Analysis - declining cash levels could lead Maersk on a $5bn new equity quest
I have been thinking a lot about the cash and liquidity profile of Denmark’s AP ...
There was good news for ocean carriers in what was otherwise a painful week for shareholders, who recorded hefty paper losses because of massive swings in the financial markets.
Oil prices were hit by global market jitters – and the container shipping industry, as we know, generally benefits from lower bunker prices, given its position as a key variable that affects earnings power and, liners’ core cash flows.
But this isn’t an article about container shipping lines; it is about forwarders and the relentless moaning I have heard from their quarters recently about how the lines are the asset owners and drive down prices in a constant quest for market share, leaving forwarders with similarly relentless eroding margins from ocean freight activities. Well that may be so, but forwarders have options and I am keen to determine how a challenging financial and trading environment could affect Kuehne + Nagel (K+N) – the global leader in ocean freight forwarding, whose annuals are due on 28 February – and its corporate strategy.
In short, my sources are tight-lipped, so I am trying to predict the Swiss forwarder’s next M&A move.
Its management ought to feel the urgency: its shares trade below the levels of mid-October, when I penned “K+N on a slow path to value destruction?“, and Thursday’s trading update by DSV (down 4% yesterday and a further 1.8% at the time of writing) proves that investors want more than numbers that meet estimates.
Ocean freight trends
I have been looking for signs confirming that the fourth quarter was a bit more challenging for K+N than the first nine months, and on 30 January US 3PL CH Robinson confirmed that growth was harder to come by in ocean freight – its net ocean revenues were up 7.2% in the first quarter, on a comparable basis; up 22.3% in the second and 43.7% in the third quarter. But the growth rate in the fourth quarter was much lower than previous readings. Of course, seasonality plays a part, but making higher profits was even harder.
DSV provided more clarity in this respect yesterday, when the Danish freight forwarder opened the earnings season for the majors ahead of Expeditors (due 20 February).
A more detailed analysis of DSV’s achievements will follow next week, but a preliminary glance at its numbers indicate freight volume growth for the fourth quarter was “10% for air freight, 4% for sea freight and 5% for road transport”. Annual air freight volumes grew 10.6% and sea freight volumes 6.4% in last year, well above market rates, while quarterly trends for ocean freight activities is shown in the table below.
“The Air & Sea division went into turbo drive, achieving its 2020 financial targets already in 2017,” DSV noted, but the table above also clearly shows that ocean freight operations are not exactly over-shooting.
That was visible in CH Robinson’s results, too. According to data from Transport Intelligence, the US company ranks 15th globally in terms of teu numbers and gross revenues generated in 2016 – it was 20th the year before.
Notwithstanding the obvious observation that its rise closer to the top 10 could provide a clue as to where the US 3PL might bulk up, via M&A, as soon as this year (it has dry powder and a war chest of over $1.5bn), ocean net revenues increased only 5.9% to $73.1m in the fourth quarter, against $69m one year earlier.
(Its global forwarding unit performed well, as opposed to its pressured core truckload division. Solid air freight numbers were expected: air net revenues rose 16.2% in the fourth quarter, while customs net revenues increased 33.3% to $21.1m compared with $15.9m in the fourth quarter of 2016.)
“These increases were primarily due to volume increases, including those from acquisition,” CH Robinson noted, and here we must consider that it acquired Milgram for $50m last summer, closing a deal expected to be neutral to earnings in 2017 and slightly accretive this year. Snapping up a tiny provider of “regularly scheduled import and export consolidations by both air and ocean freight” could have helped consolidate favourable trends, given that ocean net revenues increased 9.4% to $244.2m in 2016 from $223.3m in the prior year, primarily due to rising volumes.
Its yearly ocean net revenues rose 19% to $290.6m, a growth rate that should be adjusted for undisclosed non-organic growth contribution from added assets (K+N’s growth is mainly organic) but should comfortably double K+N’s growth rate in ocean freight, giving the Swiss forwarder a gross sales number of between Sfr8.6bn and Sfr8.8bn for 2017, which is in line with its 2015 turnover, but well below prior levels of 2013 and 2014, as the tables below indicate.
Two years ago, the amount of sales it generated helped K+N report Sfr1.38bn in gross profit.
Including inter-segment turnover and customs duties and taxes, this number is derived from gross sales minus the cost of doing business with suppliers, before all operating costs are paid, as well as bank interests, which are negligible for K+N, and taxes. It implied a gross profit margin of 15.8% in 2015, against 16% in the first nine months of 2017.
If that rounded level of gross profitability is applied to this year’s nine-month figures, in the fourth quarter K+N could have generated over Sfr320m in gross profit; or even Sfr350m if we want to be rather bullish and consider how good it has been in passing transport costs onto customers in the recent past.
However, regardless of how upbeat we are about its prospects, its operating cash flows are plateauing at best in ocean freight, because the carriers have pricing power and are fighting to win budget-cautious shippers in a market where lower yields for the freight forwarders could induce the majors to use their solid balance sheets and devote growth capital elsewhere.
Analysts at Jeffries this week predicted expansion of 5% in its consolidated EBIT, but if that is the case, most of the increased level of profits – rather than higher profitability, a completely different matter – would likely stem from air freight (its second-largest revenue contributor), especially considering the smaller size of overland and contract logistics operations, whose combined EBIT in the first nine months was only 21.8% of the group’s total.
Deteriorating profits in core ocean freight activities could ultimately jeopardise the dividend (the payout is way too rich), which means that if K+N is serious about growing via acquisitions, it is pretty obvious that air freight ought to be the next growth target.
Given recent trends, the 2013-2016 compound annual growth rate (CAGR) for EBIT was 3.1% in ocean and 10.3% in air, but the spread widens by 70 basis points based on my CAGR estimates for the 2013-2017 period, mainly due to a growth rate in sea freight struggling to match inflation in West Europe for a year or so.
Of course, K+N is also high up the league table for air freight by gross revenues, lagging only behind DP-DHL’s freight forwarding unit, in terms of tonnes. So the list of targets it could afford contains some household names: Hellmann Worldwide Logistics, CEVA Logistics, Yusen Logistics – you name it, these are all companies with meaningful air and ocean freight exposure. But K+N might want to either look outside the top 20, I reckon, to focus on growing its promising air freight business, or devote more internal resources and debt to fund it.
Strategically, bulking up in air freight would also show ocean carriers that the freight forwarders don’t rely mainly on them at a time when air exposure could command a significant equity premium. Boeing, for example, has enjoyed an incredible run on the stock market, its shares having more than doubled in the past 12 months alone. Its valuation looks high, but it is not, based on its orderbook, and because it is churning out record cash flows, with a 5%+ free cash flow yield that could easily drop as its equity continues to surge.
That is something K+N management would overlook at their shareholders’ peril.