Opinion: Heartland Bank's credibility goes on the line as George Kerr takes a pound of property flesh

By Gareth Vaughan

As a young journalist writing about telecoms companies for sharemarket investors in London in the late 1990s I developed a theory. It wasn't fool proof but it usually panned out right.

Companies whose press releases set aside waffle and cut to the chase, tended to be the ones performing best. Of the companies I covered Nokia - at that time - was the best example of this. And those who tried to obfuscate the bad news, or used a lot of spin, were ones with problems. British Telecom was the best example of this.

Here in New Zealand in 2013 our newest bank, Heartland, recently issued a press release that reminded me a lot more of BT than Nokia.

Buried deep in a May 28 statement entitled 'Heartland Bank Releases Third Quarter Disclosure Statement' was this sentence; "If the outcome of that (non-core property) review is to change strategy, this may impact currently anticipated full year financial results."

I sensed this was a warning that Heartland's annual profit wouldn't now meet previous guidance of between $21 million and $24 million. But to be sure that this walked like a duck, talked like a duck, and actually was a duck, I contacted Heartland's management. Treasurer Craig Stephen ultimately responded as CEO Jeff Greenslade was apparently too busy to.

Stephen assured me on May 29 that Heartland's management remained comfortable with its previous profit guidance, saying; "We would comment if we felt there was going to be a departure either positively or negatively from those numbers so the absence of comment I think is telling,"

But by yesterday, just a week later, everything had changed. Heartland released the outcome of its non-core property review. The most relevant immediate point in Heartland's statement, on page three of three, was that its net profit after tax for the year to June 30 will be about $7 million. That's as much as $17 million, or 71%, down from Heartland's previous guidance. Ouch.

A $24 million hit

Yesterday's release outlines a $24 million hit. This stems from a "one-off" non-cash asset write-down of $18 million before tax, plus a pre-tax hit of $6 million from writing off the balance of an $11 million fee being paid to a unit of the George Kerr controlled Pyne Gould Corporation (PGC).

These charges stem from Heartland's efforts to close the book on troubled property loans and investment properties inherited from Marac Finance when the PGC owned finance company merged with building societies CBS Canterbury and Southern Cross Building Society to create Heartland in January 2011.

But the details of the deal raise questions as to whether the wheeling and dealing is conduct you'd want to see from the plain vanilla bank Greenslade says he wants Heartland to be. They also question the extent of influence Kerr, whose preference is for high risk, potentially high reward private equity style investments, has had - and may still have - over Heartland. Kerr was Heartland's biggest shareholder for a time prior to it gaining bank registration but is no longer a substantial shareholder, IE if he's still on the share register he hasn't had to disclose a holding of 5% or more.

When Heartland was created, with the aim of obtaining bank registration from the Reserve Bank, duly obtained in December last year, management of non-core property loans was outsourced to Real Estate Credit Limited (RECL), a unit of PGC. The plan was to exit these over five years - up to January 5, 2016, with RECL to compensate Heartland for loss on those assets up to a limit of $30 million.

Heartland says it had limited rights to early repayment of this $30 million, which is already fully utilised, with most of the payment not scheduled to be made until 2016. Prior to the latest announcement, Heartland had got $3.25 million, with a further $26.75 million due in 2016.

Would you like a bond & some property with that?

But instead, a deal has been struck whereby RECL will now "pre-pay" the $26.75 million. But there's a catch. This is no cash payment.

RECL will transfer "certain assets" to Heartland, including those charged to secure the payment. These include; a Westpac bond due January 2016 with a face value of $11 million, plus loans and property assets with a value equal to the balance of the maximum compensation amount. Heartland will now manage its non-core property portfolio, which had a $139 million book value as of March 31, in-house.

So that means Heartland remains exposed to any ups and downs of those investment properties and property loans it values at $139 million.

Meanwhile, terminating the RECL management agreement gives PGC a nice fillip via a one-off increase in net profit after tax of about $7.8 million, according to Kerr (pictured right).

PGC shunted $147 million worth of property loans from its then subsidiary Marac over to fellow subsidiary RECL in 2010 at the request of its building society merger partners. At the time PGC said this would reduce Marac's exposure to real estate loans because RECL would assume a risk of loss on loan realisation. It was also expected to improve the merged entity's chances of getting an investment grade credit rating. This transfer followed the 2009 move of $175 million of non-performing property loans to RECL from Marac.

Yesterday Kerr went on to say; "The exit from RECL is a clean end to the substantial and wide-ranging support provided by PGC in the rescue of Marac and creation of Heartland."

That may be. But what cast iron guarantee can Heartland provide that yesterday's hit from its non-core property holdings is a full and final one?

Heartland appears to believe this may indeed be a full and final hit saying it's confident its earnings will now normalise and no longer suffer from the poor performance of its non-core legacy property assets.

It has issued guidance for net profit after tax of between $34 million and $37 million for the year to June 30, 2014. Furthermore it's hinting that investors should still anticipate dividends, and says a share buy-back programme will be launched to manage capital, if deemed appropriate.

 Investors cheered these three pieces of news, pushing Heartland's share price up 5 cents, or 6%, to 84c giving it a market capitalisation of $326.5 million.

And the good news for Heartland didn't end there. Standard & Poor's announced Heartland's BBB- credit rating with a negative outlook was unchanged. A BBB- rating is S&P's lowest investment grade rating, something that was crucial for Heartland to obtain before it became a bank.

'Performing, accelerating & extend'

But Heartland still has the small matter of the non-core property portfolio to deal with. It says it has split the $139 million portfolio into three categories labelled "performing", "accelerating" and "extend". It says performing loans or assets will be held unless an attractive offer's received. The stuff classed as "acceleration" will be exited within 18 months. And the loans in the "extend" portfolio will be converted over time to real estate to be better positioned for sale and held for up to five years.

Although the amounts held in each asset class are "commercially sensitive" and Heartland won't disclose them, it does say it expects the majority of its non-core property assets to be "exited" over the next 18 months. This would leave it with just performing assets being held for sale, from which it doesn't expect any further write downs.

The plans to create a Heartland Bank, unveiled in June 2010, set out the ambition of a sharemarket listed bank doubling its $2.2 billion asset base within five years through growing lending to families, small businesses and the rural sector. As of March 31 Heartland held retail deposits worth $1.76 billion.

The property portfolio savaging Heartland's annual profit was never seen as a core part of the group's future. For the nine months to March this property caused Heartland's impaired asset expense to surge 30% to $7.9 million.

For the long-term credibility of Heartland, and in the interests of its depositors and shareholders, here's hoping any future property hits are much smaller. And that Heartland discloses them in a much more straight forward manner.

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