Expeditors Puts Cyber Attack In Rear View Mirror

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Summary

  • This is an update on my long thesis on Expeditors.
  • First quarter earnings included an update on the status and impact of February cyber attack.
  • Unfortunately, working capital continues to restrain cash flow to some extent, as accounts receivable grew once again.

Oficina central de Expeditors Canada Inc en Mississauga, ON, Canadá.

JHVEPhoto/iStock Editorial via Getty Images

Following up on this article from early April, the company disclosed important information in its first quarter press release with regard to both issues that I have been tracking:

  1. The impact to the business of the Cyber Attack (first disclosed in February)
  2. The level of accounts receivable and what it says about their ability to generate cash flow while growing

Before going into both items, I'll include a brief and general overview of the company for potential new readers.

Business

Expeditors (NASDAQ:EXPD) is a service-oriented logistics provider. It owns no trucks, ships or planes. Instead, it buys in bulk and resells shipping space to customers. Founded in 1979, they have been in business for more than 40 years, initially providing customs brokerage services to its clients. They are organized around three segments, ocean freight, air freight and customs brokerage. All three segments have been booming since the pandemic started, mainly due to disruption on manufacturing and supply chains which has increased demand for their services.

I find the business attractive because of its low capital expense requirements, its sticky customer base, its decentralized nature, IT expertise and willingness to buy back shares when appropriately priced.

Some elements of its business are "moat enhancing". Particularly its incentive structure and decentralized decision making, with delegation and accountability at their 176 district office centers. Return on equity has been great, especially if ROE is adjusted to remove excess cash (see my first article on this here, for a more detailed exercise).

Recent Performance

It is important to highlight the step-change in earnings the company has experienced in the last two years or so.

Prior to 2020, when EPS totaled $4.14, the company had never earned over $4/share in its history. Earnings for 2021 were $8.37/Share (+100%). These are true operating earnings and not due to some divestiture or otherwise one-off transaction. It has now put together a string of three consecutive quarters of +$2/share in earnings.

Earnings summary QonQ

Seeking Alpha Earnings page

Management had been warning, since last year, that conditions underlying such performance might not last. The language has evolved:

  • Feb 2021: "While we are unable to predict how ongoing disruptions related to COVID-19 will affect our future operations or financial results going forward, we do not expect these unprecedented operating conditions to persist long-term"
  • Nov. 2021: "here is no simple or immediate fix. As a result, we believe these current conditions are likely to last well into 2022"
  • Feb. 2022: "While this has helped us produce strong financial results, we caution that should demand and rates return to pre-pandemic levels - whenever that may be - our revenues, expenses, and operating income are likely to decline from the all-time highs that we experienced in 2021"

In the most recent earnings release from last week:

  • May 2022 " None of the issues in the air, on the water, or at the ports have appreciably improved or are likely to in 2022."

It sounds like the favorable conditions will last at least a handful of quarters longer. Since the business has essentially doubled its earnings potential, this is very good news. Valuation is not stretched, with earnings expectations for forward earnings anchored around $6 to $7/share.

The Cyber Attack

As noted in the prior note, this is about as bad a risk as you can face in logistics, where reliance on information networks is core to day-to-day activity. The cyber-attack caused a complete systems outage for three weeks (from late February and into March), affecting all products and services. A gradual ramp up ensued and all issues were effectively resolved or worked around by the end of March.

Just looking at the level of revenues and earnings growth vs prior-year quarter, it is clear the damage to client or supplier relationships was not significant. Business continued at elevated volume levels. If there is ever a time to switch a service provider it is precisely during prolonged interruptions. But no such switching appears to have taken place. Potentially customers and suppliers have a combination of high loyalty or lack of substitutes, as business continued forward. The second quarter shall provide additional confirmation if revenue levels remain elevated.

So revenues were better than ok. Looking at the cost side, the damage was large and appeared to be uninsured. The 10-Q report is not filed yet, but there have been no comments on potential insurance coverage thus far; we have to assume there is no policy or coverage for the loss. $40m direct demurrage costs were booked at the brokerage segment due to the interruption. In addition, the company provisioned another $20m for potential future claims. The amount for recovery services and consulting fees was not disclosed. On the bright side, no incremental capex is expected in the future as a result of this event.

Overall, booming sales obscured the financial impacts of the cyber-attack, with operating earnings of $462m (+20%) including the impacts above. Any reputation impact may also have been diluted by the intense demand for expertise in the China/USA corridor that is the company's strength. Such expertise is likely to continue in high demand as parties deal with sporadic closures in China. As a reminder, 2/3 of their revenues come from the geographies of "North Asia" and "USA".

Working Capital

My concern here has to do with the increase in working capital, driven by account receivables which have increased at a much faster pace than accounts payable. The company regularly advances costs such as customs duties and fees on behalf of customers, booking receivables. As the business has grown rapidly, so have the receivable balances. Specifically, receivables grew from $2.0Bln in Dec 2020 to $3.8Bln in 2021 and again to $3.9Bln in March 2022.

Using fourth quarter sales, we can calculate days sales outstanding (AR/(Revenue/90)):

  • December 2020: 57 days
  • December 2021: 64 days, and
  • March 2022: 76 days (using Q1 revenues in this case)

The trend is not our friend here. There is some seasonality in the business (driven by seasonality in consumption/shipping generally) but this may actually help - not hurt - Q1 as compared to Q4. This is because peak shopping season around the holidays drives higher volumes in the second half of the year. Seasonality cannot explain it, so something else is going on.

Cash on hand did increase in the first quarter, to a record $2.1Bln as the company chose not to repurchase any shares. This was probably a wise decision given the attention had to be on restoring systems to support operations.

As a side comment on valuation... cash of $2.1Bln and accounts receivable of $3.9Bln total $6Bln combined. This amount is 1/3 of the market cap of $18Bln. This is some margin of safety. The company has no debt, so its enterprise value is closer to $16Bln.

Assuming you owned the whole company and wanted to quickly get cash out... you could - in theory - do some factoring on your AR and release the $6Bln the next day. I say "in theory" because these accounts are in too many different jurisdictions to make that workable. But the point remains, about 1/3 of the value is in liquid assets.

Performance Vs S&P, Share Count:

Over the past 20 years, the company has behaved like a reliable compounder, handily beating the S&P 500.

EXPD price % change
Data by YCharts

Underpinning these returns is a constant repurchasing discipline. In the last ten years, shares outstanding have been reduced from over 200 million to 167 million. The latest board action in this regard was to approve a further reduction to 150 million.

EXPD shares outstanding
Data by YCharts

Conclusion

This should continue to be a very good business going forward. The damage on the cyber attack was well contained, it seems. The continuation of elevated earnings to start the year was an unexpected surprise. Longer term, their capital allocation has been spot on and I plan to hold it forever unless something changes. However, I am also monitoring the behavior of the working capital because all the recent growth has not yet been translated into cash flow. Our cash is invested in those receivables, with time we will see if it is temporarily or permanently so.

This article was written by

RB Equity profile picture
830 Followers
Striving to compound knowledge. Long-time fan of Warren and Charlie. Always invert. "To finish first, you must first finish". Investing own and family funds for +20 years. Senior finance roles at public and private corporations for most of that time.
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Disclosure: I/we have a beneficial long position in the shares of EXPD either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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