Home Capital Group (HCG.TO) – Tender Offer – 6% Upside

Current Price – C$17.4

Tender Price – C$16.5 – C$18.5

Upside – 6% (if priced at the upper limit)

Expiration Date – December 18th, 2018

Announcement

This opportunity was shared by Chris.

 

Home Capital Group (HCG) has recently reported better than expected Q3 results together with an intention to launch $300m tender offer (about 22.5% of market cap) and to apply for a buyback in 2019. Share price jumped 24% upon the announcement and today the company has released the terms of the tender – C$16.5-C$18.5 range and no proration for odd-lots. I think there is a good chance that tender gets priced at the upper limit or might even end up under-subscribed which would cause further rally in the share price.

 

Why upper limit pricing is likely:

  • Home Capital Group has recovered from the crisis and has showed a steady growth and performance so far. Management sees it and that is why they have offered to make this tender plus buyback later on.
  • The company is cheap – HCG currently trades at c. 0.75xBV with stable ROE=7%.
  • Tender is large (c. 22.5% of outstanding shares).
  • Even at the upper limit the company would still be valued at a discount o BV.
  • Warren Buffett (20% owner) is unlikely to tender any shares as it would contradict his long term investing strategy, especially with HCG moving in a very positive direction at the moment.
  • Turtle Creek (18% owner) has increased its investment in HCG as recent as Jul/Aug 2017, when shares traded in the range of C$13-C$14, so I doubt they would be selling out at a small gain.
  • Excluding Berkshire and Turtle Creek, tender amounts to c. 40% of the remaining float.
  • Management will not participate, however they do not own any significant amount of shares.
  • A year ago shareholders blocked Berkshire from acquiring additional 18% of HCG. Even though Berkshire’s increased ownership would have added a lot of credibility, shareholders decided it would be a too much of a dilution (Berkshire’s purchases were at c. C$10/share – large discount to book and market price at a time). So there is a reasonable chance that this time the same shareholders (Turtle Creek was the main advocate) would also restrain from participating as tender offer is still at a large discount to BV.
  • Previous tender (in Q1 2016) was priced at an upper limit and share price ran up during the tender period, albeit company was in a different place at the time, so it might not be a good reference.

 

Background

Home Capital Group, a Canadian credit products provider has been trading at a significant premium to BV in 2015 (16%) and 2016 (24%). However in 2017 the company had a crisis period and almost went bankrupt following accusations from Ontario Securities Commission of failing to properly disclose the findings of fraudulent mortgages in the company. This story dates back to 2014-2015, when HCG did an internal review and found out that 45 brokers, with the combined loan value of $1.9B (10% of HCG total loan value) have counterfeited the mortgage applicants’ incomes. The relationships with them were, of course, terminated and the whole situation had to be publicly disclosed in Q1 2015 results report, but instead management decided to conceal this information and blamed macroeconomics and business seasonality on the decline in the financials. The situation was finally revealed only 2 months later, but still not all the facts were presented to the public. These accusations have costed HCG $30m (settlement deal with OSC) and drove it’s share price down by 70%. Moreover, due to publicized concerns on credibility and liquidity, the company started loosing deposits at an alarming rate and was on the brink of bankruptcy. Then, surprisingly Warren Buffet came in with an offer to buy a stake at the company for $400m + provide a $2B loan, shocking the market and helping HCG share price to recover. The initial deal foresaw Buffet acquiring 38% stake in HCG by 20% initial investment and later getting the rest by private placement, however HCG was quick to start regaining its’ financial stability and repaid $2B lifeline in a month + blocked Berkshire from getting their hands on the rest 18% amount. Shareholders have decided to not to dilute their shares any more (as Berkshire investment was made at C$10/shstr). At the end of 2017 HCG traded at 30% discount to BV. Despite the fact that Buffet’s deal expired recently, Home Capital has already secured much cheaper $500m loan from Canadian banks.

It is interesting that it was not the first time the company has tried to evade publicly acknowledging the inner issues. In 2016 it has failed to properly disclose the information on loan transfers to third parties, including Re-Charge, which one of the directors W.J. Walker was also on the board of HCG. This led to speculations that the company is trying to hide bad loans. HCG has addressed these claims and shook them off, only to be accused again in 2017 of not properly announcing information about many changes in senior management. After all it does look a bit suspicious, when two Senior VPs in charge of Enterprise Risk Management (a company’s new position made to make sure 2015 fraud story does not repeat itself) are removed silently.

The company has also received a lot of criticism from short sellers, like Marc Cohodes, who has been shorting HCG since 2014 and has not backed down even after Buffet money injection. He even sued the company in 2018.

 

Q3 results

On the 7th of Nov. HCG has announced 2018 Q3 results together with a plan to make a tender offer. The results were better than expected with net income increasing 10% sequentially and 8.7% YoY. Originations went up by 273% YoY and 17% sequentially. Besides that deposits have been stable, while non-performing loans remained at a low 0.34%, covering the sensitive spot of the company. ROE has also remained at a solid 7%. I think this quarter has showed the investors that HCG is not only growing, but growing confidently and steadily.

16 COMMENTS

  1. YVRtrader

    Quite the selloff to the low end of the dutch auction range. December 18th can’t get here soon enough! :)

  2. YVRtrader

    Most (all except $2.94 per share) of the funds paid to those tendering shares will be a dividend for tax purposes, which I believe will make shareholders less likely to tender. It’s my understanding that you will end up with a large taxable dividend, and a large capital loss. Any opinions about the effect of this tax treatment on the tender offer? I would assume that Berkshire, Turtle Creek and CIBC would be more interested in selling in the open market for cap gains, but I could be wrong.

