Description

We will be the first to admit that Dynamex (Ticker: “DDN”) is a bit more ‘growthy’ than some of the ideas typically presented here. Nonetheless, we think it represents very good value – especially in this market where one must pay exorbitant multiples for a stable or growing stream of cash flows, a good balance sheet, and a defendable business model. DDN seems to be an exception to this current rule.

For the most part, we do not like transportation and distribution companies. Why? Well, in general these companies are capital intensive, have to deal with Teamsters and other unions, suffer fuel price volatility, and are subject to trucking/shipping capacity coming on-line relatively quickly. Also, in the process of trying to get to scale, such companies tend to get pretty leveraged. At the end of the day we see many such companies making a pretty low ROA/ROE with poor margins and tenuous capital structures.

Is DDN an exception?

Yes. The company competes in the roughly $10-$15bn same-day delivery market. Our favorite part about the company is the rather than own trucks/vans, they simply contract with drivers who personally own or lease trucks. This does the following: 1.) Takes away the capital intensity typically associated with transport / shipping business - thus better ROIC and most importantly expansion of the business does not require much capital, 2.) Eliminates the need for service operations, 3.) Means drivers are not employees and therefore little problem with unionization, hiring/firing, health insurance, etc… 4.) Allows DDN to price everything on a profitability per route basis (think Southwest Airlines). This is atypical in many transport businesses where hub and spoke models obscure route profitability (or loss). Such models often cause management teams to bid business very aggressively in an attempt to utilize fixed assets. These behaviors on an industry-wide basis tend to create overly-competitive operating environments.

What exactly does DDN do?

Their business can basically be broken into three parts: 1.) On-Demand Same-Day Services: These are customer initiated requests (from existing accounts) for a particular item to be picked up at one location and delivered to another. Such items might include important legal exhibits, architects’ plans, medical samples, etc. This business line has about 30% gross margins. 2.) The second part of the business is Scheduled Distribution Services. For instance a DDN driver might have a fixed route in SF where he drives around and picks-up cancelled checks at Bank of America branches. Similarly, a DDN driver might drive to all the hospitals in a specific area and pick-up blood samples and take them to a regional lab. This business we estimate to be 27%-30% gross margin. 3.) Finally, in some cases DDN will perform dedicated fleet services (one might think of this as a sub-set of Scheduled Distribution Services). For instance, they took over certain services that Sears used to perform themselves. Specifically, in the Great Lakes region, Sears used to take lawnmowers, snow blowers, etc. in need of repair from store locations to centralized service centers and then redistribute the items once finished. Now DDN does this for them. Contracts of this nature are done at about 25% to 30% gross margin.


Is the same-day delivery business a good one to be in?

It can be. If you open you Yellow Pages and look under ‘Delivery’ the first thing you will see is big ads for United Postal Service, Fedex, and UPS. DDN does not compete with any of these. These are all asset based overnight delivery services. They are overwhelmingly modeled on hub-and-spoke transport networks. If you send a Fedex package from Miami, FL to Jacksonville, FL it will very likely go through Memphis first. Repeat - DDN does not compete with these types of over-night delivery businesses. DDN is same-day and mostly intra-market delivery. They do perform some inter-market delivery as well, primarily for high-value items.

To understand the competition, look at the smaller ads in the Yellow Pages and you’ll see ads saying things like “Dave and Dan’s Same Day Delivery: Boston and Eastern Massachusetts Only” or perhaps “Superior Delivery and Transport: Houston’s Answer to Same Day Delivery”. These are DDN’s competitors. They typically serve one or a few markets and often own a small fleet of trucks and hire their own drivers. The industry is fragmented and generally consists of less sophisticated local players.

DDN has the only true comprehensive footprint in North America which includes the U.S. and all of the major markets in Canada (see VEXP as a possible competitor – very tenuous balance sheet / footprint not as good). DDN has 56 company service locations and contracts with over 200 service partners in smaller markets. This gives them 100% coverage and makes them unique. It took DDN 10 years and over 55 acquisitions to get this network in place. It would be very difficult for someone else to replicate.

What does this footprint do for DDN?

