Into the mailstrom

Deutsche Post is soon to lose its postal monopoly, but its costly push to diversify into global express mail and “one-stop-shopping” logistics carries immense risks.

Deutsche Post is soon to lose its postal monopoly, but its costly push to diversify into global express mail and “one-stop-shopping” logistics carries immense risks.

By David Lanchner
July 2001
Institutional Investor Magazine

Deutsche Post is soon to lose its postal monopoly, but its costly push to diversify into global express mail and “one-stop-shopping” logistics carries immense risks.

Promptly at 2:00 p.m. on May 2, Klaus Zumwinkel, chairman and CEO of Deutsche Post World Net, began his first formal meeting with securities analysts since the German post office company went public last fall. Deutsche Post’s stock had slumped, and the professorial former McKinsey & Co. consultant needed to persuade the many skeptics in the 60-person audience at the company’s sprawling Bonn headquarters that its strategy to wean itself from its government mail monopoly by combining dozens of operating units into an enterprise capable of providing one-stop logistical services to businesses worldwide was less far-fetched than it sounded.

Counting express mail, freight shipping, finance and specialized consulting services, said Zumwinkel, Deutsche Post can cover everything from transporting heavy equipment to managing inventories of finished goods to leasing warehouses, in a single, all-encompassing service (quaintly referred to in German as “das one-stop shopping”). And he started to name the six industry sectors his company is targeting for its top-to-bottom supply-chain solutions: appliances, technology, telecommunications, automobiles .... But then Zumwinkel paused, looking perplexed, his train of thought having apparently derailed. At last an analyst called out “fashion,” and the relieved Deutsche Post boss nodded and added “pharmaceuticals.” The audience chuckled nervously.

Deutsche Post is making a lot of investors nervous. Like AT&T Corp. and British Telecom before it, the German post office, founded in 1490, stands to forfeit its long-standing and lucrative postal monopoly - in 2007 - and must figure out how to fend for itself. Zumwinkel and his team of ex-McKinseyites have done an extraordinary job of transforming the money- losing Deutsche Post bureaucracy into perhaps Europe’s most efficient, and profitable, postal service, with earnings of E1.53 billion ($1.44 billion) last year on sales of E32.7 billion. Along the way, they also absorbed the East German postal system.

But some four years ago, Zumwinkel embarked on a E7.6 billion acquisition spree that would involve buying DHL World Wide Express and 52 other companies around the world in a bid to build a shipping, logistics and finance empire for the day when Deutsche Post must compete in the marketplace like any other company. Now doubts about the basic business model (the product, naturally, of a McKinsey study) and concern about Zumwinkel’s ability to meld this agglomeration of companies into one - intensified by his admission that Deutsche Post would miss margin targets in some of the new divisions - are dogging its stock. It had sunk to E18.30 in mid-June, compared with E24.78 at its peak in February and E21.00 at the time of Deutsche Post’s E6.6 billion IPO.

“For now, globalization of the supply chain [which DP deems critical to its success] is as unproven as e-commerce,” contends David Ireland, an analyst at ABN Amro in London. “No one knows exactly how it will evolve.”

Zumwinkel nevertheless believes he has a compelling story to tell. “By putting these companies together, we are creating the ability to outsource our customers’ entire supply and delivery chains, not just on a local level, but on a global level,” he says during an interview at Deutsche Post’s cavernous concrete headquarters (soon to be supplanted by a glimmering glass tower). “The way we developed this strategy was by asking our customers if there is a need for one-stop shopping. Their answer was yes. Outsourcing is a trend, internationalization is a trend, and one-stop shopping is a trend. But it will take time for this business to develop.”

Along with having to demonstrate the soundness of his business model, Zumwinkel must contend with a more immediate chore: reestablishing his credibility. “They’ve accomplished a lot in the past. So for now, they’ve got the benefit of the doubt, but that won’t always be the case,” says one fund manager who has bailed out of the stock.

At the May session analysts came away disappointed that, apart from confirmation of Deutsche Post’s preliminary results for 2000, what they got was mostly a rehash of old news. The company released no financial results for the first quarter, and an updated forecast for its operations this year was noteworthy mainly for disclosing the likelihood that the margin targets would be missed by about 15 percent in the newly assembled logistics and express divisions. Compounding the meeting’s downbeat tenor was an unfortunately timed government announcement that it might sell a third or more of the 69 percent of Deutsche Post stock that it still owns. Zumwinkel seemed embarrassingly unaware of the sale when a reporter brought it up at a press conference preceding the analysts’ meeting.

