The Company trades on the Vienna exchange under the ticker POST, its symbol on Bloomberg is POST AV, and on Yahoo is POST.VI.  Austrian Post was privatized via an IPO this summer, with the Austrian government selling 35m of 70m total shares.  POST trades for around € 29.50 per share at the time of this write-up.  The Company will carry about € 8 of net cash on the balance sheet by the end of this year and has an additional € 2 of real estate held for sale.  POST will generate around €278m of maintenance free cash flow this year, or about € 4 per share.  So you are paying about € 19.50 for € 4 of free cash flow. 

The Company has suffered from several recent sell-side analyst downgrades on account of the shares reaching a stated target price.  We think the analysts don’t really understand the economics of the business.  We are looking for POST to significantly beat consensus numbers as they did in the first half.  The year end consensus is tightly clustered around stale management guidance from before the IPO, and is actually much lower than LTM performance.  POST should deliver modest growth YOY in the 2^nd half and recognize cost savings due to already completed headcount reductions of 800 people in the first 6 months.  Analysts are partly misunderstanding the financials due to some confusing accounting accruals and asset write-offs from last year – more on this later.  This management team is ultra conservative, and has prudently set a low bar, as they admitted to us recently.  This earnings and cash flow “surprise” will force the sell-side analysts to reconfigure their earnings and DCF models (which are a mess but don’t get me started). 

Austrian Post primarily makes money from postage for delivery of letter mail, direct mail and periodicals, which generates 76% of revenue and 90% of the profitability. Shipping consumer parcels and packages (similar to FedEx and UPS) represents 12% of revenue.  POST also uses the branch network to retail financial products for a banking partner (Bawag of Refco fame), sell mobile phones, stationery, DVD’s and other products, which represents 12% of revenue.  POST has a little over 24,000 employees, 6 sorting facilities and about 1,900 branches.  You can check out investor presentations at the IR website here: (http://post.at/ir/en/).

Financials and Valuation

Please note that the figures below are our estimates and are adjusted to exclude non-recurring, non-cash accounting provisions and severance costs, and gains on asset sales. For conservatism we have not excluded cash severance and related costs incurred in 2005 that are not likely to recur in 2006.  We also do not back out the €2 per share real estate value in the multiples below.  We assume all cash flow is retained on the balance sheet, rather than paid out in dividends or used to buy back shares.  Interest income is excluded from free cash flow.

Segments

The Company operates under 3 segments: Mail, Parcels & Logistics, and Branches.  The Mail segment represented over 90% of 2005 pre-overhead EBIT, and is sub-divided into Letters, Direct Mail, and Media Post (newspaper and magazine delivery).

Financial Commentary

We expect the current level of cash flow to grow modestly over time.  Overall POST should see stable, low single-digit volume growth.  Letter mail volume will be flat to up 1 or 2%, while direct mail volumes will increase by 4-5%.  Email substitution fears from several years ago have proven to be less of a threat than earlier anticipated.  Only 8% of letters are C2C, which are more prone to substitution, while B2C (bills, govt. communications, etc) remain the lion’s share of volumes.  We have not assumed they are able to raise postage pricing in our model, but that would provide significant upside.  POST raised prices by 16% in 1998 and by 8% in 2003.  Pricing in direct mail will be down 1%-2% in unaddressed and flat in addressed.  Pockets of strong growth exist in the parcels segment, especially the recent entry into B2B, and in Eastern European operations (parcels and direct mail). 

Most of the cost structure is fixed, which primarily includes labor at sorting facilities and the delivery network.  Wages are the biggest cost component and will increase by 3.5% per year.  This will be more than offset by productivity improvements, which represent a huge opportunity for the Company.  Over the last few years the current management team has begun rationalizing the employee base and infrastructure.  Employee headcount has been reduced from over 30k to 24k (CAGR of 4.6%); the branch network has gone from 3,000 to 1,900 and sorting facilities from 39 to 6.  This management team knows how to reduce costs in a politically sensitive fashion.  When questioned on this they will soft pedal future headcount reductions, as there are obvious political sensitivities and employee morale issues to contend with.  However, we know from speaking to people inside the Company, competitors and industry sources that POST still has massive levels of redundancy and waste, and management knows this.  We expect the Company to shed 4-5% of its work force in each of the next 3 years.  Keep in mind this was a jobs program run by the Austrian government for 150 years.

