PostNL spinoff opportunity in the parent

PostNL (PNL.Netherlands, TNTFF)

Price: €3.21 (10/13/11 intraday)

This company might sound familiar to readers, I discussed the divested division a few months back with a post on TNT Express.  Let me back up a minute, up until May of this year there was a Dutch company TNT which operated express shipping and local delivery of parcels and mail.  Mail delivery was in the Netherlands, parcel delivery in Germany, Italy, Netherlands and UK, and Express delivery worldwide.  At the end of May Express was spun out which PostNL retained a 30% stake.  PostNL is the non-express local mail/parcel delivery in the Netherlands.

The reason that TNT Express was spun off was that Express and PostNL had grown into two different businesses, one struggling with growth, the other decline.  The directors realized this and split the companies, as the company itself states Express is now a growth stock and PostNL a value stock.  PostNL has been hit by selling due to European fears, in addition they've been hit with selling as investors dump their shares in a seemingly dead or declining business.

I first want to look at the volume decline assumption that PostNL will experience such a precipitous drop in mail that they'll go bankrupt.  While this is possible I don't think it's probable.  PostNL expects mail volumes to drop in the mid single digits over the next three years, and in the low single digits five years out.  Coupled with the decline in mail volume they are estimating an increase in both parcels and international mail.  All of these numbers together volume estimates are running break even for the next three years, and slowly growing five years out.

It's important to note that the volume estimates are provided by the company itself, and naturally they are optimistic.  What's also important to realize is the estimates were made this summer when Europe was in the same financial uncertainty that they're currently in, which gives creedence to the fact that the volume estimates might be somewhat accurate or at least not wildly optimistic.

Value Proposition

The thesis for this investment is really very simple and I don't feel it needs to be broken down in a lot of excel files or charts.

TNT Express has a market cap of €2.808b and PostNL a market cap of €1.286b.  PostNL owns 29.9% of Express, so if we back out that value we are left with the market valuing the business of PostNL for €446m.  Let me break down how low of a valuation this is, PostNL earned €120m in net income in Q1 of this year on a 8% slide in post volume.  They had €84m in operating cash flow in the first quarter alone!  In Q2 they experienced a loss and operating cash flow for the half year was at €69m.  The loss in Q2 was due to a writedown in the value of the Express asset.  The company expects to have €170m in cash operating income at the year end, giving the company a 2.62x multiple of business to cash operating income.

In addition the company plans to pay out €150m a year in dividends which is currently a 11.6% dividend yield.  If we assume the yield is only on the PostNL business it's more like a 33% yield.

The Risks

So what are the risks?  There are a few, and I'll try to talk through each.

The first risk is that the Express holding will continue to be marked down impairing the profits of PostNL.  I think this is one of the bigger risks that has market participants wary.  A writedown will depress net income, but cash flow is unaffected.  In my analysis above I looked at what the value of Express is today, not the book value, so we've already accounted for any sort of writedown.  I don't think this aspect is that big of a deal.  Stand alone Express is already trading below book value, and looks cheap, I highly doubt the company is worthless.

The second risk is the decline in volumes I mentioned earlier.  This is truly the biggest risk for an equity investor, if volumes continue to slide 8% YoY eventually fixed cost will loom large and PostNL won't be able to service their debt and will become bankrupt.  The current view is that mail is dead or close to dead and this death will kill PostNL slowly as volumes drop.  While this is a valid view PostNL is working on growing parcel service in Germany, UK, and Italy and parcel volume is growing.  To counter act the mail volume dropping PostNL has been downsizing operations to pace with the volume decline.  As mail volume has been declining expenses related to mail volume has been declining as well.

The next risk is the pension, PostNL has a nice sized pension plan which will require €125m in contributions in 2011 alone.  The pension is currently 112% funded which isn't much of a concern, the concern is that the contribution amount can be viewed as a fixed debt payment.  PostNL needs to continue paying €125m each year or the pension will become unfunded and will be a liability in front of equity holders.

The last risk is the European risk, which is that somehow with Greek or Portuguese defaults people will stop buying from Amazon, stop receiving birthday cards in the mail, and life in general will completely stop.  I know I'm minimizing some, but defaults or not PostNL will continue to operate, and in this rough environment so far they've been executing at an acceptable level already.  I think this is a risk in the sense that no one knows the outcome, but at the same time this is the reason we're presented with such an investment opportunity.

Here is a link to the latest half year results which include the financial statements: HY and Q2 results

Talk to Nate about PostNL or TNT Express

Disclosure: Long TNT Express, considering a position in PostNL