Description

Summary: Grenke Leasing is a very high quality business with a strong moat run by a highly incentivized team with a large insider ownership. The business has grown rapidly in recent years and is positioned to continue to expand at high rates. Relative to its prospects, the stock trades at a discount and we expect it to continue to deliver solid financial performance.

 Business Description

 Founded by Mr. Wolfgang Grenke in Baden-Baden, Germany in 1978, Grenkeleasing AG is a specialist finance company focused on the small-ticket IT leasing segment for Small/Medium Enterprises (SMEs) customers. In addition to leasing, the company also offers other services such as factoring (purchase and monetization of receivables) and a business start-up financing / development loans for SMEs which has enabled it to develop strong and diverse ties with its customer base.

 The primary products that Grenke offers – IT, telecommunication and copying equipment – are part of a niche segment in the SME leasing market that account for approximately 5% of all leasing transactions. The composition of lease assets in the small ticket area has changed significantly over time. While in the past there were mostly products such as answering machines and mobile telephones, the company believes that today computers and peripheral units make up the largest portion of the small ticket market segment. Since IT acquisitions for all enterprises are of increasing importance, the rate and pace of replacement have grown materially, leading to significant growth potential in the small ticket IT leasing segment. This tendency is enhanced by the increasing use of leasing as a type of financing globally.

 Leases Distribution Channel

 The distribution of Grenke’s leasing products is handled through the following three channels:

 ·         Via independent IT retailers with whom Grenke has partnered;

·         Via IT manufacturers, with whom Grenke has umbrella cooperative agreements;

·         Via the internet, either through related e-commerce sites or directly through Grenke’s own direct sales site: www.weblease-europe.com

 Partnerships with IT retailers and Manufacturers:

 Through partnerships with thousands of dealers in around the world, Grenke has established a wide presence at point-of-sale locations. In the vast majority of cases, Grenke is the only leasing partner of the particular retailer. This partnership agreement is a win/win for both Grenke and the retailer: an end user is free to walk into the retailer, select any manufacturer and has the option (pending a successful application) to finance the IT equipment being purchased regardless of whether the manufacturer of the equipment offers a leasing option. The retailer benefits as he is likely more able to sell equipment if the ability to lease the goods is an option.

Grenke trains its dealer partners in the advantages of leasing as a sales financing tool and instructs them in how to explain the offering to the customer – thereby promoting a consistent message to end user customers throughout Europe and elsewhere. Grenke installs its proprietary software at the retailer’s location which allows applications to be processed and sent directly to the company for analysis. As Grenke is not affiliated with either a financial institution or an IT OEM, such partnerships are vital in order to gain access to end user clients. The partnerships with IT retailers are also of special importance to the company with regard to the development of new markets. Grenke’s partners, most of which are already positioned in these markets through pan-European branch networks, give the company immediate access to end users through the partners’ retail locations. Of the 14,000 IT retailers that are based in Germany, Grenke has partnerships with 7000+ of them and an independent survey that was conducted with these retailers showed that Grenke was considered the most important leasing partner to have by German independent IT retailers.

In addition, Grenke has formed partnerships with OEMs for goods that are sold in Europe. As an example, Grenke has an exclusive partnership with Hewlett Packard in Germany, Austria and Switzerland. HP products can be leased using the HP-Express service that Grenke provides. This type of arrangement is likely better suited to larger companies that purchase IT goods directly from the manufacturer and this partnership allows Grenke to participate in the purchase of goods outside the realm of retail sales.

The company is also a preferred financing partner for Microsoft in Germany and its only partner in Austria. Customers have the ability to use the Microsoft Open License Leasing option which allows the lease of software by a company. A technological upgrade provided for in the contract allows end user clients to switch to the most recent software version at constant leasing installments.

 Internet Applications

End user customers can also directly apply to Grenke for product leasing through the internet. Weblease-europe.com, the company’s proprietary internet site, handles application requests either directly from a particular lessee or via leasing modules of IT retailer websites such as Bechtle Direkt, Nemetschek, Inmac and Atrada. Applications are processed in exactly the same way as if they were received through a specialty IT retailer, but the costs of winning new business derived through weblease-europe.com are smaller as Grenke is able to avoid consulting and other services that it provides to retailers and which are amortized over contracts generated by retailers. Although new business generated through web still represents a relatively small share for Grenke, it has demonstrated high growth and generates better margins than the traditional avenue of independent IT retailers.

