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    Keep on Trucking: Sunlight or Headlights at the End of the Tunnel?

    by Stephen E. Kylander

    Over the past year, trucking stocks have been discovered, or perhaps rediscovered, by investors. Stock prices have surged, initial public offerings and secondary offerings have been floated, and CNBC lunch chats have touted the merits of the sector as a beneficiary of a domestic economic recovery.

    Such enthusiasm appears to have been well-founded as volumes, pricing, and profit margins improved for almost all industry operators during 2003, and this year has started off with the most robust industry conditions in recent memory. Looking ahead, the good news is expected to continue, with earnings growth projected to exceed 20% this year and next for almost all trucking companies.

    Normally all of this might be a recipe for premium stock valuations. However, with an average calendar-year 2004 price-earnings ratio of 16, trucking stocks trade at roughly a 15% discount to the overall market and well below their prospective three-year average growth rate.

    For many industries, the combination of increased investor visibility, improving fundamentals, and reasonable valuation would create an expectation for positive stock returns. However, skepticism abounds toward the trucking industry, as the light at the end of the tunnel—economic recovery—is greeted with concern that the industry will eventually revert to its old status as a highly competitive, capital-intensive commodity service. This sober view leads many investors to conclude that the time to be in trucking stocks is over for now.

    While one can’t ignore the industry’s cyclical past, both the broader evolution of the trucking industry and a bottom-up assessment of individual trucking companies reveal opportunities that the broad brush of sober investor psychology might overlook.

    Evolution of the Trucking Industry

    At the beginning of the 20th century, railroads dominated the movement of goods, but with the birth of the domestic automobile and truck industry the playing field was destined to change. By 1935, railroads’ fear of the rapid growth of motor carrier competition was such that they successfully lobbied Congress to enact regulations to control the operations of truckers. For the next half-century, the trucking industry operated under the rigorous oversight of the Interstate Commerce Commission (ICC).

    TABLE 1. Financial Ratios for the Top Trucking Stocks
    The Top 5: Truckload Sector Ticker Exchange P/E
    (X)
    Price/
    Sales
    (X)
    Price/
    Book
    (X)
    Market
    Capitalization
    ($ million)
    Heartland Express, Inc. HTLD Nasdaq 20.2 2.85 3.48 1,154.00
    Knight Transportation KNGT Nasdaq 26.1 2.67 3.79 909.7
    J.B. Hunt Transport Services JBHT Nasdaq 25.4 0.98 3.39 2,385.60
    Werner Enterprises, Inc. WERN Nasdaq 21.6 1.06 2.18 1,544.80
    Swift Transportation Co. SWFT Nasdaq 18.6 0.61 1.73 1,462.10
    The Top 5: Less-Than-Truckload Sector
    Arkansas Best Corporation ABFS Nasdaq 15.6 0.46 1.77 707.9
    Old Dominion Freight Line ODFL Nasdaq 20.1 0.83 2.4 557.4
    Yellow Roadway Corp. YELL Nasdaq 24.6 0.36 1.1 1,617.90
    USF Corporation USFC Nasdaq 21.2 0.41 1.41 945.2
    CNF, Inc. CNF New York 22.3 0.34 2.11 1,737.40
    Trucking Industry Average*     21.9 0.45 1.77 239.4
    S&P 500 Average     21.4 1.7 2.82 9,604.00

    The ICC controlled what routes each trucking firm could serve, what commodities it could haul, and what prices it could charge. In particular, the ICC permitted entry by new carriers or by existing carriers into new markets only if the carrier could justify its entry on the grounds of “public convenience and necessity.” It almost goes without saying that truckers were not conditioned to strive for operational perfection in such a relatively closed system. However, profits were good, railroads were happy, and shippers had to accept the situation.

    Starting with the Motor Carrier Act of 1980 (MCA) and concluding with the Trucking Industry Regulatory Reform Act of 1994 (TIRRA), the basis for operating in the trucking industry was turned on its head as the industry was opened to competition, and the oversight of rates, routes, and services was effectively left to market forces to determine.

