Description

DDN just reported earnings, and I wanted to get this out before it ran too much.

Overview:

Dynamex is a provider of same day delivery and logistics services in the United States and Canada. Services include same day, on demand delivery, scheduled distribution, and fleet management.

I find this stock to be particularly cheap, and a potential double or more in the coming year or two. Management has taken all of the right steps in a difficult industry, and they've positioned the company for significant cash flow as the last man standing in the national currier business.

The same day currier business is a fragmented business with many small mom & pop local businesses in almost every major city. As a result, competition is rather intense on a local level. The industry is also suffering from the proliferation of email and faxes which have cut into the need for currier services. Dynamex has taken steps to alleviate both problems.

The company is now focused on becoming the leader in the national same day delivery business. This gives them the ability to leverage their presence and attract much larger national customers who'd prefer to deal with one vendor for all their transport needs, rather than separate smaller businesses in each major city. For the customer, this means that if they want to track a particular package, or arrange a pickup they can just call headquarters and can be informed on it’s status through the national tracking computer system. Customers don’t have to deal with dozens of individual contractors of differing quality and dependability in each city. For Dynamex, this means that if they sign up a customer on the national level, for instance a government agency, bank, or a large hospital chain, the company’s individual subsidiaries will be guaranteed revenue flow in their individual locales. This cuts down significantly on marketing and SG&A expenses for the local subsidiaries, while guaranteeing work for the local drivers. The added savings can then be passed onto the customer, which further lets Dynamex undercut the local competition on the basis both of price, and more importantly, dependability.

Most of Dynamex’s drivers are private contractors. This means that they pay for their vehicles, fuel, insurance and upkeep. Dynamex in turn pays the individual drivers a fixed percentage of the revenue per pickup. As a result, most of Dynamex’s expenses are fixed, and most additional revenue achieved by new contracts goes right to the bottom line, as there seems to be an excess of qualified drivers looking for work who can be hired for new pickups on a per case basis. This also means that Dynamex’s cap-ex expenses are very minimal. The largest cap-ex expenses are related to providing drivers with communication and tracking equipment, which is a negligible expense. This once again lets the company leverage its existing platform and new organic growth is inexpensive for the company to integrate.

As a result of Dynamex’s efforts on the side of cost controls, their gross margins are significantly better than any of their publicly traded competitors. In the most recent quarter, Dynamex could boast a gross margin of 29.2% as opposed to 22.5% for their closest competitor Velocity Express (VEXP), and 19.7% for CD&L (CDV). I spoke to the CEO recently, and of all the company’s achievements, their commanding lead in gross margins is what he’s most proud of.

History:

Starting in 1995, the company embarked on an acquisition spree in order to gain a national presence. This acquisition spree left the company with too much debt, and an accounting scandal, which distracted management from the business for over 2 years. All of this is now behind the company, and they've begun to eliminate debt and focus on cutting expenses in anticipation of a resumption of expansion in a few years.

The rise in the use of email and fax services has significantly reduced the need for currier services. However, the slowdown in utilization seems to have finally leveled off, and management is anticipating a small increase in revenues in the coming year. I think that the industry has finally seen a trough in revenue erosion just for the simple reason that email and faxes have been around for long enough that anyone who’d have adopted them for communication, would have already done so. It seems that some things like medical specimens and other time critical items cannot be faxed. The company has positioned itself to minimize any potential future utilization erosion by diversifying its business mix and focusing on national contracts. It is in the national arena where they can gain the upper hand against their local competitors, and it seems that their efforts are finally gaining traction as they have signed a number of recent contracts. Many small competitors are exiting the business, unable to compete with Dynamex. Most likely, the rest will be forced to align themselves with Dynamex and let Dynamex feed them customer orders in order to survive.

Progress:

In FY2002, the company focused on cutting their debt, and they paid off over 12m of their outstanding debt, or 28%, and they have plans to pay off a minimum of an additional 8m in 2003. Hopefully, by the end of 2003, the company will be able to reduce long-term debt significantly enough that they can again begin to make small acquisitions (more about that below).

In past years, management was very inefficient in their tax policies. They had most of their overhead (insurance, accounting expenses, software fees, management salaries etc.) in the US, while they had very low overhead in their Canadian operations (about a third of annual revenue). As a result, they ran taxable net operating losses (NOL) in the US of 2.723m, 2.333m and 4.410m in FY 2002, 2001, 2000 respectively. They paid taxes on their Canadian income (which is a higher corporate rate than in the US), but were not able to deduct the US losses on their taxes. Management has now recognized this problem, and as contracts have expired, they are switching some of their expenses to their Canadian operations. Ideally, they’d run at a loss in Canada (with the higher tax rate) and be profitable here (with lower tax rates). While, they won’t be able to switch all expenses to Canada, they’ve begun that process, and they’ll have considerable NOL’s in the US when they begin to show a profit here. This process will take a number of years to complete, but will ideally result in much higher income for the company once it is complete.

