DX Services DXS LN (bb) W
October 21, 2005 - 9:57am EST by
2005 2006
Price: 340.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 300 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Executive Summary:

DX Services (DX) is a document, parcel and mail delivery business in the United Kingdom that was spun out of Hays plc in November 2004 as a non-core asset. I am recommending the stock as a long because the company has an excellent business model, solid earnings growth potential and a compelling valuation. DX’s business model essentially has two parts. The first is documents and parcels, which are niche, near monopoly businesses that are high margin, low growth and stable cash cows. The second is mail, which is high growth, but lower margin. Neither business is capital intensive. Growth in these businesses combined with steps management is taking to restructure DX’s inefficient balance sheet should generate earnings growth of more than 20% for the next several years. Despite this, the P/E ratio on this year’s earnings (fiscal year ending June 2006) is 12.5x, with a free cash flow yield (defined as cash flow from operations less capex) of over 9%. I think this is too cheap for a growing, highly cash generative and defensible business like DX. I think several factors make the DX story especially interesting:

1. The company’s mail business is extremely well positioned to take share from the state-run incumbent, Royal Mail. DX is also rolling out a new service to customers that I believe will increase volumes substantially.

2. DX’s balance sheet is inefficient (i.e. substantially underleveraged for a business like this) and is in the process of being restructured to deliver more value to shareholders.

3. The company’s core document exchange business is a gem. It is basically a monopoly, incremental margins are 80%-plus and prices go up annually (coinciding with Royal Mail’s constant price increases).

4. One of DX’s main competitors in parcels just went out of business. DX has picked up a decent chunk of the business and should be able to raise prices longer term.

5. The board of directors is serious about improving performance, namely by attacking the mail opportunity more aggressively and delivering value via the balance sheet. How do we know this? Because the board recently fired an ineffective CEO and approved a 10% buyback (small, but the start of much more).

Company Overview:

DX operates three businesses, all of which handle deliveries exclusively to business addresses. This enables the company to operate a smaller, denser and therefore more efficient delivery network. Behind this network is a straightforward, largely “asset-light” business model. DX owns a few sorting machines, but outscources delivery activities, including the actual physical pick-up and delivery of goods, which reduces the required capital investment in the business. The company’s drivers are independent contractors who own their own vehicles. All three businesses use the same underlying network, which is the only nationwide end-to-end pick-up and delivery network in the UK outside of Royal Mail. This is different than Deutsche Post’s operations in the UK, for example, because the Germans must still ultimately rely on Royal Mail’s network. Anticipating future growth, management significantly increased the network’s capacity in 2004, adding 100 million in item processing capacity DX’s existing 350 million capacity. The company should utilize this additional capacity over the next 4-5 years, with mail consuming the bulk of it. Management also focuses on cost control. For example, the company’s non-descript headquarters is located in a truck yard about five miles from Heathrow airport.

DX’s primary business, document exchange (64% of FY05 sales), provides for the pick-up and delivery of documents between the company’s proprietary document exchange boxes. This business mainly serves law firms, where the company has a near monopoly, and other professional firms. Very simply, customers place documents in their DX box in the evening and they appear in the recipient’s DX box early the next morning. Incremental margins are 80% or better. Rate increases (driven by Royal Mail price increases) obviously fall entirely to the bottom line. The most recent rate increase was 5% last year.

The parcel business (32% of FY05 sales) handles small, time-sensitive and high frequency items for various retail customers, primarily opticians, travel agents and betting shops. This is another niche business where DX faces limited competition as it is not cost-effective for businesses to use bigger, far more expensive express carriers (i.e. Business Post, UPS, Fedex). Incremental margins are 25-50%.

DX Services’ newest business is mail (4% of FY05 sales), a start-up operation following the 2002 award of a license to deliver first class business-to-business mail without use of the Royal Mail network. The license was granted as part of the ongoing deregulation of mail delivery in the UK. This operation should grow rapidly and is the company’s primary growth driver. From a customer’s perspective, the business should be a no-brainer: DX provides mail delivery that is faster, more reliable and cheaper. The business is breakeven today, but incremental margins should be 25% or better (potentially much better given enough volume to exploit delivery route density).

