Grenke fOllow up: Recap & Fundamentals (and why Grenke is actually a stealth insurance broker)
Disclaimer: This is not investment advice. Please do your own research and never believe anything from anonymous bloggers !!!!
A first a quick quick recap on what happened since the last post.
Friday’s written statement from Grenke pre press/analyst was actually pretty lame. I think they made clear that the money laundering and Ponzi issue were indeed minor issues but they didn’t shed any more light on the whole CTP issue.
Unfortunately I missed the press/analyst call. From what I have heard there was nothing new.
A quite surprising statement from Grenke on Monday was more substantial. All past M&A transaction with Franchises will be checked by an independent auditor, Grenke AG will have the option to buy the existing non-consolidated franchises and Wolfgan Grenke will (temporarily) step down from the Supervisory Board. It is also mentioned, that in the future, Grenke AG will fund new franchises.
The only issue that is still open is who were the old owners of Sacoma/CTP. Viceroy released a short notice to put the finger into this wound, but somehow mixing up various entities that have a “CTP” in their name.
Overall I do think that Grenke has some fundamental issues (more on that later) but I do not see any more evidence that within Grenke AG there is a high risk of substantial fraudulent activity.
Why I bought the bonds and not the shares
As mentioned in the comments in the previous post, I have bought a “full” (i.e. 6% portfolio weight) position in Grenke unsecured bonds at an average price in the low 60s. The reason why I bought the bonds is relatively easy: Relatively to the stock, bonds were a lot cheaper in my opinion and as a bond investor I have to only answer the question: Will Grenke go bust or survive.
Relative valuation: Yes, the stock lost almost 2/3 from the beginning of the year but still trades above book value and at around 12x 2019 earnings. This is still not cheap, as 2020 and maybe 2021 will be potentially ugly years, but more on that later.
However for a senior bond to lose a single cent on the Euro, the equity and the hybrids would need to be totally wiped out. When senior bonds trade at levels of like 60% or so, normally the company should be in real actual distress, i.e. having problems in rolling debt etc. At Grenke this is currently not the case. As the allegations are targeting more Wolfgang Grenke’s personal dealings, my assumption still is that within Grenke AG, things are mostly Ok.
Of course even a bond investor should look at fundamentals which will come later in the post. In my practical experience, bond managers rarely even bother to read a bond prospectus and even less look at fundamentals of the company. Bonds are bought based on ratings and spreads. So I guess a lot of bond investors decided to sell first and ask questions later as they didn’t want to be caught up in the “next Wirecard”.
As always, there is of course a certain risk that this really turns bad, but at the low 60 for me the risk/return was attractive, especially with the current low yield environment. However I do not expect a smooth ride all the way up to 100%.
A quick look at fundamentals: Impairments and non-performing assets
Grenke is at the end of the day a subprime small ticket SMB (Small/Medium Business) lender. Especially in the last 18 months or so, Grenke seems to have grown especially strong in “Southern Europe” with Italy being the biggest market. In the 2019 report they mention that the overall share of Southern Europe has increased to 30.7%.
Grenke unfortunately only drills down the sectors into Industrial (25%), Service (75%) and agricultural (<1%). Now here comes the fundamental issue for me:
The Covid-19 crisis has affected different sectors very differently. Some sectors have even benefited whereas other sectors are almost wiped out, especially the hospitality sector. In the SMB lending business, this time it is not about single address risk but exposure against the most effected sectors. However as an outsider, one doesn’t have a chance to see for instance how exposed Grenke is towards the hospitality sector (hotels, restaurants etc.) or other equally hit sectors such as small inner city retail, gyms etc.
What one can do as an outsider is to look how conservatively they create “reserves” by booking impairments. These are numbers that I have extracted from the annual reports and from the last half year report:
|Total lease assets||3966||4696||5646||5675|
|Level 2 non-perf.||106.7||256||381||489|
|Level 3 non-perf.||264.3||382||461||620|
|Total level 2&3||371||638||842||1109|
|reserve in % of non-performing||62%||44%||43%||39%|
|reserve % of level 3||87%||73%||79%||70%|
|Assets in arrears in % of total||9.35%||13.59%||14.91%||19.54%|
|Impairment in % of total||5.82%||5.94%||6.43%||7.70%|
What we can see is that problematic assets increased significantly from 2017 to 6M 2020 in total from 9,35% to 19.54% of total lease assets. However the impairment reserve rose slower. The coverage ratio both for total and for the really critical assets declined. Unfortunately I didn’t find comparable early numbers but it looks like Grenke has lowered the level of reserves against credit losses, despite the fact that the severity might be a lot higher now. If Grenke would have reserved on the 2018 and 2019 levels, they would have shown a loss or maximum break even.
