Analysis: with OOCL buy, Cosco is growing, but it's also burning more cash
China’s state-owned Cosco Shipping Holdings will likely reach record revenues of Rmb90bn ($13.5bn) this year, ...
Recently, I left a meeting with the management team of a certain Europe-based global freight forwarder, and I could not help reflecting that no matter what their size, forwarders are always to some extent at the mercy of their carriers – particularly those exposed to the ocean trade, where unfavourable consolidation trends among carriers means both they and shippers are showing a growing strength in supply chain negotiations.
In that respect, the latest results of US forwarder Expeditors International seem particularly pertinent: which way is the wind blowing for one of the most prominent and respected global companies in air and ocean freight forwarding and customs brokerage?
Financial investors were unforgiving when Expeditors reported interim results on 8 August, and its share price has been 6% down since. That equates to about half a billion dollars in lost market value in less than a month.
Notably, most of that plunge came in the wake of the release, meaning the figures and outlook discussed by management greatly disappointed investors.
Its one-year low on the stock exchange is $47.2, and could be tested as soon as early 2018, I reckon, notwithstanding bullish analysts’ recommendations – according to which fair value is still around $54 a share – if market conditions remain as challenging as they currently are, or worsen.
Expeditors filed an SEC document on 24 August regarding “selected inquiries received through 11 August”. For NYSE-listed firms this is a pretty unusual format. The normal routine is that in the immediate aftermath of company releasing its results, management holds a discussion and question and answer session with analysts, and generally these are broadcast on the web and saved for at least a month afterwards in the company’s investor relations section. For many years Expeditors has done it differently – it invites written questions from investors and at some point a few weeks later replies in writing (I have to wonder why it should take so long – perhaps a team of stonemasons need to be hired to engrave these words on granite so they may be gazed upon with admiration for all eternity…)
Anyway, I assume the questions are from investors and the replies from management.
An excerpt is below (the emphasis in bold are my own):
Q: “Do these comments suggest a shift in strategy to prioritize customer pricing over volume growth into 2H17? If so, what led you to that change?”
A: “This is not a change in our approach, which has always been to responsibly grow our business by working with customers who appreciate and demand high quality services and are willing to pay market rates. As we have commented, buy rates have significantly increased and capacity is tightening. We are responding to these current market conditions by increasing our communications with customers. We are also implementing additional internal procedures and reporting to improve our responsiveness to pricing changes.
Q: “Do you believe your customers have been less receptive to price increases in this global freight upcycle vs. prior cycles? If so, why?”
A: “We believe customers are very much aware of current market conditions, including space constraints and buy rate volatility. Customers have enjoyed a favorable pricing and capacity environment for the last several years. As such, we believe there will be an adjustment period to align customer sentiment with these new market conditions. Historically, when capacity becomes as tight as it is now, access to available capacity and on-time delivery become a shipper’s primary concerns.”
Q: “There was no airfreight net sales growth between 2011 and 2016 while gross sales were negative. Can you please elaborate what are the headwinds since 2010/2011 in terms of volume and pricing? I guess that volume is ok but pricing might offset it because airfreight capacity has decreased. What could be a catalyst to reverse this trend in your airfreight business?”
A: “The question implicates several different concepts.” If you want to know how Expeditors replied in detail, please click here.
For a start, despite falling core operating cash flows, its gross cash balances rose 14.3% to $1.1bn from $974m at the half year point – a cash pile that yields very little in terms of net returns in this environment. That’s bad in finance despite the fact that Expeditors boasts a balance sheet that is debt-free – in other words it has net cash to the tune of just over $1bn.
So, it would appear that experienced management is unwilling to exploit still convenient conditions in the credit markets. Although that stance is beyond my comprehension, if Expeditors’ offering to customers proves to be relatively inelastic price-wise (as prices rise, customers pay up), it may be right to adopt a conservative corporate strategy, which would grant continuity in a traditional approach mainly led by organic growth considerations.
It is big “if”, however, given earnings trends.
The ugly truth
Investors traditionally perceive Expeditors as being a fair mix of steady earnings growth and yield (1.5%) from dividends; and I fear that current market dynamics – lower capacity impacting air and freight rates, and more conscious shippers in the way they manage their budgets, among others – do not bode well for value creation for equity holders.
When I first covered Expeditors for The Loadstar in November 2014, its stock traded in the mid-$40s. It was under some pressure, hitting $42 within about 15 months, which was not unexpected despite a record year in 2015, but then it started to ride the consolidation, pre-Hanjin wave in the ocean freight sector, while financial discipline in air and elsewhere also helped it boost value in volatile financial markets.
So far Expeditors has been good at managing its gross profit and operating income lines, but look at latest trends, briefly highlighted by The Loadstar on 9 August.
While first half revenue grew 11% to $3.2bn, this is a corporate story where shareholder value is driven by earnings power, and the bad news is that, barring staff expenses, its main cost items (73% of total costs) – airfreight services (+19%), Ocean freight and services (+16.2%), customs brokerage (+12.2%) – weighed on operating income as much as on net earnings, which were both down about 5% on a comparable basis.
And their growth rate in the second quarter was even steeper in the three months ended 30 June than in the previous quarter of the year.
There are no signs that market conditions have markedly improved to the end of August, neither for Expeditors nor its clients, while mid-term projections remain for mild top-line growth through to 2018, and uninspiring margins growth.
It has often been said that its diverse and balanced portfolio of verticals could render it immune to changing market dynamics, but I doubt this holds true in a market where its earnings trends – and how rising earnings are achieved – show the full extent of the problem.
The last time its shares traded in the mid-$50s was December 2010, when earnings (EPS) per share came in at $1.59, against $2.40 per year in 2016 and $2.36 in the prior year – 2017 EPS stands at $2.36, although these are consensus estimates from Thomson Reuters – which implies a respectable seven-year compound annual growth rate (CAGR) of 5.9% in EPS.
In 2010, however, Expeditors had 216m shares outstanding, while its latest share count amounts to 180.7m; assuming 2010 figures for its share count apply to this year’s EPS calculations, its annualised projected EPS would be $1.80/$2 at the end of 2017, implying a much lower CAGR of up to 3% since 2010.
(Give a look to DSV’s EPS performance since 2010 in the first chart of this story, and spot the difference!)
Financial engineering did the trick in the past, but the problem now is that earnings may have peaked between 2015 and 2016, and that arguably proves that, broadly, the middle man is squeezed, finding more profitable growth an uphill struggle, particularly in terms of organic growth. Hence, managers have to buy back stock more quickly – not necessarily a good idea, given Expeditors’ rich trading multiples – or pay out more in dividends, or a combination of both, assuming M&A remains a valid option, of which there is little sign.
Of course, if pressure on EPS intensifies the debate as to whether Expeditors could be a takeover target might soon reignite, which is a distinct possibility because shippers are minutely screening the freight forwarders’ activity and related costs to the extent that the role of freight forwarders themselves and their traditional business models have publicly come into question.