|Shares Out. (in M):||24||P/E||24.7x||17.0x|
|Market Cap (in $M):||2,218||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||-558||EBIT||0||0|
Note: the numbers in the valuation box above are CHF and use consensus estimates.
Panalpina is the world’s fourth largest air and ocean freight forwarder with a market share of approximately 3%. The company generates about 45% of its gross profit from Air Freight, 30% from Ocean Freight, and 25% Logistics. Panalpina was written up last year on VIC by DCE who gave a good background, overview of the quality of business/competitive advantage, and the valuation disconnect relative to peers. Therefore, I am going to skip over a lot of discussion on those points and instead elaborate on the reasons for the valuation gap and how that gap will be closed through the transformation underway at the company.
After years of operational underperformance, Panalpina is undergoing a transformation which should result in margins at least returning to peak but more likely bridging the gap to peers, driving 2015 EPS of CHF 10.00 (peak margins) to CHF 12.85 (bridge the margin gap) compared to consensus of CHF 8.00. Panalpina is currently trading at about 15.5x NTM EPS ex cash, a modest discount to peers CH Robinson, Expeditors, and Kuehne + Nagel which trade at about 18-20x NTM EPS ex cash. If the transformation is successful, Panalpina should trade inline with peers. Assuming a multiple of 18x and taking into consideration current cash on the balance sheet (CHF 23.60) plus the cash they will generate over the next 2.5 years (CHF 17.00-20.00), results in an end of 2014 price target of CHF 220-275 for 135-190% upside to the current CHF 94 share price. Panalpina has 25% of its market cap in cash and trades at an EV/Sales multiple of 0.23x 2012 compared to 0.70-1.11x for peers.
While the general consensus view is that freight forwarding is an attractive business characterized by network economics with strong and capital light growth, Panalpina is viewed as a dog. Much of this can be traced to a somewhat tainted history and its track record of operational underperformance.
Over the last decade, Panalpina’s EBITDA/GP conversion margin has lagged European forwarders by at least a few hundred basis points and has trailed US forwarders by a couple thousand basis points. Reported gross profit growth also lagged with Panalpina growing at a 2% CAGR compared to CH Robinson, Expeditors, and Kuehne + Nagel at 11-13% and DSV at 25% (with acquisitions) over the 2000-2011 timeframe. Moreover, during the 2008/2009 recession, Panalpina saw underlying EBIT decline close to 60% compared to K&N and DSV in the mid-teens.
I believe there were a few non-structural reasons for this historical underperformance. The Ernst Goehner Foundation owned all of Panalpina by the 1980s. The business was run with a foundation mindset where the owners were happy just to earn a reasonable return on capital rather than trying to maximize growth and profits. Post the September 2005 IPO, this started to change and Panalpina was making reasonable progress on EBITDA/GP conversion margins which expanded from 14% in 2005 to 21% in 2007.
In January 2006, the CEO was forced to resign due to an accounting scandal that happened on his watch. An employee in the central air freight procurement division of Panalpina had booked capacity at above average rates, resulting in losses which he then tried to cover up by cooking the books. The losses were relatively immaterial at CHF 33 million, or 1% of gross profit over the two years they occurred. The incident was isolated and the employee was terminated.
Then in 2007, it surfaced that Panalpina had been paying bribes on behalf of its customers to get goods through Nigerian customs. This issue was finally resolved in 2010, but for three years it was a huge management distraction, Panalpina had to give up its very profitable Nigerian business, and the company was unable to tender on high profit O&G volumes given the DOJ investigation (post resolution, customers have invited Panalpina to tender again).
Meanwhile, the 2008/2009 recession hit. Panalpina had a distracted management team coupled with less sophisticated systems compared to other forwarders. As a result, EBIT was hit much harder than peers.
Over the last couple years Panalpina has been embarking on a transformation, the fruits of which are being masked by general difficulties in the freight forwarding market, namely weak air freight volumes and sharp ocean freight rate increases. I believe that ultimately Panalpina should be able to get back to its peak EBITDA/GP conversion margins of 20-21% which were achieved in 2006-2008. At the June 2011 Investor Day, management set a 20% conversion margin target by 2014. The 20% margin target was reiterated on the 2Q12 conference call although they backed off of a firm timeline until there is more clarity on the market development. Even the 20% bar seems low, and I think a 25% conversion margin is achievable by 2015, inline with European peers.
K&N’s Air/Sea/Road business did 25.2% last year while DSV did 24.9%, and analysts expect these conversion margins to continue to increase. I should note a couple points on benchmarking to these two companies. DSV includes blue collar workers in gross profit so this needs to be adjusted. I look at K&N’s Air/Sea/Road business rather than the group because K&N has a more owned contract logistics business, meaning there are very few "net expenses for services from third parties" which skews gross profit up and conversion margins down.