The company expects income for FY 2003 to range from 55-65 cents a share. Based on current guidance, at 4.3, the company is trading at 6.6 and 7.8X next year’s anticipated income, and a slightly lower level based on next year’s FCF. Management has also stated that they see 2004 income at 9m, or about 80c a share, which gives it a 2004 PE of only 5.4. I personally think that both estimates are quite conservative. Management has repeatedly had to guide higher during recent quarters. I think that this trend will continue as the competition disappears, (much more about that below).

The Future:

Dynamex is in the unique position of being one of the only survivors in an industry that’s imploding around them. Of their major publicly traded competitors, at most, only one will survive in any recognizable form. VEXP looks doomed (315.5m in sales in their last 4 quarters). CDV isn’t in much better shape (156.5m in sales in the last 4 quarters). Rapid transport and USHP have disappeared from the pink sheets (I assume they are no longer in business, but could be wrong). A number of other small to middle tier companies have also closed up operations. This means that there is a lot of extra business out there for Dynamex (only 235.9m in sales in the last 4 quarters) to pick up. This is a market with a few billion in annual sales, and customers will start scrambling for reliable service as their service providers begin to close up shop. No one wants to sign a long-term contract with someone who may not be around in six months. Customers will seek out transportation providers who are on solid financial footing, and this will lead to new contracts going to Dynamex over the competition. It just isn’t worth the disruption in service to save a few dollars. I think that in the coming years, the reduction of competition will allow Dynamex to both expand margins and make strategic acquisitions of bankrupt assets at pennies on the dollar.

Lets assume that by 2005, reduced competition allows Dynamex to raise prices by just 5% (which is negligible for most customers). They can afford to pay their drivers 100 bp more and still retain 400bp more in EBITDA. For FY 2002, 5.4% of all revenue made it to EBITDA (as opposed to and 6.4% in FY2001.) If you assume that almost all of the 400bp make it into EBITDA, after taxes on the extra income, you get a number that could have net income after taxes going up 50-75% (of course, this is assuming that all other fixed costs remain the same). With Dynamex’s focus on cost cutting and streamlining their operations, I don’t foresee costs increasing dramatically, with the exception of insurance.

Dynamex has guided for 9m in income in 2004. If you assume that revenues remain constant (I think they rise) and costs remain constant as well, I think that income can increase by 75% (the effect of taxes) in 2005 from the 2004 level which would have income of 15.75m or $1.28 a share. This is obviously a VERY rough calculation. I think that there are too many moving pieces to make an accurate calculation that is over 2 years into the future, but I hope to use it to get a point across about the minimums of the upside potential that is possible.

This calculation does not include much lower tax rates or lower interest expenses from lower debt and interest rates. On the Conference call, the CFO said that they intend to refinance the debt at a lower rate within 6 months. Increased revenues should also raise earnings quite significantly. Management has said that a 10% increase in revenues would raise income by 200% from 2002 levels. Future leverage will not be as impressive, but still powerful.

I have spoken with the CEO about acquisitions. He said that the company learned a lesson last time, and he’s very hesitant to make new acquisitions, except in cities where Dynamex doesn’t have a presence, and they have to be at bargain prices. He’s more optimistic about picking off customer lists and long term contracts from competition that will be going under. Organic growth is the real upside for Dynamex in the next few years. Dynamex can scour their former competitors and pick up the best customers and contracts at pennies on the dollar, yet servicing them will require very little in added expenses. Dynamex will be able to leverage their existing platform to both raise prices, and add new revenue, and since fixed costs will remain about the same, margins will expand dramatically. This is the hope for the company.

I don’t want to make projections on ideal price multiples or stock target, but I do know that at $4.3 a share, Dynamex is trading at an extremely discounted multiple to whatever their income will be by 2005. In fact, the combined benefits of reduced debt, better tax planning, a shift by many customers to the use of only national service providers, bankruptcy of major competitors and the resulting improved margins and additional business gives us a great potential investment. I think that we have a stock that could be worth a few times what the market is currently giving it.

Disclosure: Long

Catalyst

Continuing growth, repayment of debt, and bankruptcy of key competitors.