Can DX Group deliver for investors?

At first glance shares in delivery services business DX Group (DX.) appear to be attractive. Trading on a multiple of just under eight times forecasts for the current financial year the valuation looks cheap. With net debt almost wiped out following a £200 million IPO placing in February 2014 the balance sheet has been significantly strengthened. The shares also offer a bumper yield of just over 7%, with management having a progressive dividend policy.

But with concerns over increasing industry competition can management deliver the goods for investors?

The Business

Founded in 1975, DX delivers mail, packets and parcels in the UK & Ireland, as well as providing freight and logistics services. Across the three divisions of Parcels & Freight, Mail & Packets and Logistics the firm handled 170 million items in 2013. The company is a constituent of the AIM 50 index and listed on the market in February last year along with a £200 million placing carried out to pay off debt.

In what is a competitive market, DX specialises in services where adding value can command premium pricing. Such areas include next day or scheduled delivery of time-sensitive/high value items and two man deliveries for heavier items. The firm also focusses on growth segments of the market such as parcels, freight and irregular dimension & weight (IDW) deliveries. This is where DX stands out from other mail operators which often focus on mass market/high volume but low margin mail services.

The overall strategy is for steady organic growth; improving, efficiencies, technology and infrastructure; and further improving performance at IDW focussed business DX Freight – acquired in March 2012 as a turnaround situation.

Recent Trading

While revenues were significantly boosted in the 2013 financial year (to June) by the DX Freight acquisition, profit growth has been much more steady over recent years. Between 2011 and 2014 underlying EBITDA grew by a compound annual rate of 6.1% to £34.4 million – I am focussing on underlying EBITDA here as before its IPO DX was a debt laden, private equity controlled business, with the accounts skewed by numerous finance charges. Investors should note that while profits grew during 2011-2014, margins fell from 16.5% to 11% over that time. The 2014 results were reasonable overall, being in line with market expectations, although they included £59 million of charges related to financial restructuring and AIM admission costs.

A cleaner set of numbers for the six months to December 2014 reported underlying EBITDA up by 5.2% at £14.2 million on revenues down by 1.7%. More notable, following the IPO restructuring, net debt had fallen from £226.8 million to £12.1 million over 12 months. The balance sheet does look like it can be improved further however – stripping out intangibles gives the firm a negative net asset value of £11.6 million. More positively, net cash from operations was strong at £9.2 million in the six months to December, compared to net profits of £7.8 million, demonstrating excellent cash conversion.

A brief update in mid-July confirmed that despite a challenging backdrop trading in the second half of the 2015 financial year was “satisfactory”, with cash generation remaining strong. Full year results, due on 21^st September, are expected to be in line with current market expectations.

A maelstrom of a market

It is no secret that the UK letters market has declined in recent years, driven by the shift from physical to electronic form. According to a 2013 report by PricewaterhouseCoopers (PwC), total UK inland letter volumes fell by 6.3% per annum from 2008-2013. In DX’s case this trend is causing concerns for one specific core business.

Part of the Mail & Packets division, DX Exchange is a private members’ B2B mail and parcel delivery network, mainly used by the legal and financial services industries for the secure delivery of important documents. The business makes up around 23% of annual revenues and commands strong margins. Legal and other professional sectors (especially criminal law and property) have tended to be heavily paper based but are facing the same challenges as the overall letters market – the company stated that in 2014 DX Exchange, “continues to see sales attrition, reflecting electronic substitution”. While management have reacted by adding new services such as secure email and paper shredding services, these are not expected to offset the fall in mail volumes.

In contrast to the letters market, parcel volumes are seeing growth, driven by the upsurge in online retail. Again according to PwC, UK parcel volumes grew by 3.7% per annum in the five years to 2013 and are forecast to grow from 1.7 billion to 2.3 billion items per annum from 2012 to 2023. Adding weight to the forecasts, market leader Royal Mail estimates that the total number of parcel deliveries in the UK will increase by c.4% per annum in the medium-term.

Unfortunately the growth in the parcels sector has led to an intensification of competition as the industry looks to offset the declining letters market. The likes of Hermes, UK Mail and DPD have invested significantly in capacity in recent years, putting further downward pressure on industry pricing. Notably, online retail giant Amazon launched its own in-house delivery service in 2014, a move which Royal Mail recently commented would reduce the annual rate of growth in its addressable market to 1-2%. Amazon has gone even further by recently launching a one-hour delivery service to some London postcodes.

So in such a competitive market the keys to success are innovation, efficiency and delivering good customer service. On that front DX has implemented a number of efficiency programmes since the current management team was put together in 2010. The results of these have seen customer service levels (on time deliveries) improve from 96% to around 99%, the disposal of unprofitable business, reduced debtor days from over 50 to fewer than 30, along with a number of infrastructure & service improvements. The firm’s ongoing strategy is focussed on its “OneDX” plan, offering one brand, one network and one integrated software platform across the group.

Assessment

Shares in DX have not had the best of times since IPO. Initially they advanced to a high of 145.25p within three months of the IPO, making a quick buck for investors who got in at the 100p IPO placing price. But since then investors have seen a consistent downtrend, with the shares bottoming out at 76.5p in May this year before recovering to the current 84.5p.

This seems to be a bit unfair given that the company has pretty much met market earnings forecasts over that time. I believe that the main driver of the share price fall has been the well reported troubles elsewhere in the sector, especially at Royal Mail.

To the valuation and the expected dividend payment of 6p per share for 2015 is reasonably well covered – 1.76 times – by forecast earnings. The firm’s strongly cash generative operations and low debt also provide further confidence of the payment at least being maintained in future years. Thus yielding 7.1% DX has a higher income offering than peers UK Mail and Royal Mail, which offer a respective current year yield of 5.46% and 4.36%. On a forecast earnings multiple of 8 times DX shares are also valued much more cheaply than Royal Mail (12.7 times) and UK Mail (27 times).

Overall, we have a potential value situation here but the risks of an investment in DX Group are clear. Investors putting money into the shares should be clear that management need to continue delivering steady results in a difficult market. If they do then I believe that a share price of 120p – equating to a yield of 5% – looks possible in the medium term.