Beneath Silver Chef's polish

Beneath Silver Chef’s polish

Not all earnings growth are created equal. In itself, earnings growth can be either accretive or dilutive to value.

Achieving earnings growth is actually quite simple once you have a viable business model. As long as your return on capital is greater than your cost of capital, you can simply deploy more capital and earnings growth will ensue. This is particularly pertinent in a low rates environment. However, while your earnings trajectory is definitely upwards, the underlying quality of your earnings may in fact be deteriorating as your return on capital start to decline.

This appears to be the challenge facing Silver Chef after 10 years of phenomenal growth as a listed company.

Over the past 5 years, Silver Chef has consistently grown its headline earnings while maintaining its Return on Equity at around 20% – on the surface a very attractive investment:

Source: Silver Chef financial statements.

Source: Silver Chef financial statements.

However, its Return on Capital Employed is actually in steady decline:

Source: Silver Chef financial statements.

So how has Silver Chef been able to maintain Return on Equity at c.20%? Through leverage of course:

Source: Silver Chef financials.

Source: Silver Chef financial statements.

Turning our attention to cashflow, Silver Chef has historically been cashflow negative due to its rapid growth which necessitates an accompanying expansion in its asset base. It has undertaken frequent capital raisings as a result.

The fact that Silver Chef requires capital to grow is not a bad thing in itself. However let’s look at the effectiveness of each incremental dollar of capital deployed:

Source: Silver Chef financial statements. Defined as incremental operating cashflow divided by incremental capital employed.

Source: Silver Chef financial statements. Incremental operating cashflow divided by incremental capital employed.

And then let’s take a look at the operating cashflow generated as a percentage of rental equipment deployed:

Source: Silver Chef financial statements. Net cash from operating activities divided by average property, plant and equipments for the year.

Source: Silver Chef financial statements. Denotes Operating cashflow divided by average property, plant and equipments for the year.

Silver Chef is evidently a different business today to what it was between FY2012 and FY2014, despite superficially similar levels of earnings growth and returns on equity.

So what’s really going on underneath the polish?

A tale of two moats (or not)

Silver Chef’s hospitality business is a fantastic niche financing business offering a compelling value proposition for its customers while at the same time being extremely profitable for itself. This is where you want to be as a business.

At the core, Silver Chef is a lender that obtains funding from the markets (i.e. debt and equity) and lends it out to SMEs with the financed equipment as collateral.

The key here is that due to its narrow and deep niche focus in the hospitality sector, it has an extremely well-honed refurb and resell operation to deal with hospitality equipment returned by customers:

Source: Silver Chef presentations.

Source: Silver Chef presentations.

Consequently, the same collateral is worth a lot more in Silver Chef’s hands than it is in the hands of a non-specialised financier. This competitive advantage is the foundation of Silver Chef’s moat in the hospitality equipment financing sector.

However, its GoGetta business, which has sought to transpose the successful Silver Chef model to cater for commercial equipment financing generally (i.e. anything that is not hospitality, with a focus on the construction and transport verticals in recent years), is a completely different beast altogether being a relatively small player in a much larger market with no such competitive advantage:

Source: Silver Chef presentations.

Source: Silver Chef presentations.

Their respective Return on Assets tell completely different stories – with Return on Assets for GoGetta having essentially halved over the past 4 years:

Source: Silver Chef financial statements.

Source: Silver Chef financial statements.

Note that the numerators used in the chart above are exclusive of (1) group overhead costs (totalling $21.6m in FY2016); and (2) the $8.6m “free kick” from a change in accounting policy during FY2016 (detailed below, mostly relating to GoGetta). Once taken into account, the downward trend line between FY2015 and FY2016 would be significantly steeper.

The problem for Silver Chef investors is that GoGetta is growing much faster than its core hospitality business. As at the end of FY2016, GoGetta has grown to comprise roughly 50% of Silver Chef’s overall asset base:

Source: Silver Chef financial statements.

Source: Silver Chef financial statements.

Silver Chef’s management team are obviously aware of the problems within GoGetta and have undertook to “revert to a more sustainable growth rate”.

Pulling the accounting policy lever

Origination costs (i.e. dealer commissions) have spiked materially over the past year:

Source: Silver Chef FY2016 results presentation.

Source: Silver Chef FY2016 results presentation.

The “accounting policy change” lever was then pulled by the company.

Beginning in FY2016, Silver Chef modified its accounting policy from fully expensing its origination costs to capitalising it over the 12 months of a typical contract. The FY2016 impact of this change is as follows:

Source: Silver Chef financial statements.

Source: Silver Chef financial statements.

So Silver Chef effectively deferred $12.3m of its origination costs to the next year, getting a “free-kick” to its P&L that will persist indefinitely as long as Silver Chef keeps growing. To be fair, capitalisation of origination expenses is not wrong and is sometimes more sensible, but the issue is how Silver Chef has presented this to investors:

Source: Silver Chef FY2016 results announcement.

Source: Silver Chef FY2016 results announcement.

What Silver Chef is effectively saying here is that had the new cost deferral policy been in place all along, then Silver Chef’s FY2016 NPAT would be reduced by $3.7m (representing FY2015 origination costs that would have been amortised during FY2016).

However, the truth is that the cost deferral policy had not been in place all along. Simply, had the cost deferral policy change not taken place at all, Silver Chef’s FY2016 NPAT would have been reduced by $8.6m.

So despite Revenue and rental assets having increased by 29% and 53% respectively on a like-for-like basis, Silver Chef’s NPAT actually went backwards on a like-for-like basis.

Silver Chef’s recent trading update

And it is in this context we should view the November 2016 trading update where Silver Chef downgraded its earnings guidance due to a “material fraud event” with an estimated impact of $2.3m to Silver Chef’s FY2017 NPAT.

We should note that even exclusive of the “material fraud event”, Silver Chef is forecasting an underlying NPAT range for 1H FY2017 that is materially lower than the previous year, despite having presumably significantly more rental assets at work on its balance sheet:

Source: Silver Chef ASX announcements.

Source: Silver Chef ASX announcements.

And here are my issues with categorising the fraud event as a “one-off”. Firstly, is this indeed a single “event” given it has been described as “complex” and “across a number of low dollar value contracts“?

Secondly, if you’ve been the beneficiary of extraordinary loan book growth achieved on the basis that you “look for reasons to say ‘yes’!” and your customer proposition is that you are “more accommodating than other lenders” as follows:

Source: Silver Chef customer collateral.

Source: Silver Chef customer collateral.

Then shouldn’t risk management around fraud events be one of your core competencies as a lender?

Should this fraud event then be viewed less as an extraordinary event to be “normalised” out of our analysis, but more as a potential canary in the GoGetta mine to factor into our analysis?

Note: The above blog post constitutes the author’s personal views only and is not to be construed as investment advice in any shape or form. Being obviously passionate about the art of investing, the author may from time to time hold positions in the aforementioned stocks consistent with the views and opinions expressed in this blog post. Disclosure – I hold a short position in SIV at the time of publishing this article.