Keeping the world moving – Businesses that move goods from A to B had an excellent pandemic as supply chains stuttered. But what happens next?
In 2022, the digital world often seems more dazzling than the real one. Artificial intelligence, 5G, virtual reality headsets, and Abba-shaped avatars are hard to compete with, after all. However, the physical underpinnings of modern life remain extraordinary – specifically the processes that allow goods to move thousands of miles at the click of a button.
If you order a jumper from your living room in the UK, the product that arrives on your doorstep will have completed a mammoth journey. It’s likely to have been made in a factory in Asia and moved to a port such as Shenzhen or Shanghai. On arrival at the port, it will have been loaded onto a containership as long as the Empire State Building is tall, alongside 200,000 tonnes of other goods.
Around four weeks later (in normal times), it will have arrived in a port such as Felixstowe or Southampton, only to be transported by road to a UK warehouse. It will then have been shifted overnight to a regional distribution centre, before finally being delivered to your door. During the last leg of its odyssey, your jumper will have been scanned over 260 times.
Journalist and novelist John Lanchester described shipping as “the physical equivalent of the internet, the other industry that makes globalisation possible”. However, while we are repeatedly amazed and appalled by the scope of the online world, the average consumer until recently paid little attention to the shipping process – or, indeed, to the logistics sector in general, despite supply chain activity making up about 10 per cent of the UK economy. Much like the giant warehouses that line the motorway near Milton Keynes, the industry is designed to blend into the landscape.
Every now and then, however, something happens that pushes these companies into the spotlight. In March 2021, one of the world’s biggest container ships, the Ever Given, got stuck in the Suez Canal for almost a week, holding up an estimated $9.6bn (£8.5bn) of goods each day. A dredging company and a fleet of tugboats eventually freed the vessel. However, pictures of it wedged in the Egyptian waterway provide a useful symbol for the state of logistics more generally, and reflect a newfound interest in the industry that was sparked by the pandemic.
For since Covid-19 struck, supply chains around the world have been in disarray. Ports have been congested, warehouses have been low on space, drivers have been elusive and other workers have gone on strike. This has resulted in misery for retailers and consumers, with higher costs mutating into higher prices.
The impact on companies tasked with keeping the world moving has been rather more positive – but their winning streak could be coming to an end.
Stage One: Across the sea
The swollen profits of oil and gas companies have come under intense scrutiny this year. However, shipping lines have also been enjoying a “super-cycle bonanza”, in the words of Simon Heaney, senior manager of container research at maritime consultancy Drewry.
Since the second quarter of 2020, the industry’s rolling earnings before interest and taxes (Ebit) has exceeded $400bn. The second quarter of 2022 was the best yet, with AP Moeller-Maersk (DK:MAERSK.B) reporting its sixth consecutive three-month period of at least 30 per cent organic revenue growth. Its European competitor Hapag Lloyd (DE:HLAG) banked $9.9bn of Ebit in the first half of 2022 – almost three times more than last year – while Orient Overseas Container Line’s (HK:0316) operating profit doubled to $5.7bn. Across the sector, Ebit is thought to have reached $84bn in the second quarter, with the average Ebit margin sitting at 55 per cent.
The mood is darkening, however, as Investors’ Chronicle reported last week (‘Plummeting freight rates bring relief for importers‘, IC 4 Nov 2022). “Despite the latest results… the current state of the market is undeniable,” says Heaney. “Arrows are pointing down wherever you look: whether it’s spot rates that have fallen for over 30 weeks in a row, or charter rates which have dropped by around two-thirds since their peak, or indeed slackening port and trade volumes in most regions.”
Much like the oil industry, the performance of shipping lines rests on rigid supply and demand dynamics. Demand for finished goods soared in 2021, as online shopping increased and global lockdowns eased. This collided with labour shortages and China’s zero-Covid policy, resulting in a supply chain chokehold.
Now, however, supply is on the up. According to investment bank Peel Hunt, containership owners have put in a flurry of orders for new vessels, and fleets are expected to grow by 4 per cent in 2022 and by 8 per cent in 2023.
