Investment summary

The market is pricing this high-quality business for zero growth when it is more likely that growth will resume post the hard catalyst of audit reports that should bring a close to allegations made by short seller Viceroy. In this case the shares should at least rerate to their 5-year average of ~4x book of €90 or ~145% upside from today's €35 price. In the unlikely, worst case, run-off scenario the shares are worth tangible book of €20 or ~40% downside.

Company description

The prior VIC write-up on Grenke provides an excellent explanation of the long case for the business and be found here (shares were trading at the equivalent of €40 post the 3-for-1 split). The crux of the LT investment case is Grenke specialises in an area of the market that most other competitors retrenched from in the aftermath of the GFC: small ticket IT leases. Grenke has over 1 million running contracts with an average ticket size of €8,000. The efficiencies necessary to operate a profitable business with such low contract values and high volumes are enormously difficult to replicate. Over multiple decades Grenke have largely standardised and automated the process providing them with a cost advantage that is unmatched. Underwriting is obviously another key strength of the business and one which saw them navigate unscathed through the GFC. Effectively this is a company that has a large TAM, generates returns on equity north of 13% while incurring costs to grow (15%+ would be a more stabilised level) and has a natural growth rate of 11% (RoE of 15% with retention of 75%) before it needs additional capital. The business has performed well and by all accounts is one of the few financials that earns well above its cost of capital on a sustained basis with material growth. It is therefore justified that it should trade at a multiple of book value (simple formula of ROE + growth / CoE + growth).

Current situation

The first down leg in share price is COVID related in March when the shares fell from ~€103 to ~€44. Shares recovered and traded within the €60 - €80 range. The big drop in mid-September was post the release of this short seller report from Viceroy. The report is sensationalist and mostly factually inaccurate. Viceroy leveraged the fear created around fellow Germany company Wirecard and the failings of the German regulator to weave their narrative on Grenke. This is a similar playbook that Viceroy used on Capitec in early 2018 where they released a short report trying to link fraud committed at Steinhoff to Capitec. The shares fell 25% on the day. They subsequently and ultimately demonstrated Viceroy's lack of knowledge of the company. I believe this will play out in the same way with Grenke.

Thesis

Having followed the company for a while I think Viceroy has this wrong. The claims on the business model have been rebutted by the company here in the detailed response document. I provide some further details on the main points from the report below and can discuss any questions in the comments section. Discussed later I think Viceroy have unearthed one set of facts relate to the franchise system but which I do not believe impair the business model.

Allegation: Serious regulatory malfeasance in the banking division

The bank guarantees Grenke's bonds which is critical to maintaining its investment grade credit rating. The bank has weak AML controls KYC failings and imply the banks license to operate is at risk.

Rebuttal:

• The banking subsidiary does not guarantee any bonds. The bonds are issued out of the FinCo based in Ireland Grenke Finance PLC
• The banking business is one component of the financing mix at 28% of total funding. Bonds comprise 57% and ABS 15% as at 3Q20
• Grenke's credit rating is based on maintaining equity capital ratios for the overall entity at certain levels. The calculation is a basic adjusted equity capital to risk weighted assets. It is not dependant on the banking subsidiary
• The allegations on AML/internal control failings at the bank lack any substantive evidence. The reality is all banks face these risks and it is very difficult to enforce AML in practise. The worlds biggest and most well resourced banks regularly fail. While not an excuse I see no actual evidence of PERVASIVE control failures
• Viceroy point to a figure of €700k. As an isolated instance on €1.6bn of deposits I view this as a risk to the banks license to operate

Allegation: Grenke’s business is built on malpractice and facilitates fraud

Grenke's leasing business knowingly finances fraudulent schemes and turns a blind eye to this behaviour. Only 15% of its revenues are directly acquired and the remainder are from resellers where Grenke is a finance partner. One example Viceroy provide is of Grenke financing €500 TV's on leasing contracts valued at €10k-€15k each. The TV's display advertising in the lessee's establishments (restaurants, shops, bars etc) and would receive payments from a third party ad agency to finance the contracts. Soon after the inception of the lease the ad revenue would cease and the lessee is stuck with a TV worth a fraction of the lease. Grenke then sues for non-payment. Viceroy claim Grenke knowingly financed deals that would sour.

