Kuehne und Nagel International AG

SIX:KNIN

Earnings Call Transcript 2018-Q3

[Operator]

Ladies and gentlemen, welcome to the Kuehne & Nagel Q3 2018 Results Conference Call. I'm Sherry, the Chorus Call operator. The conference must not be recorded for publication or broadcast.

At this time, it's my pleasure to hand over to Dr. Detlef Trefzger, CEO of Kuehne & Nagel. Please go ahead, sir.

[Dr. Detlef Trefzger, CEO]

Thanks, Sherry. Good morning, good day, good afternoon, and good evening to all of you and welcome to our analyst conference on the 9-months 2018 results of Kuehne & Nagel International AG. Our CFO, Markus Blanka-Graff, and I welcome you from sunny Schindellegi in Switzerland. As always, we will lead you through the slide deck published earlier this morning. And as always, we start on Slide number 3.

The success of the Kuehne & Nagel Group in gaining market shares and improving profits continued in quarter 3. For the first 9 months, the group's EBIT posted an increase of CHF60 million over last year. Strong volume growth in seafreight were gained with 8.8% or 284,000 TEUs more shipped in our seafreight networks. Strong volume growth also in airfreight posted with plus 16% or 180,000 tons more in our airfreight networks. We've seen overland with substantial net turnover growth of 16.2% and contract logistics with a strong net turnover growth of 10.6%.

As always, a short overview on the key KPIs on the following page, Page 4. Net turnover plus 13.6%, gross profit plus 11.7%, EBIT improvement CHF60 million or 8.8% and earnings per share were up CHF0.33 or plus 7.3%. I assume it's more interesting to go into the details for you, and we continue with sea and airfreight on Slide 5. Seafreight posted strong volume growth in quarter 3 with more than 10%. It's the second quarter with a growth of more than 100,000 TEU, or to be very precisely, 112,000 TEU in our networks shipped in addition to the previous quarter 3 this year.

The margin pressure continues, but we were able to offset this margin pressure by operational leverage in our cost measures, and we will come to the details of that very soon. The tremendous success of our airfreight operations continued both with the perishables but also with our industry solutions, and I will go into more details on the following slides.

Slide 6. The success of our seafreight sales colleagues combined with the excellent performance of our seafreight operators and the seafreight solutions led to a strong volume growth. This volume leverage supports the high conversion rate of almost 30% in quarter 3. We launched 2 digital platforms end of quarter 1, and these platforms got a lot of traction with our customers. The new business wins are based on KN ESP, our digital end-to-end solution, and they attract a lot of new customers for the seafreight organization. Our investment in digitization in the seafreight business is ongoing and will continue fast-forward as we see the leverage in the market.

With regards to trade lanes, we saw strong growth in export from North America and Asia. And looking down to the airfreight details, we have seen the same strong volume growth in the airfreight network from both North, from exports from North America and Asia.

Airfreight successfully deployed our solutions in the pharma, health care, aerospace and e-commerce sector, contributing to an increased gross profit margin. And the remarkable performance of airfreight is also based on the seamless integration of the perishable acquisitions that we posted in the previous quarters.

As you know, we operate the largest, by far largest perishable network globally and this attracts more and more customers to get the solutions, the perishable solutions from Kuehne + Nagel.

Let's go into some details of the volume growth on page or Slide 7. Volumes in the seafreight market, our volume rose, increased, or stayed double-digit in quarter 3, while the markets slowed down in the last quarter, especially Asia, Europe stagnated or maybe was a bit negative, although all markets show high consumption and high purchasing powers.

Our investments into trade lane development and digital platforms and solutions showed expected traction, and these investments we will continue with. And the growth that we have posted, the 8.8% or plus 284,000 TEU, equals more than the controlled annual volume in seafreight of some of our competitors. Only the incremental growth in the first 3 quarters of the control business is outperforming some of the annual volumes of our competitors.

With regards to airfreight, we have seen also the airfreight market slowing down last quarter slightly and our strong growth is generated based on 2 facts or maybe 3 facts. First fact is our compelling solutions, the solutions I mentioned before, KN PharmaChain to mention one, which were good for 8%, 9% of our growth and the perishable integration and the perishable solutions for the rest of our growth. We will give more guidance on the market developments at the end of the presentation.

Seafreight on Page 8. Quarter 3 versus quarter 2, you see this on the upper part of the slide, margins are stabilizing. They have stabilized in quarter 3 and our operational leverage and the operational, and the productivity measures show the expected results. We have a stable net margin EBIT per TEU of CHF 90, CHF 92, CHF 94. And as always, I would like to give you a bit more a flavor of the volume, margin and cost effects. In GP, the volume effect in seafreight for the first 9 months has been CHF92 million. The margin effect only minus CHF7 million. The cost effects or the high volume increase CHF67 million. So that the EBIT improvement, incremental EBIT, summed up to CHF14 million for the first 9 months. And these are the aspects that we can influence.