“The supply glut is a response to the huge increase in rates that container ships were able to charge as we came out of the pandemic,” says Peel Hunt analyst Thomas Pocock. “Rates reached almost 10 times the average rate being charged prior to the pandemic. But I fully expect that container ship rates will come down to levels we saw before Covid – if not lower – if supply overtakes demand.”
Demand itself is looking shaky as consumer confidence and consumption falls.
There’s another problem, too: pollution. From 2023, shipping companies must comply with new carbon emissions standards imposed by the International Maritime Organisation. This follows a sulphur emissions cap introduced in 2020. That is unlikely to be enough of a headwind to supply to rebalance supply/demand dynamics, meaning it could bring downsides for specific companies, rather than a boost for the industry as a whole. Pocock said some shipowners will have to retrofit their ships in order to meet the new regulations, meaning “their ships are out of the water and they won’t be able to charge the higher rates”.
The issue stretches beyond regulation. Last year, a group of nine international companies, including Amazon (US:AMZN) and Unilever (ULVR), committed to zero-emission shipping by 2040. This will require huge amounts of investment by shipping companies to find green solutions, and risks the premature depreciation of ships.
This is not the only threat. “There’s increasing focus on ‘nearshore’ sourcing,” says Paul Martin, head of UK retail at KPMG, citing improvements to companies’ carbon footprints and supply chain resilience.
“If you think about a lot of the outsourcing countries, China still has its zero-Covid policy, and various other markets such as Bangladesh and Vietnam have had different degrees of reliability. Many organisations in the UK, America and Europe are thinking they can reduce cost and unreliability [by bringing production closer to home],” Martin says.
Last year, Swedish furniture giant Ikea announced plans to shift some production from east Asia to Turkey – Investors’ Chronicle understands the company wants 80 per cent of products in its top 10 global markets to eventually be sourced on a nearshore basis –and analysts suspect that more retailers will follow suit.
Stage Two: Over the land
Shorter supply chains spell trouble for international shipping and air freight companies. However, they could usher in opportunities for smaller UK groups, such as Wincanton (WIN), DX Group (DX.) and Xpediator (XPD), as regional complexity increases. Indeed, there is already evidence of this.
Aim-traded Xpediator has reported strong tailwinds from its freight forwarding operation in Central and Eastern Europe, with divisional revenue jumping by 54 per cent in the first half of 2022 and operating profit increasing by 44 per cent. Business in Bulgaria and Lithuania is proving particularly strong.
It hasn’t all been good news, however. Xpediator saw group-wide profits decrease between January and June, and we recently downgraded the shares to a sell after the group’s UK logistics operations fell into the red. Its UK freight-forwarding business has also been underperforming.
Xpediator’s mixed performance reflects a sector-wide tension. Let’s start with the positives – namely that the importance of companies that deal in haulage, warehousing and home delivery came to the fore during the pandemic.
“For years and years, the likes of Wincanton have been underappreciated,” says Liberum analyst Gerald Khoo. “It’s a classic situation where, if logistics companies do their jobs really well, the customers and stakeholders don’t really notice. The moment anything goes wrong it really shows up.”
Khoo says Wincanton handled labour shortages better than many companies because of its driver training programme, and investment in automation had given it a competitive edge.
Panmure Gordon analyst Andy Smith adds that Wincanton is an attractive option for mid-market retailers that are not big enough to develop their own distribution centres, but who still experience high volumes and don’t mind sharing space. Space is at a premium at the moment, as retailers have bulked up their inventories to combat supply chain issues.
Despite several years of improved performance, Wincanton is still very cheap. On several valuation multiples – price-to-sales, enterprise value to cash profits, and forward price-to-earnings – the group’s shares trade at or below their five-year average.
Collaborations between retailers and logistics businesses are likely to increase further, as companies such as Amazon raise consumers’ expectations, and technological advances usher in more sophisticated fulfilment – the branch of logistics focusing on warehouse storage, packaging and final delivery. Smith predicts that the cost of distribution centres will continue to rise, “leading retailers to further outsource their logistics requirements to dedicated logistics companies which can offer a cheaper service through automation”.
But the larger players are looking to vertical integration rather than outsourcing. Deloitte retail director Marie Hamblin notes that the pandemic has prompted some companies to bring their logistics in-house in order to have greater control. Last December, for example, US retailer American Eagle Outfitters (US:AEO) bought Quiet Logistics, while Marks and Spencer (MKS) bought Gist Logistics this summer in order to modernise its food supply chain.