Rebuttal:

• Grenke has partnerships with 40,000 resellers where at checkout the buyer gets offered financing on their purchase. Building out the relationships with is a clear competitive advantage but out of that many there will be some bad eggs.
• The examples Viceroy provide are clearly scams except what Viceroy seem to miss is that Grenke, in addition to the lessee, is a victim of fraud
• The origination of a €15k lease contract results in Grenke paying out that money on day 1 of the lease and booking an associated lease receivable. It makes zero sense that Grenke would outlay funds knowing the lessee would not be able to make the lease payments
• The balances involved in these examples are small relative to the overall lease book

Allegation: Grenke’s diminishing finance lease segments

The assets Grenke is financing are redundant and in decline i.e. who uses photocopy machines anymore. Customers are getting a bad deal buying €8k printers/photocopiers

Rebuttal:

• Viceroy confuses contract values with item values i.e. the average contract size is ~€8k therefore that must mean a single item when in reality a contract can be comprised of multiple assets.
• Grenke makes financing available for items that lessees demand, not the other way around
• The table below is from the Viceroy report. We can see that photocopiers as a proportion of total contract value has fallen substantially which in fact support the data presented by Viceroy that photocopies are in fact used less...

Allegation: Junk lease receivables and failure to book impairments

Lease receivables are of low quality to high risk borrowers that are mostly SMEs. Borrowing rates can be over 10% on some assets. Impairments are not being correctly taken.

Rebuttal:

• Grenke's entire business is built around making small ticket IT leases to SMEs. These are inherently higher risk and therefore the rates are higher. No one should be surprised by this, it is exactly what Grenke say they do
• Post GFC banks pulled back meaningfully from financing SMEs and competitors such as GE finance withdrew from this segment which opened up Grenke's TAM. Their competitive advantage is underwriting these small ticket loans (refer to the prior VIC write-up linked above). They provide a quote to 80% of applicants but acceptance is only ~50%. This is a similar approach to P&C insurer Admiral's in the UK who got good at underwriting by taking on a diverse set of risks to build up the loss experience data required to price better
• In addition the leases amortise over time and have a contract duration of 48 months. This short duration combined with the small ticket size spread over a huge number of borrowers offers diversification
• The impairment policies are laid out in the annual reports and there is not a large NPA balance because leases are written off once they are in default and balances are irrecoverable
• In a normal year the loss rates are in 1.5% to 2% range and during the GFC they peaked at 2.7%. While that isn't quite the 4%-5% credit card range I don't think it is unreasonable. First, there is tangible value in the physical asses and ownership is retained by Grenke as lessor. In the event of default Grenke repossess the asset to help mitigate the loss. Second, the assets are typically important for the functioning of the lessee's business and therefore are less likely to be defaulted on i.e. you can't operate your business without a laptop so you make sure you make the lease payment. Third, the loss rate is understated as the lease receivable book is growing 15%-20% inflating the denominator of the loss ratio

These are just a few examples raised by Viceroy where they demonstrate a misunderstanding of the business. Viceroy is picking a few instances of where things have gone wrong but the reality is that this company wouldn't have grown if they weren't good at what they do (underwriting, risk management and cost control) and if SMEs didn't want access to finance. The reason the stock is still down is because Viceroy did uncover something on related parties which remains unclear but in my view does not impair the business model.

Allegation: Related party transactions not reported correctly

One feature of Grenke's business model is when it expands geographically to a new country it uses a franchise model whereby an ex-Grenke employee and a set of financiers bankroll the start-up costs and using a pre-determined valuation give Grenke the option to buy the franchise operation at a later stage. The franchisee receives support from Grenke with the most material aspects being the use of their credit system to underwrite loans and the financing of qualifying loans. Viceroy allege that the franchises were all bankrolled by the same company CTP Handels-und Beteiligungs ("CTP"). They further allege that CTP was in fact a related party because it was owned and controlled by the founder of Grenke (Mr. Grenke) and his associates. Therefore franchises should have been consolidated and were misreported. Viceroy goes on to say that the €100m spent on franchise acquisitions since 2011 didn't exist and was a way to convert fake cash from fake earnings into goodwill.

