Analysis: Still too early to know potential redundances at UTi following DSV acqusition

Shares of Denmark’s DSV rose over 9% last Wednesday after the world’s fourth-largest freight forwarder reported its quarterly and annual results. Its stock price was confirmed in the following two trading sessions, but DSV stock is essentially flat for a week, given that it was hammered ahead of its trading update. What does all this mean for shareholders?

Expectations are high in 2016 because a large part of the integration of UTi Worldwide – the takeover was completed last month – is expected to be completed in the first 12 months, according to DSV.

However, investors weren’t upbeat about DSV before results were released, and while it reported a strong set of numbers, it didn’t manage to reassure the investor community during the conference call that followed the announcement, and shareholders will just have to hope that its estimates in regard to UTi turn out to be correct.

Otherwise, its equity valuation could fall like a stone, even if management continues to deliver strong quarterly figures.

Rabbit

DSV pulled a rabbit out of the proverbial hat this week, and its operating performance – particularly in air and sea freight – was truly impressive.

Yet its shares, which currently change hands at Dkr255, are still 10% below the record high they reached in early November, three weeks after the purchase of UTi was announced. Market volatility can only partly be blamed for that. Investors are concerned about execution of the takeover and prompted analysts to ask if UTi was worse off than DSV had expected when it pulled the trigger in early October.

DSV management argued that they “got the keys of UTi only a couple of weeks ago”, and acknowledges that UTi needs some serious work, but it remains confident – based on an impressive track record in mergers and acquisitions (M&A) – that integration will be smooth.

In my view, DSV didn’t present any evidence or reassuring forecast about critical elements – such as synergies – to prove its point. Track record in M&A means very little at times, and this is a cross-border deal that won’t be easy to execute, given the number of unprofitable accounts that UTi held on its books.

Savings

One major issue is the cost savings DSV will be able to extract from UTi in order to deliver the same level of returns and profitability it enjoyed before the deal was struck.

DSV diluted shareholders to offer them a brighter future in a difficult freight market, but investors are nervous about a big deal that was largely funded by equity, and that brings uncertainty, and where the number of possible layoffs – a critical component to value creation – is still undisclosed. We still don’t know what DSV’s target for lay-offs is, but its management labelled some market speculation as unreliable.

DSV’s organic growth rate was outstanding in 2015, although it has decided not to release guidance for 2016 volumes. Given the complexity of the UTi deal, it is hard to accurately predict volumes, and anyway, the uncertainty in the global economy does not currently lend itself to hard and fast forecasts.

Nonetheless, there are a few problems with UTi – namely the level of net working capital, which has to fall to below 3% from 9%, and a bloated and at times indecipherable cost base. It revealed for example, that it had a “different way of looking at” external help from advisors.

On top of that, asset disposals are very unlikely to provide much of a fillip. To paraphrase DSV management, UTi had already sold off all the assets it could sell before DSV arrived, although management said that, in addition to redundancies, other costs could be cut through tending some office leases and in IT.

So, it’s back to basics for DSV. “We have to look at how they allocate capital, how they organise the billing,” management said.

Losses

Investors have reasons to wonder whether the loss-making assets of UTi will ever help DSV become a stronger entity, and whether DSV will manage to report the same level of net profitability and returns it has become used to.

Management says it knows how to do it; it has done it before and it will do it again, and points to a strong ebit guidance of up to Dkr3.5bn ($525m) for 2016. But several questions remain, and one in particular stands out: how many jobs will DSV/UTi have to cut to achieve its targets?

In my previous coverage, I hinted at up to 9,000 redundancies, but I now think that could be a conservative estimate, and largely depends on a number of variables, including revenue synergies.

Calculating a number is a hard task, because DSV itself appears unable to say how many employees the combined entity has right now – but here’s an attempt based on what we do know:

Its global workforce should have almost doubled to 44,000 from 23,000 following the UTi deal – based on the initial guidance from DSV. In its annual results it was vaguer and simply said the combined workforce would grow “to more than 40,000” .

Between 40,001 and around 44,000, there could be a discrepancy of around 2,000 employees between October and now, although all DSV management could tell us last week was that it has a “moving target” for staff and redundancies.

Consider that, based on the trailing staff cost base of both DSV and UTi, each employee costs the new company some $38,000 in salary. So, assuming 42,000 employees, it would have already saved about $76m, which represents over 20% of its net profit in 2015.

The Wall Street Journal reported on 4 February that DSV had already begun to shed employees, with the dismissal of 41 workers in Portland.

“We are unable to predict the number of layoffs that will take place during this phase,” DSV said – a view reiterated during the call by its chief financial officer, Jens Lund, who hinted at phase one and phase two as the most critical phases with regard to layoffs.

Just how many?

DSV’s staff costs totalled Dkr5.4bn ($821m) in 2015, which is slightly less than UTi ended up paying for staff ($870m) in early 2015. As The Loadstar reported, synergies are expected in areas including property, headcount and IT – the target for 2016 is Dkr450m, Dkr750m next year, with the final Dkr300m being clawed back in 2018.

But here is the problem: pre-synergy and excluding integration costs of Dkr1.5bn, staff costs will likely amount to Dkr11bn ($1.6bn) in 2016, which would imply a pro-forma net loss of about $500m for the year.

After all, the stated synergy target is pretty low. Once cost synergies for years one and two are factored in (about $70m for year one alone), and considering a few benefits from lower taxes, other one-off income items and additional growth in revenue, DSV would still have to cut between 9,000 and 11,000 employees to return to its level of net profitability.

This assumes no revenue synergies, which are seldom easy to predict but will become a very important element in this deal, and could push down the number of redundancies to about 4,000-6,000 jobs. In fact, DSV management might have pencilled additional $600m-$1.2bn of revenue stemming from cross-selling DSV’s services to UTi’s clients and vice versa.

DSV is well known in the freight industry for its M&A ability, but some investors have already noticed that it pulled the trigger when the Nasdaq index traded some 10% higher than its current level. In other words, UTi could have been bought for less than over $1bn, and the cost synergy it offers aren’t particularly appealing.

What appears evident is that DSV is pulling out all the stops to grow but is running the risk of diluting its underlying profitability permanently, and that could be one of the reasons why its target for return on invested capital seems overly cautious into 2016 across all its units (see page 8 of its annual results).