Investment Merits:

1. DX has a huge opportunity in mail delivery. The company can leverage its existing network (bypassing the large fixed investment required of true start-up competitor) and sell a product that is a logical extension of its current business to an existing customer base. Started in September 2003, the mail business delivered a run rate of roughly 20 million items per year by June 2005. Yet the market opportunity remains huge: management believes its document exchange customer base alone sends at least 300 million items per year. Moreover, Royal Mail is a good competitor to have, as it provides poor service and lower reliability at a higher price. Royal Mail also plans to raise prices over the next several years, which provides DX a pricing umbrella to do the same.

Having said this, I must add that DX has encountered reluctance from many customers to dump Royal Mail. The main hurdle is the customer’s mail room, where mail workers aren’t wild about going from sorting mail into two piles: DX document exchange mail and everything else (to be delivered by Royal Mail), into three piles: DX document exchange mail, DX business mail and other mail (still to be delivered by Royal Mail). To resolve this problem, DX is rolling out a “take-all” strategy in October 2005, in which DX will simply take all a customer’s mail and sort it themselves. While this sounds simple (and obvious) it is somewhat tricky because DX must still use Royal Mail for non-business addressed mail, and therein lies the rub: DX cannot access Royal Mail’s network for free. But this is about to change. Royal Mail recently introduced “zonal access”, a pricing and logistical scheme designed to encourage bulk mailers to use Royal Mail’s network. This system is perfect for DX, as it allows the company to drop its non-business address mail on Royal Mail’s network at no extra cost. The company should sign a flexible zonal access agreement with Royal Mail shortly (possibly as early as this month). Why would Royal Mail do something that obviously helps a direct competitor? Because DX is the least of Royal Mail’s concerns. It is vastly more concerned about losing market share to Deutsche Post, TNT and other major carriers, and zonal access marginalizes the value these players offer.

So now let me tie this back to earnings. DX’s existing document exchange customers have ₤50 million (in revenue) of business mail that the company could – but is currently not – delivering. Extensive customer studies indicate that two-thirds of these customers think they have no reason NOT to use DX’s new take-all service. Assuming a 25% margin on two-thirds of that mail volume, DX generates ₤8.4 million in incremental EBIT, or a 27% increase on FY05 EBIT. Remember that this amount represents only DX’s captive document exchange customers, not thousands of other customers who could use the service.

2. DX’s balance sheet is currently inefficient and should be the source of considerable shareholder value creation going forward. Most obviously, a low capital intensity, high free cash flow generating business should have a debt-to-EBITDA ratio higher than 1.7x. Management recently took its first steps to remedy this situation by announcing a 10% share buyback and a target net debt level of ₤75-100 million, up from ₤60 million at June 30, 2005. While this is a positive first step, it is also inadequate longer term. By the end of the current fiscal year (June 2006), the company can buy back 10% of the company (~₤30 million) pay its dividend (~₤11 million) and generate enough free cash flow (~₤27 million) to have a net debt balance of only ₤74 million, implying DX’s debt-to-EBITDA ratio remains flat at 1.7x. DX’s management is both new to the public markets and conservative, so I believe there was some hesitation in being too aggressive less than a year after the company’s spin-out. This will change, particularly as investors continue to hammer the company on the obvious benefits of recapitalizing the company. A few numbers illustrate the value that could be unlocked from recapitalizing DX’s balance sheet without placing undue financial strain on the company:

Key assumptions:
- Net debt increases to ₤150 million
- Incremental debt of ₤90 million used to buyback stock at 360p, a 5% premium to the current price

Financial impact:
- Almost 30% of the shares are repurchased (shares outstanding drop from 87 million to 62 million)
- EPS accretion is roughly 20% in FY06, growing thereafter
- Debt-to-EBITDA is only 3.6x in FY06, declining thereafter
- EBIT-to-interest expense is 4.0x in 2006, increasing thereafter

In other words, DX can easily return capital to shareholders by increasing leverage without jeopardizing the company’s financial health. The good news is that management understands that DX can carry a substantial debt burden (theoretically even higher than the ₤150 million I used in the previous example) and they have acknowledged that the current buyback initiative is just a start. In fact, I think it is possible for DX to recapitalize the balance sheet today and continue to buyback stock and increase dividends (using just free cash flow) going forward. In essence, DX could (and should) resemble a publicly traded LBO.