There are several reasons why POST trades at a steep discount to intrinsic value:

The shares have only been traded for 4 months and were priced in a difficult market for US and European IPO’s.  In determining the valuation it was decided to price the shares off of a 5% dividend yield, while giving shareholders the cash and real estate for free.  The current dividend of €1.00 per share used as the basis for this dividend yield is highly arbitrary and represents 25% of free cash flow.

It was not in management’s interests to push for a higher valuation. Management was granted “appreciation rights” (free options with a 1.5x multiplier) that were struck at the average price of the first 60 trading days.  As long as they can generate a 40% total return to shareholders over the next 3 years, they will receive a cash payment equal to 150% of the future trading value of the share price times their options.  In order to receive the options, they were required to purchase 30% of the current value in shares at the IPO valuation with their own money.  The 60 day pricing period recently ended and the Company has begun meeting with investors.

Moreover, the government of Austria aggressively marketed the shares to retail investors, and the Company encouraged and financially motivated (through a matching program) employee share ownership.  Over 50% of employees now own shares. 

Finally the Austrian government wanted to prove that they could execute a successful result, which was defined by how much the shares appreciated after the offering.  The Austrian government still owns 51% of the shares.

It remains in everyone’s interest to see the share price continue to appreciate.

2. Non-cash non-recurring provisions obscure true economics

The Company recognized approximately €107m of non-cash provisions in 2005 and expects to take another €95m of provisions in 2006.  These provisions are mostly related to “underutilization” of certain employees.  Under Austrian law, certain employees left over from pre-1995 days were designated as “civil servants”.  These employees can not be laid off.  Six hundred of these individuals are currently in a jobs bank, a la General Motors.  They only work part-time.  If they choose to sit in the “development center” until they reach retirement age, they are entitled to do so, at full compensation.  Under IFRS accounting guidelines, the Company is required to take a provision equivalent to the net present value of all future payroll obligations for these individuals until retirement, multiplied by the degree of underutilization (~50%), and put this total on the balance sheet.  So basically they are taking about 20 years (on average) of future payroll expenses all in the current year.  As these employees are paid, leave or are reassigned, the provision will be reduced.  Without this non-cash provision 2005 earnings would have doubled, as would the dividends (based on 70% stated payout ratio).  To get to the true earnings power of the Company you need to add back the non-cash portion of the provision found in the cash flow statement.

Although many of the sell-side analysts mention that this is a non-cash provision, all of them include it in on an unadjusted basis in their EBITDA, EPS and dividend payout ratios.  When the Company was marketing the IPO, the provisions were run through the P&L and deflated earnings when doing relative valuations with Deutsche Post and others.  It also impacted the dividend level, given the stated 70% payout ratio of net income.

If no additional employees are made redundant the Company would recognize no provision in 2007.  However next year the Company expects that it will recognize approximately €60m of underutilization expense related to additional employees becoming underutilized, or a greater degree of underutilization of existing employees in the jobs bank.  According to management the provision will continue to diminish over time.

3. Depreciation overstates capital intensity and depresses earnings

Finally depreciation expense is approximately 2.5x maintenance capex.  The first reason is that in 2005 the Company recognized €29m in asset writedowns, which increased depreciation expense.  They also recognized a €17m non-cash provision for underutilization of real estate assets.  Of course this €46m decreased net income, which suppressed the dividend used as the basis for valuation. 

Another reason depreciation expense overstates the ongoing capital intensity of the business is due to the fact that the Company is almost finished with a €600m investment program modernizing and automating its infrastructure.  POST converted its 39 mail sorting facilities into 6 state-of-the-art automated facilities. 

The Company will recognize about €100m of depreciation expense this year, and will spend about €40m on replacement and maintenance capex.  In the first half of this year total capex was only €14.6m.  This year’s growth capex of €20-30m is related to completion of the final of the 6 sorting facilities and construction of an Eastern European parcel facility.

4. Sell-side overestimating the impact of liberalization

Today only 2 segments of POST’s revenue are protected from competition – any letter mail and addressed mail under 50 grams is delivered exclusively by POST.  Letter mail and addressed direct mail over 50 grams have been liberalized in stages over the last several years.  Parcels, most direct mail and newspapers have always been open for competition.  We have spoken with a number of competitors and industry sources to gain a better understanding of the full opening (“liberalization”) of the postal market and general competitive dynamics.  In summary, only about 30% of POST revenue (direct mail and newspapers) should be subject to increased competition over time.  The earliest possible date will be January of 2009.  This date could easily slip several years after that, depending on the level of wrangling among competing interests in the EU.  Importantly, recent discussions at the EU indicate that the national regulator of the individual countries will have the final say in opening the market to competition.

