Swiss quality in the form of one of the world’s largest freight forwarders. Each year, more than 4.5 million container units are transported by ship, and more than 1.7 million are transported by air. Kuehne + Nagel’s story is one of strong and profitable growth, and with investments in new solutions meant to take profitability to new heights – the target is to grow twice as fast as the market.
For years, we have outlined our positive view on the business model of freight forwarders through our ownership of DSV and Expeditors, and now Kuehne + Nagel has re-joined our group of freight forwarders, as it is once again one our companies, as it was from 2008 to 2013 as well. In our view, management’s visionary business initiatives are undervalued while the perceived risks from potential new competitors are overestimated. We believe there are good opportunities for Kuehne + Nagel to grow their earnings and free cash flows by attractive double-digit annual growth rates in the current strategic period running until 2022.
With the reacquisition of Kuehne + Nagel, we are now co-owners of three freight forwarders which we believe are among the best managed companies in the industry. This Swiss freight forwarder operates in more than 100 countries with over 1,300 offices and around 80,000 employees. Freight forwarders often work in several different aspects, ranging from transport by road, air and sea, and several freight forwarders also manage parts of, or entire, value chains on behalf of their customers. Kuehne + Nagel has its focus on sea, air and contract logistics.
Measured by operating income, sea freight represents almost 45 percent of the business, while air freight is around a third. Road freight represents around 5 percent with the logistics business representing the remaining 17 percent. However, it is worth noting that the reported earnings by and large underestimate the overall contribution from the logistics business – which management has had an increasingly positive view of with good opportunity for creating more value. In 2018, some customer implementation at warehouses did not go according to plan, and negatively impacted the reported earnings in the short run. The company has a strong focus on re-establishing a higher level of earnings.
Some are uncertain about a strong business model
For the company’s largest business area, sea freight, Kuehne + Nagel is the world’s by far largest freight forwarder. In order to put its size into perspective, the more than 4.5 million container units could fill up more than 9,000 football fields. However, sea freight is not growing as fast as air freight when measured by the growth in transported volumes. Over the last five years, Kuehne + Nagel’s volume of transported containers has grown by more than five percent per year, and this is in a market that is generally assessed as growing at around three to four percent a year.
The quality and value creation of a freight forwarder is found in the fact that they do not themselves own planes, trucks or large container ships. Kuehne + Nagel purchases cargo space from suppliers, when a customer has made a booking. Therefore, very limited capital is tied up and most of the capital is a result of there being a gap from the time when Kuehne + Nagel pays its suppliers (the shipping companies or airlines) to when they receive payment from the customer after the shipment arrives – i.e. working capital.
Currently, freight forwarders are involved in approximately four out of every ten containers transported by sea. This number is gradually growing with around one to two percentage points per year. Sea freight is of course a lot slower moving than air freight, and therefore it typically carries types of products that have longer delivery cycles. Future cargo transport can be planned in good time, and for some kinds of sea freight, the additional service that freight forwarders can provide to the customer is less than for others – thus the fee charged for each transport is lower. The more services a freight forwarder can provide, the more they can charge the customer, rather than invoicing the customer for the shipping rate that the forwarder must pass on to the supplier.
Today, Kuehne + Nagel is growing significantly in the types of shipping where the service fee is smaller. All other things equal, this means that the profit per unit is lower. This is a deliberate choice, as the company’s defined strategy is to increase volumes drastically as this will bring considerable economies of scale on current IT investments. We find it admirable that the management is making the right kinds of investments, even if – in the short term – this has a negative impact on reported earnings. For some stock market speculators and media reporters, the investments seem to add uncertainty about changes to the business model (based on the use of IT). Yet timely investments in creating greater future value are sensible, and we see no indications of changes to the business model.
The race for market leader status
While this focus on volume includes less differentiated services, Kuehne + Nagel has for a long time been focused on specialisation and being the leading company in a number of industry-specific value chains. These include, for example, pharmaceutical products, aerospace and industry, where there may be specific requirements for the transportation. In the case of pharmaceuticals, this involves minimal shaking and maintaining certain key temperatures. These products will lose their functionality and thus also value if they are not transported correctly. However, with Kuehne + Nagel as the intermediary and partner, the customer can sleep soundly at night with the knowledge that their valuable products are being taken well care of.
As mentioned, Kuehne + Nagel is the largest freight forwarder within sea freight and the second largest within air freight, with a clear ambition of being the largest – maybe even before 2020. The company is mainly growing organically, on top of which it is expected that there will be minor acquisitions of smaller freight forwarders.
These acquisitions are made in cases where they can add unique competences or a regional presence, as the goal is not size itself. We strongly believe that management is acting in a long-term and disciplined manner when it comes to allocating the capital that the co-owners provide. Historically speaking, Kuehne + Nagel has demonstrated that they can grow and gain market share organically in the areas where the value creation is, all other things equal, higher and less risky. The volume growth of air freight has been at more than nine percent per year for the past five years.