3. The company’s core document exchange business is highly attractive. DX has dominated this niche for thirty years, and has amassed over 27,000 customers. Benefiting from a network effect, DX has a near monopoly among legal firms and is perceived to be faster, cheaper and more secure than its only real competitor, Royal Mail. Customer renewal rates exceed 90%, while the average customer life is over eight years. DX only loses customers when a firm goes out of business or is acquired. Like in the mail business, Royal Mail provides a pricing umbrella, although management notes that its customers are largely price insensitive anyway. Contract renewal is automatic and prices increase annually. The business requires virtually no capital and has extremely high (80%-plus) incremental margins. Frankly, this is one of the most intriguing businesses I have come across: a highly profitable, non-capital intensive, near monopoly service viewed as essential by customers that has pricing driven by an inefficient state-owned entity.

4. DX’s parcels operation, the least interesting of its businesses, will get a near term benefit with the recent collapse of a major competitor, Print Movers. Print Movers went bust in July, and DX promptly added about ₤4 million in annual revenue, with the prospect of an additional ₤1-2 million. But because Print Movers had been pricing aggressively to stay alive, the business is coming on at only a roughly 25% margin. Still, this is ₤1 million of incremental EBIT (+3% on FY05). More importantly, however, the elimination of an irrationally pricing competitor should enable DX to raise prices going forward.

5. After taking heat from investors about the company’s somewhat lackluster recent performance, DX’s board is finally taking action. First, the board sacked the company’s ineffective CEO, Peter Brougham. Normally this is cause for concern, but in DX’s case, it’s a major positive (the stock rose after he announced his resignation). Brougham took over the company shortly before the Hays spin-out. His management style was, to say the least, conservative. This meant that Brougham failed to push the company’s mail product aggressively, which put him at odds with the board and investors. Moreover, he failed to recruit additional management to the company, as evidenced by the fact that the position of head of sales and marketing has been unoccupied for nine months. The board is currently running a search process, which should conclude no later than mid-November. The good news is that the document exchange and parcels businesses basically run on auto-pilot. In mail, where real leadership is needed, the strategy has already been laid out by the board, so the new CEO will not need to conduct a lengthy strategic review once he/she joins.

Second, the board also just recommended a 10% share buyback, which is to be ratified shortly. The financial benefits of the buyback are obvious (as discussed above), and though the 10% figure is light, in my view, it’s a start. But I am pleased to see that the board is finally backing its first non-dividend capital return to shareholders.

Financial Projections & Valuation:

I believe DX is cheap relative to the strength of its business model, its free cash flow generation and its potential for sustained earnings growth. A few numbers tell the story:

Share price: 340p
Market cap: ₤295 million
Dividend yield: 3.7%

P&L Summary 2005A 2006E 2007E

Sales (₤)
Document Exchange 84 89 94
Parcels 42 47 48
Mail 5 9 14
Total 131 145 155

EBIT (₤) 31 36 41

EPS (p) 21.4 27.2 33.6

Free Cash Flow (₤) 28 27 28

Net Debt (year end) (₤) 60 73 80

P/E Ratio 15.9x 12.5x 10.1x
FCF Yield 9.7% 9.1% 9.6%

A few notes on my assumptions:
1. My sales and margin projections are not aggressive, especially for mail, where I have not given management a lot of credit for adding customers. This number could be much higher.
2. Free cash flow slips a little in FY06 as certain cash flow items (cash taxes, working capital and capex) normalize from unusually low levels in FY05.
3. The company buys back 10% of its stock in FY06 and 8% in FY07.