On Page 9, you find the same details on airfreight. Margins continue to improve slightly. We have posted a margin per 100-kilo of CHF70 in quarter 3, which is mainly driven by hard cargo and our solutions business and a stable margin in perishables. The cost of implementing our new IT software, the airlock software, as well as dealing with the high volume growth showed a operational cost per 100-kilo of CHF50. On average, we assume that CHF48 per 100-kilo would be the normalized cost that we expect in airfreight. And we see a strong EBIT per 100-kilo of CHF20 in airfreight for quarter 3.

Also here, some details on the margin, volume, cost and EBIT effects for the first 9 months. The volume effect in airfreight has been CHF120 million for the first 9 months 2018, the margin effect has been plus CHF26 million and the cost effects have been minus CHF102 million, resulting into an incremental EBIT improvement of CHF44 million.

Let's move to Slide 11 to our overland business. Another record quarter for overland, and the improvement in overland is going on. Currently, we see high rates and margins in the market, the highest since December 2016. We also see a strong demand and have a strong pipeline in the U.S. And we expect less of the overheated market for quarter 4 but a continuation in the strong demand. Details of overland, of the overland business, you will find on Slide 12.

As you know, Q3, quarter 3 usually is the weakest quarter per year. Also this year, it's the weakest quarter. But to be clear, it has been the best quarter 3 for overland in the history of our company with CHF40 million EBIT incrementally, or absolutely generated in quarter 3. The performance of the overland business has improved throughout the last quarters. And despite the onetime effect of a disposal of the overland business in Brazil, that we informed you about in quarter 1, the overall performance in overland is incrementally higher than 35% year-over-year.

We always said it's fun to do overland business. Remember, 5 years ago, 4 years ago and with quarter 3 2018, for sure, we have proved that this business is a very, not only important part of our integrated solution offering but as a stand-alone business, a very profitably attractive one as well.

Contract logistics, Slide 13. I have to say, it's also fun and important to do contract logistics business, and you have seen this during the past years, but this year, and we said so when we posted quarter one results, the contract logistics business is influenced by our investments into new operating platform, into technologies for picking enhancement, into a new warehousing management system and as well as the restructuring of our drinks logistics business in the U.K. All this as planned. Nevertheless, we see a decreasing EBIT year-over-year in contract logistics for this, for the first three quarters 2018, and we assume this will be ongoing for another couple of quarters.

On the market side, we see lot of success in contract logistics, strong net turnover growth and gross profit growth of more than 10% and, as said before, impacted by the investments into the new operating platform. Where does the growth come from? The growth comes from e-commerce fulfillment. We have seen year-over-year growth of 40% in new operations for e-commerce fulfillment and in pharma more than 20%. All these new wins lead to startup investments, startup costs that will be recovered throughout the course of the contractual period. I think that in total with 27 million EBIT for quarter three and 93 million EBIT for year-to-date 2018, the contract logistics business has done a tremendous job while transforming the whole portfolio of activities.

And having said so, I would like to hand over to Marcus, who will lead you through some of the details of our figures.

[Markus Blanka-Graff, CFO]

Thank you, Detlef. Good afternoon, ladies and gentlemen. I am on Page number15, income statement. And the most important number on the income statement is the net profit earnings for the period. And I think what we have achieved in the first 9 months is we delivered 580 million net profit after tax, which is 40 million more than last year or 7.5% more than last year.

From my side, we could actually conclude the call at that moment, because that is what we're here for. We're here for delivering bottom line, and 7.5% increase bottom lines for the first 9 months is our starting point. But let's look at some of the KPIs a bit closer. So we have increased our gross profit by 600 million. And out of 600 million additional gross profit, we have generated 60 million or 10% more EBIT. That is below our target for 2022, which is a 16% conversion rate for the group. When I look into the quarters, quarter one was around 14%, quarter 2 10%, quarter 3 6.5%. That is a slowdown, but it is exactly what Detlef was explaining in the investments and the business growth that we are initiating in the contract logistics and also in the strong growth in the seafreight business unit. Overall, a few technical details; we have exchange rate impacts that had been a bit stronger at the beginning of the year until the first six months. At the current stage, in the mix that we are having in the currencies in the income statement, we are having a positive FX impact of plus 2.4%. Tax rate, we're still expecting to maintain a stable tax rate around 23%.

Leading to the next, Page number 16, the balance sheet; only three things I want to highlight. The first one, equity ratio. In December 31, 2017, we started the year with equity ratio of 31%. We're now nine months in the year after payment of dividends at 28% equity ratio. This is a very healthy equity ratio. This is a very healthy balance sheet. To preempt some of the questions, I know I have spoken about it last time already, there are new components in the balance sheet on the asset as well as on the liability side called contract assets and contract liabilities. In simple terms, IFRS 15 is requiring a reclassification for these. So work in progress was it called in the past, contract asset is it called now and associated contract liabilities are shown as a specific line in the balance sheet. IFRS 16, the integration of lease commitments into the balance sheet as of 1st of January, 2019. For information purposes so that everybody is prepared, that will add approximately 1.4 billion on both sides of the balance sheet, so an extension to the balance sheet, of which we would expect our balance sheet to have an overall size of around 9 billion.