Management in Kuehne + Nagel consists of CEO Dr. Detlef Trefzger, who has been CEO since 2013 when he joined Kuehne + Nagel. Trefzger has almost 25 years of experience in the industry. CFO Markus Blanka-Graff has been in his respective role since 2014, but has been with Kuehne + Nagel for more than 20 years under the legendary CFO Gerard van Kesteren. Likewise, the heads of both the sea and air freight divisions have been with the company for more than 20 years.
Kuehne + Nagel has been characterised by strong continuity in the top management team, and have only had four CEOs over the last 50 years – and one of them, Klaus-Michael Kühne, was CEO for 33 years. Klaus-Michael Kühne remains a member of the board of directors, and he has direct and indirect control of 58 percent of the voting rights in Kuehne + Nagel. Klaus-Michael Kühne is a descendant of one of the company’s founders. We appreciate the value of having a major shareholder with controlling interest that can add an element of stability and promote long-term visions in the board of directors. We appreciate, that Klaus-Michael Kühne keeps his potential asset-heavy investments outside of Kuehne + Nagel.
Experienced and knowledgeable major shareholder
One of the keys to a successful freight forwarder is to maintain long-term customer relationships – the customers will be more trusting of a business partner wherein the names and faces are familiar and well-liked. Long tenures in the company can therefore be a significant asset, and it highlights the very fact that this is not a business model based on substantial and costly tangible assets, but rather growth that is capital and asset light. For this reason, staff costs are one of the primary expense items, and they represent 70 percent of operational expenses.
The advantage of a majority shareholder with a long-term view is that, in the short run, the company can make the right kind of investments without facing undue pressure and unease from the stock market. The logistics business which, as mentioned, represents close to 20 percent of the operating income, does not report the same returns on invested capital as the sea and air freight business. In brief, the logistics business consists of Kuehne + Nagel managing warehouse operations on behalf of its customers and ensuring that the right amount of goods – whether it be spare parts for airplanes, clothes or other consumer products – find their way to the correct regions at the right time. Earnings reported for this part of the business do not, however, show that this warehouse management also had a positive impact on the rest of the freight business. The transport of goods from these warehouses to their destinations can thus be organised by the other divisions in Kuehne + Nagel, and therefore the logistics division contributes to the sea, air and overland divisions.
A few years ago, the logistics business was not viewed as a large source of value, but rather a necessary evil needed in order to be competitive. This is not the case today – and there has thus been a greater interest in investing in the expansion of this division. In terms of margins as well as the returns on invested capital, this has had a negative impact on Kuehne + Nagel’s reported figures. Yet – this is a bit misleading, as there is real value added to the company even if the financial ratios in isolation, are not as good as the rest of the forwarding business.
Prospects of a significant increase in margins
The returns on invested capital were thus around 35 percent in 2018, which was around the level seen in 2013, despite annual growth in operating income of more than 5 percent in Swiss francs. Reported earnings in this period have been negatively impacted by the strong appreciation of the Swiss franc and is thus not a reflection of the strong growth and development that Kuehne + Nagel has had in the period on a currency-adjusted basis.
Management has several financial objectives for the period leading to 2022. For this period, Kuehne + Nagel aims to grow approximately twice as fast as the market and, in addition, the working capital (consisting of receivables from customers and advance payments) is to be kept at the current levels of around 3.5 to 4.5 percent of sales. And finally, the so-called conversion margin, which is operating income as a percentage of gross profit, should be increased from around 13 percent to 16 percent in 2022.
Part of the increase in the conversion margin is to come from factors such as improved economies of scale from optimising the profitability of ongoing IT investments. The increase will lead to a rise in earnings of almost 250 million Swiss franc, which can be compared to earnings from operations that amount to approximately 1 billion Swiss franc today. This is significant growth – however, the stock market seems to have little faith in it materialising, which is why the share price of Kuehne + Nagel has become increasingly attractive to us.
The business model generates significant free cash flows amounting to more than 5 percent of the market value, and the company has significant cash reserves of approximately 700 million Swiss francs (almost 5 percent of the market value). This provides management and the board of directors with the opportunity to allocate dividends amounting to a yield of more than four percent, and it is possible to increase these dividends on an ongoing basis without taking on debt.
The return on invested capital at Kuehne + Nagel is more than 35 percent after taxes and including goodwill. Management has a clearly stated objective of increasing this number. We have many years of experience with, and knowledge of, freight forwarders, and every year we are confirmed in our beliefs that there are great opportunities for creating value when a freight forwarder is well-run. Kuehne + Nagel is managed by a forward-looking and competent management team, and we are therefore pleased to once again be co-owners, as this is a growth adventure that we are happy to partake in.