Notwithstanding Wincanton’s experience, well-run listed logistics companies’ potential has not gone entirely unnoticed, either. At the start of this year, GXO Logistics (US:GXO) snapped up Clipper Logistics – formerly listed in the UK – for almost £1bn, representing a 32 per cent premium to the group’s three-month average share price. More generally, accountancy firm BDO noted that “significant” private equity investment continues to drive deals in the sector.
There’s a catch, however.
“A lot of the positives have now started to unwind for logistics companies,” says Zeus Capital analyst Robin Byde. “Think of Royal Mail. Parcel deliveries have gone down as people have tentatively gone back to work and the high street.” The cost of living crisis isn’t helping matters, with consumers reining in their online spending, and logistics companies are contending with notoriously skinny margins.
BDO’s ‘logistics confidence index’ has slipped from 62.5 last year to 50.4 this year, with less than half of surveyed companies expecting to increase their profits in the year ahead. The accountancy firm added that logistics companies’ share price returns had fallen back in line with the FTSE All-Share, after a period of outperformance in 2020 and 2021.
Stage Three: And back again
There is one particular part of the process where retailers – even those who are choosing to bring logistics in-house – need all the help they can get: returns.
In its results for the year to 31 August 2022, Asos (ASC) warned that a rise in customer returns had contributed to a working capital outflow and an increase in inventory. (The fast-fashion retailer ended the period with over £1bn of stock, and intends to write off £100mn-£130mn.)
It is a similar story at Boohoo (BOO), where returns have overtaken pre-pandemic levels, resulting in a fall in net revenue. Retailers are often coy about how high their returns rate actually is, but analysts at Jefferies estimated in May that a third of Boohoo UK purchases were being sent back, and things are likely to have worsened since then.
This is bad news for shops, but Clipper chief executive Tony Mannix has described returns as a “huge growth opportunity” for third-party operators.
“Returns has almost become an entire ecosystem in itself,” says Deloitte’s Hamblin. Companies are rethinking how they deal with consumers, with Boohoo and Zara now charging customers to send back clothes – a potential revenue stream for logistics companies to share.
Businesses are also getting cannier about what they do with their unwanted products. “There has always been a second market for this,” Hamblin says. “A retailer would use a ‘jobber’, who sells products to a market or an eBay store. But a lot of the retailers are realising that it’s such a loss of revenue for them.”
Given the scale of the problem, companies are now trying to sell old clothes at a higher margin. Zara, for example, has recently launched a website for second-hand garments and repairs, and it seems likely that returns could make an appearance.
There are risks for logistics companies, however. Dealing with returns is hugely labour intensive, as clothes must be clean and intact in order to be resold, and this usually involves a human unpacking and examining the garment. This is a very difficult process to automate, meaning companies who enthusiastically take on the work could be stung by high labour costs and sluggish operations.
Stage Four: The last mile
Of course, the existence of ‘reverse logistics’, as returns fulfilment is known in the trade, depends on your new jumper arriving on your doorstep in the first place. This act of shifting goods from distribution centres is often the most challenging part of the entire supply chain, not least from a profitability perspective. As the chaotic state of Royal Mail – now International Distributions Services (IDS) – has made abundantly clear, companies run the risk of disputes over pay and conditions, while struggling to boost efficiency and reduce pollution.
It’s hard to predict what shape the ‘last mile’ will eventually take. According to KPMG’s Paul Martin, Switzerland essentially nationalised the final mile during lockdown to ensure food parcels could be delivered to vulnerable people. Universities are now being asked to consider whether this is a long-term prospect. Could the same happen in the UK?
“Can I see something like that happening with a government that’s free market, libertarian? No. We’re quite far away from some sort of mandatory solution,” says Martin. “But there could be one carrier, or one dominant player, that thinks about how to build an ecosystem around this. A platform for supply chains where they offer different services, with ESG (environmental, social and governance) principles at the forefront.”
The obvious candidate is Amazon. Amazon has handled its own logistics for years, and has recently created a $1bn venture investment programme “to spur and support innovation in customer fulfilment, logistics, and the supply chain”. It has also started offering delivery services to rivals such as Walmart and Etsy, in a bid to grow its empire.