But let's get away from the more technical part into the more real part. Cash and cash equivalents, Page number 17. Cash is all that matters, if you like, and we continue and confirm a very diligent and tight cash management. When you look at the year-to-date results out of the cash balance, you can see that we started the year with around 700 million cash. And you will see, through the cash flow, three components what reflect our growth strategy that reflect higher rates within the business, I'm talking seafreight, airfreight rates, and the reflection of the largest year of contract logistics in the sales ledger. Especially the changes in working capital, we have put 310 million into the working capital in the first nine month, which is an increase of 136 million over last year, which is driven by the three components that I just said. Kuehne + Nagel is growing very strongly and with large volumes, hence volumes growth and rate growth is driving the working capital. Cash flow from investing activity, which is mainly CapEx, that is the part where contract logistics plays a major role, is 176 million in the year 2018, around 70 million over last year, which is CapEx. And last but not least, we paid in the, in May 2018 approximately 30 million more dividends than we did in 2017. Adding all that together, we have a current cash balance of 218 million on the balance sheet, which is around 350 million below last year out of the reasons that I have just explained.

So let's have a bit of a closer look at the working capital since that is the bigger item. Page number 18, working capital intensity 4.3%, still within our corridor, 3.5% to 4.5%, which we have extended 1.5 years ago exactly to accommodate a growth strategy. How did we achieve that to remain also in the DSO, DPOs or on the spread between the DSOs and DPOs around 11 to 12 days? DSOs, as we all know, customer pressure, DSOs are expanding. It's just the fact of how the industry works. We are mitigating this pressure with enlarging of DPOs mainly through our supply chain finance solutions that we have developed together with Citibank and has a very good acceptance rate in the industry.

So going forward, and especially in the light of tariffs or additional higher rates and bigger volume growth, I see that the working capital intensity will remain at an elevated level. I cannot foresee that the higher tariffs will lead to a lower working capital. That is not logical and what's not logical is not science. So at the end of the day, we will probably see more pressure on the working capital intensity.

Having said that, Page number 19, and I apologize at least on my side that, that page doesn't have a page number. The return on capital employed, we are currently at 60%. 60% is the value excluding the acquisitions. The mix effect that I have been talking about three months ago is still valid. We have a stronger growth relative in contract logistics, which leads to a higher asset allocation as it is in the sea and airfreight business. As well as the currency effect, which is wearing off a little bit compared to three months ago but is still valid. No matter what our opinion, how we drive return on capital employed up again to the 70%, which we still maintain as our target based on the business mix and the balance sheet composition. It's a simple answer to that question, we will increase profitability.

Hence, financial targets for 2018, Page number 20. We confirm our targets 2022: conversion rate for the group, 16%; return on capital employed, 70%; effective tax rate in the corridor, 22%, 23%; working capital in the corridor, 3.5% to 4.5%. So the long-term targets, I think, are not impacted neither positively or negatively. We are very well on track to get there. Short term, and short term means market 2018, I appreciate that we are mid of October, so that is 2.5 months ago, we believe market in the sea and airfreight is going to settle at around 3%, which you can easily translate to that there is a slowdown, that Detlef has already mentioned, overland and contract logistics at around 4%.

With that page, I would like to hand over back to Detlef for the further part of the call.

[Dr. Detlef Trefzger, CEO]

Thanks, Markus. While indicators signal lower growth, we are very confident about our own performance. We have proven over the last 9 months that we can outperform market growth by factor 2 to 3, and there's no reason to believe that this will change. We are able to control our costs well in order to ascertain the leverage effects that you are known, or that you know from us. Our investments into digitalization as a game changer in seafreight, in airfreight, in the contract logistics business units and overland continue and help us to drive better services and improve productivity further.

And we have shown, for example, with perishable acquisitions that we made, that the acquisitions as an accelerator helped to drive the overall performance of the network as we are able to integrate additional volumes seamlessly in our networks. Our roadmap 2022 is in full swing of implementation and well on track. We invest successfully and will continue for the next quarters in the digitization, new platforms and also eTouch, and of which the benefits we will see in the future as per our detailed explanation and presentation during the Capital Markets Day.

And as promised, dear friends, we will inform you about the details on how much traction we got in eTouch, or we will get in eTouch this year during the next analyst call on the full year results 2018. Based on what we have presented to you and the very good results of the first 9 months, our full pipeline of new customer contracts as well as the cost control program is well underway, plus the investments into transforming our business, we expect to close this year, the year 2018, successfully again.

Thank you very much. And I hand over to Sherry to open up the Q&A.

[Operator]

The first question is from Mark McVicker from Barclays. Please go ahead.

[Mark McVicar]

So 2 or 3 questions, really. First of all, because it's a much-asked question this morning, could you give us some idea of the proportion of your airfreight and seafreight volume that goes across the Pacific?

[Dr. Detlef Trefzger, CEO]

Yes, continue with the questions, Mark.

[Markus Blanka-Graff, CFO]

Please continue with the questions.