The Transaction Process and Product Offerings

By far the most common channel through which Grenke generates new business is an independent IT dealer with whom the company has a partnership agreement. Although Grenke rewards dealers through up-front commission payments, retailers are actively discouraged from inadequately assessing the creditworthiness of potential leasing clients by the higher refusal rate Grenke imposes on leasing applications submitted by retailers with an unsatisfactory portfolio performance record.

When a potential customer opts to purchase let’s say €20,000 worth of IT equipment from a retailer (notebooks, servers, PCs, etc.) a Grenke-affiliated retailer offers the possibility of leasing the equipment as an alternative to a cash purchase. Within certain bandwiths, the customer is free to choose the length of the lease, although the average lease currently runs for just shy of four years (45 months).

If the customer chooses the leasing option (allowing him much greater financial flexibility – a very attractive option for most SMEs), the retailer will ask for certain credit-related information and feed it into the Grenke-Online software, which has been installed by Grenke. This information is sent directly to the nearby Grenke branch via the web and an answer to the customer’s application is given within 20 minutes. Grenke has built a proprietary risk monitoring algorithm which is based on data gleaned over 32 years in business and this algorithm forms the basis of the decision as to accept or decline the application.

Proprietary Credit Monitoring System

In 1994, Grenke introduced a proprietary, automated scoring model for credit checks based on empirical knowledge gleaned from a database of all the contracts that it has entered into. The primary purpose of this model is to keep the default rate of contracts to as low a level as possible. An efficient credit risk assessment is very important for the large volume business in the small ticket leasing industry, as a large number of applications have to be reviewed and settled at a low cost and within a short time.

During a potential lessee’s application, a number of questions are asked about the business that will lease the equipment and the proprietor of the business as well. Factors that are considered are the candidate’s credit standing, the industry that the lessee’s business operates in, the age of the business, commercial register information, credit card details and a number of other data points that Grenke believes indicate the potential of possible default. This information is entered into the Grenke-Online software and is processed using a two stage examination:

·         First, a fully automated preliminary analysis is carried out within a few seconds of receiving the information. Grenke’s scoring model processes the candidate’s information using proprietary algorithms, and generates a positive or negative answer almost instantaneously.

·         If a positive result has been generated, the model then checks the accuracy of the data provided by the applicant against data provided by credit monitoring agencies.

If the preliminary result is positive and if the data provided is proved accurate, Grenke approves the customer’s application. If accepted, the contract is printed out at the dealership and is sent to Grenke, who in turn pays the retailer in full within 24 hours.

The proprietary credit check that Grenke uses has two clear advantages. Firstly, it allows the customer to have an answer quickly and relatively unobtrusively. A lengthy, cumbersome process would potentially deter many customers, even those with good credit standing. But most importantly, Grenke’s system has led to a very low default rate for the company. This ratio has averaged at 1.7% over the long-term (claims settlement / volume of leased assets) which is rather low. The ratio rose to 1.85% during the recent financial crisis.

This is a testament to Grenke’s risk controls that during the worst credit crisis of recent history, the company has managed to ensure that only qualified customers with sustainable businesses are granted leases. In addition, the advantage of small ticket leasing is that the large number of contracts enables Grenke to diversify against defaults and this strategy should help keep the default rate low.

Compelling Value to End Customer

Grenke’s product offerings represent compelling value for the end client. Due to the fast processing of leasing applications, the company enables its clients to realize their investment decision in the short term without assuming any ownership risks. By way of a flexible lease financing the client is able to keep up with the short life cycles of IT products and to exchange them for other or newer products even before the expiration of the lease term. In addition, Grenke offers the inclusion of the leased products in a general insurance contract at favorable terms so that the client saves himself the expense of taking out separate insurance (a mandatory requirement).

Contrary to the leasing of more expensive capital goods, the efficient settlement of contracts on a large-scale basis in the small ticket area is a central key to success, as the costs for the initiation, execution and current management of a contract are largely independent of the financing volume. A profitable leasing business in the small ticket area is only made possible by optimization of the cost structure. Grenke has optimized the processing of contract applications through the utilization of standard products, automated procedures and the centralization of contract settlement in Baden-Baden so that contract-related costs have continuously been reduced over the years.

