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
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.
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.
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.