    I’m considering holding my shares to sell after the tender results are disclosed, but that could be a crowded sell the next morning if many do the same.

    “A Canadian Resident Shareholder who sells Shares to Home Capital pursuant to the Offer will be deemed to receive a taxable dividend equal to the excess, if any, of the amount paid by Home Capital for the Shares over their paid-up capital for purposes of the Tax Act. Home Capital estimates that the paid-up capital per Share as of the date hereof is approximately C$2.94. As a result, Home Capital expects that a Canadian Resident Shareholder who sells Shares pursuant to the Offer will be deemed to receive a deemed dividend for purposes of the Tax Act. The exact quantum of the deemed dividend cannot be guaranteed.”

    1. dt

      Agree, tendering shareholders get disadvantageous tax treatment as HCG paid up capital is small relative to the share price. This should further discourage anyone from participating in the tender and in turn increases the likelihood of tender being priced at the upper limit and subsequent share price run-up after results are announced.

      Daily liquidity is C$6m vs C$300m tender, so it seems that the only reason to participate in the tender is the opportunity to exit large position, even if that means that net proceeds would be lower than the market price of the shares.

      However, might institutional shareholders have ways to avoid or claim these taxes on dividends? I really have no idea, but would be surprised if every tendering shareholder would be facing this tax burden.

    2. Thinley w

      Good catch. This info should have been mentioned in OP’s post.

      1. dt

        Thinley, have a look at comment below from Michael regarding US holders.

  3. Vincent

    So the idea here is to buy and sell on the open market after the tender, instead of tendering the shares?
    Any thoughts on the likelihood that the share price will run up if the tender is priced at the upper limit? I would expect the opposite, since it costs the company more to buy back their own shares.

    1. Vincent

      *I mean buy now of course and sell on the open market after the tender.

  4. Michael Lax

    I read the offering circular, and it appears that US shareholders who tender all shares will be taxed based on cost basis as a capital gain, rather than based on paid in capital, quote follows below.

    The purchase of Shares from a U.S. Holder will be treated as a sale if (a) the purchase results in a “complete redemption” of the U.S. Holder’s equity interest in the Company, (b) the receipt of cash by the U.S. Holder is “not essentially equivalent to a dividend”, or (c) as a result of the purchase there is a “substantially disproportionate” reduction in the U.S. Holder’s equity interest in the Company, each within the meaning of Section 302(b) of the Code, as described below (referred to as the “Section 302 Tests”). The purchase of Shares from a particular U.S. Holder will be treated as a distribution if none of the Section 302 Tests is satisfied with respect to such holder.
    In applying the Section 302 Tests, the constructive ownership rules of Section 318 of the Code apply. Thus, a U.S. Holder is treated as owning not only Shares actually owned by the U.S. Holder but also Shares actually (and in some cases constructively) owned by others. Under the constructive ownership rules, a U.S. Holder will be considered to own Shares owned, directly or indirectly, by certain members of the U.S. Holder’s family and by certain entities (such as corporations, partnerships, trusts, and estates) in which the U.S. Holder has an equity interest, as well as Shares that the U.S. Holder has an option to purchase.
    (a) Complete Redemption. A purchase of Shares pursuant to the Offer will result in a “complete redemption” of the U.S. Holder’s interest in the Company if, immediately after the sale, either (1) the U.S. Holder owns, actually and constructively, no Shares; or (2) the U.S. Holder actually owns no Shares and effectively waives constructive ownership of any constructively owned Shares under the procedures described in Section 302(c)(2) of the Code. U.S. Holders who desire to file such a waiver are urged to consult their own tax advisors.
    (b) Not Essentially Equivalent to a Dividend. A purchase of Shares pursuant to the Offer will be treated as “not essentially equivalent to a dividend” if it results in a “meaningful reduction” in the selling U.S. Holder’s proportionate interest in the Company. Whether a U.S. Holder meets this test will depend on relevant facts and circumstances. In measuring the change, if any, in a U.S. Holder’s proportionate interest in the Company, the meaningful reduction test is applied by taking into account all Shares that the Company purchases pursuant to the Offer, including Shares purchased from other Shareholders.

  5. v5015

    Strange price action in this today. Obviously market sell off hurting but wonder if someone has a look on one of the big boys tendering shares.

  6. Michael Lax

    Preliminary results indicate that it was oversubscribed, proration at 83%, price at 16.50. Guess this one did not work out too well, win some, less some.

    1. dt

      Tender results are quite surprising:
      - Total tendered shares were 26m out of which 18.2m were accepted – thus the expectation that only small part of shareholders will participate was correct.
      - However, out the tendered shares 22m were tendered at the lower limit (or without specifying the limit) and only 4m above the lower limit. Keeping in mind that overall shareholder participation in the tender was low and that HCG traded in the middle of the range for most of the offer period such a split is quite a striking.
      - This seems to suggest that one or several larger holders (Turtle Creek?) were using the tender to liquidate their positions in HCG.

      Also, still interested to hear on eventual withholding tax implications for US based shareholders.

        1. dt

          ok, thanks, somehow missed this announcement before posting the comment. All makes sense now – the assumption that Berkshire will not tender was clearly broken.

  7. YVRtrader

    Who am I to tell Berkshire how to exit a position, but it seems they shot themselves in the foot with this one. It looks like it $18.50 was likely without their shares tendered, and shares would subsequently trade stronger than they did. Their willingness to sell at $16.50 also hurts the confidence they brought to HCG shareholders, so they’ll be holding their remaining shares, or selling well below $16.50. Now to decide what to do with my remaining 17% of shares…

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