“Basically, the press conference and the analysts’ presentation underlined that the transformation of Deutsche Post from a boring Old Economy mail carrier to a high-growth, one-stop shop for distribution and logistics will be neither rapid nor pain-free,” says Thomas Meier, an analyst and fund manager at Union Investment in Frankfurt. “Zumwinkel failed to really clarify or illuminate the strategic issues facing the company, and he may not have been able to do so, considering that a huge amount of integration work lies ahead.”

Deutsche Post’s share price dropped a further 5 percent on the day of the meeting.

Zumwinkel and his right-hand man, CFO Edgar Ernst, also a former McKinsey consultant, were urged to be more forthcoming by disgruntled institutional investors they met with in Frankfurt, London and New York in the ten days after the May 2 presentation. “When we saw management, we told them they needed further training from their investment bankers,” confides one Frankfurt money manager. “We know it takes time to get used to capital markets, but we were flabbergasted that at the beginning of May, they were holding presentations on five-month-old results and would not be presenting their first-quarter results for four weeks.”

Admits CFO Ernst: “It is new for me, but I think it is a very important part of my job to talk to analysts and investors. I invest more than 30 percent of my time in communications.”

Starting off on a new foot, Deutsche Post announced its final first-quarter results two weeks ahead of schedule, on May 16. Sales were up 10 percent, to E8.58 billion, largely because of consolidation of subsidiaries’ results. But profits slid almost 6 percent, to E539 million. And the figures confirmed that the margins were below target as well as below industry averages.

Many fund managers who bought the stock at the time of the IPO have been dumping it. Recent sellers include Loomis Sayles & Co. of San Francisco; Luther King Capital Management of Forth Worth, Texas; and TT International Investment Management of London. Says a manager at one of the funds: “We were very happy with the strong cash flow coming from the regulated mail business, but that won’t last forever. We were looking for evidence that they could quickly improve margins in their new units, but that just was not forthcoming.”

Still, others see opportunity in Deutsche Post’s current distress. “Whether they can even make their business model work is a big risk,” notes Timothy Stevenson, a fund manager at Henderson Global Investors in London. “But with the stock selling at a 30 to 40 percent discount to its peers, it has a lot of upside potential if they succeed.” Both Stevenson and Union Investment’s Meier are building up their positions.

In raw profit and loss terms, crunch time for Deutsche Post is unlikely to come soon. Its government-protected mail monopoly, with an enviable 16 percent profit margin, still accounts for 74.3 percent of the company’s operating profit, though only about 34.5 percent of revenues. By contrast, the new express-delivery and logistics divisions, with profit margins of less than 1.5 percent, account for 42.1 percent of revenues but only 7 percent of profits. Financial services, including retail banking and a specialized logistics unit, bring in 23.4 percent of sales and 18.7 percent of profits (see box, page 52).

Thus Zumwinkel can probably count on having at least a couple more years to prove that he can push up margins in the express and logistics divisions, mainly through the one-stop-shopping model. But if there is scant evidence by then that he can diversify out of a mail market that is undergoing deregulation under European Community dictates, he may be forced to follow the lead of other onetime monopolies and dismember Deutsche Post.

AT&T, the former U.S. telecom monopoly, had to abandon ambitious plans to become an operator of broadband networks after a series of ill-conceived acquisitions and is now in the process of breaking itself up. AT&T’s U.K. counterpart, British Telecom, is drowning in debt after having purchased expensive so-called third-generation telephone licenses for mobile Internet services in the U.K. and Germany. It has begun hiving off units to pay its bills.

Pulling together Deutsche Post’s array of businesses represents a daunting task even for ex-consultants like Zumwinkel and company. For instance, the express division, whose revenues are E6 billion, contains more than a dozen parcel-delivery and mail-courier services spread across 20 countries. Zumwinkel reports that Deutsche Post expects to finish integrating the express companies on a national level this year. But he must still link them internationally, creating common platforms for information technology, marketing and sales. “Integrating the businesses throughout Europe over the next two to three years should significantly boost higher-margin, cross-border delivery services,” says the the head of worldwide express, Uwe Dörken, yet another ex-McKinseyite and a member of Zumwinkel’s boardroom brain trust.

One unresolved issue: Will Deutsche Post be able to fully mesh the other companies in the express division with its dominant member - Brussels-based DHL World Wide Express? Deutsche Post took control of DHL, the world’s largest cross-border express-delivery company, in September, when it paid $649 million to up its existing 25 percent holding (bought for $467 million in 1998) to 51 percent. Zumwinkel anticipates boosting Deutsche Post’s position to around 75 percent over the next few years. Dörken’s strategy for DHL calls for hooking up the express division’s mainly domestic European ground-transport businesses with DHL’s air-transport network, which flies to 635,000 cities in 227 countries.

