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To say that Denmark’s DFDS is lean and mean would be an understatement. As a sea and land transport services provider with a market cap of €2.3bn, it is a crown jewel in the logistics and transport arena.

Founded in 1866, it now operates one of the largest integrated shipping networks in Northern Europe, managing ro-ro liner traffic and passenger shipping on overnight routes.

Inbound and outbound UK flows have been critical to its success since its inception – but will Brexit eventually spoil its plans and those of its shareholders?

As a historical footnote, it is interesting that its narrative has been entwined with compatriot company DSV, which bought its haulage operations at the turn of the century. The deal marked DSV’s transformation into a major road transport provider and announced its arrival as a canny M&A operator, and DFDS saw consolidating itself as a pure play shipping firm.

DFDS's network

DFDS’s network

Let’s look at the risks it might face.

From opportunity to risk

The table below shows its main performance drivers for 2016, which will also be key success factors next year.

Performance drivers

Performance drivers

However, following the UK “Leave” vote, opportunities could turn into threats in 2017 – heavy investment has steadily risen since 2013, while a few other risks highlighted in the chart above will likely become harder to model.

“Recessionary forces in the UK may force us to reconsider our exposure to DFDS,” a London-based fund manager who has been successfully invested in the company since 2014 told me last week.

“It’s not going to happen anytime soon, though, so we are fairly relaxed about the downside risk.”

While the shares look fairly priced, based on multiples for net earnings and cash flows, I wonder whether my source has overlooked the disconnection between DSDF’s share price and its dividend yield, which indicates that the stock – currently trading some 10% below a record high of Dkr333.4 – could be overvalued by as much as 30%, following a rally that has seen its share price grow 194% over the past two years.

Of course, much depends on how DFDS would cope with the downturn in the UK and the domino effect across Northern Europe, which is truly unpredictable – but its financials offer a clear indication of what might be next if the company had to do business in a recessionary environment.

In short, will the axe fall on employees or investment?

Investment

Salaries and wages are steady at group level, but by the end of 2015 DFDS had installed 17 scrubbers in response to European ship emissions regulations, relying on a corporate strategy focused on new heavy investment, which has paid off in recent years, testified by surging returns on invested capital and healthy cash flows.

Net investments last year totalled Dkr571m, with “Dkr423m related to ships comprising scrubber installations, dockings and upgrades”. It also booked DKr108m from the sale of a freight vessel, while the remaining net investments of Dkr256m was primarily associated to cargo equipment, terminals and IT system development.

As the chart below shows, rising investment is made possible by a sound capital structure, and free cash flow hovering around five-year highs in 2015.

 

Capital structure

Capital structure

Free cash flows

Free cash flows

Unsurprisingly, Ebitda is on its way up, spurred by investment, while profitability received a boost, too, as the charts below indicate. These trends were broadly confirmed at the end of the first quarter, and the group now expects to generate record Ebitda this year.

EBITDA

EBITDA

Units margins

Units margins

People and ships

People and ships

DFDS said in its annual results that investment would amount to Dkr1.6bn in 2016, including “Dkr900m related to the delivery of two Channel ferries in February 2016 on finance leases.”

(Full details can be found at page 16 of its annual report.)

In the wake of the “Leave” decision, chief executive Niels Smedegaard was quoted as saying that he didn’t forecast any notable effects from Brexit this year, and even though “it would have been better for us if the UK remains in the EU and the single market … we shall regard the UK’s forthcoming exit as a change of conditions which we will adapt to.”

But 2017 might be different.

Brexit

Firstly, a few thoughts on Brexit. There is going to be a significant time lag before the full impact on the transport and logistics is felt – the crisis crippling the country’s political class has given the country more time to assess its options and Article 50 will not be triggered for some time, regardless of when negotiations with the EU start.

However, prolonged sterling weakness is very likely, at least according to my sources, with many arguing that parity for the £:$ and £:€ exchange rates could be on the cards.

I am less bearish on the pound, notwithstanding that the Bank of England has little choice but to entertain more quantitative easing, as it emerged last week. Still, less stringent capital requirements for banks – a possible positive element stemming from Brexit – could boost domestic growth and, in turn, the domestic currency.

Royal Bank Canada told clients on Thursday that real GDP in the UK was now forecast to contract 0.1% quarter-on-quarter in Q3 as the “the shock to confidence hits business spending”. The bank now forecasts a growth rate of 1.4% for 2016, down from 1.8% previously, yet the revision of GDP figures was more significant for 2017, with “”no growth at all in 2017, down from 2.1% previously” – God knows how bad it could get in 2018 and beyond.

Room for manoeuvre

So, DFDS might have to adjust the level of required investment to cope with a slump in passengers and freight volumes, but the good news is it has room for manoeuvre.

If the business was badly hurt in future, it could swiftly cut buybacks (Dkr400m, or €53.7m in 2015, up 36% year-on-year), tweak down the dividend (Dkr325m, or €53.5m, up 87% in 2015), or cancel both if signs emerge of a cycle turning south. Combined, dividends and buybacks represented 66% of its annual Dkr1.1bn Ebit in the past year, and 72.6% of annual net earnings.

Those in the bear camp insist that a recession in the UK is virtually inevitable, with the core services sector likely to be hit hardest. I have a rather different view on the outcome, but bears and bulls should agree DFDS might have to face a few challenges at a time when its financial performance has never been stronger.

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