Despite a global and financial credit crisis, Huge Group has found a way to repurchase 16.07% of its own shares, thereby lifting pro-forma earnings per share, and net asset value per share at 31 August 2008, by 19.14%.
While traditional financial and banking credit lines have been eroded since the start of the credit crisis, destroying many opportunities along the way, Huge Group has been quietly at work finding ways and means of opening alternate credit lines and benefiting from the tougher investment environment.
James Herbst, Huge Group's Chief Executive Officer, says: “As a board of directors, we are constantly looking for investment opportunities where return on investment exceeds the cost of capital. Around June last year, when the price of our ordinary share was trading around 395 cents per share, we noted that the forward earnings yield (or return on investment) in a Huge Group ordinary share exceeded the forward cost of debt capital. What better investment than an investment in one's own ordinary shares? You don't have to perform any due diligence investigations and you know the jockeys intimately!”
“At the time our problem was raising traditional debt to fund the repurchases. So we decided to make use of the JSE's SAFEX-guaranteed single stock futures (“SSF”) mechanism, and general contracts for difference (“CFD”) mechanisms available in the market.” Herbst, and Executive Chairman Anton Potgieter, therefore agreed to effectively “bond” their existing shares in Huge Group via SSF contracts, in order to provide the company with the means of repurchasing its own shares and making other capital investments. However, even with the injection of their own capital, the repurchase by Huge Group of its own shares proved to have other obstacles, mainly because of the complexities of a company using debt to repurchase its own shares. This resulted in the collapse of Huge Group's contemplated and published repurchases in July 2008.
So, in the face of these additional obstacles, Huge Group looked for other ways to achieve its goals. Herbst continues: “We found that the use of SSFs and CFDs would provide the company with the means to hedge the cash-flow risk of repurchasing its own shares at some point in the future at an unknown price. Our company generates EBITDA, a measure that approximates operating cash-flow generation, of over R4 million per month. It seemed nonsensical to have to wait 13 or so months to accumulate the cash-flow to repurchase our own shares for cash, and then at a price we could not fix in the present. So we used the JSE's SSF and CFD mechanisms.”
On the subject of the recent controversy surrounding SSFs in particular, Herbst says: “The SSF and CFD mechanisms have been a very successful tool for the company to repurchase its own shares and make capital investments, and it is unfortunate that we have been mentioned in the same news articles as our contemporaries, who have used SSFs and CFDs for other reasons.”
Herbst elaborates: “We have always understood the pitfalls inherent in using SSFs and CFDs and how to make appropriate use of these mechanisms. Our decision to gain exposure to the ordinary shares in our company was never a gamble on the upside performance of the share, but rather an intelligent way to hedge the cash-flow risk of the repurchase of the company's share some time in the future.”
SSFs and CFDs also provided Huge Group with a quick way of getting access to very cheap funding, funding that was effectively provided at a rate of prime less 3% with no guarantees or surety-ships required, and with limited security requirements. Herbst emphasises that the situation at Huge Group, which effectively had the strength of the company itself as guarantor behind its contracts, was vastly different to that of the highly leveraged personal investors in SSFs, who had nothing to fall back on when the banks decided to increase their security (or “initial margins”, as they are more commonly referred) late last year. Furthermore, the SSFs taken out personally by Huge directors were against their fully owned and paid-up stock, as opposed to the norm, which would be speculative and highly leveraged purchases of new shares.
Herbst refers to Russell Loubser, CEO of the JSE, who has said in recent speeches that it's not the product that is evil, but the inappropriate use thereof. Herbst also emphasises that: “It is really unfortunate that we have been linked in the press to the recent SSF failures, purely because we also have SSFs on our stock - whereas, for us SSFs - and CFDs - have actually been a huge success.”
In a nutshell, Huge Group's use of SSFs and CFDs has therefore successfully ensured that the future repurchase of ordinary shares is pegged at a known price, and as such, Huge Group has hedged itself against the cash-flow risk of a rising stock price and a continually shifting goal post. Herbst elaborates: “We have effectively ensured that since July of last year, our future repurchase of shares will cost us no more than 289.79 cents per share. While this is well above the current market price of 160 cents per share, it is substantially below the life-to-date weighted average price at which Huge Group ordinary shares have traded since its listing in August 2007.”
This means that Huge Group's repurchase programme has cost a total of R52 million, which has been funded over time from internally generated cash-flows, and via the cash-flow hedge mechanism inherent in the use of SSFs and CFDs. Herbst says the repurchase programme has yielded lasting and tangible value to shareholders. “Despite the current depressed share price, you need to look at the effect of this repurchase in terms of the relative costs of capital to see the true effect of it. If we had raised R52 million of debt funding on listing, to repay this would have cost us the equivalent of R3.17 per share today against our listing price of R2.50 per share. So, funding the future repurchase of shares at an effective price of R2.89 is a really good deal for us, regardless of the current share price, and represents significant value added for our shareholders.”
Herbst concludes: “We currently have as little as R4.5 million of outstanding synthetic debt embedded in our exposure to single stock futures contracts, and also have very little debt on our balance sheet, with a current equity to debt ratio of under 10:1. Obviously at debt levels of less than 10%, it is prudent for us to investigate other means of raising debt, and this we are already doing.”
Huge Group Executive Chairman, Anton Potgieter, comments: “We have achieved our aim here, which was to increase value for our shareholders. We have effectively bought back R52 million of equity, funded from internal cash-flows. Given the current market conditions, we are extremely happy with this result.”
Huge Group is currently in a closed period pending its 2009 annual results, as its financial year-end is 28 February.
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