[Mark McVicar]

Right, fine, okay. All right, so that was the first question, proportion of total volumes on the transpac. Second question was you're obviously in the middle of your budgeting process. What are you saying to your people, what are your people saying about the likely rates of volume growth on that transpac route in 2019, and how do you work your budget given the uncertainty? And then the final question is, I took your point, Detlef, that consumer confidence is quite strong in most of Europe. We in the UK are waiting for Armageddon, of course. But to what, why do you think those Asia-Europe volumes are down a little bit year-on-year?

[Dr. Detlef Trefzger, CEO]

Okay. So let's start with the transpac volume. We have around 8% to 10% of our total volume as transpac-related for both sea and airfreight. The budgeting process is in full swing at the moment. And as said before, there's no reason not to aim for market gain, market share gains as well as strong volume growth. We have compelling solutions, Mark. We have solutions that matter for our customers. We have customers moving back. And the growth that we anticipate is still, let's say, strong, double-digit, yes? The only insecurity in the market might be quarter 1 next year, to say this also clearly, as we, at the moment, don't know whether the insecurity of new trade regulations being, becoming effective January next year might cause some higher volumes to be shipped and stock levels to be increased in quarter 4. That is to be seen. But in total, low taxes, high purchasing powers, increasing, decreasing unemployment rates, I would say, that speaks for high consumer confidence and ongoing investments into consumption. I think, the third question, Mark, what was that again?

[Mark McVicar]

It was, given that Europe is actually in pretty good shape at the moment, why do you think the Asia-Europe volumes are flat or very slightly down, as you rightly said?

[Dr. Detlef Trefzger, CEO]

Asia-Europe, the, I think that the consumption pattern has shifted slightly. There has been a strong double-digit growth on Europe-North America, so, vice versa. So some of the sources for consumer goods have shifted. Is that a permanent shift? I wouldn't say so. You know that some of the Asian economies have concentrated their market on Asia as well. So we benefit, we have strong double-digit growth on intra-Asia. So we benefit from the overall market development. On this trade at the moment, we see this to be flattish, maybe, is the right word.

[Mark McVicar]

Okay. That's great. Thank you very much.

[Operator]

Next question is from Sathish Sivakumar from Citigroup.

[Sathish Sivakumar, Citigroup]

Yes. Good afternoon Markus and Detlef, my first question, do you see any changes to your dividend policy on the back of free cash flow coming in well below the dividend for this year?

[Markus Blanka-Graff, CFO]

Sathish, we had problems to understand your question. Can you please ask again?

[Sathish Sivakumar, Citigroup]

Yes. So do you see any changes to your dividend policy on the back of free cash flow coming in well below the dividend?

[Markus Blanka-Graff, CFO]

No, Sathish, we have been obviously in conversations between the boards, and I think we have a very healthy cash flow. At the current stage, we have not discussed any changes in the dividend policy, which, to remind everybody again, is between 75% and 100% of the net profit after tax.

[Sathish Sivakumar, Citigroup]

Okay. So just on the follow-up, right, so do you foresee any long-term targets around free cash flow coverage of dividend? Because you said you're just discussing with the board, so is there any...

[Markus Blanka-Graff, CFO]

I cannot, well, it is natural, obviously, that we are updating our board on a quarterly basis with the supervisory board meetings on the financial performance of the group. So that is where, obviously, that is discussed. And there is no such discussion going forward.

[Operator]

Next question is from Damian Brewer, RBC. Please go ahead.

[Damian Brewer, RBC]

Good morning everybody. I've got one question, please. And I just wanted to come back to the airfreight business. Given you've had significant expansion in the perishable business, which one would expect to normally be both GP and margin-dilutive. Can you talk a little bit more about what the air business would've looked like just on the nonperishables and give us a feel of what's going on there? Clearly industry platforms have helped. But it would be interesting to get a little bit more flavor of what's going on under the surface there. Thank you.

[Dr. Detlef Trefzger, CEO]

Yes. Good afternoon, Damian. Our airfreight business shows improving margins in the nonperishable sector. And I said so when I went through Slide 9, I think it was, when we post or when we sell our solutions, we are able, because we usually sell end-to-end solutions and have reflected the specific industry and customer demand in those solutions, we are able to have a robust or even a strong margin for this business. While perishable stays, at the moment, on the known much lower margins.

[Damian Brewer, RBC]

Okay. And just as a follow-up, if you're able to characterize your business on the air side, how much of the volumes you handle would you say are perishables nowadays versus nonperishable volume?

[Dr. Detlef Trefzger, CEO]

Our perishable business is good for around 32% to 35% of our total volume. Again, this gross profit or the margin per 100-kilo is flat, while the improvement in margin is due to our investments into solutions business. KN chain solutions, as we call them, BatteryChain, PharmaChain, SecureChain, InteriorChain for the aerospace industry. We have a lot of those solutions up and running, and they drive both, volume growth as customers are extremely interested in those solutions, but also stable or improving margins.

[Damian Brewer, RBC]

Okay. That's very helpful. Thank you.

[Dr. Detlef Trefzger, CEO]

You're welcome Damian.

[Operator]

Next question is from Daniel Roeska from Bernstein. Please go ahead.

