Analysis: Kuehne + Nagel on a slow path to value destruction?
There could something fundamentally wrong in an industry where the market leader and other players ...
When the news hit the wires last week that e-commerce behemoth Amazon was trialling a delivery service to consumers that would also be offered to third-party retailers, I received a couple of calls from banking sources, one of whom asked: “Do you remember our chat this summer?”
“Of course,” I replied.
“FedEx could be readying to up the ante, to show Amazon who is in charge in delivery services worldwide,” he said.
This, in typical banking jargon, means that FedEx could be preparing a move to grow again via acquisitions rather than organically, in order to give another boost to its already sky-rocketing valuation, two and a half years after its €4.4bn takeover of TNT Express was announced.
“If so, the UK could be the next battleground,” I replied.
For Amazon, Royal Mail is a precious ally in the UK, while for FedEx, according to another London-based banker ready to feed the rumour mill, “it could be a matter of pride” as well as other priorities, such as scale and better services to European and US shippers.
About two-thirds of FedEx’s revenues were generated in the US last year, and it looks very well balanced already, a senior analyst countered. However, I think it could also be a matter of opportunity, as the chart below suggests…
…just as it was, among other strategic considerations, when FedEx acquired TNT Express in 2015.
Royal Mail’s fundamentals are not pretty and, unsurprisingly, its stock languishes at record lows. Its market cap is now about 40% lower than in early 2014, when it reached an all-time high only a few months after its much-criticised IPO.
Notably, its depressed valuation comes not only as its core UK Parcels, International & Letters (UKPIL) activities remain under a huge amount of pressure, both in terms of profitability and growth, but also at a time when the British pound has weakened significantly both against the US dollar and the euro, which favours foreign buyers. Currency trends, by contrast, have greatly contributed to strengthen the FTSE 100 since Brexit.
Its dividend payout ratio, too, offers little reassurance, in my opinion.
More importantly, though, given my focus on extraordinary corporate activity and M&A, all these elements render Royal Mail a more palatable takeover target than at any time in recent memory.
Share price movements notwithstanding, and aside from obvious restructuring considerations (a common theme linking TNT Express and Royal Mail), there is another striking similarity with the situation TNT Express found itself in before it was acquired.
As you might know, TNT Express needed new investment (subsequently granted by its new owner, FedEx), while Royal Mail is also past its investment cycle peak; in fact, net cash deployed fell significantly in 2016 versus the previous year and is not expected to recover anytime soon.
As competition intensifies, it lacks alternatives in its homeland, so Royal Mail plans to invest less than £500m annually at group level – although its smaller General Logistics Systems (GLS) division, its crown jewel, “represented the majority of spend” in 2016.
A £5bn target
Ground operations in the US are under the analysts’ microscope at FedEx.
GLS operates one of the largest, ground-based deferred parcel delivery networks in Europe, as Royal Mail says. It is growing inorganically, and as a gateway to Europe and the US, it is “a strategically important part” of the group.
It would be hard to convince managers they do not need it, and that is why a fully-fledged takeover of Royal Mail, with the idea of offloading most of UKPIL to another suitor, perhaps Belgium’s bpost (which failed to acquire PostNL in 2016), could make sense – although bpost (€4.7bn market cap) is, surprisingly, pushing to increase its cross-border and transatlantic e-commerce capabilities, as The Loadstar reported this week.
As a reference, Royal Mail’s outstanding shares are worth only £3.8bn at present, so a typical 30% premium – the premium for TNT Express stock was 33% based on FedEx’s offer – would push up its price tag to about £5bn, excluding net debt, which is almost negligible in this context.
An appealing footprint
Last year, GLS acquired assets in Spain (ASM) and North America (GSO and Postal Express7) – its rather appealing footprint is shown in the table below.
In its interim results this year, it confirmed most recent trends (see table six below), which were favourably supported by exchange rates. Nonetheless, its performance was remarkable both in terms of growth and margin expansion in 2016, as chart seven shows.
