DX Group - A Clearer Picture

https://www.thedx.co.uk/


With the oil price stabilising at lower levels (at present), and industrial transportation sectors movements generally being bullish on the back of that, it makes sense to re-look at logistics and mailing company DX Group to see whether there is now a clearer valuation case. Previously the IPO, which saw a large injection of cash to dismantle debt structures, led to a particularly opaque picture and it was relatively difficult to place a valuation on DX with confidence. The company has since released results, which help to form a clearer picture. Are the shares now worth buying or are the same concerns voiced in the initial review still valid?

This article is a follow-on from the below post. For full context and information, read this article first:
http://www.theel1tetrader.com/2014/03/dx-group-delivering-on-aim.html

Technicals


From a technical point of view, as long as the share price does not close below 95p, then a recovery towards 105p - 110p looks the favoured scenario. The RSI and MACD have both turned up and the share price has moved off a cluster of lows around the 95p level. However, selling pressure does appear to persist, and there is not a clear direction for now. The spread is roughly 97.00p -> 97.50p.

The share price has performed poorly since the initial review, which ties into what I commented upon about how it was "not particularly cheap" and that "upside is limited". That first review was back in March when the share price was 130p and the market capitalisation was £261m. I also said, "I'd even argue that UK Mail's rating itself is too high and that certain companies within the wider Industrial Transportation sector could be liable to a downwards rating adjustment", in light of the high fundamental ratings that peers were trading on. That prediction has materialised, with UK Mail adjusting downwards from a share price of around 650p at the time, to 400p at present; a decline of nearly 40%. That is likely to have contributed to the downward pressure on DX's share price.

Another technical reason for the share price fall has been that a couple of institutions have provided selling pressure, and that can be seen through the volumes processed (several lump trades have been traded). That selling may partly be down to the recent market correction, but the share price weakness started long before that, so I would attribute the selling down to profit taking. After all, DX IPO'd at 100p, so some institutions were able to lock-in a quick profit.

One question you have to ask when private equity list a company is why they are doing it. If the company was very cheap and had excellent growth forecast, then the private equity firm would not shed the company; the shedding is because the private equity firm can extract value at a time they feel is right (which is usually a time which is unfavourable for shareholders to invest!). Therefore, always be wary when private equity choose to list a company during a bull market.

In this instance, the shareholder list is high quality with many highly regarded institutions. Since the first review, J O Hambro, Standard Life, Hargreave Hale and Ruffer Group have all increased their stakes, but FIL has decreased, and Henderson have shed over 3% of their stake and now hold under 10% of the shares in issue. That has likely provided some of the downward pressure, although obviously fundamentals play a role.

Operations

Rather than just re-wording the company's operations, here is an extract from the first review that categorises their operations.

"DX currently operates as a number of business segments in three separate areas, mail and packets (1, 2 and 3), Parcels and Freight (4, 5 and 6) and Logistics (7). Its customers include a number of blue chip clients including HSBC and Johnson & Johnson.
1. DX Exchange = Private Business2Business (B2B) mail and packets
2. DX Mail = Low cost, 2nd class mail equivalent for smaller volume users
3. DX Secure = Operates in the Business2Consumer (B2C) retail parcels market. An example is that they are the distributor of passports in the UK with the HM Passport Office in a contract that runs through to July 2015
4. DX Courier Tracked = B2B next-day parcel delivery with a strong current backing by pharmaceuticals and gambling industries
5. DX Freight = Predominantly B2B. Express delivery of irregular dimension and weight packages
6. DX 2-Man = B2C for heavier items (up to 150kg)
7. DX Logistics = Outsource provider for logistics services such as the provision of liveried fleet. Customers include B&Q."

What I want to focus upon in this section is the state of the sector and DX's role within in. DX is not a growth play; top-line growth is modest at best and the sector is fiercely competitive meaning that taking market share can be particularly difficult. Instead DX is in a turnaround phase since it has shed the bulk of its pre-IPO debt, and is now looking to exploit operational efficiencies and turn around the DX Freight division. That included closing 12 sites during the last financial year and opening three new co-located sites to drive efficiencies. DX now operates out of 70 service centres across the UK with DX Freight alone operating 730 vehicles and over 550 trailers.

There are two sides of the equation; letters and parcels. Letters is very much in structural decline, falling by a CAGR of 4.9% and that is largely down to electronic substitution in non-critical industries. The other side is parcels, which is growing quickly across the industry, driven by increase online sales as a proportion of total sales (i.e. street sales). In light of that DX has been keen to note that roughly 75% of total group revenues are derived from growth areas of parcels, freight and outsized deliveries.

