Description

 Please note the figures above are for the parent entity while the write up is for post separation. For all charts and detailed financials please refer to http://www.scribd.com/aliejaffar/documents 

TNT N.V. intends to split into two separate businesses in Q1 2011.  Mail business which is traditional postal services business in the Netherlands and Express business which is a global Courier-Express-Parcel ("CEP") business that competes with the likes of FedEx, UPS and DHL.  I believe the Mail business, post-separation, offers a very compelling short opportunity at the current implied and estimated enterprise value.  

Brief Background

Netherlands passed a legislation in April 2009 that opened up the domestic mail business to competition for the <50g mail category or ~75% of market by revenue (the other ~25% of market had been de-regulated over a decade ago).  Since the passage of the law several competitors have announced entry into the sub 50g category and have set aggressive growth plans. 

Pricing competition: here it comes...

Many analysts and investors alike have assumed that pricing competition in Netherlands will be benign post-liberalization.  Analysts often point to the fact that Netherlands has one of the lowest priced mail in Europe and conclude that as a result of this the market is unlikely to face significant amount of price erosion and.  Yet this simplistic analysis ignores the very attractive geographic structure of Netherlands which provides for a very low cost of mail distribution.  The average population density of Netherlands is over 1,000/sq mi as compared to less than 600/sq mi for most of Europe and the median below 300/sq mi.  This translates into very attractive margins for TNT Mail which earns ~30% EBITDA margins on its domestic mail business as compared to ~10% for the next most profitable peer and less than 5% for most of the other peers

I believe pricing for the overall sub-50g market is likely to fall by over 15% over the next 2-3 years.  I derive this estimate by triangulating through a number of different methods all of which point to similar or bigger drops in estimate.  Please refer to Exhibit 1 with detailed market-segmentation for below discussion:

• Method 1: Comparing to liberalized part of the market: As one can see from exhibit 1 the price for "Direct Mail" (liberalized over a decade ago and represents 25% of market revenue) is ~€0.14/item as compared to "Letter Mail" (recently liberalized) at ~€0.43/item. This is despite the fact that "Direct Mail" is heavier by definition and as such should command a higher price all else equal. I do not believe the prices for "Letter Mail" overall will fall from current price levels to the level of "Direct Mail." However I do believe that prices are likely to fall from ~€0.43/item to ~€0.35-0.38/item. This is because within "Letters Mail" the competitors are only targeting the "addressed bulk segment" which is easier to distribute than the "single mail items" which require sorting centers and would fall under the Universal Service Obligation (USO) regulations (more on this later). As such, I believe pricing for the "single mail" items~€0.67/item are likely to remain relatively flat while pricing for the "addressed bulk market" are likely to fall from ~€0.30/item to ~€0.20/item in-line with current pricing for "addressed direct-mail" market. This brings the overall average for "Letter Mail" from ~€0.43/item to ~€0.35-€0.38/item
• Method 2: Comparing to competitors pricing: Another way to look at pricing is to see what competitors are currently quoting. Both Sandd and Deutsche Post (the two primary competitors) quote on their website ~€0.20/item for the "addressed bulk mail" market or about 15-20% below TNT Mail. The competitors currently deliver mail only 2-days a week as compared to TNT which delivers mail 5-days a week. TNT currently offers a slower delivery service for similar price to competitors and has said they plan to transition all "addressed bulk mail" to a 3-days/week delivery schedule down from 5-days/week. Hence the company itself acknowledges that demand is moving to the lower-tiered price category and will be working to move all its "addressed bulk mail" to that tier. The company has laid out an aggressive cost-cutting program to reduce labor costs over next 3-5 years and while the analysts have all modeled out the cost-cutting programs associated with the move to 3-day delivery schedule in great detail most have failed to recognize the related decline in pricing that will come with the reduced delivery schedules.
• Method 3: Economic Theory: Basic Econ 101 theory states that a company will continue to grow volume until its marginal revenue (MR) equals marginal cost (MC) MR=MC and will stay in business as long as pricing is above its average total cost (ATC). Looking at competitors cost structure, the ATC is ~€0.19/item and MC is ~€0.10-11/item. Hence competitors will be incentivized to continue to drop prices to gain market share. This would suggest that pricing at current volume levels would need to drop to ~€0.19/item before competitors start losing money.
• Method 4: Channel Checks: Recent channel checks indicate that competitors are pricing for large businesses that are coming up for renewal in the ~€0.13-14/item. While this makes perfect logical sense for some large accounts (as its still above variable cost but below average total cost) it does not make sense for the overall average. Hence the channel checks confirm the analysis above as accurate however I do not believe these are indicative of how far the prices would fall and are likely exaggerated

Long-term competitive disadvantage: high cost structure:

Perhaps even more concerning than the coming price declines is the structural cost disadvantage that TNT Mail has as compared to competitors.  While I do not currently model out company losing share beyond management stated guidance of maintaining above 70% market share (from current ~81% market share and ~85% last year) The company faces a real threat of losing significant amount of market share over long-term which has the vicious cycle affect of causing decreased competitiveness due to increasing cost-structure as a result of de-economies of scale.  In particular:

• High labor cost: Labor represents ~55-60% of the cost structure for the Mail business. TNT Mail currently pays its unionized employees ~€24/hr before pension benefits (pension add another €4-5/hr) in labor cost. This compares to competitors paying their not-unionized labor force ~€12-13/hr. TNT has attempted to reduce its own labor cost but has been unsuccessful in reducing wages after it finally settled with its labor unions in what was a long 3-year negotiations process to bring down costs. The company is also vigorously lobbying regulators to require minimum wage levels for competitors. These lobbying efforts are viewed as unlikely to have any affect and in worst case scenario would likely cause labor cost for competitors to go up by €2-3/hr. Nowhere near the '€10-15/hr in labor cost differential
• Universal Service Obligation: Unlike its competitors, TNT Mail is bound by the "Universal Service Obligation" regulation in Europe. This states that for "singl-mail items" TNT must deliver the mail 5-days a week with certain minimum delivery standards that require most of the mail to be delivered within 48hrs. The competitors have thus far avoided entering the "singl-mail items" business and as such do not have to keep the added labor force related to maintaining a 5-day deliver schedule for a sub-segment of the market. This puts TNT mail in at a structural disadvantage as well

Hence, while one would at first assume that TNT mail would have the low-cost structure in Mail due to the high-fixed cost nature of the business and the large economies of scale benefits the above two factors currently lead to competitors having average total cost/item that is in-line to slightly better than TNT.  As competitors continue to gain market share they will see their ATC slide down the cost scale which will allow them to continue to reduce prices.  I estimate that at 25% market share, Sandd would be able to reduce its ATC to €0.14/item down from €0.19/item at the moment.  While TNT Mail has a very aggressive cost-cutting program this program will only allow it to reduce number of employees and hence move to 3-day delivery schedule for mail that is not covered under USO.  This program does not reduce the actual labor cost/hr for TNT which is likely to remain a key competitive disadvantage for the company.

Secular decline in mail

I will not go into much details about the secular decline story for the mail business.  I believe this story is fairly well understood by the market and both management and analysts have discussed this in great details.  Suffice is to say that management expects continued volume declines in the 4-6%/yr for mail business as result of substitution from online billing and other e-commerce based trends.  The company has shown some good data during its last two analyst days showing that while interent penetration and online banking are highly penetrated in Netherlands, the move toward e-billing is still in early stages with penetration for e-billing below 20% for most bill-types (eg utilities, phone bills etc).

Valuation

In Exhibit 2 I show the sum-of-parts valuation analysis on the street for the Mail business.  As can be seen from this exhibit both the market-implied price as well as the street consensus estimates indicate the mail business is likely to have an enterprise value in the range of €3.8-4.5b or about 5.5-6x 2011 EV/EBITDA multiple.  In-line with closest publicly traded peer Austria Post.  I believe this valuation method is misleading as Austria Post currently pays a 6.5-7% dividend yield and trades at 11% free cash flow yield.  TNT mail on the other hand would be trading at 3% free-cash-flow yield at the indicated valuation (this is because TNT mail has large pension and restructuring cash outlflows that are perpetual and lead to a structural ongoing free-cash-flow that is significantly below EBITDA).  These valuation levels are in of themselves expensive for TNT mail.  I believe the free-cash-flow would further fall by circa 40% over the next 2-3 years driven by the 15% estimated decline in pricing and loss of volume due to secular declines and market share losses.  The sensitivity table in Exhibit 1 show how EBITDA and adjusted free-cash-flow (ex-restructuring cash outflows and normalized for steady-state pension outflows) change based on varying assumptions around price and market share losses.   Using 11% free-cash-flow yield from Austria Post and applying to adjusted free-cash-flow I get to valuation range of ~€2b for the mail business or about 50% below the current implied valuation.

Catalyst

  The short-thesis is based on following key points:

• The passage of liberalization of postal service in the Netherlands in 2009 has opened up the domestic mail market to competition from foreign as well as domestic players. This will likely drive down prices for domestic mail business significantly.
• The company is the high-cost player and as a result stands to lose significant amount of market share due to its inability to price competitively
• Secular declines in mail volumes are likely to add incremental pressure on what is a high-fixed cost business with high negative operating leverage
• Valuation is expensive on current cash flow estimates and will likely get significantly more expensive in the next 2-3 years