As an side note, while cash inflows rose, so too did net debt…
… while net cash and other relatively cheap liquidity sources of funding fell.
Royal Mail said in its annual results that, “as at 26 March 2017, the group had available resources of £1,317m (2015-16: £1,418m); made up of cash and cash equivalents of £299m (2015-16: £368m) and undrawn committed revolving credit facilities of £1,018m (2015-16: £1,050m).”
To facilitate a sale, I suspect Royal Mail might have to engineer a break-up. That works on paper, less so in reality, because the market value of UKPIL assets could be seriously harmed were they separated from GLS.
By the way, if you recall TNT’s corporate history, a spin-off would resemble what the Dutch group did with its operations before the failed takeover of the express unit by UPS – and then the successful offer by FedEx – materialised.
Alternatively, Royal Mail could use proceeds from the sale of GLS to re-invest into its core operations – yet it doesn’t need investment there, so we can safely rule out such an outcome.
Incidentally, DP-DHL is another obvious suitor for Royal Mail, but is far less likely to succeed after its UK Mail purchase at the end of 2016. Of course, domestic regulator Ofcom would carefully monitor any material development on that front, likely ruling against further consolidation in the postal sector.
Finally, if you wonder whether UPS could also be interested, I think its latest strategic moves suggest otherwise.
Fred the Dread
With hindsight, the UK government got away with a decent deal, given the average sale price for Royal Mail stock, after centuries of ownership, but a buyer could secure a still better deal if the right terms are agreed.
For its part, FedEx’s interest could be pre-emptive, of course. If Amazon snaps up Royal Mail, resulting pricing/volumes dynamics could be tricky at best for its European operations, and that is not to mention other smaller players.
While FedEx executives often refuse to be drawn into discussing how harmful Amazon’s actions could be eventually for its core delivery services, it is also reasonable to consider that corporate finance strategy and M&A are not driven purely by emotions – although in recent calls with analysts, FedEx’s top brass have become less complacent as far as questions on Amazon are concerned, and less sanguine than they were last year.
Founder and chief executive Fred Smith said in a quarterly call last month – structured, as usual nowadays, in a format where management cherry-pick, via email, the questions they answer – that he “would like to make two points about expected FY18 performance”.
“Absent the cyber terrorist attack on TNT Express, our annual guidance likely would have remained unchanged. And second, FedEx Ground operating profit is anticipated to exceed FY17.”
When asked whether recent M&A moves by Amazon deserved attention – in particular with regard to the purchase of Whole Foods as being “indicative of a trend to drive a greater combination of e-commerce and in-store fulfilment” – Mr Smith carefully managed expectations, explaining that, firstly “the drivers of cost (…) are the mix between very large customers and small and medium customers, because the yields are higher with the latter given the purchasing power of the former. And the second is the mix of commercial versus residential deliveries, because the vast majority of houses, even with the growth of e-commerce, do not get an e-commerce delivery per day”.
He added: “E-commerce has basically been made possible by the postal services’ mail deliverers – delivery routes and mail personnel, putting small e-commerce packages and with the mail and delivering them for very low rates. That’s challenged (…) by the reduction of mail due to digital disruption.
“So my guess is that everybody that’s in the e-commerce business is seeking to develop greater route densities one way or another. The Walgreens on-site locations that we just mentioned, all of the efforts that Amazon is making, UPS is making and so forth,” Mr Smith concluded.
So, is all this enough to justify – or to rule out – a possible takeover of Royal Mail?
Far from being a statement of intention, it is likely that FedEx will continue to sift through alternative investment possibilities, and arguably GLS would nicely fit within its huge assets base.
Meanwhile, Amazon – Royal Mail’s biggest client, one key factor that often drives takeovers – may sit idle and continue to grow inorganically in sectors that are transversal to logistics, forcing integrated logistics players to gauge their chances and make their first move.