With oil prices (which are a core part of sector costs) having declined sharply over the past few months that theoretically positive backdrop of parcel growth, combined with lower costs should drive greater returns for DX and even the potential for short-term expectation beats. The problem is that the positive backdrop is not actually so positive. The sector is fiercely competitive with low barriers to entry leading to numerous operators such as UK Mail, Royal Mail, but also unlisted peers such as Parcelforce, DPD, CityLink and Hermes. Add in the lack of service differentiation and it's a price battle to the bottom, with the most cost efficient firm (with sufficient scale and a good reputation) taking the lead.

Several peers have been warning on that point recently:
- TNT warned on "increasing competition" in the UK driving pricing pressure
- Royal Mail noted "a weaker than expected performance in UK parcels" and guided that UK parcels revenues for the full year would be below internal expectations
- UK Mail commented that Q2 was challenging with parcels volumes below expectations. They could not tell whether this was a blip or the start of a more serious trend

Therefore, although the longer-term picture may be sound, there are clearly short-term issues that the sector is facing. It is essentially a race to the bottom with a continuous need to invest in operational efficiencies; DX spent £8.7m on CAPEX in 2014. That scene doesn't show any near-term signs of abating with Royal Mail announcing earlier in H2 that they would up the size and weight allowed in various parcel categories, thereby making it cheaper to post certain dimensions; a move made to cement their market share over the Christmas period. Given how DX notes that the Christmas period will be important to the overall group performance, that is something to watch carefully. Beyond that, these operating efficiencies that will be embarked upon will include more automated processes that only the larger players can afford, so it is likely that some of the challenger companies will struggle to build scale and match the prices of the larger players across the board without taking their own niche.

The one point in DX's favour against the competitive backdrop is that they have carved out a niche to an extent, with an increasing focus on time-sensitive, mission critical and 2-man deliveries, alongside irregular dimension and weight deliveries. That is likely to provide some protection, but there is not much stopping competitors stepping in and exploiting those niches too, as long as it is profitable for them to do so. The same can be said with DX's document exchange division, which is in decline; DX has set up a secure emails division ("eDX") and started offering a secure paper shredding service in an effort to provide differentiating factors, but this might simply be a case of fighting the inevitable decline, and might only be successful in retaining their share of that segment, and slowing the rate of decline.

Financials

That has failed to faze management though, noting a "positive outlook" and "Encouraging progress over the year with a turnaround programme and operating initiatives" in their last FY results.

Peter Cvetkovic, Chief Executive Officer, commented, "Our recapitalisation and admission to AIM in February has marked an important point in DX's development.  We are now very well placed financially and operationally to pursue our long term growth strategy, underpinned by a strong balance sheet and good cash flows. Over the next three years, our main focus continues to be on the turnaround of DX Freight, the underperforming delivery business we acquired in 2012.  Hand in hand with this, we are streamlining and developing DX's distribution network.

Our goal is to create a 'OneDX' culture and service offering, underpinned by enhanced technology and unified systems. This transition puts us in a better position both to grow profitably and to provide Customers with the outstanding service delivery that we are constantly striving for.  We have accomplished much in the year. Trading in the new financial year is in line with management expectations and we continue to view prospects for the new financial year positively as we implement our turnaround and efficiency programmes."

That all said, the actual numbers are underwhelming and it is perhaps easier to see why private equity looked to offload DX at the point that they did:

-   Continuing revenues up 4% to £304.2m
-   EBITDA flat at £34.4m
-   Net debt stood at £12.2m at the end of June; expected to trend downwards
-   An apparently 'strong' balance sheet, although I would beg to differ
-   Highly cash generative with cash generated from operations at 69% of EBITDA
-   The main driver going forward is touted to be the turnaround of DX Freight, which will positively benefit margins
-   DX "won a significant number of new contracts in the second half"

Looking at the profit lines of the income statement in the results is a relatively meaningless task given how many legacy issues still remained. That said, there are some points to glean and certain numbers (such as on the balance sheet) that have been cleared up.

Divisionally the performance was lacklustre. Parcels and Freight, which is supposedly a core growth division, say revenues relatively flat at £163.6m or 52% of total revenues. That said, it can be accepted given the focus was on turning around the DX Freight division and that included withdrawing from low margin freight and untracked courier services. However, with the market backdrop noted earlier, it hardly paints a positive picture for investors. Mail and Packets was in decline (as expected) with revenues down 3% to £116.1m, although Logistics revenues were up 35% from a relatively low base.

The comment that the balance sheet is strong is absolutely not something that tallies with the results. At the period end current assets were just ~72% of current liabilities, and although DX no doubt has access to debt, the balance sheet strength was probably just relative to previous periods when the company was debt-laden. It is not strong in an absolute sense as tangible asset backing is just £69m, and there are actually negative tangible assets of £16.9m, which is an obvious negative for a value proposition.