·         The limitation to full-amortization leasing contracts excluding any residual value and to partial-amortization contracts where the residual value risk remains with the lessee;

·         The exclusion of warranty risks through the assignment of warranty claims against the vendor to the lessee;

·         The mandatory contracting of property insurance;

·         The reduction of refinancing risks through cooperation with various refinancing partners, the contracting of refinancing transactions with matching maturities as well as interest-rate caps;

·         The independence of individual IT manufacturers and IT retailers as well as end clients through cooperation with a variety of distribution partners and a diversified contract portfolio; and

Significant Domestic and International Growth

Since its formation, Grenke has amassed a leading market share in Germany and other German-speaking countries such as Switzerland and Austria, and has also expanded aggressively into other international market. Today, the company derives over 70% of its business internationally with operations all throughout Europe but also North America, South America and Asia. In addition to organic growth opportunities, the company has also created a franchise model which allows it to grow in new markets with a lower upfront cost structure while maintaining the entrepreneurial culture that has been so instrumental to its successful growth to date.

Grenke’s lean cost structure and proprietary credit monitoring tool have enabled the company to effectively compete against a myriad of competitors and have proved to be vital in small ticket leasing. As is described below, these two items have created an economic moat around its business and have allowed the company to price new business at a level which effectively makes it uneconomical for many other competitors; this would not be the case if the company focused on larger ticket items.

As of year-end 2014, Grenke had a lease portfolio that included 427,212 current contracts with customers, covering €3.5bn of leased equipment (€8,163 average contract value), with an average contract length of 45 months. As an independent player, its business model combines the advantages of leasing with an intelligent and efficient distribution and administrative organization.

Despite already having a large market share in its home markets, the company’s main markets still offer growth potential as the concept of leasing continues to be culturally more accepted. However, the company has developed an intriguing franchise model for entering new geographic markets: the company spends €125,000 in IT equipment and training so that a franchise partner can interface with Grenke’s main support system. If the franchisee’s business develops well over the next 4-6 years, Grenke has a pre-arranged call option to buy that franchise business at a pre-specified earnings multiple.

Grenke enters into franchise agreements with experienced local partners as a means of testing new markets without having to make up-front investment or carry the risk of establishing a new subsidiary without the benefit of local knowledge and experience. Grenke supplies its franchise partner with the Grenke brand, IT infrastructure, administrative and processing backbone, centralized financial controlling and its proprietary credit scoring system. In return, Grenke receives a flat fee (believed to be €100 per new contract) originated by the franchise.

Funding Sources

In addition to the company’s use of banking revolvers, bond issues and Asset Backed Securities to help finance its lease portfolio, the company recently acquired a small Hamburg-based private bank and renamed it GRENKEBANK. This ingenious acquisition allows the company to use the bank’s deposit base to help finance the lease portfolio, thus lowering its dependency on external capital markets. 

There is one other attractive element to the business model that is a direct result of the recent credit crisis: as large state owned banks received government support, they have been forced to increase their capital requirements. As leasing involves the use of equity, many of these capital constrained competitors have been forced to retrench. This has provided Grenke the opportunity to grow in markets that were previously thought of as mature markets.

Other Business Segments

The company has used its strong IT leasing positioning within the SME market to expand into adjacent businesses, namely factoring (the purchase and monetization of SME receivables) as well start-up business financing and development loans. The company’s robust credit-scoring system has been the basis for growth into these areas. By offering financing options as well as IT leasing services to SMEs around the world, Grenke has been able to become deeply entrenched into the SME community by developing relationships from the very start of a young company’s existence.

Economic Moats

Grenke is one of few companies that truly benefits from significant barriers to entry that help protect its position within the growing market of small ticket leasing. Therefore it is not surprising that the company has historically generated consistently high ROEs:

We have identified the following barriers to entry:

·         An extremely lean cost structure: The company’s standardized approach to assessing, executing and maintaining its vast portfolio of small ticket leases has been key to its financial success to date. Many of its potential competitors are simply not able to compete in the niche area of small ticket leasing as they do not have the same cost structure to profitably manage a book of leases when the average ticket size is €8,100. The standardization that Grenke employs today is the result of being focused on one specific niche of leasing for 30+ years and it would be extremely hard for a competitor new to this business to replicate this.

·         Proprietary credit scoring model: Beginning in 1994, Grenke developed an in-house IT based credit monitoring system which it uses to estimate the likelihood of an applicant’s chance of default over the life of a lease. Numerous factors about the corporate applicant – such as age of business, personal credit statistics, type of industry – are fed into the database and Grenke uses this information to accept or deny a lease application. This information can be processed in less than ten minutes. As a result of this information, default rates for Grenke are materially lower compared to a range of other competitors, including traditional bank lenders.

