value and opportunity

After my post about Australian Leasing companies a few days ago, I decided to start with Silver Chef, a company I found interesting.

Negative Free cash flow at Silver Chef

As many other value investors have, I have incorporated the concept of Free Cash flow into my investment process. A company which produces great earnings but no free cash flow is often a big red flag (see for instance the Globo Plc case)

So a first look at Silver Chef seems to indicate that they  have a big problem. Great earnings but negative free cash flows and increasingly so:

However, for a typical financial servives company with strong growth, this is not unusual. If you are in the business of renting out or leasing equipment to someone, you have to buy it first and get paid back later over time. This is why it is called “financing” and why free cashflows are only signifcantly positive if you are stable or shrinking.

Free Cashflow “Grenke style”

As I mentioned in the last post, Grenke so far has been my “Gold Standard” for Leasing companies, so let’s look how Free Cash flow looks like at Grenke:

I was actually flabbergasted (sorry, I always wanted to use this word at least once) when I saw those numbers. Grenke grows strongly but actually manages to produce Free Cash flows higher than earnings.

For a leasing company, this is actually an extraordinary achievement. So I decided to  look into Grenke’s 2015 annual report first.

This is the Cashflow statement and I circeled the interesting parts:

When I look into a balance sheet, I always do one very simple check: I look at how financial liabilities developed over the last year and check this against the financing cash flow.

In Grenke’s case we can read from the balance sheet, that financial liabilities have increased overall by around 400 mn EUR, however financing cashflow is only +13 mn. How can that be ?

The solution is found in the Operating cashflow part: Grenke actually reports the increase in borrowing as operating cash flow. Just out of interest I checked different leasing companies such as Sixt Leasing, Aercap and a few others and Grenke is the only one doing so.

What are the implications of this ?

The implidation of this is very easy: Grenke’s reported cashflows are absolutely meaningless. If you include borrowing into operating cashflow, you can create any free cash flow number you like just by borrowing some more money. This is not the meaning of Free Cash flow.

If you read the actual IFRS rules (IFRS 7 Cash flow), it is pretty clear that Grenke’s way of cash flow reporting is “unique”. Those are the relevant sections:

Operating activities are the principal revenue-producing activities of the entity and other activities that are not investing or financing activities. Cash flows from operating activities are primarily derived from the principalrevenue-producing activities of the entity.

and

Financing activities are activities thatresult in changes in the size and composition of the contributed equityand borrowings of the entity. The separate disclosure of cash flows arising from financing activities is important because it is useful in predicting claims on future cash flows by providers of capital to the entity.

I have double checked, Grenke is reporting in this way since 2000 (this was the oldest annual report available), so at least they do it consistently.

How would Grenke look with “normal” Cash Flow reporting ?

This is a quick restatement how Grenkes cashflow statement would look like if they would report as all the other leasing companies do:

Overall cash flow stays the same, but Free Cash per share flow changes daramatically from +6,6 EUJR per dhare to -20,0 EUR per share. And suddenly Grenke looks much more similar to Silver Chef.

Just for fun we can use Silver Chef’s stated CF statement and redo it “Grenke style”:

What a mircale, suddenly the negative free cash flow turns into a flat cashflow. Why is it not positive ? Is Grenke still better ? The answer is no, Grenke just borrowed more (around 100% of increase in leased assets) . Silver Chef actually funded most of their investment out of equity. Adjusted for that, Silver Chef is much more Cash generative than Grenke.

Summary: Does it matter if Grenke  is doing it “Grenke style” ?

For me what matters most is that if I compare Grenke to another leasing companies, one needs to be aware that Grenke’s cashflow should be either ignored or better restated in orther to get a clear picture and a good comparison.

I think however the example of Grenke leads two 2 very important lessons:

1. Don’t rely on stated cash flow numbers. Many investors look at cashflows as the “Truest form” of eanrings. But the Grenke example clearly shows that IFRS seems to allow some pretty significant “modifications” which might make those cashflow numbers almost meaningless. I am surprised that they actually got sign off on that.
2. As a Grenke investor I would ask myself: Why are they doing it ? I have no answer on that and I don’t plan to digg deeper into Grenke, but if any of my reader has better accounting knowledge, I would be interested why auditors sign of such a cashflow statement.

Just to be clear here: I am not saying that Grenke is doing something wrong here, I don’t know the IFRS rules good enough if this practice is allowed. All I am saying is that Grenke is reporting Cashflow differently than any competitor but in a way that makes the cashflow statement look better but completely meaningless.