In the previous review I commented that, against Royal Mail and UK Mail, DX had a lower FY14 dividend yield, a weaker balance sheet, but also a lower rating. Royal Mail was on a debt-adjusted PER of 15.9 and UK Mail was on a cash-adjusted PER of 19.7. Whilst the PER I forecast was higher than has transpired, it was not low for an industrial transportation company and was unattractive given the state of the balance sheet. That has now partly changed.

Brokers Arden have forecast marginal revenue growth in 2015 and corresponding EPS of 11.27p, with 6p in dividends. That relays through to a relatively low (but not ridiculously low) PER of 8.61, and a highly attractive dividend yield of 6.2%, which places DX towards the top quartile in terms of dividend yield. In 2016, EPS are forecast to grow only slightly to 11.51p and 6.20p in dividends. Whilst the yield should protect against major downside from the current level and the valuation is expensive, short-term headwinds plus the lack of growth and weak balance sheet are sufficient deterrents at the current point in time. Nonetheless, yield seekers could find value at this price.

It's worth performing a quick comparison against peers in both the UK, more generally across Europe, and also in the US (although these two companies - UPS and FedEx - can be disregarded in a comparison given the differing growth dynamics).


DX is the smallest company by market cap in the peer group, yet excluding the US firms it is on a MCAP/Sales metric above the European peers (Royal Mail, UK Mail, Deutsche Post, TNT Express) who trade on a mean value of 0.46. DX's margin is towards the upper end against peers, which supports the idea that the company operates within a niche hence can price higher and attract that higher EBITDA margin. However, against all peers, DX has the weakest balance sheet with a TA/TL of just 0.80, which is not a comfortable position. UK Mail's balance sheet is far superior to DX's.

 
DX does not display much in the way of forecast EPS growth either, with a minimal 1% forecast to the FY 2016. However, several of the other larger peer increases are down to restructuring rather than excellent absolute growth, and the US peer growth figures do actually justify their 2015 forecast PERs. DX is trading on the lowest forecast PER by a clear margin at just 8.70, although that rises by between 5% and 10% when factoring in the debt pile. That low PER is likely as a result of the weak forecast growth and the relatively weak balance sheet vs. peers. The latter point may change as a result of strong cash flows, but they will be offset by the excellent 6.12% dividend (covered almost 1.9x) and CAPEX going forward, preventing a fair proportion from being diverted towards debt reduction. The yield is nonetheless one of the biggest, if not the biggest attraction of DX at current levels. Nonetheless, if you were looking predominantly for a yield, UK Mail appears more attractive given the strong balance sheet and net cash position.

The last column shows the price performances of peers over the past 6 months; this shows that all European companies within the sector have been under pressure, with US peers outperforming. Again this shows that there are different market dynamics at play.

An Attractive Yield and Low Multiple

Although DX now boasts both an attractive prospective dividend yield of over 6% and trades on a high single digit price-earnings multiple; the lack of balance sheet strength combined with an unclear short-term industry picture still mean that it makes sense to remain watching DX and adopt a No Rating position. The lack of forecast growth combined with the weak financial position means that it is difficult to see enticing upside in the near term, despite the fact that the prospective yield will provide a high level of downside protection barring a marked deterioration in the operational performance. Notwithstanding the decline in fuel costs, which could provide upside that is unaccounted for, further clarity on the outlook would be useful. No Rating

5 comments:

  1. Now that is interesting. If i wanted a yield would I choose dx or UK mail? I woul probably take a bit of both because downside in dx is probably 85p? an the yield is better. The downside in Uk mail is probably 350p? and the yield is way over 5%. Maybe a bounce after the drop too

    04.11.14

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  2. Japanese shares hit a record high today after the bank of japan started round 1 zillion of q.e to get the economy out of their dreaded deflationary spiral. God knows what will happen is Europe goes into one so we will be quantitatively eased to death before that happens lol. Amazing how ups and fedex are so highly valued but they looks like average investments. Wheres the yield lol.
    James Brockham

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    Replies
    1. and the uk markets are down. Typical.
      James Brockham

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  3. Thanks very much for this informed piece. I have been a shareholder of DX since it listed on AIM and felt a bit hooked in as I saw the share price decline. Sometimes it is difficult to know when to exit an investment as I hate taking losses even if it is only a perception thing. In this case I have held on and formed a 12-18 month view of it reaching 125p and collecting dividends along the way

    Great website. Bookmarked and subscribed. One of the best for free information

    Chris (chrisf102@gmail.com)

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