So impairments are an issue and I expect that Viceroy will come out with a “hit piece” within a few days/weeks as Perring mentioned this topic in the podcast I had linked to earlier.
I do not think that this is an existential threat, however it could potentially drive a necessary capital increase at pretty dilutive terms if the worst case happens and defaults strongly increase in the next 6-18 months.
There are is one line item in Grenke’s P&L that is not self explaining: “Profit from the Service business”. As we can see in the following table, this line item drives the profitability of Grenke:
|Profit from service business||70.6||85.6||101.7||56.5|
|in % of EBIT||52.06%||54.11%||58.35%||109.71%|
What is it ?
Looking into note 4.4. in the annual report reveals, among less important stuff, an extraordinary profitable “side” business: 109 mn EUR revenue in “service and protection” business require only 8 mn of corresponding costs, resulting in an EBIT margin of 93%.
The question is: What kind of “service” does create such margins ? Grenke is not very transparent (as always) but this is my interpretation: Grenke only finances the lease if the asset is insured (see Grenke FAQ). As a special service, it brokers the insurance and what they show is actually commission income. I have no information on this, but my assumption is that this is very low claim insurance and that the majority of the premium is kept by Grenke as commission. It would be interesting to know what percentage of the premium is attributed to commission and what percentage ultimately results in claim payments. My feeling is that claim percentage is ultra low.
As we can see, The share of this line item grows consistently from 52% of EBIT in 2017 to more than 100% in the first 6M of 2020. One could of course divide this number by the operating profit or any other line but my argument is as follows: As the report it, the only costs that would disappear if they abandon this business would be the 8 mn allocated.
Above I had said that Grenke is actually a subprime lender but I have to correct myself: it rather looks like that Grenke is a stealth insurance broker that uses the leases only as a sales tools for insurance. This is not a crime and companies like Easyjet work the very same way (they earn more on a sold flight cancellation insurance than on the ticket), but I am not a 100% sure that the clients realize just HOW MUCH Grenke makes on the mandatory insurance.
In my experience, these kind of “add-ons”, especially if they are mandatory, are often not sustainable over long periods of time. There is the famous example of the PPI mortgage insurance in the UK which at the time being has cost UK banks 50 bn GBP in fines so far.
Yes, Grenke’s clients are not private customers but (very) small businesses which enjoy much less protection. But I think following Covid-19, there is some risk that maybe courts and law makers become a little bit more protective on small business owners. This has happened for instance in business interruption insurance where claims had to be paid by insurers that normally would not have been covered due to public pressure.
I also wonder who actually has the legal role of an insurance broker here. In many jurisdictions an insurance broker has some responsibility of making sure that the client gets the best coverage available but I am not sure if this applies here as well, i.e. if the clients have actually the opportunity to look for cheaper insurance (note to myself: Business opportunity ??). I would be highly interested if someone actually knows how this insurance sales process works in practice (disclosures, flow etc.).
I also expect that Perring might come up with a piece on this subject at due time.
So far I still feel relatively comfortable as a senior bond holder, but I do think that Grenke has at least two serious fundamental issues:
- It is unclear how much they will be impacted by the coming wave of SMB defaults and if their more aggressive reserving is enough
- A significant part of the profit seem to come from “sneaking” in low value insurance policies, which at some point in time could turn out as unsustainable or even worse
For me, at this stage it is just too hard to get a grip on the valuation of the equity. I do not know enough about the company and have no strong opinions how Covid-19 will play out in 2021.
But even as a bond holder, this is a high maintenance position and I expect that this could be a wild ride.
I will need monitor the situation closely, especially how the non-performing asset situation develops. If I have learned one thing form Silver Chef, then it’s that asset quality and conservative impairments are really key for a strongly growing subprime leasing business.