value and opportunity

Disclosure: I have no exposure to Grenke nor do I plan to have no exposure for the foreseeable future.

Grenke is a company I have written about quite often in this blog. My only investment had been the purchase of Grenke Bonds after the “Short Attack” in September 2020. I divested them relatively soon after the first rebound with a decent profit.

Since then a couple of things happened: The COO suddenly resigned on Feb. 8th, with an understandable explanation given only one day later. The story that was also communicated via some back channels was, that everything was fine and the main issue was that the German regulator BAFIN is over eager after the Wirecard Fiasco and there is no reason to worry. Another story is that Grenke is still an “innocent” inexperienced company and therefore communication is not so professional but the company as such is a great company with a great future.

Personally, I always had issues with Grenke. Yes the numbers always looked great, but I found the reporting very intransparent, for instance their “Free Cash Flow” definition which included debt issuance which at least in my “old school” thinking is not even close to free cash flow.

Last week now, Grenke came out with an update which at first sounded like what we in Germany would say is a “Persilschein” or a proof that everything is great. It starts as follows:

• Mazars’ interim report commissioned by BaFin reveals no doubt as to the existence of the lease receivables; allegation of money laundering not confirmed
• Points of criticism of Mazars concern specifically the accounting treatment of the franchise companies, lack of disclosure of related parties, as well as deficiencies in money laundering prevention and parts of the customer lending business at GRENKE Bank
• Franchise companies will be fully consolidated for the first time
• Earnings after taxes for the 2020 fiscal year expected to be in the upper double-digit million range
• Net liquidity of EUR 1,290 million as of February 22, 2021

Investors seem to have liked this and the stock price went up by ~+15% following the release:

Personally, the first paragraph in my opinion was not a surprise. i think it was pretty easy to spot that Grenke is not the next Wirecard.

However, once you read the text in more detail, some really ugly details surface.

CTP returns

My biggest issue has always been the “related party transaction” with CTP and the Franchises. W. grenke has still not disclosed who the owner of the mysterious CTP company was. What we know now however is, that they really made some serious money by funding an selling the Franchises to Grenke (emphasis mine):

In this context, Mazars criticizes the returns of CTP and the other financial investors ex post as excessive. Mazars concludes this from an analysis of the top 10 acquisitions by amount of goodwill. Mazars points out that for the franchise investments between 2003 and 2018, paybacks of EUR 62.6 million compared to investments of EUR 7.2 million occurred.

So CTP (who ever it was) made on average 9x their money with a pretty negligible amount of risk. In my opinion, this is clearly “too good to be true”. In the PE business, a 3x return /over 7-10 years) is considered absolutely top notch. The combination of these returns and the refusal of W. Grenke to disclose the beneficiaries in my opinion is really really close to embezzlement. Maybe not in the legal sense but economically.

Consolidation / Goodwill:

This is what one finds in the Adhoc:

A significant point of criticism by Mazars concerns the accounting of the franchise companies. Mazars is of the opinion that these should have been consolidated in the consolidated financial statements as soon as they were established. 

Despite what has been communicated so  far, the whole Franchise structure was clearly used to hide losses of subsidiaries which is confirmed here:

Upon consideration of all available information, the Company believes there is greater evidence suggesting that the franchise companies should have been consolidated in the consolidated financial statements as soon as they were established, irrespective of the ownership structures, due to de facto control in accordance with IFRS 10

No problem says Grenke: 

The retroactive full consolidation leads to a change in the depiction of company acquisitions, notably exclusively in the consolidated financial statements according to IFRS. This has no effect on the Group’s cash flow. No goodwill is shown in the consolidated Group’s balance sheet for the franchises acquired after December 31, 2012, and thus since IFRS 10 came into effect. The acquisitions are accounted for directly in equity. Equity is reduced by around EUR 90 million compared with what has previously been shown.

No cash impact, just 90 mn EUR equity gone. This 90 mn reduction in my opinion is a combination of the money paid to CTP and the losses incurred. The cash flow effect has clearly already happened but was disguised as Goodwill paid.

Clearly Grenke has find a way to book this directly into equity instead of booking it as a loss through the P&L but make no mistake: Economically these 90 mn EUR are past losses that Grenke has been hiding.

W. Grenke’s girlfriend:

Mazars has criticized that Corina Stingaciu was not identified as a related party in the group accounting, although the relationship with Wolfgang Grenke appeared to be known within the GRENKE Group. 

