope the suspended /closed products in PosPP (which are excluded from “normalised” resultsbut are still a real loss) will finally show only a tiny loss in 2H24. Thesehave been dragging on for many reporting periods: the $33m loss after tax fromthese in FY23 was shocking. Even 1H24 still had a loss of $8.2m for this.

The MS analyst is concerned about lack of info on the debt covenants:that is fair because HUM and its peers are very highly geared through securitisationfacilities (SPVs). I don’t know if the covenantshave ever been disclosed, but they were not in the last 5 years. It’s understandable that HUM would choose notto, because the pricing and covenants of such facilities are a crucialcompetitive edge for cos like HUM versus their peers. The Annual Reports for 5 years say thatthe covenants on the (much smaller) corporate facilities were fully compliedwith. At the last two HUM agms I asked the Board to confirm that HUM had fullycomplied with the all the securitisation covenants throughout FY22 andFY23. The CFO responded “YES” both times.

Although HUM does not disclose the covenants it does providecopious info on its bad debt provisioning, both specific and macro overlay, andits reasoning. It also points out that the accounting standards require it tomake greater loss provisions at balance date than have actually been experiencedin the FY (the reason for the AASB9 adjustments). So, even without covenants,there is plenty of info for MS to analyse what HUM has provided for bad and doubtfuldebts, and for MS to decide if it wants to use harsher numbers.

MS did (once) mention” restricted cash” held in these SPVsas a buffer to help service their debts, but did not mention that HUM alsohas $157m of unrestricted cash. That is held outside the SPVs: HUM can do whateverit likes with that $157m. If HUM wanted to it could use some of that cash to addan extra buffer to its “equity” tranches of the SPVs, or for corporate purposes,pay divs etc.

I wonder whether Morningstar has misunderstood the SPV facilitiesof HUM, or perhaps I have! Myunderstanding is that the SPVs are all non-recourse. Hence the two worst case possibleconsequences for HUM’s SPVs are 1) that if bad debt experience is terrible itsown losses are limited to the most junior (equity) tranches of the notes in theSPV’s debt structure; and 2) if HUM seriously breaches an SPV covenant that SPVwould be put into runoff. I expect thatthere would be a grace period for HUM to rectify a breach, before this happened.I don’t know if it’s ever happened at HUM, at least in the last 10 years. Itdid happen at Thorn, in the early days of Covid. Thorn’s expected bad debt losseswere high and the nervous financiers put the facility into runoff. That meantthat Thorn could not write any new loans on that facility, and that all cash flowfrom incoming loan repayments had to be used to pay down the debt in the SPV. But it was NOT required to make immediate repaymentof the debt in the facility. I expect that HUM’s SPVs would be similar: i.e.the worst case result for a serious covenant breach would be that the SPV wouldbe put into runoff, which might take five years. I greatly doubt that HUM/SPV wouldbe required to repay the SPV debts immediately,which would be nigh impossible. It would be good to know if HUM has cross-defaultcovenants between its facilities: I imagine HUM would have strongly resistedsuch a requirement.

A typical SPV is established by an investment bank for itsclient (say HUM) and the debt tranches sold to institutional money market investors.HUM (the client) would only be required to invest the riskiest level (“equity”)in the debt stack. Recent SPV deals have been done at only 5% equity and the trendis getting lower. In view of the veryhigh leverage in these SPVs, and the inherent reputational risk, the investment bankwould do very extensive due diligence on HUM’s loan books – both on its ownaccount and on behalf of the institutional investors. It’s unthinkable that a major investmentbank, with very experienced institutional investors who specialise in suchfunding, would agree to arrange funding to a client that had dubious or veryvolatile loss experience in its loan books, or in its processes for managingcredit risk. The SPVs would no doubt have covenants as well, but as with all lendingthe financiers don’t want to have to rely on them. The important thing is to dovery deep due diligence before the facilityis approved, to minimise the risk of being surprised by a covenant breach later. The due diligence would, as with banks, includemodelling various downside scenarios where the economy suffered degrees of downturn. Barringa severe and protracted downturn in Australia or NZ, I assume that the professionalinvestors in all this funding would have concluded that default risk was negligible,or they wouldn’t have provided the funding. Nor would the investment bank have attached its name to such a proposal.

The professional involvement above, and HUM having $157m of freecash as well as the mandated cash buffers inside the SPVs,makes MS’s decision to allow for (expect?) a $140m equity raising as extremelystrange (and I think wrong), yet MS mention it only in passing.

Not advice. DYOR.