·         Significant investment in IT infrastructure: Over the past 32 years, Grenke has invested meaningful amounts of capital into developing a multi-national IT infrastructure that allows the company to instantly review a lease application in 20 geographic markets, monitor its portfolio of over 420,000 current leases and examine the day to day operations of its franchise partners. In addition, this IT infrastructure has enabled the company to use the aforementioned standardized approach to its business model that provides the low cost base.

·         Large network of independent retailers: Over the course of the company’s history, the company has built a network of over 15,000 independent retailers of IT equipment – effectively the company’s main sales channel. Grenke installs its terminals into these retailers and instructs the retailers’ employees on how to market leasing as a source of financing and on the application process. Due to Grenke’s clever product offerings, retailers are incentivized to persuade customers to use Grenke’s leases, in addition to the fact that the leasing of equipment is usually a more palatable decision than an outright cash purchase or a cumbersome 3 week application for bank financing. As these retailers do not compete in the leasing space, there is generally no need to replace Grenke with a competing leasing provider as there is no upside for the retailer so long as Grenke can fulfill its obligation of granting a speedy decision and paying for the goods in full within 24 hours and sometimes on the same day.

·         Ample access to various refinancing markets: Unlike many of Grenke’s competitors who are independent in nature and are therefore flexible and nimble enough to compete in small ticket leasing, Grenke has the critical mass to gain continued access to a wide variety of refinancing channels through which it finances its leasing portfolio. In fact, the company accessed the Asset Backed Securities market and the bond market during a few instances in 2008 and 2009 – a time during which many far larger companies could not refinance. This shows that the fixed income markets view Grenke’s business model in a very positive light and its cost of financing (as measured by a spread of its average interest expense over benchmark European fixed income indices) has come down in recent years.

We believe that the combination of the aforementioned points allows Grenke a strong competitive advantage in its chosen niche of small ticket IT equipment leasing and should help the company enjoy consistently high ROEs over time.

The Management Team

Grenke is managed by a very strong five-man senior management team who have been with the company for many years. The company is led by founder and largest shareholder, Wolfgang Grenke, who founded the company in 1978 as a small proprietorship in Baden-Baden, Germany. Together, the management team currently own 42% of the company, implying that their interests are totally aligned with those of other shareholders. Mr. Grenke and his management team have dominated small ticket IT leasing in Germany and other parts of Europe for a number of decades now and have invented many aspects of the business that have led to the significant wealth creation that they have enjoyed.

It is clear after seeing their risk-averse attitude to growth during the recent financial crisis, that this management is indeed playing with ‘its own money’ and this should continue to sit well with other shareholders who invest with them over the long term. In short, this is a very sound, highly experienced management team who know their business and the industry in which it operates extremely well and whose economic interests are totally aligned with those of other shareholders.

Sound Financial Posture

Standard measures of leverage are not valid when trying to measure the inherent risks within the company’s business model (the company needs to employ significant refinancing leverage to finance its book of business) as is the case with most finance conduits.

However, upon close examination of the company’s accounts, as well as detailed conversations with the management, this company’s financial posture appears very sound due to:

·         A matched duration profile between its lease portfolio and its refinancing book

·         A relatively smooth debt maturity schedule

·         Ample current untapped debt capacity on hand to help fund growth over the medium term

·         Access to numerous low-cost sources of refinancing, including a wholly-owned retail bank

·         A current S&P credit rating of BBB+ 

·         One of the lowest default rates for any lender in Europe

·         A long history of careful and profitable use of derivatives to protect against volatility in European credit markets

Risk Factors:

 ·         Counterparty risk / SME Default rates

·         Lending risk

·         Financing / Interest rate risks

·         FX Risks

 Valuation

 The Company’s generates revenues through the net interest margin on its existing book of business and through new business growth (adding new leasing contact to its portfolio) as well as from its factoring and financing business. Over the last decade, with some minor exceptions mostly during the financial crisis, the new book of business has expanded at mid-to-high teens rates. Given the focus on low costs and the interest margin expansion the company has experienced from its low-cost bank deposit base, EPS have grown substantially in recent years. They have increasing 150% in the last five years. Recent growth has been particularly strong at 20-25+% CAGRs. Given the solid moat, combined with strong trends in the business and its rapid international expansion we believe that this growth is sustainable. Relative to its growth prospects, the stock trades at a discount, currently priced at 18x 2016 EPS. We believe it should trade at 20x+, which should lead to 20-25% appreciation over the coming year. Grenke is a very high quality business that trades at a reasonable valuation and we expect that it will continue to deliver 20-25% annual stock performance based on the continuous superior execution by the well-incentivized management team. 

Catalyst

International Expansion

Growth of new Business segment

Economic recovery in Europe