Analysis: All eyes on 2024 but already DHL smells (a lot) of break-up value
…the parts have seldom been more compelling
It has not been the greatest of years for Deutsche Post DHL shareholders – the value of their holdings is down 5% so far in 2015. Still, there’s hope that things will get better in 2016, at least according to management.
My advice would be for them to adopt cautious optimism, however.
From last week’s quarterly update, the German mail and logistics company clearly has a lot of work to do across most of its divisions if it is ever to meet its ambitious guidance for core operating earnings.
Aside from one-off charges, what concerns me a bit is the effect that a mix of negative elements could have on its performance next year and beyond, namely: declining cash flows; rising net debt; and higher investment.
Consolidated Ebit, a key measure of performance, is expected to come in between €3.4bn and €3.7bn in 2016, which is at least €1bn more than the Ebit that the group will likely report in 2015.
DP DHL has defined 2015 as a year of transition, during which revenue rose €423m to €14.4bn in the third quarter, driven “to a significant extent by positive currency effects, which increased this item by €498m”, it noted.
The financial markets expect higher interest rates from the Federal Reserve in December, and I remain relatively bullish on the dollar, so DP DHL will likely continue to be favoured by its strength.
However, there are some details that are disturbing when it comes to determining its underlying sales performance. Firstly, excluding currency adjustments, quarterly revenue actually declined by €75m in the third quarter, due to lower fuel surcharges, among other things.
The top-line was essentially flat, but the pain was really felt at operating level, where a few charges contributed to a drop in core operating earnings. As it announced on October 28, the group booked a one-off charge of €345m related to its ill-fated New Forwarding Environment (NFE) IT project, yet the board also identified further “potential one-off effects of around €200m, €81m of which was already recognised in the third quarter”.
Managing impairment risk is important, and short-term pain for long-term gain is the name of the game, according to chief executive Frank Appel. However, one-off charges are increasingly recurrent in this market and they could draw the attention of credit rating agencies, which is not ideal because DP DHL’s cash flow is falling on the back of higher investment, and its credit rating is safe, but is only a couple of notches above junk.
Moody’s and Fitch rate it “A3” and “BBB+”, respectively, with a stable outlook.
With regard to one-off charges, the sooner they show in the income statement, the better – it is that simple. And Mr Appel is doing all he possibly can in order to manage expectations and deliver long-term value.
“We are taking these measures to underpin our earnings guidance for 2016 and 2020,” he noted last week.
On the face of it, things are not great, but it doesn’t look like Mr Appel is kicking the can down the road. Rather, these accounting adjustments are necessary when certain projects, particularly NFE, fail so miserably.
The Ebit line after charges fell from €1bn to €294m in the nine months of 2015, and was down to €186m from €321m in the third quarter. Excluding one-off items, Ebit would have been below 2014 levels, which is another warning sign for me.
Although not unexpected, its poor performance in the third quarter determined a plunge in earnings per share. Economic profit tells only a part of the story however, and at times can be dismissed, but it cannot have passed unnoticed that the large NFE €345m charge represents over 30% of the dividend payment that DP DHL made to its shareholders over the first nine months of the year.
Cash flows are not affected by one-off charges, yet shareholders could have done without them, and could be worried now that the payout ratio may become less sustainable if DP DHL doesn’t deliver higher Ebit into 2016. All this becomes more important because dividend risk is not priced into its shares, in my view.
“You look at what Appel has done over the years you are not going to say he failed,” one institutional investor recently told me. “But it’s a very critical moment, although he’ll pull it off.”
I am not surprised that management still has the backing of key shareholders, and with the German government holding a 21% stake in the company, there should be little to fear.
However, at €1.1bn in the “first nine months of 2015, net cash from operating activities was down €244m on the previous year,” DP DHL also said in its the most recent results, which means a 17% drop on a comparable basis – and operating cash flow fell 25% to €1.5bn before changes in working capital are considered.
Cash and cash equivalents declined from €2.9bn on December 31 2014 to €2bn on September 30 2015, while net debt doubled to almost €3bn in nine months, which comes at a time when free cash flow is down 90% to only €19m in the first nine months of 2015. Net leverage remains manageable, but all these elements suggest that the group has little room for error, also in the light of higher capital investment than in the past.
One year ago, when I argued DP DHL stock looked a lot like an overpriced bond, and traded around its current level, I said higher operating profitability would be difficult to achieve.
It has now become a mission that has to be accomplished.