[Daniel Röska]

Gentlemen good afternoon. Looking forward to Q4 and more detail on eTouch. But would you be willing to share, kind of, progress on eTouch and what the current penetration rate across the 2 main modes, air and sea, are? And then secondly, you, of course, talked about the continued investment into the different businesses. Could you give us some more color when you would now expect those investments, kind of, to end or at least decrease again? And thirdly then, that, of course, I would assume translates into improvement in conversion, but could you break the 13% to 16% increase on the conversion rate you're targeting into broad buckets? How much of that is eTouch? How much of that is, kind of, lower investments? And what the other components may be? Thanks.

[Dr. Detlef Trefzger, CEO]

Sure, Daniel. Let me start with your first question. We presented the eTouch mechanism at the Capital Market Day September, and we started the whole road map 2022 9 months ago. So to answer your question, you will all get details altogether in our end of February call on the overall 2018 performance. And here, we will detail eTouch, not only structural but also by business unit. The penetration to see this also clear is slow at the moment, because we still invest into the full eTouch and automation, digitalization of the supply chain. Your question, when do investment stop? At the moment, we are focusing on the internal process optimization. There are three elements of eTouch: the carrier side, the internal and the market side, customer side. We focus at the moment on the internal part, because that will drive our productivity immediately or seamlessly.

One example is airlock. We invest at the moment, and we have said so in the last quarter review calls, into deploying the new operating system for airfreight, called airlock, by end of this year. When the rollout is fully established, then we can, with the new system in place and switching off the legacy system, by the way, then we can invest into, or then we can implement the eTouch elements for our internal processes.

The carrier processes in seafreight, for example, have already 80%, 90%, 95% eTouch for carriers. But it's only the carrier side. Our seafreight operating system, called sealock, will not be fully deployed before end of 2020. So there's also a certain time, like here, because we have to roll all those systems out in each and every location to ten thousands of employees. We have to train them on the new system. And we have, with China exports, for example, in seafreight, only 25% of the vendors online at the moment with regards to eTouch from a vendor's side. KN ESP, those platforms, the operating system, sealock, they are all elements of what we call eTouch. All this pays into eTouch. And what I've mentioned before with contract logistics, also here, our growth with e-commerce fulfillment and pharma, 40% for e-commerce fulfillment and 20% for pharma, both are based on our capability of a seamless interface with our customers.

Hundred thousands, millions of order lines per location per day can only be processed in what we call eTouch, in an eTouch environment. And these are the investments we are currently making. When will this stop or be reduced? That was your second question. For sure, it will continue next year. I mean, we are in the ninth or 10th month now of deploying our road map 2022, and our targets remain firm for 2022. This is what we said before, yes? We still aim for 20% to 40% eTouch shipments in the year 2022, gentlemen. We have 9 or 10 months out of 60 already in our strategy. Don't expect wonders immediately. You can expect wonders, but don't expect them overnight.

[Daniel Roeska, Bernstein]

And then maybe on the last question, any other big buckets aside from eTouch and lower investment in the step-up from 13% to 16%?

[Dr. Detlef Trefzger, CEO]

No. I think for the overall volume growth, our systems are capable for much stronger volume growth once we have deployed them. No other recipe that we would apply. I think we are showing with our figures a net profit improvement of 40 million year-over-year for the first nine months of this year that we get traction with our strategy while we are investing and transforming the business at the same time. We are rebuilding our plane and ship and truck and warehouse, so to say, in full swing while running from one all-time high record result for a quarter to the next.

[Operator]

Next question is from David Kerstens from Jefferies. Please go ahead.

[David Kerstens, Jefferies]

Two questions, please. First on your yields in seafreight. Container rates were up 17% that you seem to have fully passed through to customers. Would you say that you have been helped by the bunker surcharges that were announced by most carriers back in June? And in relation to this, obviously, your view on the IMO 2020 surcharges that have been announced and will be implemented in January '19. Do you expect you'll be able to offset those as well and in your discussions with your customers? And secondly, regarding your airfreight volumes. I think if you backout the acquisition effects, would that imply that your third quarter volume was up only 2%? Since you're highlighting exactly the same verticals as last quarter, I was wondering what is holding back that volume number. I think 2% is roughly in line with the other volume numbers.

[Dr. Detlef Trefzger, CEO]

So David, let me answer your bunker surcharge question as well as the sulfur-induced bunker and cost increases becoming effective early 2020. We have stated so at the JOC Conference, these costs have to be borne by customers eventually. So we prepare our customers on this already. At the moment, we see different strategies with regards to bunker costs with the different carriers. But our customers start to understand this is market and the cost structure of shipping containers with carriers is changing. So yes, we will be able to offset these costs eventually with our customers. And your question with regards with to, I think, the airfreight volume for quarter 3. I think we have seen a slowdown in the market. Our growth was more than twice as fast as market, while we were concentrating on stabilizing yield and improving yield. I would even say, our organic growth, despite the acquisitions, have been higher than, clearly higher than market, 4% to 6% would be my answer.

[David Kerstens, Jefferies]

4% to 6% organically in Q3?

[Dr. Detlef Trefzger, CEO]

Yes.