For now, however, retailers are embracing more, rather than fewer, last mile options – in part through companies such as Deliveroo (ROO).
The ultra-fast delivery market has not been a cheerful place of late. Shares in Deliveroo have fallen by almost 70 per cent since its IPO late last year, and Just Eat Takeaway.com (JET) has been on a similar trajectory. As the cost of equity continues to rise, there is more pressure than ever to turn a profit, just as customer demand is starting to soften.
In a third-quarter trading update, Deliveroo noted that orders had fallen by 1 per cent, reflecting the “difficult consumer environment”. Meanwhile, Just Eat saw group orders decline by 11 per cent year on year in the same period. Many of the start-ups that sprung up in lockdown are no longer around.
Recent developments have been intriguing, however. Deliveroo no longer focuses exclusively on takeaways, having struck deals with WH Smith (SMWH), Boots and Waitrose. “They are going to go into a lot more categories – anything that can fit into a Deliveroo driver’s backpack,” said Jefferies analyst Giles Thorne.
It sort of makes sense. Online grocery retail is notoriously difficult, with shops often struggling to turn a profit themselves. Ocado (OCDO), for example, has increasingly begun to emphasise its ability to license its technologies to other businesses in the face of mounting losses in its retail business. This month it signed a deal to build robotic warehouses for a South Korean retailer, causing its shares to jump by almost 40 per cent – albeit they remain 60 per cent down year to date.
Meanwhile, Deliveroo could help retailers dodge many of the labour issues blighting the logistics sector. Despite record unemployment in the UK, delivery platforms have continued to attract and retain riders, who seem drawn to the flexibility of the work.
There’s an issue, however. “A restaurant makes 90 per cent gross margins on a pizza, so sharing the order value with a platform like Deliveroo is not that big an ask,” says Thorne. “But if you took, say, 20 per cent of a milk order, the supermarket would be operating at a negative gross margin. They would be making a loss. Establishing utility to a supermarket is very hard.”
The obvious solution is to up the price of the products, which is what Deliveroo has done. A Waitrose pepperoni pizza costs £4.90 if you buy it in store, compared with £5.90 on Deliveroo. Similarly, three chicken breasts cost £5.70 on Deliveroo, compared with £5 in store. If platforms raise prices too much, however, they risk alienating the customer entirely.
There is another option. “One way to address the economic issue is to operate your platform model not via a Tesco Express on the corner, but to lease a physical warehouse and have it all optimised for online fulfilment,” says Thorne. “This strips out a huge amount of cost which means a much smaller mark-up. You are having to cover less of an inflated business model.”
Deliveroo has cottoned on to this, and last month opened Deliveroo Hop, its first bricks-and-mortar grocery store in the UK, in partnership with Morrisons. The shop is known as a “dark store”, meaning products are laid out for maximum efficiency. Jefferies praised this as a “low capital cost and scalable revenue stream”.
Ultimately, however, a profitable Deliveroo will always have to charge more for a pint of milk that is delivered to your home, than for one that you pick off the shelf yourself. This discrepancy will only increase as worker conditions attract more attention. (Deliveroo is being challenged in the UK Supreme Court over the rights of its riders, less than two years after Uber (US:UBER) lost a landmark legal battle in the same court.)
This is not just the case for start-ups – the logistics sector as a whole is coming to terms with the fact that speedy delivery doesn’t come cheap. “Like with budget airlines, I think we’ll continue to see very low prices. But when you add on all the extras for delivery and returns, people might end up paying more for the service than for the product itself,” says Andrew Berry, a supply chain specialist in EY’s consulting team.
Silvia Rindone, head of UK retail at EY, agrees. “I think, as a consumer, you will eventually have to pay for that convenience. If you really, really need something, you will pay for it.”
How much we are willing to pay – economically, socially and environmentally – for such convenience is the big question. If certain advances in logistics ultimately prove unprofitable, they may not turn out to be so pioneering after all.
Original article found here: https://www.investorschronicle.co.uk/ideas/2022/11/10/keeping-the-world-moving/
Author: Jemma Slingo, Investment Writer, Investors’ Chronicle
Director, Research Analyst, Logistics & Industrial Services