At the same time, Dörken intends to build up DHL’s share of the U.S. market - a daunting challenge, considering that DHL accounts for a smidgen of the market (0.6 percent), while rivals FedEx Corp. and United Parcel Service control almost 80 percent. This has prompted speculation that Deutsche Post might make a major U.S. acquisition. “For a large group like ours, there will always be acquisitions,” says Zumwinkel cagily, “but I can’t tell you where we will make them.”

The logistics division consists of four major companies operating in more than 130 countries. It transports freight by road, rail, air and sea, and its revenues are more than E8 billion. Zumwinkel built the freight business essentially from the keel up. In January 1999 he spent E993 million to buy Basel-based Danzas, Europe’s No. 1 ground-transport company (with 5,000 trucks) as well as a significant ocean shipper. At the time, Deutsche Post had virtually no presence in freight shipping outside Germany.

Now it must try to meld Danzas’ operations with those of its other European ground-transport companies: Sweden’s ASG, bought for E384 million in August 1999; and Holland’s Nedlloyd ETD Holding, acquired for E678 million in March 1999. But the key to the global logistics network will be linking up to Air Express International Corp., the largest airfreight forwarder in the U.S. and also a major ocean shipper, which Deutsche Post bought in January 2000 for E1.14 billion. Zumwinkel sees “fully integrating” these companies and AEI as the means to “significantly increase” Deutsche Post’s share of “higher-margin intercontinental shipping” from Europe.

Danzas’ fledgling Solutions operation - the specialized one-stop-shopping logistical service - is potentially the biggest, highest-margin revenue generator. Deutsche Post’s E280 million-a-year logistics contract with Deutsche Telekom illustrates how Solutions’ top-to-bottom supply-chain management is supposed to work (see box, page 54). “Telekom is a wonderful example because they just outsourced everything,” says Zumwinkel. “It really shows how we can add value.”

The hitch is that Deutsche Telekom is the only significant one-stop-shopping contract Deutsche Post has signed so far, and other companies remain skeptical. One-stop logistics shopping is something “that is not here today but that could evolve with time,” says Johann Schuberthan, head of logistics planning at car manufacturer BMW. “But it remains difficult to outsource much beyond the transport of goods because logistics providers generally have standard processes, when the needs of companies are far from standard.”

“How many customers will ever want to outsource logistics?” asks ABN Amro analyst Ireland. “With today’s just-in-time inventory systems, if something goes wrong with your outside contractor, your sales can grind to a halt in half a day, wiping out savings from a logistics contract in short order.”

Overall, Deutsche Post’s logistics division lacks specialized expertise in the most dynamic industries - such as pharmaceuticals and electronics - as well as sophisticated logistical-management tools. That largely explains why the division’s margins are only about 1.5 percent, in contrast to 5 to 7 percent for its competitors TNT Post Group and Exel. Holland’s TNT Post Group, the only other publicly quoted postal carrier, has built up considerable logistical expertise in auto components and doesn’t deal in low-margin freight forwarding. The U.K.'s Exel has developed a specialty in technology goods. “It is absolutely true that we have low margins,” concedes Zumwinkel. “But we have a lot of integration work to do. The synergies will come afterward. In two to three years, we will have margins that are in line with our competitors’.”

Investors seemed readier to accept Deutsche Post’s assurances at the time of the IPO, last November. The E6.6 billion offering was eight times oversubscribed. But then, Zumwinkel and Ernst worked tirelessly to sell the deal by doing what consultants arguably do best: make presentations. Coached by their co-lead underwriters, Deutsche Bank and UBS Warburg, the pair held 26 group meetings and 148 one-on-ones for institutional investors in 36 cities in Asia, Europe and North America during a three-week tour. An astonishing 96 percent of the one-on-ones generated orders. Institutional investors ended up buying half of the 29 percent stake in Deutsche Post sold by the German government; retail investors, most German, bought the other half. Among the large fund companies taking a stake were Frankfurt-based Deka Investmentfonds, London-based Invesco Fund Managers and Boston-based Fidelity Investments.

“Deutsche Post was a rock in a stormy sea,” points out Michael Bednar, one of the UBS Warburg bankers who advised Zumwinkel. “We presented it as the perfect defensive stock because of the strong cash flow from the regulated mail business. At the same time, it still had the appeal of a New Economy stock because it stands to benefit from globalization, outsourcing and the Internet, since goods ordered on the Web have to be shipped.”

