OceanX: China post-CNY – less cloud, more balloon; Mærsk's moves; a tough Q4
Things are looking up, in China at least
Clearly, this week’s headline news was FedEx’s proposed €4.4bn takeover of TNT Express, which promises to be a more favoured attempt than that of UPS two years ago – and represents another blow for UPS.
As M&A activity roars back with a vengeance, which other companies could soon be on the auction block in the freight forwarding and logistics industry?
A deal could happen in the opposite direction, with a European suitor chasing US assets, I believe.
A much smaller takeover target than TNT Express has become particularly appealing following a plunge in its equity valuation: US-headquartered 3PL UTi Worldwide, which would cost a fraction of TNT, based on its current valuation of $1.4bn, including net debt.
UTi reported fourth-quarter results last week that made for a grim reading, as we predicted in December.
“In hindsight, we made far too many process changes at once. Most of the changes were a textbook correct decision, but the collection of them together altered almost every variable in our forwarding business,” chief executive officer Ed Feitzinger said last week, after the company reported pretty dire quarterly figures that missed expectations on several counts.
The share price was subsequently hammered.
As UTi struggles, the most likely suitor, Danish 3PL and road haulage company DSV, is on a decent path of growth and value creation, which suggests an opportunistic move –one mainly financed by its highly valued stock – remains a distinct possibility and could entice DSV management, who approached UTi in the middle of last year.
UTi is now worth 30% less than in early December, when its stock spiked on the day it confirmed it had held preliminary talks with DSV. The longer DSV waits, the cheaper UTi equity may become, however, and that’s one reason why a takeover of the troubled US forwarder may not happen for at least a couple of quarters, in my view.
What is also clear is that would-be suitors may eventually have to cut a deal with UTi’s lenders, rather than with its shareholders, if management doesn’t turn around the business.
On the face of it, life was never going to be easy for UTi’s chief executive officer, who has been leading the group for only about three months.
“On our third-quarter call, at which point I’d been in my new role for about 24 hours, I said our situation was not a complicated one,” Mr Feitzinger acknowledged in the analysts discussion last week.
The Loadstar‘s initial coverage in December expressed skepticism at management’s bullishness – UTi defined itself as a “highly attractive organisation” that strives to deliver shareholder value – mainly because its plan for Ebitda growth was unrealistic.
This time around we have delved into its new working capital plan, outlined last week, to determine whether, and why, any improvement in its short-term liquidity profile is of such paramount importance for the US forwarder.
Mr Feitzinger has pointed out that fourth-quarter free cash flow was positive for the second quarter in a row, although it fell short of “our free cash flow goal due to the loss we experienced in the fourth quarter”.
Economic losses are unlikely to turn into net income for a year, at least – and The Loadstar is not that optimistic about free cash flow, either.
“While I’m disappointed that we didn’t achieve our free cash flow target, I’m very pleased with the progress we’ve made in managing our working capital during the fourth quarter, as it improved by approximately $100m,” Mr Feitzinger added.
That improvement takes into account the negative free cash flow in 4Q14 (-$46m) and the positive free cash flow generated in 4Q15 (+$41m), which would make a difference of $87m and appears to be in the right region.
The interesting thing will be to see how the first quarter of the financial year 2015, when it had a negative free cash flow of $132m, compares with the first quarter of financial year 2016 – given the seasonality of the business the year-on-year comparison is a much clearer indication of the company’s progress than any sequential quarterly comparison.
The most interesting change in the company’s 4Q 15 working capital was a cash inflow of $126m, spurred by a massive reduction in receivables. Given that such a large cash inflow is due to seasonality (+$68m in 4Q 14) it should not be considered as a one-off benefit, although UTi might find it more difficult to negotiate advantageous payment terms with its clients.
In this context, not only are receivables 4% below their last three-year average, which signals limited upside from future cash inflows, but payables are almost 10% lower than average, which is another issue for management to address – although it acknowledged that based on the working capital/sales ratio, UTi has much room for improvement versus its competitors.
My personal opinion is that UTi is focusing on the wrong side of the balance sheet – ideally, it should take more risk on current liabilities than on current assets – yet the big hurdle here is its lack of options, as it would be very difficult to squeeze suppliers instead of clients.
Balance of payments
The cash conversion cycle needs lower receivables or higher payables, or a combination of both, to grant any business more financial flexibility with regard to short-term liquidity management, but only in the third quarter UTi managed to record positive free cash flow – of just $7m – on the back of positive cash inflow from payables (+$42m).
Here’s the problem: management is selling investors the idea that efficiency is the way forward – which is a very good thing – and that working capital management will likely do the trick, but working capital management alone, unfortunately, rarely represents the way out for businesses whose underlying operations are fragile.
The fact is that when cyclical businesses bang on about efficient working capital management, it often signifies that other troubles lie ahead, as proved by the global automotive industry and its supply chain soon after the credit crunch; and by mining and oil companies more recently.
In most cases, companies such as UTi need to adjust capital structures if relentless cost-cutting doesn’t take place and/or revenues do not equally grow at a commensurate pace.
UTi may be the exception, of course, and its promise of returning to a granular focus on improving the margins it makes on individual shipments may indeed prove to be the silver bullet for many of its problems.
Additionally, chief financial officer Rick Rodick noted that during fiscal 2015 the company had “developed and implemented cash flow forecasting tools to help our locations manage their cash”.
“We can also do a better job of enforcing our terms. We have a renewed focus on payment terms and going forward, 30 days means 30 days, not 31 days,” he added.
This strategy also has weaknesses.
One problem is the risk of alienating clients. Troubled companies can find it hard to dictate terms on payments to clients when their difficulties are widely known and there are plenty of alternative options in a market where oversupply dominates the headlines.
So much will depend on the individual relationship UTi has with existing customers and how it is able to conduct these conversations.
UTi is a relatively small company that only a year ago had to restructure its debts and now pays hefty interests to its core shareholders. In the corporate finance world, it remains difficult to focus on the operations when the books are not in good order, and it appears UTi management is trying to improve free cash flow profile to keep lenders at bay – which is why DSV could do well to wait a bit longer before making an opportunistic move.
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