    For the less-competitive and less-responsive operators, this brave new world proved their undoing. For others, the opportunity to grow was finally unleashed. Several of these operators mined the public markets for capital, and the birth of the modern public market for the trucking sector was born.

    Joining the legacy operators, a flood of well-financed new companies and shoestring-startups entered the sector to seek their fortunes. So while the motor carrier industry is approaching its 100th birthday, the modern era of trucking is really not much more than a decade old, and is still very much evolving.

    Trucking Segmentation

    According to the American Trucking Association (ATA), the domestic motor carrier industry generated approximately $585 billion in revenue in 2002. The trucking industry consists of private fleets (fleets owned and operated by companies who move their own goods) and for-hire carrier groups, each comprising approximately 50% of the market.

    The for-hire segment is generally divided into the truckload and less-than-truckload (LTL) carriers:

    • Truckload carriers dedicate an entire trailer to one customer from origin to destination;
    • LTL carriers typically pick up multiple shipments from multiple customers on a single truck and then route the freight through service centers, where freight is aggregated for delivery on other trucks with similar destinations.
    The difference between the service offerings of truckload and LTL carriers has resulted in very different competitive dynamics in their sectors.

    Truckload Market

    The truckload market (approximately $250 billion in 2002) is highly fragmented, with the top 10 carriers representing less than 10%. The vast majority of the truckload market is comprised of fleets with fewer than 100 trucks and less than $10 million in revenue, who compete primarily on price and service.

    Following deregulation, with no clear industry leader, low barriers to entry, little technology innovation, and readily available financing, the truckload segment was characterized by oversupply and little economy of scale. All of this led to low returns and a host of marginal and over-leveraged operators. Once the first major recession following deregulation hit in 2000, truckload company failures skyrocketed to a pace of 1,000 per month. At the same time, orders for new tractors plummeted from a pre-recession high of nearly 30,000 per month to below 10,000 for much of 2001, well below the replacement level of approximately 15,000 required to maintain the existing fleet size.

    Figure 1.
    S&P 500
    and S&P Trucking
    Index:
    Five-Year-Performance
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    The truckload industry stabilized, if not prospered, during 2003, as shipments resumed growing, capacity remained constrained, and the sector successfully implemented the Holy Grail—price increases. In the opinion of many leading truckload operators, the industry environment had never been more attractive, at least for the survivors, since deregulation. Interestingly, no sooner had the industry pronounced this assessment in the second half of the year, than the stocks abruptly plateaued (see Figure 1), despite rising earnings expectations for the remainder of 2003 and full-year 2004. This stalling out was apparently due to the market still viewing the truckload sector as a cyclical commodity business.

    The prevailing investment thesis for a cyclical commodity holds that outperformance will occur in the period preceding confirmed improvements in an economic cycle. This implies that the time to own trucking stocks is during periods of poor economic activity or uncertainty and that once a recovery has materialized, the stocks will at best trade sideways.

    The current market valuation of the sector seems to support this view. Based on 2004 estimates, truckload operators trade at a price-earnings ratio of approximately 18, but based on 2005 estimates they trade at 15, which is the average historical price-earnings ratio for the sector. The underlying assumption in this scenario is that the truckload sector remains captive to economic cycles.

    This view may be overly simplistic because it ignores the evolution of the industry since deregulation, potential changes in the barriers to entry, and, perhaps most importantly, the ability of individual companies to differentiate themselves from the pack.

    The LTL Market

    The cyclical thesis for trucking plays out a little differently for the LTL sector. Unlike the truckload sector, the LTL sector is highly concentrated, with the top 10 firms accounting for approximately 70% of the revenue. This represents a dramatic change since deregulation that is still unfolding—as demonstrated by the shuttering of Consolidated Freightways and the merger of Yellow and Roadway in just the past 18 months.