So where should a business like DX trade? I think there are a few ways to think about this. If you look at comparable companies, you won’t find much in the UK. Business Post Group trades at over 17x FY06 earnings, but this is after a recent 30% drop in the stock. Another comparable company, Exel, just announced that it will be acquired by Deutsche Post at a price that translates into almost 21x calendar year 2006 earnings. Both these benchmarks suggest higher valuations for DX, especially Exel’s valuation, which shows that there is no takeout premium in DX’s stock price, despite ongoing consolidation among European mail and parcel carriers. While I’m loathe to predict multiples, I’m pretty sure that 10x forward year earnings is too low for a company growing earnings at over 20% that is buying back stock and has balance sheet capacity to buy back a lot more. Moreover, the business is not cyclical and consistently generates ample free cash flow. I think DX is also an acquisition target down the road given its attractive business franchises. Considering all this, it is possible to envision DX getting a Business Post/Exel-like multiple of perhaps 17-18x, which would imply a share price in the 550p neighborhood, or 60% above the current price.

Another way to think about returns is to consider only the capital returns we are getting from DX in the form of dividends and share buybacks. With an almost 4% yield and a 10% buyback, we are getting a 14% return this year. This seems like an attractive return, with limited downside, while we wait for management to execute on the mail opportunity.

FOOTNOTE (since I drafted this write-up, two things have happened that I'd like to add):

1. You will recall that DX Services operates under a pricing umbrella set by Royal Mail. When RM raises prices, DX does the same. Recently RM has raised prices somewhat more aggressively as it attempts to cope with increasing competition and higher legacy costs (mainly pension). Currently the price of a first class stamp is 29 pence, with the understanding that prices will rise to 34 pence in the 2009-2010 timeframe. Last week, however, RM’s chairman announced that RM’s “one price goes anywhere” service could be threatened unless first class stamps increase to 39p by 2009-2010, or 15% higher than the current estimate. Behind this warning are ever increasing pension costs and the need to reinvest in new equipment. Regarding pension costs, RM pays ₤400m per year, rising to ₤800m under soon to be implemented accounting standards. RM has said there is no way it can handle this “short of robbing a bank”. Meanwhile, RM estimates that it needs ₤2b to bring its equipment up the same standards Deutsche Post and TNT – both of whom are vying for share in the UK. The bottom line here is that DX will have more room than I initially thought to raise rates across its businesses. This incremental revenue falls entirely to the bottom line (before taxes of course).

2. Insiders are buying. DX’s CFO recently picked up about ₤10,000 of stock to add to his holdings. While this might not seem like a huge amount, we’re not talking about a guy worth a ₤10m. DX is really his opportunity to make some coin, and I think it says a lot about the company’s prospects that he continues to buy shares. Full disclosure: the outgoing CEO (who was fired) just sold his paltry holdings in the company. Effectively, the CFO picked up his shares.


1. DX has been somewhat slow in building out the mail business so far, which has been disappointing. Part of the blame falls on the shoulders of the recently resigned CEO and a strategy that was not aggressive enough. The company could continue to encounter reluctant customers, however, despite the new take-all strategy, which would dampen growth.

2. There is always risk with the introduction of a new CEO. The board could select a candidate that is ill-suited for the job (like the last one), which would be a problem. But I am hopeful that the board has learned its lesson with Peter Brougham.

3. I could be too optimistic about management and the board’s willingness to restructure the balance sheet to return capital to shareholders. While the recently announced 10% buyback is a nice start, there is no guarantee that management will see the light and more aggressively pursue buybacks.

4. Liquidity in the stock isn’t great. DX is a smaller cap company and liquidity in the name is, frankly, poor to the extent one would like to build a large position quickly. Alternatively, some UK brokers have, in the past, been able to facilitate larger block trades.

Disclaimer: I own this stock and may buy or sell at any time, without notice. This is not a recommendation to buy or sell the stock.


1. The board authorizes a larger, more aggressive buyback or special dividend.
2. Management provides better guidance on the mail business (it frequently updates investors on the run rate in revenue in the business).
3. The announcement of a new CEO.
4. DX signs a flexible zonal access agreement with Royal Mail (this could easily happen without a press release).
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