Good Morning. In this newsletter, we will dive into Canada’s current interest rate, after a rate cut on September 4th, which now stands at 4.25%. Next, with inflation reaching the 2% target in August, the Bank of Canada is likely to reduce rates further, potentially revitalizing the housing market, which saw a sharp decline in 2023, including a 30,000-unit drop in housing starts. Shifting gears, we’ll also explore a major M&A deal where DSV is set to acquire DB Schenker for EUR 14.3 billion, positioning DSV as a global leader in logistics. Finally, by learning more about DCF assumptions—like revenue growth and discount rates—you can deepen your understanding of company valuations and enhance your financial modelling. Keep reading to find out more!

ECONOMIC UPDATE

CANADIAN INTEREST RATES AND THE HOUSING MARKET

Current Interest Rate Standing

Since the September 4th interest rate cut, the current interest rate stands at 4.25%. Since, Canadian inflation reached the 2% target in August, the Bank of Canada is likely to continue to cut rates into the future. This achievement of the target range of inflation (1-3%) shares insight that the next rate cut by the Bank of Canada on October 23rd will likely be a more significant reduction. 

Previous High Interest Rates Impact on Housing Market

As of Oct. 3rd, 2024, Canada Mortgage and Housing Corp. (CMHC) has reported statistics from the 2023 housing market, and how previously high interest rates have resulted in significant shifts in the market. 

Higher interest rates in Canada significantly reduced housing starts by approximately 30,000 units in 2023, with condominium construction seeing sharp declines. The Canada Mortgage and Housing Corporation (CMHC) reported a 10-15% drop in new projects, especially in cities like Toronto, where the effects of rate hikes are most pronounced. However, rental construction remained more stable, supported by government policies. As interest rates begin to decline in 2024, CMHC expects housing activity to pick up. Addressing long-term housing supply issues will require substantial private sector investment and regulatory reforms to facilitate smoother development processes.

The private sector, responsible for 95% of Canada’s housing, is highly sensitive to economic changes, particularly interest rate fluctuations. Developers often depend on borrowing and pre-sales, and financial institutions’ willingness to provide credit influences their ability to move forward with new projects. The reduction in regulatory barriers and quicker approval processes are crucial to boosting the housing supply. Additionally, government initiatives, like exploring domestic investment opportunities for pension funds, aim to direct capital into solving the housing shortage. Lower interest rates in 2024 could provide a needed boost to construction and affordability efforts.

MARKET TREND

THE RISE OF INFRASTRUCTURE INVESTING

Infrastructure has been available as an arbitrage or alternative asset class since the mid-1990s and has grown significantly since then. As an illustration, the asset class currently raises over $100B annually, with more than 100 funds closed every year. Infrastructure is notably popular amongst pensions due to the long term, stable nature of the assets, which perhaps explains why Canadian pensions like CPP make up 5 of the top 10 investors in the space. This money often flows towards firms like KKR and Brookfield that own multi-asset investment strategies as the scale of these institutions enable successful sourcing and operations of the assets. However, infrastructure-only investors like Global Infrastructure Partners are also well known in the industry.

There are four main types of investment strategies within the industry:

Core: Considered the most stable, returns are largely from operating income rather than asset capital gains. Most often held for 7+ years and include assets like water systems or bridges.

Core-plus: Slightly riskier than core as cash flows are more volatile. Provides greater scope for capital appreciation over a 6+ year holding period. Examples include thermal or renewable power generators.

Value-add: Risker than core-plus as these assets are not monopolistic (like core assets) or are expanding/repositioning. Returns are mostly from capital appreciation over a 5-7-year holding period. Examples include data centers and early-stage oil processing facilities.

Opportunistic: Riskiest infrastructure assets as these are still in development or located in emerging markets. Most similar to PE investments with a holding period of 3-5 years. Returns are almost entirely from capital gains.

With governments and the public recognizing the need to upgrade infrastructure for the environment and growing housing demand, these investment firms are looking to provide much needed capital. Unlike traditional investments in the private markets, infrastructure offers a blend of stability, long-term growth, and protection against inflation, making it stand out to investors after the COVID pandemic.

