Supply chain radar: Mind the drop? Beware logistics (still) on steroids

There have been casualties on the stock market in the past week as we expected since briefly touching upon “logistics on steroids” on 8 January and afterwards – click here, here, here and here – only a few days before the coronavirus scare emerged and the initial reports highlighted a “grave situation” out of China.

But if you think the latest retracement – my 2020 Black Monday coverage here – was enough to punish several logistics stocks on our radar, well, think again: a cautious approach seems more appropriate, although the Asia trade on Monday started on the right footing, Europe was in the green – yet the joy was short-lived – while preliminary indications from the futures market in the US suggested a mild rebound from the abyss, before all the three main indexes turned lower.

Naturally it’s the coronavirus threat keeping us all busy drafting doomsday scenarios. But under a so-called “tail risk” fall, by definition a slew of uncontrollable risk elements could push down valuations much further, even according to a base-case scenario where growth prospects matter the most worldwide for all asset classes.

Background

Perhaps we easily forgot a) the Iran affairs, including that passenger plane that was ignobly shot down; b) the trade war “phase 1” saga between China and the US, mostly handled on Twitter (sigh) for months; c) the interest rate/other related risks stemming from the 2020 elections stateside, often managed on social media, with President Trump slamming the Fed once again over the weekend – so much for the Bank’s stated mission as an independent agency, which in order to support “maximum employment and stable prices”, erm… “doesn’t take politics into consideration“; d) and then political “leadership” that is just so pathetically ineffective in so many countries, with populists in places trying to convince the electorate to have reinvented the wheel – the higher the wall to protect a country, the better – and then their opponents, unable to get their act together and propel sustainable growth without external financial aid.

Deflation risk is real in a rather sickening world of finance running out of ammunition and spurred by artificial value – and then, incrementally more quantitative easing (QE) will be less effective after the binge of the past decade. In all this, major governments are struggling to force upon large corporations (it’s not only Big Tech, think Starbucks) the tax rates that ought to be paid fairly, in a world where only free money (allegedly printed) by the central banks have shored up the banks’ balance sheet rather than the real economies, making us feel as we have been actually fine for about… a decade or so. Wrong. It’s been capex investment, or the lack thereof, against burgeoning buybacks for years, so it’s payback time for the shorts.

Rant over: the world is not ending tomorrow but with so much pain in a late business cycle, logistics firms are also set to pay the highest price for their own wrongdoings. Many insiders and outsiders alike are now betting, for instance, on the next large bankruptcy in the container shipping sector (candidates are plentiful, spanning France, Singapore and Taiwan, to name a few), just as certain air carriers and air freight operators in mature economies aren’t better off if uncertainty lasts, given their unbalanced capital structures. And that’s not to mention the cash-strapped cargo handlers, among others.

Moving on 

Knowing the ocean asset owners/operators have a debt pile to deal with – a return to the “moral hazard” debate could be around the corner, given possible government intervention where distress is apparent – let’s focus here on the asset-light players that have used M&A or just the promise to do deals to prop up value.

To start with, let’s compare the performances of two traditionally aggressive players against the largest listed 3PL by revenues in Europe, Kuehne + Nagel (K+N), which lately has entertained only minor acquisitions, as gauged by size and value against its own market cap.

The chart below should be self-explanatory, with XPO Logistics giving up more than the value it added after the announcement of a break-up in mid-January and the stock trading as low as $70.6 on Friday within a whisker of my $69.5 a share fair value estimates. There is huge value in the parts, some say, as if the parts’ assets and liabilities were easy to identify and there were appetite for sub-scale transport and logistics assets in this market.

Maybe the bulls are right. Regardless of that, think about how harmful the fall could have been if XPO Logistics had not announced the intention to shuffle the corporate cards earlier this year.

In fairness, M&A plans and actions didn’t really matter in terms of superior value accretion if you throw into the mix organic growth-led K+N, which even lagged DSV Panalpina in recent weeks, although the Danes – as opposed to K+N, traditionally, and XPO, at least lately – are using a massive, seemingly ill-timed buyback programme to prop up their stock value and earnings per share.

Shrinking the share count to hedge current downside brings us ideally to North America, looking elsewhere at highly capex-intensive border-protected transport companies who have little/no exchange and transport of goods with other countries outside the Americas.

Add to those three, railroad CSX Corporation – a domestic buyback machine with a lowly yield similar albeit higher than DSV’s (XPO yield’s is 0%; K+N has just cut the payout by 33%, but its yield remains close to 3%) – and, unsurprisingly, the stock of the latter has been more defensive than those of the international, asset-light operators…

… yet then take into consideration Union Pacific (UP), CSX’s larger peer (double in size by revenues), and really the findings are disappointing. Although UP spent $5.8bn in 2019 to repurchase its stock, down from $8.2bn one year earlier – by comparison, CSX’s cash outflows from share repurchases fell by about 30% to $3.37bn from $4.67bn one year earlier, a similar drop to UP’s – it was the worst performer behind XPO, before others are added for comparable purposes.

It’s not even buybacks, then, helping stock values defy the law of gravity in recent weeks. What about those others who acquired stock and still paid out dividends to investors, such as freight brokerage firms CH Robinson, Expeditors and JB Hunt, with their different product propositions and modes of transport?

Well, just as XPO reached a peak valuation (still well below previous highs above $110) and the coronavirus scare built up, these three didn’t manage to get the wooden spoon award…

… only because XPO played up expectations so much that inevitably – given the latest events – they have backfired so far, keeping all three behind it. Unless you take into account the battered, asset-heavier integrated logistics companies too, and then the absolute loser since mid-January was UPS, with DP-DHL battling closely with XPO for second place at the bottom of the rankings.

From bubble to bust, with US Treasury yields testing 1.1% – so much for the death of the bond bull market advertised in the past two years or so, eh? – all these stocks could be even more exposed while other sectors aren’t better off. Take energy for one; integrated oil company Exxon has shed 24% of value since mid-January.

But let’s stick to some major logistics names, and look at the chart below…

… and pray the coronavirus scare is sorted before the world has to deal with another bigger threat that jeopardises its own financial existence, at current trading multiples.

Because the one aspect to blame for the current situation boils down to logistics + virtually all other sectors having been on steroids for years – logistics more so than others, though, given its inherent complex dynamics, often poor shareholding structures on the global scale and shifting IT trends driven by new entrants, leading to thin underlying margins getting thinner.

More broadly, massive capital appreciation and real economic growth have been mainly propelled by QE policies that, as we know, have led to the so-called Japanifican effect, coupled with ever-rising valuations (well above trends, according to the cyclically adjusted price-to-earnings ratio)…

… that have grown crazy for most stocks across various sectors and are hardly representative of fair values, with the BTFD mentality now gaining strength with each passing hour.

How cool is that.