KN HQ 2

The stock of Kuehne + Nagel (K+N) continues to defy the law of gravity, but enthusiasm in financial circles may be shortlived, unless institutional investors who have bought it over the past few weeks know something we don’t.

Once again, I find myself wondering if something is brewing in Schindellegi, pictured above, where the Swiss 3PL is headquartered.

Surge

After all, its stock, changing hands at around Sfr170, is some Sfr30 – 25% or so – above what I consider to be fair value for equity holders, and that could be perceived by traders as a very nice “M&A upside”; although I seriously doubt it could also represent an “M&A premium”, given K+N’s size.

There is a subtle distinction here: the ‘upside’ represents the possibility that some kind of deal-making will be entertained by K+N, with investors positioning for such an outcome; while the ‘premium’ refers to the remote possibility that the company will be bought out.

This swift rise is puzzling because certain underlying trends for gross profit and earnings were not that appealing at consolidated level in recent quarters, and its rally on the stock exchange – which arguably is only partly driven by fundamentals and yield – has pushed up its market value to Sfr20bn from about Sfr17bn since the end of March.

K+N Share price (Source K+N)

K+N Share price (Source K+N)

That increase is equivalent to slightly more than the entire market value of Panalpina (Sfr3bn), which also recently drew my attention, although that was for other reasons.

So, what could this share price action point to?

However, before speculating on potential scenarios, what are the recent and long-term trends for K+N’s main financial metrics?

Trends

Its first-half performance in each year since 2011 shows why it is hard to believe that its valuation has been propelled only by an upbeat trading update – which, notably, comes in the wake of several upgrades from the sell-side between March and July – although the necessary premise here is that its balance sheet is rock-solid, which is generally the norm for the industry. In fact, barring CEVA Logistics, most of largest freight forwarders are pretty sound, financially.

Despite a rise in current liabilities, the right side of its balance sheet looked in good order around half-year.

Balance sheet liabilities and equity (Source K+N)

True, K+N managed to beat consensus estimates for revenues and earnings in the second quarter, yet my focus remains on deteriorating cash flow trends, which may dictate a more conservative dividend policy over time.

KN Forecasts (Source: 4-Traders.com)

KN forecasts (Source: 4-Traders.com)

As the table below shows, K+N’s cash flows are under pressure, having fallen significantly, year on year, once working capital adjustments are taken into account.

K+N cash flows (Source K+N)

K+N cash flows (Source K+N)

Of course, an attractive yield continues to support its frothy valuation, but there has been no meaningful news concerning the payout, although elsewhere some contract wins have grabbed the headlines and could have contributed to value creation of late.

K+N dividend and yield (Source K+N)

K+N dividend and yield (Source K+N)

Something’s got to happen?

In most years until recently, K+N’s gross profit growth comfortably outpaced revenue growth in the first half, while its decline has been less pronounced than the fall in revenues; meaning it has traditionally been very good at dealing with the carriers, as I have pointed out in previous stories.

However, despite multi-year record net revenues in the first half of 2017, an implied 8.2% top-line growth rate, on a comparable basis, only translated into a 3.7% growth rate in gross profits, although this was expected given recent trends in the industry – specifically rising freight rates.

On top of that, heavy operating costs such as personnel expenses (almost 70% of gross profit), grew well above average in the first halves of 2016 and 2017, at 8.1% and 3.6%, respectively – incidentally, these growth rates are bang in line with gross profit growth, as the table below shows.

K+N revenue, gross profit, costs (Data source K+N, calculations made by Hedging Beta)

K+N revenue, gross profit, costs (Data source K+N, calculations made by Hedging Beta)

Investment in staff is of paramount importance to preserve competitiveness in the industry, I am often reminded by my contacts, although the new investment had the effect of diluting the growth rate of its operating profit, although its underlying profitability has been holding up well.

Unsurprisingly, its cash flows from investment shows higher cash inflows from the disposal of property, plant and equipment, which partly offset working capital outflows in the first half, but at times can also anticipate deal-making, in my experience.

K+N cash flows, cash on hands, dividends (Data source K+N, calculations made by Hedging Beta)

K+N cash flows, cash on hands, dividends (Data source K+N, calculations made by Hedging Beta)

Maybe it is just business as usual in Schindellegi, but the implied market value of K+N currently seems to “discount” the possibility of combined K+N/Panalpina entity – although such a combination could emerge as a stronger dividend machine, if meaningful synergies were achieved.

Admittedly, the strategic merits of such a deal are less obvious, particularly for K+N, and at this point I am reluctant to bet on it. Yet certain signs are there for everyone to see: crucially, the rise in K+N stock and the fall in Panalpina’s means the former has been catching up quickly in terms of trading multiples against the latter, which makes it easier to speculate on an all-stock deal between the two.

My sources are tight-lipped on the matter, but what the share action also implies is that a leveraged buyout of K+N is virtually out of the question, given its current implied enterprise value – and given brokers’ bullishness, which has clearly contributed to boost its shares…

Consensus estimates (share price vs average consensus price, Thomson Reuters)

Consensus estimates (share price vs average consensus price, Thomson Reuters)

… there is also the strong possibility that a K+N/Panalpina deal could be just one of those thoroughly thought-provoking events that takes place only on paper.

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