Analysis: K+N needs to find some courage and a new corporate plan
Six months ago, I predicted value destruction was on its way for Kuehne + Nagel, ...
“Expeditors has long believed that it is a competitive advantage to focus on organic growth and to utilise an enterprise technology platform designed and built by logistics technology professionals for logistics professionals.” (Expeditors, 2018 annual report)
After Denmark’s DSV reported another set of outstanding results last month and Switzerland’s Kuehne +Nagel, unsurprisingly in my view, disappointed the market last week, Expeditors recently showed the industry where its strengths and weaknesses lie.
It is pretty tough out there for most firms, but judging by Expeditors’ operational standards and share price levels, there is a lot to like in the way it has protected its business model. Many risks could have harmed its organic, growth-driven performance over the past few years, but they didn’t; operating risks and exogenous shocks have been properly managed, while organic growth is the secret sauce – so investors should be happy, right?
One caveat is that while capital gains have far outperformed earnings per share appreciation and total shareholder returns, including dividends, have been outstanding, there remains hard evidence that Expeditors is struggling to outperform financial benchmarks on a relative basis.
This is not unusual, given its intrinsic defensive characteristics at mid/late cycle – which is where we are now, and Expeditors is penalised due to a lowly beta of 0.6 – but its relative performance leaves plenty of room to speculate about what could be next.
Firstly, it actually doesn’t need to be a public company because it doesn’t exploit the full benefits (funding alternatives) offered by capital markets.
Secondly, cautiousness in capital deployment is common to many asset-light businesses, but to my mind this is a little crazy and reinforces the view that Expeditors is by far the best takeover target in the freight forwarding industry, particularly now following a year during which it reported record net revenue and net earnings of $2.3bn and $489m, respectively.
Admittedly, it would be an ambitious target, yet as “a perfectly oiled machine”, as one deal-maker in New York described it, it would only need to attract the investment required for a change of ownership and in four years would likely generate awesome returns to its owners – without having to do much work.
While market rumours and my banking sources continue to indicate that XPO Logistics (market cap $11.8bn) could be the next takeover target in the T&L industry, Expeditors (market cap $11.1bn) is much more attractive, as far capital arbitrage (swapping debt with equity in the capital structure) is concerned. Also, it has a free float close to 100%, and a net cash position that screams for more leverage.
Core margins are typically thin in the industry, but its operating profitability is best-in-class, at about 10%. This is significantly higher than DSV’s, which is 300 basis points or so lower, and double K+N’s, while Panalpina’s is a lowly 2%.
While it is true that Apollo’s ownership of CEVA Logistics has at times been painful to watch over the past decade, Expeditors is not CEVA – it is much better run than the latter has been historically – and anyway, it seems likely that the private equity owners of CEVA will float it at a decent price this year, regardless of all the restructurings and debt problems that have hindered its performance.
How could it work
A management buyout (MBO ) of Expeditors led by existing executives and backed by a financial sponsor should command a lower amount of debt than the typical 75% as a percentage of the total purchase price by private equity – say 50% of debt in the debt-equity funding mix to finance a $15bn takeover, for an implied 36% premium. After all, Expeditors has plenty of free cash flow to play with.
Assuming it cuts buybacks and dividends to zero for the first few years under new ownership, Expeditors could churn out almost $1bn of free cash flow, once new interest expenses are considered, which means that half of the $8bn of debt supporting the take-private deal could easily be repaid by year four (assuming EBITDA grows in line with prior years’ growth rates), yielding an internal rate of return not far off 20% annually. It could be higher, though, based on my calculations.
By early 2022, Expeditors would carry net leverage of between 3x and 4x, and that is when its owners could comfortably look for an exit. By comparison, that range is broadly in line with XPO’s net leverage these days, while CEVA’s stands at 7.5x. A 36% premium would buy about five years of growth, assuming constant trading multiples, so it could entice shareholders.
Expeditors is a benchmark and ranks fourth globally, just behind K+N, DHL Global Forwarding and DB Schenker, according to market data from Transport Intelligence.
It is clear that current management, spearheaded by company veteran Jeff Musser, has little or no intention of going for M&A, but private equity involvement almost certainly would represent a paradigm shift, driving a radically different corporate strategy – it would also make sense given that freight forwarders need a lot of financial engineering these days to buck the trend of possibly fast-falling share prices. Expeditors, as many others, is down 6% this year since it hit a record high on 27 February.
Of course, it could continue to focus on larger buybacks and a higher yield, but rising interest rates make this combination likely less remunerative for stakeholders. Buyouts of this size have been incredibly difficult to pull off since 2007, but a change of ownership could be supported by a jumbo buyout package that would be much smaller than the record $13.5bn debt deal put together by Blackstone and its bankers.
There are obvious risks in the industry. Expeditors depends on a variety of asset-based service providers, including air, ocean and overland freight carriers.
“The quality and profitability of our services depend upon effective selection, management and discipline of service providers,” it said in its annual results, adding that in recent years, many “of our service providers have incurred significant operating losses and are highly leveraged with debt”.
Additionally, several ocean carriers have consolidated, and more could occur in the future.
“When the market experiences seasonal peaks or any sort of disruption, the carriers often increase their pricing suddenly. This carrier behavior creates pricing volatility that could impact Expeditors’ ability to maintain historical unitary profitability.”
Most of its revenues and operating income come from outside the United States, but I doubt an experiment as the one I recently performed with DSV would make sense, given that management is focused solely on organic growth.
Mr Musser was appointed as president and chief executive on 19 December 2013, and since then shares have risen almost 50% after several years of stagnation, and he could be the man to shake a place that has not seriously been shaken since Peter Rose left five years ago.