[David Kerstens, Jefferies]

And maybe can I ask one follow-up, please, regarding the comment on the weakness on Asia-Europe. Are you saying that the Chinese imports into Europe are being replaced by more imports from United States and other markets? Or is that general weakness that you see going into Europe?

[Dr. Detlef Trefzger, CEO]

At the moment, I would not mention any structural change in markets. I think it's a general weakness, but if you look into the pure import pattern of Europe from all markets, there's no decrease in imports. From that point of view, they must have been substituted by other markets. Whether this is North America or Middle East or South America, too early to say, and whether that leads to a longer lasting structural change, too early to say. We watch this carefully. At the moment, no change in the trade patterns, no permanent change in trade patterns. It's a weakness, nothing more. And maybe I should say, Asia-Europe is weak in seafreight, but in airfreight, it's still growing.

[Operator]

Next question is from Neil Glynn, Crédit Suisse. Please go ahead.

[Neil Glynn, Crédit Suisse]

Good afternoon and really just one last from me with respect to contract logistics. Just interested your customer dialogue with respect to pivoting supply chains away from China to the extent that you're having any at the moment. I realize this is something that can't change that quickly, but just interested in terms of your expectations and understandings of customer intentions there. And also what proportion of your contract logistics business is actually based in China operating for international customers?

[Dr. Detlef Trefzger, CEO]

Neil, first of all, good afternoon to you. Pivoting supply chains away from China, it's an interesting question, because I think the answer is twice fold. We have a strong consumption and growth going on in China. Many of our customers producing in China concentrate more and more their production on the local Chinese market, while they set up new productions or mirrored production in neighboring countries, surfing for exports. A trend, by the way, that is existent already for, I don't know, five to 10 years, a decade most likely. I would say, this trend is accelerating at the moment, but it's also based on the clear five years plan of the Chinese government that has been published, I think, October-or-so 2016, which concentrates more and more on the local domestic Chinese market. And supply chains, because you were alluding to supply chains, are very agile. They can react like overnight. That's not a topic. The topic is more of can our customers find a Tier 1, Tier 2 supplier who can produce the same quantity in the desired quality in a different market? I think that's the challenge for our customers. Supply chain is not the challenge. We are very agile and adaptive.

[Neil Glynn, Crédit Suisse]

Understood. If I can actually...

[Dr. Detlef Trefzger, CEO]

And the percentage of our business. Our business in China is concentrating, so to say, on international customers.

[Neil Glynn, Crédit Suisse]

If I could just follow-up with 1 more, actually, sorry. In 2015, you took a bit of a new approach to seafreight, a far more selective approach given the challenges in the market at the time. And it just brought to my thinking, given the outlook for 2019, given how uncertain it is, with net working capital and requirements or intensity rising with more uncertainty with respect to seafreight volume quantity, is it a prospect that you may well take a far more selective approach to volume in 2019? Or should we be thinking business as usual in terms of 2018's trend continuing?

[Dr. Detlef Trefzger, CEO]

No. You want to...

[Markus Blanka-Graff, CFO]

I think, Neil. Business as usual never exists in our business.

[Dr. Detlef Trefzger, CEO]

Exactly.

[Markus Blanka-Graff, CFO]

It is changing very quickly. But our strategy is clearly geared towards volume growth. Why is that clearly geared to it? Because with the new systems, with SALog coming in place over the next 2.5 years, the leverage on operational efficiency will be higher the bigger the bases we work on. So volume growth clearly is our aim to achieve.

[Operator]

Next question is from Michael Foeth, Vontobel. Please go ahead.

[Michael Foeth, Vontobel]

Two questions really. You were talking previously about the pricing trends in airfreight underlying, and I was wondering what those pricing trends in seafreight looked like. There's always a lot of mix trade lane effects in there. It looks like GP per TEU was stable sequentially. But can you talk about the underlying trends really that you're seeing, is that under pressure? That would be the first question. And the other one is, you were also talking about investments before, but I'm not sure whether you were talking about investments for the entire company? I was interested in the contract logistics-specific investments that you had in Q3 and for how long we should expect those to remain high?

[Dr. Detlef Trefzger, CEO]

Sure. So for air, Michael, for airfreight, we expect stable airfreight rates now moving forward to the next couple of months. And the only topic is how do oil prices and therewith fuel prices develop? But that's the only major varietal that is difficult to assess. But it will not impact the overall development from our point of view in the next couple of months, yes? The investments that you were asking related to contract logistics. We mentioned that a couple of times, it's investment into new generation of warehouse management systems.

As I mentioned before, we see 40% volume growth in e-commerce fulfillment or e-commerce fulfillment in contract logistics. And for sure, these investments will continue in the next quarters first, or in 2019. We invest into picking enhancement, into new technologies to drive our picking efficiency and also this will be ongoing. And then Q3, Q4 2019, these investments shall be completed and shall show the respective effects. The effects we are aiming for is higher productivity in the warehousing space we operate as well as faster capability to integrate high-volume solutions in certain locations. As said, we have locations that see up to 1 million order lines per day, and our systems need to deal with these volumes. They do today, but if we continue to grow with 40%, we are preparing for future growth here.