US forwarders did even better last year with Expeditors posting a 34.5% conversion margin and CH Robinson doing 44.4%. While I think there is some merit to benchmarking forwarders regardless of product exposure, and even merit to benchmarking to other distribution type businesses where conversion margins matter, I’d probably throw CH Robinson out due to its significant exposure to domestic trucking and an incentive structure which cannot be replicated by Panalpina. It would also be tough for Panalpina to achieve Expeditor’s margins for a variety of reasons: Expeditors is exceptionally strong and focused on the Trans Pacific, has a greater focus on higher profitability SMEs, and again a degree of variable compensation which is not feasible at a European company. That said, CH Robinson’s margins are up from 32% and Expeditor’s from 27% in 2000, illustrating that margin potential could be a moving target even at high levels.
For your convenience, here is a chart showing Panalpina’s historical and consensus margins compared to peers: http://imageshack.us/photo/my-images/140/convmargins.jpg/
The margin gap to peers is largely driven by productivity and will mainly be closed through process improvements and investments in technology. Last year, Panalpina posted GP/employee of about $110,000 compared to K&N’s Air/Sea/Road business of about $135,000 (my estimate based on disclosure of operational staff, grossed up for its share of non-operational staff), indicating a 20%+ productivity opportunity. Another way to look at this is one sell-side analyst has estimated that Panalpina employees handle 35 orders per month compared to K&N at 40 orders per month, indicating a 14% productivity opportunity. Either way you look at it, that’s enough opportunity to get to 25% conversion margins. I think as you will see in the “Productivity Initiatives” section below, what needs to be done here is not rocket science. It’s really just improving/standardizing processes and cutting back on paper.
This transformation is a bit unique in that it is not being spearheaded by a new CEO, but I believe by changes at the Board level. The Board consists of seven members, three of which are also members of the Board of Trustees of the Ernst Goehner Foundation (Rudolf W. Hug, Roger Schmid, and Beat Walti). The other four joined in 2010 and 2011, including Lars Forberg, Co-Founder and Managing Partner of activist fund Cevian Capital, who obtained a Board seat in May 2011. It is my understanding that the new Board members are very performance oriented. The transformation will likely be accelerated by the new CFO Robert Erni, who was appointed in February 2012 and will begin January 2013 when his contract at K&N expires. Robert is very well regarded by the investment community. He was most recently the Head of Corporate Controlling at K&N and thought to be the likely successor to current CFO Gerard van Kesteren.
Aside from changes to the Board and CFO, there have been other significant management and organizational structure changes. Organizationally, they have gone from being primarily area focused to adding industry and product focuses. Through the implementation of a regional structure they have streamlined to 3 direct reports into the CEO as opposed to 21 direct reports previously. Former CFO Marco Gadola has moved to be the CEO of Asia Pacific. In February 2012, Panalpina hired Ferdinand Kurt as the CEO for theAmericas. Ferdinand is also a former K&N employee having most recently been the CEO of South andCentral America. In September 2010, Panalpina hired new product heads. Frank Hercksen came from K&N to become the Global Head of Ocean Freight. He was the #2 in K&N’s Sea Freight business and is very well regarded. Henrik Lund came from DHL Global Forwarding to become the Global Head of Air Freight and Mike Wilson was formerly an SVP of Global Supply Chain at Timex before becoming the Global Head of Logistics at Panalpina.
The CEO Monika Ribar has held her role since the accounting scandal in 2006. Put nicely, she is very underwhelming and seems to have been appointed CEO because she is part of the old boys’ network. I think investors would be ecstatic if she resigned. There were some rumors floating around last year that she was looking for a new job and had been approached by the Swiss Post but that role was ultimately filled by someone else. While nothing has transpired yet, given the changes at the Board and other management spots, I’m keeping my fingers crossed.
At the end of 2009, Panalpina implemented a Management Information System which provides management with data such as profitability by industry verticals, trade lanes, customers, products, etc. Speaking to ex-employees, historically most of the focus was on very high level data, with senior management basically looking at the P&L by four geographic regions. The increased transparency provided by the MIS has allowed them to improve unit profitability by retendering for better prices and through customer rationalization, which led to Air Freight GP/ton constant currency growth of +21% last year.
They are implementing SAP TM which will drive productivity improvements through automation and process standardization. This rollout is being phased with the first deployment to major countries in Ocean Freight in 2012, followed by major countries in Air Freight in 2013, with a complete rollout to all businesses and countries by 2015. SAP TM will make processes leaner, so for example somebody who is handling customer orders won’t have to click through many different screens entering the same data over and over. Instead he will only click through a few screens and enter data once. Furthermore, the quality of data is improved. The company has indicated SAP TM will result in a 10% increase in productivity.
Another initiative is E-File which is an internal tool for handling shipment documents. As you can imagine, there are lots of documents starting from when an order is generated to when the goods are finally passed through customs and delivered to the customer. Instead of having a bunch of paper documents, sending around e-mails with attachments, and guys saving data locally in their individual spreadsheets, everything will be stored electronically in a central database and anybody who needs access to these documents can get them.