Zumwinkel must prove that his one-stop logistics scheme as well as his business model function before margins in Deutsche Post’s protected mail monopoly come under pressure. He has considerable wiggle room, however. French and British resistance has deferred the European Union’s timetable for deregulating mail monopolies communitywide from 2003 until at least 2007.

The European Parliament has recommended instead that national monopolies only on letters weighing more than 150 grams (5.3 ounces) be eliminated now, and the Council of the European Union - consisting of national government representatives from all 15 member states - is widely expected to confirm this extremely modest liberalization (affecting only 6 percent of the European postal market) before year-end. The European Commission has called for an end to all mail monopolies by 2007. But many European Community governments want their exclusive mail franchises extended until 2009. This past March the German government, responding to the EU’s procrastination, extended Deutsche Post’s monopoly from 2003 to 2007.

Nevertheless, most analysts deem it likely that Germany’s postal regulator, the Bundesanstalt für Post und Telekommunikation, will implement a roughly 10 percent reduction in postal tariffs within two years. Mailing a letter in Germany costs 22 percent more on average than it does in the rest of Europe, and Germany’s federal states have been clamoring for lower rates. “The federal states are also unhappy that market deregulation, which they see as a source of job creation, has been postponed,” says a London-based analyst. “It will be very difficult for the federal government not to cut tariffs.”

This could further erode Deutsche Post’s postal business margins. They’ve already slipped from 18 percent in 1999 to 16 percent, because of a surge in relatively unremunerative mass mailings and the regulator’s decree that clients that pre-sort mail are entitled to a 23 percent discount. The likely cut in postal tariffs would push margins down to 15 percent, analysts estimate.

Nevertheless, CFO Ernst sees postal tariffs “staying stable.” His reasoning: “First of all, they are justified by the quality of service we provide. And second of all, we can’t believe that our owner [the government] would reduce tariffs at almost the same time that it is trying to sell a stake in Deutsche Post to the public.”

The high postal rates could also get the company into trouble with the European Commission. Brussels is investigating whether Deutsche Post’s use of profits from its postal monopoly to pay for acquisitions constitutes illegal state aid to a public company under EU strictures. The possible penalty is full or partial repayment of any such aid - potentially billions of euros.

Although no clear precedent exists for such a case, Deutsche Post can take some comfort in a settlement it reached recently with Brussels in another antitrust case. The EU had charged it with using revenues from its letter monopoly to illegally subsidize parcel services. The potential fine: 10 percent of annual group sales. Instead, Deutsche Post wound up paying a E24 million fine and agreeing to separate the parcel business from the letter operation by creating a distinct subsidiary. “That provides some basis to believe the EU will deal leniently with Deutsche Post,” says Union’s Meier.

For his part, Zumwinkel contends that “if there was a penalty, it would be the responsibility of the Federal Republic and not Deutsche Post.” Analysts, however, caution that this is not as cut and dried as he suggests, given the lack of precedent. Conceivably, the government and Deutsche Post could end up splitting any fine.

A more palpable threat to the company’s margins in the near term is a loophole in its monopoly protections permitting others to offer competing mail services if they’re deemed to be of “higher quality.” Several rivals have begun offering either same-day delivery or evening pick-up in Germany’s main cities. Neither service is provided by Deutsche Post’s mail division. Moreover, the competitors benefit from a lower cost structure, since they can choose to to deliver only in urban areas, whereas Deutsche Post is obliged by law to operate in Germany’s hinterlands as well as cities. The rivals typically charge about 14 percent less than Deutsche Post. Although they have only about 2 percent of the mail market now, they’re maneuvering for more. A potentially formidable rival - TNT Post Group - has purchased several of the more than 700 licenses awarded under the loophole and plans to be delivering mail in every major German city by 2004.

Deutsche Post is challenging its incipient competitors in several court cases, arguing that they aren’t in fact offering higher-quality services because they don’t provide comprehensive coverage. TPG disputes this contention, arguing that it is “conforming with the current regulatory framework” and noting that “as the market is liberalized, we intend to continue broadening our postal services in Germany.”

Deutsche Post purports not to be worried by the possibility of losing its argument. “The biggest barrier for competitors in our mail market will remain scale,” says investor relations chief Hans-Richard Schmitz. “Every day we transport roughly 70 million items of mail in Germany, and to operate throughout the country, you need that kind of economy of scale. Otherwise you can’t establish profitable operations throughout the country.”