[Michael Foeth, Vontobel]

Okay, very good. Just a follow-up on the first question. You were talking here about airfreight, am I correct? And I was wondering about the trends in seafreight as well.

[Dr. Detlef Trefzger, CEO]

Seafreight, we see trades like transpac continue to grow. That's our ambition or that's what we anticipate and plan for. Some of the other trades are rather flat or there's a very low growth. And I think the rates, because of 2020, rates, not margins, the rates, because of 2020, sulfur, being part of the rate structure, shall go up over the next quarters. That's our assumption. That's the way we read the market.

[Michael Foeth, Vontobel]

Okay. So pricing will remain under pressure in that respect for you as well? GP per...

[Dr. Detlef Trefzger, CEO]

Why should that be the case? We negotiate rates with our customers usually back-to-back. If this is a process that is not as agile or iterational as we have seen this 2, 3 years ago when I was alluding to saw-chain patterns, remember? Then I shouldn't see any irritation in our pricing moving forward.

[Michael Foeth, Vontobel]

Okay. Thank you very much.

[Dr. Detlef Trefzger, CEO]

You're welcome.

[Operator]

Next question is from Andy Chu from Deutsche Bank. Please go ahead.

[Andy Chu, Deutsche Bank]

Thank you. Good afternoon. Just 2 questions from me, please. First one is on the airfreight volume growth that you mentioned organically was doing, sort of, 4% to 6%. And I just wondered with your comments that Asia-Europe is still growing. Can you put that Asia-Europe growth into context versus the growth of 4% to 6%? And then secondly, just in terms of numbers, IFRS 16, balance sheet adjustment of CHF 1.4 billion, what is the D&A adjustment, please? Is it roughly, sort of, a CHF 300 million something of that order?

[Dr. Detlef Trefzger, CEO]

Sure. So Asia-Europe, our volume growth is higher than market growth on these trades. And yes, I think that's the answer to your question very briefly. And the second question...

[Markus Blanka-Graff, CFO]

The second question is on the latest IFRS 16, the balance sheet remains at CHF 1.4 billion. I would expect currently an EBITDA impact of around CHF 400 million and an interest portion of around CHF 30 million.

[Andy Chu, Deutsche Bank]

Thank you very much. And then just clarity in terms of Asia-Europe, when you say market growth, do you mean the, sort of, overall market with 3% you're pointing to? It's above 3% or the growth rate on the Asia-Europe trade language, which I guess I don't know at this point in time. So to dig a little bit more on that growth rate. Thank you.

[Dr. Detlef Trefzger, CEO]

What is your precise question, Andy? I was talking about the market growth, and we grow and our ambition is and we are able to achieve that ambition to grow minimum twice as fast as market. At the moment, we grow double-digit on these trades.

[Andy Chu, Deutsche Bank]

Okay. Thank you very much.

[Operator]

Next question is from Poulain, Aymeric from Kepler.

[Aymeric Poulain, Kepler]

Good afternoon everybody. I've got 2 questions. The first is on the operating leverage size and obviously the difficulty we have to, to separate what is the underlying cost inflation from what are self-inflicted investments. So I understand you said that the CHF 2 per 100-kilo increase, extra cost per increase you saw in air trade would not recur in Q4, but could you confirm that? I think you gave a clear explanation on contract logistics. But on the seafreight, I was wondering, given the investments that you're planning, what we should expect in terms of this extra cost that you alluded to? And also just to get a sense of the underlying inflation that you budget for cost in the current, or the remaining of the year and 2019. That's the first question.

And second question is, obviously your drive for scale is very visible on the organic side, but we currently see a bit more movement on the consolidation side with the DSP approach on CEVA and with that, of course, streaming off and so forth. So I'm just wondering what's your stance on this. Last year, you mentioned a renewed interest in this scale M&A and I just wondered what's your thought on that process at this stage?

[Dr. Detlef Trefzger, CEO]

Aymeric, good afternoon to you. Sure. Let's start with the latter question. The consolidation is ongoing and we clearly posted we have an active M&A process. And more we will not disclose until we post a press announcement. But we are active in the market. And we also said that we will not buy any potential target just for the sake of an equity story. We are looking for niche markets, for footprint, for competence in order to leverage our networks based on our strong organic growth further, that, this is a positive, that we can develop positive momentum. We have shown with the takeover of CFI, Commodity Forwarders Inc. in the U.S., the perishable market leader in the U.S., and seamless integration into our networks always re-trends in the U.S., the intermodal provider that we integrated into the overland business and purchased 2 years ago. And you can expect other stories here as that we have an active process.

And we are, our belief is, yes, we talk about the big acquisitions in the market. Whether they pay off eventually, it's on you to judge, not on us. But the consolidation in our market is happening from the bottom of the pyramid. The local specialist, Freight Forwarder, that serves the trade lane for certain customers in a commodity, like coffee or beans or whatever, and all of a sudden, through e-commerce, their customers are asking for other trade lanes. And these providers, these local forwarders are not able to serve them. And here's a very strong consolidation to notice. That's one reason why we are able to grow minimum twice as fast as market. We capture market share most likely from those. We don't know them individually, but our global networks become more and more compelling for small and medium-sized shippers in other parts of the world, because we can offer them access to world markets. And therefore, our drive for scale will continue, as Markus said and I said before, because our operating systems are in place. Our operations are scalable and this scale, we want to make best use of.