Their network is a core competitive advantage. DDN is really the only company that can sell same-day delivery to national accounts (typically they sell Scheduled Delivery rather than On-Demand Services). This is where they are growing (this is very well laid out in the company presentation). A hypothetical example might be:

Example 1: A large pharmaceutical company formerly contracted with many different mom-and-pop delivery companies in each market to deliver (often pallet sized) sets of product samples, displays, and promotional items to their pharma sales reps. After years of dealing with so many companies and the annoyance of so many contracts and varied service quality, they go to DDN for a national solution. In a matter of months DDN has found drivers with their own trucks or directed new drivers where to lease trucks and established the routes. The result is a much cleaner, single-vendor solution for the large pharma company.

Example 2: A large manufacturer of MRI equipment has guaranteed buyers of its equipment that if their machines (at $1.5mm a pop) go down, the mfg will guarantee a new part to arrive there in eight hours. The solution is that DDN keeps what amounts to a disassembled MRI at its small warehouses in 25 markets. They can deliver a part from one of these locations to anywhere in the U.S. or Canada where one of these machines rests in less than 5 hours.

Large accounts include Sears, Novartis, 3M, Frito Lay, Agilent Technologies, Office Depot, etc. and many others.

The value of the network is not simply a function of the number/breadth of locations – DDN has taken years to build relationships with drivers, customers, and service partners. In addition, DDN has acquired the knowledge base about the types of work that are profitable in a given market – taking the right work and charging appropriately is fundamental to profitability.

It is also worth noting that our discussions with drivers suggest that the model is attractive to them, allowing a high degree of independence and an ability to dictate their hours and how much money they can make

Enough of this business model and strategy stuff. How much money does DDN make?

The On-Demand business has been weighing on results for a number of years. In the go-go years of 2000/2001 apparently people thought just about anything that could not be faxed or e-mailed (prototypes, computer components, bound business plans) had to get delivered immediately. As an example, if you passed through SF at the time, the streets swarmed with bike couriers (more than they are now). On demand is the higher margin business and we think about $40mm went away. The good thing is on-demand has stopped shrinking and is probably growing again.

Scheduled distribution via national account sales has been cooking right along and accounts for most of the growth. There is also limited in-market account growth servicing local companies.

Gross margin has ticked down some as the company is selling more national accounts and they are willing to price these a bit more aggressively – essentially they need to do this to wrench the business out of the hands of the entrenched local competitors. The decline in GM is slowing and it should settle in somewhere in the 27%-28% range (28.5% now on a TTM basis).

All combined – on a TTM basis (through Sept 03) the company has done $260mm in revenues, $74mm in gross profit, $12.6mm in EBIT, and $14.5mm in EBITDA

There is very little capital investment required as Capex has been consistently been running at $1.0 to $1.5mm per year.

It is also important to note that over the last few years, net debt has been ratcheting down significantly. The debt was the result of 10 years of acquisitions of which no more are needed since the network reaches all North American geographies. Leverage has come down dramatically and we expect to company to be close to debt free in 18 months.

What do I have to pay for all this?

Well, at an $11 share price the market cap is about $127mm and the enterprise value is $143mm. Thus EV to EBIT is 11.4x and EV to EBITDA is 9.9x. EV to EBITDA less Capex is around 11.6x.

On an EPS basis the company trades at roughly 13x mgt’s YE July 2004 EPS estimate (Note that D&A is probably a bit higher than recurring Capex so GAAP EPS slightly understates Cash EPS). As the very least DDN looks to be a 20%+ bottom line grower trading at 13x this year and 11x next year on an EPS basis.

Thus, on an enterprise value basis, DDN is not screaming cheap but is probably decent value. On an EPS basis they are getting a pretty low multiple given expected growth. Most importantly though, our diligence suggests that there is more growth for DDN than the market expects. Management is very conservative (almost to a fault) and is entirely focused on execution (which is good). We have been watching the rate at which DDN has been adding business and think it portends very well for the remainder of FY 2004 and for FY 2005 (July 04-July05).

Specifically, we have spoken with a number of their branches and followed the rate at which they are hiring drivers (a good proxy for route growth). By our estimates they are definitely adding revs faster than management’s stated goal of 10%. Even at this goal with think they will hit $0.85 cents this year and $1.08 to $1.12 in FY 2005. This is solid EPS growth and would have DDN trading at 10x next year’s EPS.

The thing is, management has conceded that they could potentially grow the top-line much faster than 10%. We think they are and will continue to do so. Apparently, companies are dying to sign national accounts rather than cobble together relationships in each market. This is driving substantial growth and we know they have only been constrained by the rate at which they can get drivers.