My speculation from back then was actually well known within Grenke, which I friend interesting. This means that a lot of people have known and played along which in turn tells me something about the company culture.

Lending in Grenke Bank

The Mazars report lists several deficiencies at the subsidiary GRENKE Bank. These include violations of the Minimum Requirements for Risk Management (MaRisk), which relate to complaints in the customer lending business. Specifically, a number of granted loans were mentioned in which either no or insufficient collateral was provided or the borrower’s ability to service the loan was not sufficiently verified.

Yes, the amount is relatively small but something very similar actually almost killed Metro Bank. Underestimating risk capital sounds harmless but has all ingredients for a full blow up when things get tough. The general issues of “sloppy process and methods” really seem to be present within Grenke Bank as well

Risk Management

Another finding by Mazars concerns the methodology for calculating risk provisions in accordance with the IFRS 9 accounting standard. Model and documentation weaknesses are identified. With regard to the model, Mazars finds, among other things, that GRENKE has not yet taken into account macroeconomic factors. GRENKE AG continues to use its model-based approaches derived from statistical methods, but has expanded them in line with the standard, without causing significant changes in the estimates of the amount of risk provisions.

Another item that would make my hairs stand up. Again they seem to have found a way to smooth the numbers but ignoring macro factors in calculating provisions is “naiv” if I want to be very friendly. It will be really interesting what kind of creative provisioning they will have developed in the year end accounts.

Internal controls/Compliance

The Mazars report also contains findings on missing or ineffective process-dependent controls in the internal control system as well as severe findings on the internal audit and compliance organization. The latter two largely coincide with the criticisms made by BaFin, about which GRENKE had provided detailed information in the letter from the Chairman of the Supervisory Board dated February 8, 2021, and which had led to the resignation of Board of Directors member Mark Kindermann. The Board of Directors has begun to significantly develop the internal control system on the basis of these findings.

This clearly debunks the backstory that only the BAFIN was over sensitive and also contradicts the statements from Grenke on the CFO dismissal. There are real issues and they don’t just go away with a new CFO.

Outlook:

The time-consuming audits in particular were the primary cause for significant delays and the reason it has not yet been possible to set a corporate calendar for 2021.

The audit opinion with regard to the consolidated financial statements is expected in the second quarter of 2021. KPMG will report the final results of the audit as of December 31, 2020 in the audit report and in the auditor’s opinion.

It will be interesting to see when Grenke will actually be able to come up with audited statements, but to me this sounds that the problems are far from over.

Summary:

The things I pointed out here, in my opinion clearly shows that Grenke had big issues in the past. They seemed to have cut corners at every occasion and the related party issue is still not resolved in my opinion, especially with regard to the significant transfer of money from Grenke to some mysterious third parties.

I cannot judge how much Grenke has changed in the meantime, but in my opinion, the character of  financial institution doesn’t change so easily just if you remove the CFO. To me it looks that everyone knew about these things and didn’t dare to speak up due to the presence of W. Grenke even when he was already in the Supervisory board and for a financial services company, this is a very problematic culture. The communication by Grenke to me looks like they want to say: “Please leave us alone and let us just continue what worked so well in the past”. 

Another point to mention is that especially for financial institutions the following rules almost always apply:

As long as you grow you can “paint over” many problems  with a growing balance sheet. However once you stop growing, almost always the “real sxxx hits the fan”. However, once refinancing costs increase an the reputation is broke, growing becomes very difficult and financial services companies can enter a “vicious circle”. This can be seen in many many cases, such as Provident Financial in the UK or Wells Fargo, once Buffett’s favorite, in the US.

So Grenke needs to find a way to grow again with significantly more with a much stricter governance which will not be easy 

Looking at all the points from above, to me Grenke remains un-investible in its current form. The communication from the company to me indicates that they don’t really want to change the ways that they are running the business despite some changes in the Board of the company. To be clear: Grenke to me doesn’t look like a “Quality company” but rather the opposite.

Before anyone asks: I also would not short the company as in today’s markets anything can happen. There is so much money going around that even Grenke could go up like crazy despite the fundamental problems. 

Personally I do think however if one wants to have exposure to (troubled) financial companies, there are many opportunities where you might get a better potential upside at much lower valuations.