Airfreight, your first question or initial question. What we said is we didn't give any guidance. We said a normalized or a normal cost structure per 100-kilo would be CHF48. That CHF48, CHF49, CHF50 and that was what we mentioned before. And you saw that volume and margin effects in airfreight clearly outperformed the cost effect. That's for us the most important message. Likewise, and we have seen this for the first time in seafreight in Q2, for seafreight, where we see that the rates are stable now, or the margins, not the rates, sorry, the margins are stable now. And also the cost per TEU is stable and we leverage via the volume the overall performance of our seafreight network. I hope that answers your questions?

[AymericPoulain]

Yes, more or less. Thank you.

[Dr. Detlef Trefzger, CEO]

Hopefully, more than less, Aymeric.

[Operator]

Next question is from Bruce Chan from Stifel. Please go ahead.

[Bruce Chan, Stifel]

Just a couple left on my side. With regard to contract logistics, can you share with us what the cost development would have been like, absent the platform investments? And then also maybe just a point of clarification. Detlef, you mentioned that there was a decrease in year-over-year development in contract logistics EBIT for the first three quarters and that you assume that that's ongoing for a few more quarters. Should I think that means that the investment impact will be taking place for the next few quarters or that the decrease in EBIT will be taking place for the next few quarters? And maybe this is a good time to ask when you expect that EBIT margin to inflect or to begin increasing again?

[Dr. Detlef Trefzger, CEO]

So the decrease will continue versus previous year for the next couple of quarters, because our investments will be ongoing. And our investments in total are between 10 million to 20 million a year, into platform, ramp-up of new projects as well as the new warehouse management software.

[Markus Blanka-Graff, CFO]

Annually, not per quarter. Annually.

[Operator]

Next question is from Edward Stanford, HSBC. Please go ahead.

[Edward Stanford, HSBC]

Two questions left for me. Has there been any evidence of stock building ahead of the tariffs as already been introduced by the U.S. and China? And secondly, can you give a flavor of how you see the peak season, particularly in Asia, developing this year? It was particularly difficult to understand it last year. With capacity issues, can you give us a flavor of how you see it this year?

[Dr. Detlef Trefzger, CEO]

So we have not seen any evidence of stock building yet. People are talking about it, but we haven't seen it. And therefore, that's maybe then one of the varietals for the remaining months. Not yet to be seen. The peak season, from our point of view, with a slow down in quarter three, I would say maybe it's on the same level than previous year, because at the moment our capacity is secured. Whatever comes in, we are able to capture, and the order intake from customers at the moment doesn't show any deviation or significant deviation, yes? Our peak season, I would say, in airfreight, peak season we are prepared for it, and we can even better execute than previous years because capacity is secured. And for seafreight, as said before, orders are well underway. But don't expect a special season or a overheated season. I said so also for overland before. It will be the normal heat in the remaining months, not an overrated situation, which leads to margin pressure.

[Operator]

The next question is from Sebastian Vogel, UBS. Please go ahead.

[Sebastian Vogel, UBS]

Just 1 actually left from my side. It's with regards to the airfreight side of things. You mentioned a couple of times over the course of the call that there's a slowdown. I guess, that slowdown was also expressed in your reduction of your market growth there. With regards to the slowdown, is it a broad-based one? Or can you pinpoint more in the direction where this is more pronounced? That would be a great help.

[Dr. Detlef Trefzger, CEO]

The slowdown we have seen is Asia exports, that is transpac-related. That's the only significant deviation that we see. But it's an important stream. There might be effects all over, because as you remember, a year ago, all of a sudden, the market starts to spike, but it's too early to predict. Asia exports usually is a early indicator, so that guides a bit our cautiousness for the overall performance of the market in Q4.

[Sebastian Vogel, UBS]

Just one follow-up. You said Asia transpacific, right, the exports?

[Dr. Detlef Trefzger, CEO]

Yes.

[Sebastian Vogel, UBS]

And keeping with what you said earlier, I mean, that was one of the trade lanes that was showing quite decent volumes, right? In particular with regard to Asia-Europe, for example, right?

[Dr. Detlef Trefzger, CEO]

Yes. Year-to-date.

[Operator]

There are no more questions at this time.

[Dr. Detlef Trefzger, CEO]

Then, gentlemen, alright, ladies and gentlemen, thank you very much for calling in and listening to our Q3 and first nine months 2018 review. We look forward to have you with us in the review of the full performance of the year 2018 end of February next year. And as said before, based on the very good results of the first nine months and our full pipeline with new customer projects, our cost control paired with the investments into leveraging our networks further, we are very confident that we will be able to close the year 2018 successfully. In the meantime, I wish you all the best, and talk to you again soon. Bye-bye.

[Operator]

Ladies and gentlemen, the conference is now over. Thank you for choosing Chorus Call, and thank you for participating in the conference. You may now disconnect your lines, goodbye.