KHNGF - Kuehne + Nagel: Valuation And Near-Term Uncertainties Are Concerns To Be Aware Of

2023-04-27 08:04:12 ET

Summary

• KNI's shift in strategy towards retaining a better mix of business has the potential to drive earnings growth, but the market may take time to reflect this change.
• While the 1Q23 results were strong, there are concerns about KNI's long-term viability of Sea GP/TEU and EBIT.
• Valuation is another concern which is trading at a premium compared to the market and peers.

Thesis

Kuehne + Nagel International ( KHNGF ) is a global logistics provider. They run logistics centers and transportation companies that move goods by sea, land, and rail. KNI's new direction has me leaning optimistic, but for the time being I'm suggesting a hold rating. The shift in strategy toward retaining a better mix of business is responsible for much of my optimism; however, I believe it will be some time before the market shares my views (only when EBIT starts to show the results of this change). Other than this, KNI's strong balance provides flexibility on M&A, which may be a catalyst to drive earnings growth (but I am not betting on this). The stock also offers a respectable return via dividends (5%), which I believe KNI will have no trouble paying out given the large cash stack it has on its balance sheet ($4 billion), making it a good option for risk takers willing to take an early leap of faith. As for the 1Q results, while it was very strong, I anticipate some of this momentum to wane in the coming quarters (explained below). Importantly,, the massive intraday price swing leads me to believe the market may need more time to digest the conflicting messaging surrounding dividends. Lastly, I have concerns with regards to KNI valuation which is trading at a premium vs the market and peers.

Results review

The 1Q23 results blew away projections thanks largely to a high margin on the Sea freight unit. The volume of sea traffic fell by 6% year over year, while air traffic fell by 17%. Comparatively, Sea unit margins increased 13% sequentially while Air unit margins fell 13%. However, I should caution that this high Sea unit margin is largely due to a one-time windfall benefit from sharply falling freight rates and is not sustainable in the long run.

Dividend

KNI distributed CHF14 in DPS in 2022, and consensus expects that this will drop to CHF9 in 2023. There was some ambiguity in the call response to a question about the DPS for FY23, leading some to worry that it is unlikely for the same level of DPS to be distributed again. I think this has scared off some dividend-focused investors. Nonetheless, I think the DPS is too low, especially as management has the financial resources to keep paying the same level of dividends. If KNI were to declare a DPS that was significantly higher than what the market was anticipating, it could serve as a catalyst to boost the stock price.

My outlook and concerns

Future worries include the long-term viability of Sea GP/TEU and EBIT. Due to declining ocean freight rates, Sea revenue per TEU dropped 21% sequentially and 40% year over year. However, Sea gross margin increased to 23% in 1Q from 15% in 4Q22 and 18% in 1Q21. The record high gross margin is consistent with the typical late-cycle pattern in freight forwarding, where gross margins expand as underlying rates fall, suggesting that KNI traded a weak freight market effectively. In the coming quarters, I anticipate a decrease in both profits and margins, especially GP/TEU as rate volatility decreases at a lower nominal level. As a result of lower Sea unit margins (which were boosted by a one-time event in the current quarter), I expect EBIT to fall in the coming quarter. However, given the improvement in volumes and the shift in business mix, I would not be surprised to see EBIT increase sequentially after 2Q23. Overall, a word to describe the current situation is an elevated of near-term uncertainty which makes modeling and underwriting the next few quarter extremely tough. I believe the best course of action is to wait this out.

Valuation

Another area of concern for me is valuation. To begin, KNI is trading at a 1.8x ratio versus the STXE 600, which is significantly higher than the historical average of 1.5x. More importantly, when this ratio reaches such a high level, the rate of change reverses quickly and sharply. As a result, investors today face the risk of a sharp mean reversal, which the 5% dividend yield would not be able to mitigate. Assuming the reversion occurs, the stock's downside is around 17%, pushing it to CHF216, where it was in early 2021 before the massive spike. Second, despite having a similar company size (in terms of revenue and net income), KNI trades at a premium to a direct peer (DSV A/S), with a forward PE of 24x vs 20.7x.

Conclusion

KNI shift in strategy toward retaining a better mix of business has me leaning optimistic about the company's future. However, given the current elevated level of uncertainty in the near term, I suggest a hold rating for now. While the 1Q23 results were impressive, I anticipate some of this momentum to wane in the coming quarters, and I have concerns about KNI's valuation, which is trading at a premium compared to the market and peers. Moreover, future worries include the long-term viability of Sea GP/TEU and EBIT. Therefore, I believe the best course of action is to wait and see how the market reacts to these changes before making any investment decisions.

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