They are also working to increase connectivity with customers and carriers which will be enabled by SAP TM due to standardized data fields, again resulting in improved productivity through automated data flow. A nice additional benefit is that it provides more value to customers through things like automatic initiation of orders when their inventory is running low and helps Panalpina get more integrated into the customers’ systems, leading to increased stickiness.
There is a rate standardization program to centrally store rate data. Having a central repository of carrier rates should improve quotations to customers. They are also working on things like shared service centers centralized at the regional level rather than the country level, which will result in headcount cost savings.
It is also worth noting that incentives and compensation have changed. Previously managers were primarily incentivized on volume growth, but now the KPIs are GP, EBITDA/GP, and working capital management. Previously variable compensation for area managers would have been 50/50 area KPIs/individual objectives but this has changed to 1/3 each for area KPIs, individual objectives, and group KPIs. Discussions with ex-employees suggest there were historically internal “competition” issues where different offices would not cooperate with each other (for example, during global account tenders) due to the incentive structure and aided by the opacity of the company’s systems, so I am glad to see some incentives linked to group level performance. They are also working to increase the degree of variable compensation, although again it will never match US forwarder levels.
It has been a tough 12-18 months for the freight forwarding industry. Air freight industry volumes turned negative in 2Q11 and were down 1% for the year. Declines accelerated through the year and the market has been down 3-4% in the first half of this year. Ocean freight industry volumes have been decelerating from 11% in 2010 to +5% in 2011 to +3% in the first half of the year. Furthermore, forwarders have seen some GP/TEU pressure due to sharp increases in freight rates by the ocean carriers. While the effect of freight rates tends to be a wash in the long-run, there is some short-term pressure on unit profitability in a period of rapidly rising rates as forwarders pass through rate increases with a lag (and conversely in a period of rapidly declining rates, forwarders tend to see temporary improvements in unit profitability).
At its 2011 Investor Day, Panalpina talked about the air freight market growing at a 5% CAGR from 2011-2014 and the ocean freight market growing at a 7% CAGR over that period, with the company aiming to outgrow the market. These market growth forecasts are broadly inline with what K&N has laid out. Keep in mind that Panalpina is the fourth largest freight forwarder with 3% global share and the top 10 forwarders are about 30% of the market. Forwarders have been gaining share from shippers going direct to carriers, and within the forwarding pie, the large forwarders have been gaining share. Therefore, I would expect Panalpina to grow faster than freight volumes.
I am assuming Panalpina’s Air Freight business is flat in tonnage this year with some pressure on GP/ton. The company has guided to a down 1% market and they aim to take share. GP/ton 1Q was +5% ex fx, 2Q was down 4% ex fx, and the company has guided for GP/ton to decrease this year. After 2012, I assume 6% volume growth and flat GP/ton. This gets to 2015 tons of 1.01 million at CHF 787/ton = CHF 795 million in gross profit.
In the Ocean Freight business, I am assuming +6% TEU growth this year with a stable GP/TEU. The company has guided for market share gains in a +3-4% market with stable GP/TEU. In the first half of the year, Panalpina’s TEU growth has been +7%. After 2012, I assume 9% TEU growth based on a +7% market CAGR (inline with guidance) and some market share gains. I also assume stable GP/TEU. This brings 2015 to 1.8 million TEUs at CHF 335/TEU = CHF 603 million in gross profit.
For Logistics, I am assuming the year is down 4% ex fx after 1H was down 4-5%. I assume +6% growth thereafter and a gross margin of 40.5%, stable with 2010. This drives gross profit of CHF 428 million.
The above assumptions lead to constant currency gross profit growth of down 1% this year followed by +7% thereafter, driving 2015 gross profit of CHF 1.825 billion. I am looking at it ex cash so I assume no interest, the tax rate is 25%, and there are 23.6 million shares outstanding. Thus assuming a 20% EBITDA/GP margin in 2015 drives EPS of around CHF 10.00. At a 25% EBITDA/GP margin, 2015 EPS would be about CHF 12.85. If Panalpina improves its performance to be more inline with peers, then it should also get a peer group multiple. It actually traded at a premium to K&N in late 2006/early 2007 when it had strong operating momentum and prior to the Nigeria issue. Assuming 18x NTM EPS ex cash and taking into consideration current cash on the balance sheet (CHF 23.60) plus the cash they will generate over the next 2.5 years (CHF 17.00-20.00), results in an end of 2014 price target of CHF 220-275.
Even though it is underperforming peers operationally, Panalpina still generates healthy returns on capital, is highly cash generative, and has 25% of its market cap in cash, so I think it is unlikely there is high risk of significant value destruction or permanent impairment. So aside from the obvious macro risk, I think the key risk here is that the transformation falls flat and the stock languishes.