We think they will hit at least $0.85 (top of Mgt’s range) EPS this year which is impressive given the major contracts they have taken on. These contracts are not profitable for a least quarter as DDN has to find drivers and overstaff the routes to ensure they deliver. This, route growth dampens earnings initially. The fact that they can earn decent EPS while growing so fast is a testament to the model.

What could it be worth?

We are looking at this as a long term hold given that we do not see significant impediments to their growth and because we do no see much by way of competition for national footprint, same-day delivery services. If they make $1.10 next year up from $0.85 then I am not sure what multiple the market will place on that type of EPS growth (30%). We think it should at least be an $18 to $22 stock in 12-18 months. We see this potential with relatively limited execution risk in the business model.

From an EV to EBIT perspective – FY 2005 should generate between $21mm and $23mm in EBIT. With some debt reduction in the next 18 months that would mean roughly 6x future EV to forward EBIT. Not bad considering at that point the market should be looking forward another year to FY 2006 and more growth.

It is important to remember that these contracts and services are very sticky. Once someone has outsourced an internal delivery function or moved to a national account from many local accounts, they tend to stick around for a while. For all intents and purposes, DDN has never lost a major account in the last 5 years.

What about on a relative basis? Don’t most transportation companies garner pretty low multiples?

Most transportation companies get low multiples due to asset intensity and poor capital structures. Non-asset based transport companies are the exception. There are no perfect comps to DDN but look at other non-asset based companies like EXPD, LSTR, EAGL, and FWRD. They are more like 21x-28x forward EPS and 14x-20x forward EBIT. As DDN substantiates the growth potential of the company and it gets a bit more institutional recognition, perhaps these gaps will close in their favor. We never invest based on the assumption a stock will get multiple expansion but at least in this case the differential could work on DDN’s behalf.

Just because you say the growth will be there does not mean it will be. Can you substantiate the growth?

Fair point. How does one know this thing can grow as we say? Well, first I would suggest you look at recent press releases and listen to the conference calls. I will not repeat all the details here but they make a good case for growth (also note the on-demand business is not falling anymore). Second, management will be glad to set up a meeting for you at one of the branches. We physically visited one and talked with a number of others. There is a clear and almost universal message: They are taking on new drivers and routes almost as fast as they are able.

First quarter FY 2004 revs were up 8% (excluding positive currency effects) and a lot of these were new contract revs (as opposed to on-demand) meaning they will not simply disappear in following quarters. More recently announced contracts will be incremental to this 8% 1st quarter growth.

Forecasting top-line growth is undoubtedly an imperfect science. We think there could be close to 15% growth in the next 12 months. What if we are wrong? Ok, run a model with mgts 10% growth forecast – still quite strong as suggested above. Ok, what if mgt. is wrong and this company flat-lines after FY 2004. Well, then take costs associated with growth in previous years (hiring, route optimization, etc) and you will have a company trading at roughly 10-12x FCF by FY YE 2004.

Bottom line we see a lot of upside with limited downside.

As you will note, the stock has had a decent run in the last 12 months. We certainly feel that much of the market is overvalued. There are some stocks where the increase is justified though – and further gains will be justified in the future. DDN looks like one of those stocks to us.

Summary
-Only same-day company who can deliver national integrated footprint
-New contracts with marquis national customers validate the business model
-Very difficult to replicate model. Would take many years to get locations, hire drivers, get contracts, and most importantly learn how to profitably, bid for business in particular markets
-Very sticky contracts – people will stay with DDN once they join DDN – we very much like the recurring revenue nature of this business
-Solid demonstrated growth and very good indications of future growth
-Weakest part of business (On-Demand) is now flat and is showing signs of potential increase
-Non-promotional execution focused mgt.
-Very compelling valuation based on a number of metrics (both relative and absolute)
-Limited downside with significant potential upside

Catalyst

Catalysts
-Mgt could raise EPS guidance at the next call. This will be a function of whether new business has dampened earnings so much that they will not go above the stated range. Alternatively or in addition, Mgt could raise revenue guidance (more probably IMO).
-More announcements of large national account signings
-Market sees the decline in On-Demand services has stopped and gross margin is close to flat
-Mkt realization of growth / earning potential in the model
-If any of the large overnight guys want to get a same day function, there is really only one place to go to buy it. Hard to know how to handicap this possibility but at least there are not too many places for them to look