    The greater competitive concentration of this sector is a result of the LTL business model, which is both labor- and asset-intensive and entails greater fixed costs. These barriers should prevent new players from entering the industry and allow the survivors of the industry to enjoy operating leverage from increased volumes concurrent with an economic recovery. However, the sector remains extremely competitive and company-specific strategies such as a low-cost emphasis and differentiation will ultimately determine the best investment opportunities.

       Sources of Industry Information
    American Trucking Associations
    www.truckline.com
    The trade association Web site for the trucking industry. You can find generalized information about the industry, including financial trends, although it tends to be dated.

    Transport Topics
    www.ttnews.com
    This is the on-line version of Transport Topics News, a magazine published by the American Trucking Associations that covers the trucking industry. Here you can find recent news about the trucking industry, as well as news briefs about the individual companies.

    Comprehensive Web sites


    These comprehensive financial Web sites provide industry comparative data, including financial data and ratios for the overall trucking industry (a subset of the Transport sector) as well as individual companies within the industry.

    CBS MarketWatch
    www.cbs.marketwatch.com

    Wall Street City
    www.wallstreetcity.com

    Reuters
    www.investor.reuters.com

    Performance Drivers

    While trucking stocks often trade in tandem based on short-term macroeconomic issues, the longer-term results for individual stocks in the sector diverge substantially.

    For example, in the truckload sector, Heartland and Knight have achieved stellar returns, Werner has proven steady, if not exceptional, JB Hunt has pulled off a turnaround in the last two years, and Swift has languished.

    Similarly, in the LTL sector, Arkansas Best has shown both consistent and stellar performance, Old Dominion has vaulted from the pack in the last 18 months, Yellow had a good run until year-end results disappointed, and USF and CNF have treaded water at best.

    A bottom-up analysis of these companies reveals that the divergence in share performance is not coincidental.

    Internal Growth vs. Acquisitions
    First, all the top-performing companies have increased their revenue primarily through internal growth rather than acquisition. Internal growth has been managed by adding additional trucks to existing routes/territories and by firms expanding their successful operating model into new territories.

    In some instances, trucking acquisitions have succeeded, whereby the acquiree was fully and seamlessly integrated into the acquirer’s business model. However, among the sector’s worst performers are examples of companies where large acquisitions have not been integrated (e.g., Swift and USF).

    In this regard, the Yellow/Roadway merger, which closed at the end of 2003, may yet prove a good strategic fit. Yet, the first few months of performance of the combined entity have been disappointing, and conviction appears to be lacking in integrating the two companies.

    ‘Good Freight’
    Another distinguishing difference between the top and bottom performers in the trucking industry has been managements’ approach to balancing the profitability of freight versus maximizing total freight carried. In the industry, this has come to be known as focusing operations on “good” freight.

    Variables that enter into the characterization of “good” freight include pricing, length of haul, opportunity for back-haul (i.e., the pickup of another load at or near the initial destination for the trip back to or near the original point of departure), and minimization of non-driving time (e.g., handling and/or waiting time at the shippers’ docks). The enactment in 2004 of new government regulations restricting the maximum number of consecutive hours drivers are allowed to work has increased the focus for shippers on “good” freight and will likely favor those companies that understand how to manage their operations and charge their customers appropriately.

    Consolidated Freightways’ bankruptcy and ultimate dissolution in 2002 is testimony to the ultimate cost of unprofitable freight. JB Hunt’s significant change in operations over the past three years to eliminate unprofitable freight, after a decade of pursuing revenue growth, has much to do with the outperformance of its share price over the past year.

    Managing Labor
    Many other operating factors—such as the cost of insurance, repairs and maintenance, and fuel—also come into play in the management of trucking operations, but the most significant variable among competitors is labor.