Below are some key reasons why infrastructure is drawing more attention from investors and funds:

Inflation Protection and Revenue Stability

Infrastructure assets typically provide inflation-linked, long-term revenue streams (ex. toll roads, utilities). This offers a buffer against market volatility and makes them attractive for diversification compared to traditional equities and bonds.

The Role of Nearshoring and Localization

The trend of nearshoring (shifting manufacturing closer to home markets) is driving increased demand for infrastructure investments. As companies look to secure supply chains and reduce transportation costs, there is a growing need for upgraded ports, transportation networks, and energy grids.

Decarbonization and Energy Security

Governments globally are pushing for energy independence and decarbonization, particularly in Europe, as geopolitical tensions like the Russia-Ukraine war highlight the need for reliable energy sources. This has led to a surge in investments in renewable energy projects such as wind, solar, and hydrogen, making infrastructure key to the global energy transition.

Powering AI with Digital Infrastructure

The surge in AI and data-driven technologies is driving a huge demand for digital infrastructure like data centers and fiber networks. Investors are focusing on developing scalable infrastructure to support AI's rapid growth, making this sector a prime opportunity for long-term investment.

MERGER AND ACQUISITION

DSV EXPANDS ITS GLOBAL LOGISTICAL DOMINATION

DSV (Buyer)

DSV is a global logistics leader, providing road, air, sea, and contract logistics services in over 80 countries. With a strong focus on efficiency, technology integration, and sustainability, DSV is a key player in streamlining supply chains for industries worldwide.

DB Schenker (Target)

DB Schenker, the logistics arm of Deutsche Bahn, provides end-to-end supply chain solutions across 130 countries. Specializing in land, air, ocean, and contract logistics, DB Schenker serves a wide range of industries, offering services such as freight forwarding, warehousing, and supply chain management. With a strong emphasis on digital innovation and sustainability, the company leverages cutting-edge technologies to optimize efficiency and reduce carbon emissions, making it a key player in global logistics.

Transaction Details

DSV announces its biggest transaction to date after signing an agreement to acquire Schenker from Deutsche Bahn. The acquisition will strengthen DSV's global network, expertise and competitiveness, benefiting employees, customers and investors. The value of the acquisition is EUR 14.3 billion. Together, DSV and Schenker will have an expected pro forma revenue of approximately EUR 39.3 billion (based on 2023 numbers) and a combined workforce of approximately 147,000 employees in more than 90 countries. The deal still requires regulatory approval from German and EU authorities, with the transaction expected to close by mid-2025. This acquisition will reshape the global logistics landscape, giving DSV a dominant position in the industry and further consolidating its global leadership in supply chain management.

Strategic Rationale

DSV's acquisition of DB Schenker is strategically driven by the opportunity to become the world’s largest freight forwarder, significantly expanding its geographic reach, and thus, market share. The integration enhances DSV's service offerings, allowing for greater efficiency and economies of scale while leveraging DB Schenker’s expertise in digital innovation and sustainability. On top of strengthening DSV’s presence in Europe, particularly in Germany, the deal also creates operational synergies and vertical integration, positioning DSV to streamline its supply chain operations and capitalize on technological advancements.

Implications

The acquisition, however, has raised concerns about potential job losses, particularly in Germany, where DB Schenker employs around 15,000 people. DSV has indicated it plans to cut 1,600-1,900 jobs, but it has also committed to investing $1.06 billion in Germany over the next five years to support local operations.

FINANCIAL CONCEPT SPOTLIGHT

DCF ASSUMPTIONS: BUILDING A RELIABLE VALUATION

When making a DCF, the correct assumptions are the backbone of your model. These sets of assumptions make or break the valuation of a company since they drive the projection of their future cash flows. Whether you are valuing an emerging markets firm or a mature company, understanding the business model and industry landscape generally provides the basis for correct assumptions.

Revenue Growth

One of the most important assumptions is revenue growth. Historical performance and industry benchmarks serve as a guide, but so do macroeconomic trends. For instance, a technology company in an expanding market would have a higher-than-industry-average revenue growth, while the utility industry is more mature, with probably slower growth. Similarly, gross EBITDA and operating profit margins should be analyzed historically for consistency or to reflect efficiency in operations or cost-saving measures.