Rebuttal:

The annual reports have consistently explained how the franchise system works, but investors were never told there was a single entity behind all of them, so this unsurprisingly, surprised the market. Post these allegations surfacing Mr. Grenke has denied he is the backer behind CTP and that the entity is not a related party to Grenke. I am not really sure whether CTP was a related party or not. To date we haven't been given a simple explanation for what's going on. But the question is, should this matter? I would posit that no it doesn't. Assuming CTP is a related party and Mr. Grenke is the ultimate owner there are two scenarios that could explain what is going on here.

The first is that Mr Grenke wanted to expand geographically. Recognising loss making start-ups would be a burden on the growth levels of the established business due to capital requirements, Mr. Grenke decided to keep the start-ups off-balance sheet and integrate them into the business once they reached a level at which they were less of a financial drain. Through the CTP entity he funded the start-up phase with the knowledge that the main Grenke business was backstopping the losses. If things went well then Mr. Grenke recouped his funds and added another revenue stream to his business. If things went badly, the company bailed him out. The second scenario is that the entire franchise exercise was fake and just a way to siphon off cash from the main business. However, this doesn't make sense because Viceroy says the cash never existed in the first place.

In either scenario the worst case is that Mr. Grenke faces legal consequences personally and the company will have to restate historical financials. This is not going to permanently impair the business, the market just needs closure. This will come from the numerous reports currently being conducted looking into ALL the Viceroy allegations. We've already had some results from the on-going KPMG audit which have led to a recovery in the shares.

Valuation

The market is pricing Grenke as ex-growth. The core reason for this is because Grenke is mostly wholesale funded and its bonds are trading at yields well above where they were issued. This effectively breaks the business model as new business would be unprofitable to write as the liability spreads would eat into the net interest margin. Positively, Grenke takes no duration risk and has excellent ALM practices which mean that its labilities are covered by leasing contracts that mature at the same time.  In addition, Grenke's new business volumes are expected to be 40% lower YoY in 4Q20 due the pandemic. This is actually positive in a sense as the impact on growth is not as bad as it would have been absent the pandemic.

Like other financial companies 2020 is impacted by loan loss provisions flowing through the income statement in-line with the change in accounting standards (IFRS9 achieves a similar goal to CECL). Therefore as credit losses normalise next year the earnings profile improves and RoE can begin to recover. The difference is that while other financials require higher rates to regain their pre-covid earnings power Grenke doesn't. Lease rates are sufficiently high that lower rates actually lead to NIM expansion as funding costs fall while lending rates remain high.

In addition, Grenke went into this crisis with a strong leasing book and is also benefiting from the various government measures to assist borrowers which also mute ultimate loss rates.

The base case is that the various investigations confirm that the business model is sound, but the franchises need to be consolidated going forward. I would then expect a return to normal access to capital markets albeit at a higher rate initially than pre-pandemic.  The shares should be able to rerate to from to 4x offering 145% return.

The downside case is that the business cannot access wholesale funding at an appropriate rate and the portfolio is liquidated and the company wound down. In that case the business would be worth tangible book of  €20 or downside of 46%.

Concluding remarks

In my view Grenke has not transitioned well from being a small, obscure, underfollowed company to a multi-billion euro firm. For example the company only within the last year began providing company presentations on its website. Other examples include: having non-industry standard definitions of cost-income ratios (including provisions whereas other financial companies exclude these); not paying for transcription of quarter calls despite hosting them. In fact over the years Grenke has proved to be a fruitful long for investors who have followed the name because the market panics over things discussed in prior calls but these aren't available if you weren't on the calls. Many of these actions come across as not being transparent and along with the narrative referencing Wirecard have aided Viceroy's story. The reality is this is a great business suffering from a temporary setback.