We recently researched Qube Holdings (ASX:QUB) in The Dynamic Investor following a recent trading update. While the latter highlighted resilient earnings in light of current challenges for the domestic economy, the Company has yet to achieve the expected earnings uplift following a period of significant capital expenditure (CAPEX). With QUB embarking on a plan to improve returns, and having an under-geared balance sheet at its disposal, are the shares primed for a re-rating?

Overview Of Qube Holdings

Qube Holdings provides comprehensive logistics solutions across multiple aspects of the import-export supply chain. The Company’s Operating Division comprises two core business units: Logistics & Infrastructure and Ports & Bulk.

Logistics & Infrastructure proviWith QUB embarking on a plan to improve returns, and having an under-geared balance sheet at its disposal, are the shares primed for a re-rating?des a broad range of services relating to the import and export of mainly containerised cargo as well as outsourced industrial logistics services across heavy transport, mobile crane and renewable energy industries.

Ports and Bulk has two core activities comprising port logistics and bulk logistics. It provides a range of logistics services relating to the import and export of mainly non-containerised freight, with a major focus on automotive, forestry, bulk and break bulk products.

QUB also owns a 50% interest in Patrick, which is an operator of container stevedoring services in Australia’s four largest container terminal ports. Patrick is considered the most profitable of all stevedores nationally. As QUB owns a 50% interest in Patrick, its financial results are not included in QUB’s consolidated accounts, however its valuation at present accounts for around 30-35% of the group enterprise value.

Key Fundamental Drivers

Earnings Proving to be Resilient

The Company noted that for the first quarter of financial year 2023 (1Q23), revenue, earnings and margins were ahead of internal expectations, despite challenges such as adverse weather, ongoing weakness in NZ forestry export volumes (although some improvement expected in late FY23), labour challenges, slower China volumes and supply-chain disruption.

In light of the stronger-than-expected 1Q23With QUB embarking on a plan to improve returns, and having an under-geared balance sheet at its disposal, are the shares primed for a re-rating? performance, the Company confirmed previous guidance for FY23 Net Profit After tax & Amortisation (NPATA) growth compared to FY22. While this was not quantified by QUB, consensus estimates indicate 9% NPATA growth, which is expected to be driven predominately by Logistics & Infrastructure (more so than Ports & Bulk).

QUB confirmed the above guidance at its AGM in November. It appears that the slowing domestic economy is not presently having an impact. This factor is evidence by the 1Q23 period demonstrating high volumes across most activities resulting in overall margin improvement; continued strength in container related activities (in both Logistics & Infrastructure and Patrick); very high access and storage volumes of vehicle, roll-on/roll-off and general cargo volumes; very strong contribution from agricultural related activities (which will also see significant carryover into next year); and steady volumes across resources and energy. Further:

i. Warehouses are currently at (or near) full capacity, with additional 150ha in warehouse capacity coming on line and likely to be filled.
ii. Cost inflation is having limited impact on earnings because of the Company’s ability to recover higher costs through contract protections, rate adjustments and productivity.

Evidence Needed That Return Targets Can Be Met

The Company has invested significant growth CAPEX into operating assets and warehouse facilities to support customer projects. In light of the potential profit growth over the medium term from this investment, QUB has set a Return on Average Capital Employed (ROACE) target of >10%. This measure was 8% in FY22. Although there is no timeframe set by the Company to achieve this target, the potential to lift group ROACE towards the target level is underpinned by a recovery in earnings and a re-allocation of invested capital following the MLP sale, whereby new investments also have a ROACE hurdle of >10%.

The ROACE currently earned is slightly below the current Weighted Average Cost of Capital (WACC) of ~8.5-9.0% according to Company disclosures. While there is potential for Patrick to continue generating improving returns, the long-term ability of the Qube Logistics and Ports & Bulk businesses to drive the required margin expansion will need to be demonstrated in order for the market to gain more confidence it can exceed its ROACE target. Further, it is yet to be seen whether the retention of full ownership of the intermodal terminals following the sale of MLP can result in these assets generating a return above the WACC, as expected.

Balance Sheet Capacity – But Acquisitions Likely Delayed by Cashflow Pressures

FY22 saw a significant reduction in net debt and gearing levels following the receipt of $1.56b in proceeds from the sale of 100% of its interest in the warehousing and property components of the Moorebank Logistics Park (MLP) project in December 2021, as the sale proceeds were predominantly used to pay down debt. Accordingly, there is sufficient balance sheet capacity for the Company to undertake incremental project CAPEX as well as pursue Merger & Acquisition (M&A) opportunities.

However, we consider that significant M&A opportunities are unlikely to be pursued in FY23 given that:

i. There is pressure on free cashflow over the short term as a result of increasing CAPEX requirements. Notably, maintenance CAPEX has been increasing as a result of large growth and acquisition CAPEX spend over past three years and
ii. Capital Gains Tax of A$190-200m payable in December 2022 arising from the MLP sale.

Fundamental View

We highlight several factors underpinning the investment case for QUB: i) A strong track record of capital allocation, ii) A defensive earnings profile (as demonstrated in the 1Q23 trading update), iii) A strong balance sheet that provides scope for further acquisitions and iv) A unique offering, whereby QUB provides customers with “integrated” logistics services that few, if any, of QUB’s competitors can offer to the same extent.

However, we consider that the shares are unlikely to re-rate over the short term until a more meaningful improvement in ROACE can be achieved; especially as additional acquisitions appear off the agenda in FY23 (i.e. any new investments will have a ROACE hurdle of >10%).

QUB shares are currently trading on a 1-year forward P/E multiple of ~23x. While this is lower than that over the last two years (likely due in part to MLP being sold when it previously supported valuation), we consider the current multiple to be demanding in the context of an EPS growth profile of 12% over FY22-25 on a CAGR basis – especially as EPS growth is higher than underlying profit growth (~9% over FY22-25 on a CAGR basis) as a result of the share buyback.

Charting View

QUB has been trending lower since September 2021. It still remains in that range. Recent negative price action suggests that, at least in the short-term, it is likely to head back again. If it can build a base and head sideways for a bit longer, then we can start to be confident that a low might be in place. But from a charting perspective, there is still a risk that the selling in QUB is not over yet.

 

Michael Gable is managing director of Fairmont Equities.

 

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