Capital Expenditures

Another crucial assumption to get right is capital expenditure, an investment in the company’s growth. CapEx should be consistent with the company's growth plans, considering new projects and acquisitions. Remember that higher CapEx reduces near-term cash flows but may deliver long-term growth.

Discount Rates

Another assumption is the discount rate, which projects the valuation of future cash flows. This is normally captured through WACC. A higher WACC would indicate a higher risk asset or a higher expected return for an investor, while a lower rate suggests stability. And this most definitely will give a final different valuation of the company.

Slightly summarizing, good assumptions for a DCF model should balance optimism and realism in that they are always based on extensive research and historical trends. The better your assumptions, the more reliable your valuation will be.

In a DCF there are more than just 3 assumptions, so you need to consider more than what was covered. A deeper understanding of what your company does will play a big role in projecting the best assumptions possible.

Full List of Assumptions Needed in a DCF:

Revenue growth
COGS growth
SG&A growth
R&D growth
Dep.&Amort. growth
Effective Tax Rate
CapEx growth
NWC growth
Discount rate
Perpetual growth rate

Understanding these assumptions and their interdependence will provide a more comprehensive and accurate valuation. Always tailor your assumptions to the company’s specific situation and its broader industry environment.

Recruiting Questions – Valuation Theory

What is an appropriate range for assuming a terminal growth rate in your DCF analysis? Why is this range appropriate?

An appropriate range falls between 2% and 5%. If a company is in an industry which is expected to have higher than normal growth rates or in a country that is still developing it may be acceptable to use the higher end of this estimation, whereas a mature company would use something closer to the lower end. In general, it is better to be conservative with this estimation if you don’t have strong conviction for a high perpetual growth rate.

It is important to note that the terminal growth rate should not exceed the GDP of the country that the company is operating within. This would imply that the company would eventually engulf the entire economy which is not something that is going to happen.

Another factor anchoring this number is inflation. For fully mature companies their perpetually growth rate should be somewhere along the lines of the long term expected inflation rate. Anything below this is not a reasonable estimate as growth should at least keep up with inflation for a mature company

Where do you find growth assumptions when determining revenue models and expense and drivers’ models?

The best place to start looking for growth projections for both revenue models and expense and driver's models (COGS, SG&A, CapEx, etc.) is from company investor presentations, typically found on their websites. These investors presentations will often provide a good indication of what management is planning for the future of the company. It could be in the form of target projections (specific goals management has set for the company to hit by a predetermined time) or can even be qualitative through indicated upcoming projects (maybe one that requires a large amount of CapEx or one to make supply chains more efficient). If you are given target numbers, you can calculate the CAGR over that period (CAGR = [[target/current] – 1] x 100) to use as your growth rate for the specified metric.

If investor presentations do not provide sufficient growth metrics, the next place to look would be the company filings. Company filings often have miscellaneous information that can be useful in determining growth rates for the metrics mentioned above. You can also look at equity research reports and base your growth rates around what the street is using. Another way would be to take historical averages across your projections period. To do so, you would take the average of your historical figures (usually three years) and use that to project your metrics out over your projection period.

Ultimately, the idea is to come up with a number that supports the company’s trajectory in the market, whether it is bullish or bearish. Your growth rates should be a solid indication of where you believe the company will end up over your projection period. There is no single way to calculate growth rates, and sometimes you just need to be a bit creative. As long as it supports your beliefs and the company’s plans moving forward, growth rates are very subjective.

Assume that you have calculated a terminal value using the exit multiples method. How can you sanity check that the exit multiple you used and therefore the terminal value is reasonable?

You can back into the perpetual growth rate that is implied by the exit multiple and therefore terminal value that you chose. If the perpetual growth rate comes up at 7% for example you may want to consider why your exit multiple might need to be lower. If it came back at 1% you might want to consider why the multiple should be higher.

The perpetuity growth formula is as follows:

TV = terminal value

FYFCF = final year free cash flow

g = terminal growth rate

r = discount rate

TV = FYFCF (1 + g) / (r – g)

Using simple algebra, we can rearrange this into the formula:

g = (TV(r) - FYFCF) / (TV + FYFCF)

This will allow you to calculate your implied assumed growth rate and sanity check your assumption to make sure it is reasonable.