Let’s look at what happens when a great company, enjoying favorable trading conditions, falls into a black swan and a critical unforced error. First, about great deals and favorable conditions…
A quick overview of the company Model
I’ve covered EXPD in previous notes, here and here. In summary, the business model is very attractive due to the following characteristics:
- Phenomenal returns on equity with no debt used.
- Long history of share buybacks and dividend growth (again, without resorting to debt).
- Very low capital investment is required.
- Steady growth in the three businesses (sea freight, air freight and customs brokerage).
The surrounding moat has ensured a long period of above-average returns on equity. In 2020 and 2021, the company largely benefited from supply chain disruptions.
Shippers had a great 2021
It’s hard to overstate how good 2021 has been for EXPD:
With operating profit and EPS more than doubling, and revenue jumping 72% from an already strong 2020, one thing is clear: supply chain pain is proving to be a magnificent tailwind. With those sorts of numbers, you would expect the company to be trading at or near all-time high valuations, but that’s not the case. And here is the reason.
All businesses are subject to risk. In this case, one of the worst things that can happen to a network operator has happened to EXPD. There is an almost total dependence on IT systems for logistics and when these systems need to be shut down, everything stops. Given the well-documented tension in supply chains, the timing couldn’t be worse (I won’t speculate where the attack originated, but others might).
The first thing that comes to mind when one holds a senior position in a business facing critical risk is: will they survive? This is where having enough money (over $1.7 billion as of December 2021) and no debt comes in handy. The answer follows immediately from knowing the balance sheet: of course, they will survive. The next questions are equally important but less urgent… how long will this last? and, will the goodwill of customers be permanently altered?
That’s what happened. On February 20, the company revealed that it was the target of a cyberattack. Later updates made it clear that the scope was essentially enterprise-wide and would take several weeks to recover. As of today (six weeks after the event), the latest update appears to indicate that most systems are back online, but also that service issues remain.
I expect a tough Q1 as a result, with potential spillovers to Q2 as well. More importantly for long-term investors – and others may disagree with me – I don’t expect long-term damage to customer relationships and earning power.
Indeed, their competitive advantage extends beyond its IT – which will nonetheless be fully restored. The advantage includes its supplier network, built over decades, and its decentralized operating structure and culture, also built over decades. These benefits have proven difficult to replicate and the cyber event will not cause significant damage either. Customers will be annoyed, of course, and some of them may be lost, but a year from now few will remember the service interruption.
Because they will survive, they will also emerge stronger. We don’t know what the nature of the vulnerability was or if it could have been avoided. I called it an “unforced error” because an owner expects this risk (amply identified in 10-K) to be mitigated to a very large extent. This was not the case, despite contingency plans working, something went wrong here, and management shares the blame. I haven’t read anything about potential insurance coverage either, maybe something to address in the next earnings release.
Few good things come from events like this. One of them is that we get to see management responses to big business problems. How honest and direct were they? Too early to tell, here’s what came out of the 10-K:
On February 20, 2022, management determined that the Company was subject to a targeted cyberattack. After discovering the incident, the company shut down most of its operating systems worldwide to manage the security of its global systems environment. The Company had limited ability to conduct business during this time, including, but not limited to, arranging freight shipments or handling customs and distribution activities for our customers’ shipments. The situation is changing and although the Company has partially resumed its activities, the Company is currently unable to estimate when it will fully resume its activities. The Company is incurring cyberattack-related expenses to investigate and remedy this situation and expects to continue to incur expenses of this nature in the future. The Company expects the impact of the shutdown and the ongoing impacts of the cyberattack to have a material adverse impact on its business, revenues, expenses, results of operations, cash flow and reputation. At this early stage, the Company is unable to estimate the ultimate direct and indirect financial impacts of this cyberattack.
So prior to this news, my focus for the Q1 release was going to be around cash flow developments, as explained below. Now, I will primarily be looking for more clues about the impacts of the cyber event, as I don’t know how much revenue and working capital will be skewed by the mid-quarter system shutdown.
Evolution of free cash flow in 2022
Due to the increase in revenue, accounts receivable also increased significantly, from $2.0 billion in 2020 to $3.8 billion in 2021. This roughly matches the increase in revenue and is not unexpected. The Company provides financing to customers as part of its regular business activities, in particular by paying customs duties and other charges on behalf of customers to be collected later. These credit extension decisions need to be disciplined and I will be looking for any signs of reversal during the first quarter. The level of receivables is unprecedented, but so is the level of revenue and the overall supply chain disruption. For now, this is something to watch, not necessarily a negative development.
The level of increase in accounts receivable was not fully offset by an increase in accounts payable. Debts increased from $1.1 billion in 2020 to $2.0 billion in 2021, for a total of $0.9 billion. Significantly lower and half of the $1.8 billion increase in receivables. As a result, despite revenue up 72% year-on-year, operating cash flow only increased 33%.
Unlike companies that produce things, where revenue growth of this magnitude is only achieved through unit growth and therefore plant growth (capital investment); EXPD was able to grow without additional capital investment. A fabulous feature of asset-light businesses like this.
This does not mean that there was no investment. The investment instead appears on working capital as shown above. However, unlike a new plant, working capital retains its value and can potentially be recovered through other means (eg, factoring of receivables).
I expect the working capital position to stabilize and begin to recover through 2022 as revenues also settle to a more sustainable – and lower – level. It is important to confirm that AR balances remain healthy, in line with revenue levels and free of impairments. This will be a key element to watch over the next two quarters.
Everyone, including the company, expects a return to normal activity levels once supply chain constraints are resolved. No one can really say when that will happen. In the meantime, the recent rise in earnings and sales has pushed the valuation to historic lows, including 1x sales and
Future earnings are expected to be around $7/share for this year and $6/share in 2023, compared to $8.3/share in 2021.
So that’s what happens when a great company, facing strong industry conditions, comes across a critical (but solvable) problem… A window of opportunity to acquire stocks at attractive prices.
Admittedly, the first quarter could be much worse than expected, and spending on future cyber protection could dampen earnings for some time. Further volatility and downside is always possible. However, in the long run, two or three years from now, I’m sure the focus will be back on the terrific returns and moatic characteristics of the business, and buying such a revenue stream at less than $100/share will seem very wise. .