Zumwinkel dismisses Deutsche Post’s would-be rivals across the board. “Others are copying our strategy, but more timidly,” he declares. “In three to five years, we will be the No. 1 logistics company in the world.” It’s a bold prediction, based on a bold strategy. But as any consultant could tell you, giving up monopoly powers may be the single hardest job in business. Can Deutsche Post deliver?

Would you like a loan with your stamps?

When you think about it, post offices constitute ready-made bank branches, and Deutsche Post World Net has 13,500 of them scattered conveniently throughout Germany. Most offer loans, investments and insurance as well as stamps.

So it’s unexpected but entirely logical that financial services would emerge as one of the more lucrative quadrants of Deutsche Post’s eclectic empire. Last year financial services provided operating profits of E505 million ($476 million) on sales of E7.9 billion - or roughly one quarter of Deutsche Post’s revenues and nearly 19 percent of its operating profits. Margins are a solid 6.3 percent.

Financial services on this scale are a relatively new addition to Deutsche Post’s portfolio. Chairman and CEO Klaus Zumwinkel wanted to make more efficient use of his postal network and achieve economies of scale. So in 1999 he bought the 82.5 percent of money-losing Deutsche Postbank that Deutsche Post didn’t already own from the government for E2.2 billion. He followed that up in 2000 with the E631 million purchase of DSL Bank, a mortgage specialist, and incorporated it under the Postbank name.

So far, Zumwinkel has trimmed Postbank’s annual operating expenses -

E7.7 billion last year - by roughly E200 million through staff reductions and integration of six information technology centers into one. Eliminating overlaps between bank and post office branches should generate further savings. Postbank now operates out of 14,000 branches, counting banks as well as post offices selling financial services.

“We are obliged by law to maintain 12,000 branches throughout Germany,” notes Deutsche Post CFO Edgar Ernst. “But the future profitability of this network does not lie in selling stamps and taking parcels alone. We sell retail banking products to boost the profitability of these branches. Postbank is also an ideal financing base for our logistics operations in areas such as leasing.”

Deutsche Post aims to boost sales of financial services at Postbank from 1.2 products per customer to more than two over the next three years. But that won’t be easy. Postbank has a less than 1 percent share of Germany’s mutual fund, consumer loan and life insurance markets, and a less than 2 percent share of mortgages (the acquisition of DSL notwithstanding). Most of Postbank’s income to date has come from bread-and-butter savings and checking accounts.

Investors, however, worry that Deutsche Post may already have withdrawn most of the easy gains from banking, especially since it must compete with state-subsidized savings and cooperative banks.

Germany’s hypercompetitive, overbanked market could prove tough to crack in years ahead.

Das one-stop shopping

Outsourcing management of a company’s entire supply chain is so complicated that it took Deutsche Telekom more than a year just to negotiate its one-stop-shopping logistics contract with Deutsche Post World Net. The E280 million-per-year, five-year deal - the largest (and most detailed) logistics agreement ever concluded in Europe - was signed in September.

Deutsche Post now manages the planning, administration, stocking, ordering, transport and delivery of virtually all the equipment used by Deutsche Telekom in its fixed-line, wireless and business-to-business and business-to-customer Internet operations. (Deutsche Post, in turn, is outsourcing many of its computer needs to Deutsche Telekom.) “For Deutsche Post, this deal represents the holy grail, since it allows them to cross-sell across all their divisions: logistics, express and mail and finance,” says one analyst.

Deutsche Post’s express division takes care of shipping lightweight electronic components from suppliers, while its logistics division handles heavy equipment, such as huge cable drums. The company’s engineers determine how much equipment to store in warehouses, based on seasonal and regional usage patterns. They’re responsible for making sure that repairmen have the right equipment stowed in their trucks before heading out on the road.

Although Deutsche Telekom still gets to haggle over prices with its hundreds of suppliers, Deutsche Post handles all the billing. And it prints up invoices and sends them out to clients. Post offices even serve as Deutsche Telekom retail outlets.

Deutsche Telekom has transferred eight warehouse complexes throughout Germany to Deutsche Post, along with 2,200 employees, for estimated savings of E42 million a year. Deutsche Post has now begun offering warehouse space as well as telecommunications logistics support to rivals of Deutsche Telekom and says it’s negotiating with several companies.

Deutsche Post chairman Klaus Zumwinkel cites the Deutsche Telekom contract as proof that his company can manage entire supply chains. But most of Deutsche Telekom’s business is in Germany. One-stop-shopping logistics for companies with operations around the globe will be that much more complicated.

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