    TABLE 2. Total Stock Returns and Return on Invested Capital: 1999-2003
    The Top 5: Truckload Sector Total Stock Returns Return on Invested Capital
    Cum’l
    (%)
    Annual
    Avg
    (%)
    Current
    (%)
    5-Yr
    Avg
    (%)
    Heartland Express 173 22.3 17 18.1
    Knight Transportation 116 16-Jan 15.4 15.1
    JB Hunt Transport Services 136 18-Jan 11.1 5.4
    Werner Enterprises 87 13-Jan 10.1 9.4
    Swift Transportation 12 2-Jan 7.5 8.8
    The Top 5: Less-Than-Truckload Sector
    Arkansas Best 444 9-Feb 10 11.8
    Old Dominion Freight 349 4-Feb 9.8 7.4
    Yellow Roadway 118 Jan-00 16.6 6.8
    USF Corp. 24 4-Jan 4.6 9.6
    CNF Inc. -4 -0.9 5.9 9.1
    S&P Trucking Index 57 9.4

    For truckload operators, labor averages approximately 35% of revenue, and recruitment and retention of drivers are considered among the most significant constraints on growth. The more successful truckload operators generally have an advantage in recruiting and retaining drivers, as they tend to pay more and provide their drivers with the most up-to-date equipment.

    For LTL operators, labor is an even greater factor, as it can account for 60% of revenues. Many believe that the competitiveness of the unionized, national LTL carriers such as Yellow/Roadway and Arkansas Best is waning as the non-unionized, regional LTL carriers expand. This theory is best illustrated by the success of Old Dominion, which has grown internally at double-digit rates over the past three years versus the low single-digit growth rates of its unionized peers. Lower cost and more flexible labor contracts were also an important value proposition for Overnite Freight and Central Freight Lines, both of which completed IPOs in late 2003.

    Return on Invested Capital
    All the factors above can, in effect, be boiled down into one statistic—namely, return on invested capital (ROIC). Table 2 shows ROIC and annual stock returns for the top five trucking companies in each segment. It is clear from the table that the companies that have created the most shareholder value over the past five years are also the companies with the best absolute or most improved ROIC. For Heartland in the truckload sector and Arkansas Best in the LTL sector, ROIC is not just a target but a religion that filters throughout the culture of their organizations.

    What’s at the End of the Tunnel?

    What is the sector outlook now with economic recovery upon us?

    Near term, concerns abound about:

    • Full or extended stock valuations relative to historical values,
    • Greater competition as tractor build rates rise,
    • Driver shortages if unemployment declines,
    • A persistent risk of higher fuel costs, and
    • Any potential stall in the economic recovery.
    In short, now that the economy has improved, investors appear to be asking what can go wrong. In contrast, when trucking bankruptcies were at their highest, investors were asking what ever could go right. This psychology is the hallmark of a cyclical industry.

    Going forward, more of our manufacturing base may shift overseas; but goods will still have to be physically shipped to consumer end markets around the country. Technology can change the economics of the business, primarily by increasing efficiency and lowering costs, but only on the margin. The basic structure of the industry is not likely to change, absent some new form of transportation.

    As it has in the past, and despite the industry’s link to the pace of expansion in the gross domestic product (GDP), success will come to those who intelligently manage their business and focus on operating basics, like achieving a strong and steady ROIC. That success can be measured in faster-than-GDP growth in sales and earnings.

    The trucking business is no doubt cyclical, but the longer-term performance numbers show that even within an economically sensitive sector, steady growth can occur. The question for investors is whether these companies are well-positioned to take advantage of the next decade in the industry. Company-specific factors for the industry are relevant not only at the beginning, but also at the middle and end of a cycle.

    The broader lesson here is that better-managed companies can prevail in the long run regardless of what industry-specific conditions apply.


    Stephen E. Kylander is an analyst with David L. Babson & Co., an investment counseling firm based in Cambridge, Massachusetts.

    This article originally appeared in the February 27, 2004, issue of The Babson Staff Letter. It is reprinted with permission.

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