News / Kuehne + Nagel: flawless strategy, but is financial engineering an opportunity?

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Let’s set the record straight: Kuehne + Nagel’s strategy is flawless.

Its managers should be praised – the Swiss freight forwarder aims to preserve returns by chasing higher-paying clients, while ditching less-profitable accounts.

Financially, however, the group should consider a more efficient capital structure in order to boost returns. Its share count could shrink further via debt-financed stock buybacks, with obvious benefits for its core shareholders, including Kuehne Holding AG, which controls the business with a 53.3% stake. Its free float currently stands at 46.7%.

A rising free cash flow yield at 2.5% is the first indication that K+N could be more aggressive in managing both its finances and its overcapitalised balance sheet.

Generous dividend policies, such as the one K+N currently has in place, are less tax efficient than buybacks, and will be unlikely to help it shore up its equity valuation, at a time when growth is hard to achieve. Its recent quarterly results confirm the view that flat sales into 2017 are very likely.

A smart financial plan is needed to offset operational hurdles over the medium term, and that’s a good enough reason why K+N’s managers should act – and they do have options.

Why now?

To start with, K+N stock is more likely to fall than to rise. At present, it resembles an overpriced bond, and its balance sheet carries no debts.

Both elements point to financial engineering as a possible solution, while focus on the operations should be maintained. Of course, the freight forwarder could hit the acquisition trail, but cash would be better spent elsewhere given that transformational acquisitions are not in its DNA.

With p/e multiples at 26x and 24x for 2015 and 2016, respectively, its cost of equity is not prohibitive — but the real opportunity here is called capital arbitrage, spurred by a very low cost of debt in the current environment.

In a base-case financing scenario, the borrower could buy back its own stock and exploit loose credit market conditions – not many companies in the industry could do that.

There are risks, of course – by the very nature of the business, margins are thin, but risks could be mitigated by properly structuring the debt package.

Stock buybacks

K+N could deploy CHF500m of cash from its balance sheet (40% of its total gross cash pile), while raising CHF1.5bn of bank debt.

Say that a seven-year bank debt package is priced at 150 basis points over Libor, and is structured to include a three-year grace period: then, K+N could use cash and debt to launch an accretive and tax-friendly stock buyback programme totalling CHF2bn, which would equate to 12.1% of its current market cap. This assumes 15 million shares outstanding, out of the total share count of 120 million, will be bought at an average price of CHF137.

K+N has plenty of room for error because the cost of bank debt could be lower than 150p over Libor.

On a pro-forma basis, some CHF1.5bn of additional gross debt would push up forward net leverage at about 1.5x, which would be surely manageable, and is based on the conservative assumption that K+N will not grow Ebidta at all, when in fact it has risen at a compound annual growth rate of 4% since 2012.

Under this scenario, it is reasonable to assume a minimal loss of yield (CHF5m) from CHF500m of cash held on the balance sheet, which would be deployed in the buyback – and that would combine with additional interest expenses at about CHF22.5m yearly, for a total of about CHF30m, including fees, according to The Loadstar estimates.

To cut the bank fees, Kuehne + Nagel could self-arrange a club loan instead.

Accretion & risks

We estimate that if the buyback is carried out at an average stock price of CHF137 – i.e. 3.5% below its current stock price – it will be 10% accretive to earnings in year one and year two, assuming the company meets estimates for net income of CHF652m and CHF720m in 2015 and 2016, respectively.

The risk would depend on how much time the borrower is granted by lenders before it starts repaying the principal on its debts.

A three-year grace period is usually granted to core relationship clients, and K+N is in a very strong position financially – less so operationally – so it will have to negotiate an appropriate repayment schedule. It can easily dictate terms based on its track record, strong financials and healthy operations.

When capital repayments are due, say in 2018 or in 2019, K+N will simply have to roll over existing debts at more convenient rates – interest rates are not set to rise significantly, but competition among lenders will remain fierce. Alternatively, if its focus on profitability pays off, it will have accumulated enough cash to pay down part of the principal, so cash flows could be used to service lower interest payments.

Of course, managers could keep promising higher dividends, just as they are doing, but that’s not exactly a shareholder-friendly option. Buybacks seldom create value, history shows, but a large buyback programme would also open the door to a take-private deal, which would make a lot of sense for a company that has little reason to remain listed on the stock exchange at this particular economic juncture.