After consulting with industry sources, we learned that both major Austrian political parties are resisting open competition against POST.  The outgoing administration has often butted heads with the EU competition authority.  The government has limited competitor access to apartment mailboxes, required competitors (not POST) to charge a value-added tax of approximately 20%, and offered opaque regulatory guidelines. 

Geography is an important factor.  Austria has only 8m people.  Vienna has a population of 1.5m, and is the only large city – the next closest is Graz with a population of 285,000.  It is a very mountainous country with low population density, hardly ideal for a new entrant.

Despite having competition in most segments for years, POST has a 95% market share in B2C and C2C parcels, an 85% share in direct mail, and a 56% share in newspaper delivery.  POST is now among the most effective postal services in Europe with 97% delivery on the following day, from 62% a few years ago.  High customer satisfaction is a strong impediment to development of competition.

It makes the most sense to go through each of the sub-segments.  As is the case in most other European markets, the letter mail business will not see any material competition.  Letter mail is a natural monopoly.  This is because a new entrant in the letter mail business would need to make a prohibitively large investment in infrastructure (branches, sorting centers) and personnel (for daily delivery) that would not likely be profitable, much less deliver a sufficient return on capital.  For example, if Deutsche Post (Germany) were to some day enter and achieve a 10% share of the total Austrian letter market and generate a 10% EBIT margin (better than their current operations in other large countries), it would represent about €5m of incremental earnings, or .004 of incremental EPS.  This would pale in comparison to the capital investment.  Vienna’s sorting facility was completed in almost 2 years at a cost of €150m. 

Direct mail makes up 20% of POST revenue. Revenue is evenly split between addressed direct mail (credit card solicitations, catalogs) and unaddressed direct mail (coupons, fliers, restaurant menus, etc).   This is the segment where most competition exists in European markets.   Fortunately for Austrian Post, a couple years ago they were given clearance to acquire their largest competitor, Feibra.   At this point the only competitor of any scale is a JV between a struggling Austrian publishing group and the Dutch postal provider. 

A good case study is the liberalization of the Swedish market, which occurred in 1993.  Thirteen years later Sweden Post has 93% market share.  One competitor, CityMail, emerged in 4 urban markets and delivers direct mail and newspapers only. Like Sweden, Austria is an extremely mountainous country with a small degree of urbanization.

For more information on the development of competition in European postal markets, you can look at several market studies on the EU Commission’s website:

http://ec.europa.eu/internal_market/post/studies_en.htm

Management

Management comes from industry (Siemens, banking, several consulting firms, retail and logistics companies), and the CEO and CFO have been with the Company since 1999.  They have done an impressive job converting a sleepy government run bureaucracy into a modern and competitive enterprise.  Besides modernizing the Company, they have dramatically improved customer service and delivery times. 

Eastern European expansion in parcels and direct mail

Real Estate

POST has sold off some of its excess real estate, but continues to own a lot of its branch network and all of its sorting facilities.  All of POST’s property is unmortgaged.  POST also owns real estate no longer in use that is classified as investment property, which is booked at €60m but appraised at €135m (€2/share).  We believe this valuation discrepancy probably exists for a great deal of its buildings and land on the balance sheet, which is carried at €527m.  The investment property will be sold in the next year or two.  We think the portfolio is valuable.  Austrian Post receives €20m in annual rents in a long-dated arrangement with Telecom Austria for storage of equipment in its branch network.  We think this revenue deserves a market cap rate (6 or 7%).  After talking with management, we think a sale-leaseback transaction is unlikely, but does provide some margin of safety. 

Use of cash

Management would like to use some of its cash hoard on acquisitions of Eastern European mail and parcel businesses.  Unless there is a privatization in the next few years, it is unlikely that this will be a large use of proceeds.  Management is also interested in opportunities where they can leverage their existing infrastructure, such as logistics providers in Austria.  They have publicly stated that if they do not find assets that will generate a sufficient return on capital in the next 2 years, they will return cash to shareholders in the form of regular and extraordinary dividends.

Comparable Valuation

Deutsche Post and TNT are in more competitive, large, urban markets.  Deutsche Post is being penalized for its heavy loss-making DHL operation in the U.S. 

Trading

The share volume statistics on Bloomberg are inaccurate, as we know for certain that volume has been greater than what has been recorded recently.  The shares trade until 11:30 am on the East Coast.

Catalyst