Truckers' Valuations Overheating

Following almost two years of anemic pricing, the truckload, or TL, shipping landscape saw a remarkable recovery in the second half of 2017. Capacity has rapidly tightened on accelerating freight demand, carriers’ fleet reductions, and weather disruptions. Highly constrained supply is driving a resurgence in TL carriers’ pricing power; spot rates have rebounded to record levels and contract pricing won’t be far behind. We expect TL capacity to stay firm this year on the back of widespread adoption of electronic logging devices, or ELDs, and the limited driver pool, enabling top-tier TL carriers to capitalize on an unusually strong pricing backdrop. Less-than-truckload, or LTL, carriers should also see healthy rate gains with help from spillover freight from the supply-constrained TL sector.

That said, throughout 2017, stock prices across the trucking space surged as spot rates spiked and optimism grew regarding U.S. tax reform. TL and LTL valuations have become quite lofty and remain so despite the pullback in March. We think the market is extrapolating carriers’ strong operating performance too far into the future. We’ve seen this before--trucking valuations spiked during the 2014 capacity crunch but spent 2015 falling back down to earth as demand and pricing softened and reality set in. We would sell or avoid overvalued asset-based TL and LTL stocks despite the prospect of robust pricing conditions throughout 2018.

2018 Shaping Up to Be Stellar Pricing Year Following robust conditions in 2014 and the first half of 2015, the period between mid-2015 and mid-2017 proved to be lackluster for truckers across the $350 billion TL and $40 billion LTL markets. This was thanks to a slowdown among industrial end markets and minimal inventory restocking among retailers (elevated inventory/sales levels), resulting in a pullback in freight demand. These factors were felt most acutely in the TL sector, where sluggish demand sparked a period of excess capacity. Average linehaul pricing (excluding fuel) fell about 2% in 2016, with rates down significantly more than that midyear. TL dry van spot rates were hit hardest, declining 9% for the year, according to trucking data provider DAT Solutions, and contract rates (down 4.5%) entered a painful rut as the 2016 bidding season ensued. Despite soft demand, pricing in the much smaller and more concentrated LTL niche fared better (flattish) in 2016. This was in part because carriers have become materially more disciplined and rational with network capacity and yield management following a devastating period of irrational pricing in the early stages of the post-2009 freight recovery, when competitors attempted to knock out former industry leader YRC Worldwide YRCW.

The trucking market made an impressive about-face in mid-2017 as U.S. economic growth accelerated, including an industrial production recovery and marked pickup in retailer inventory restocking. During the second half of last year, the full-truckload industry’s supply/demand balance turned rapidly in favor of carriers’ pricing power as capacity tightened on strengthening freight demand, carriers’ fleet-reduction efforts, and disruption from the late-summer hurricanes. ELD adoption--mandated as of December 2017--may have had a slight impact on capacity, but that will be more of a factor this year.

According to trucking data specialist FTR, active truckload capacity utilization (needed trucks divided by active/in-service trucks) spiked to 100% in the fourth quarter of 2017. This means supply and demand is remarkably tight, like it was during the 2014 capacity crunch, when this metric last reached such a high level; the historical average is near 90% over the past few decades. While the market is very tight, we note that over-the-road freight is getting moved and reaching its destination; cargo isn’t permanently sitting on shippers’ docks. However, shippers need to go deeper into their routing guide (or call list) of core carriers and pay more to secure service on many lanes. Meanwhile, carriers have gained solid pricing power.

Tightening capacity has pushed TL carriers’ spot rates to staggering heights in recent months, with the national average dry van spot rate (according to DAT) reaching historic highs in January. Additionally, even though year-over-year spot rate increases will ease on tougher comparisons later in 2018, contract rates are starting to rise, and a marked acceleration won’t be far behind as the bidding season moves into full swing. March kicked off the spring peak shipping season and full ELD enforcement kicked in April 1, so we look for capacity to stay constrained and shippers to be amenable to higher rates. Carriers’ contract discussions with shippers had already turned constructive in the fourth quarter, and industry leader

The smaller LTL landscape isn’t seeing the same pricing surge because capacity isn’t nearly as variable, thanks in part to carriers’ efforts to avoid a repeat of pricing wars in 2009 and 2010, the limited driver pool is less of a constraint, and capacity is more a function of density (trucks can still run with partial loads). LTL carriers specialize in moving smaller shipments from multiple customers relatively quickly via a network of consolidation terminals. Tight TL supply historically lifts LTL pricing with help from spillover freight from the TL sector and as shippers become more amenable to rate increases in general. LTL yields gained momentum in the fourth quarter as TL capacity became squeezed.

Overall, it doesn’t take much in the way of demand growth or weather disruption (such as hurricanes or winter storms) to tighten the TL market; similar factors were at play during the capacity crunch in 2014. Despite carriers’ bout with excess supply in 2016 as demand softened, fleet growth has been much more rational and controlled than in previous economic cycles; carriers learned their lesson during the 2009 freight recession and haven’t persistently overexpanded; margins take precedence. In fact, carriers acted quickly to reduce their tractor counts in 2016 to match sluggish demand, and the industry is grappling with chronically limited driver availability, which tempers carriers’ ability to add trucks even when they wish to. Overall, there’s scant elasticity in the TL space, and that won’t change overnight.

We expect to see momentum continue for the trucking landscape in 2018. We expect top-tier TL carriers like Knight-Swift and

We don’t expect 2019 to be a bad year for asset-based TL and LTL truckers because underlying freight demand should remain healthy. On top of that, the constrained driver pool will prevent TL carriers from overexpanding their tractor fleets, and small truckers will still be grappling with lingering productivity pressure from ELD adoption, which bodes well for capacity trends and thus absolute rate levels. For 2019, we expect TL pricing (excluding fuel) as measured by the Cass Truckload Linehaul Index to still be ahead of 2017. However, year-over-year rate comparisons will turn very difficult by year-end 2018, and that will continue well into 2019. Thus we look for TL industry core pricing excluding fuel surcharges to see slight declines in 2019 on average relative to a historically robust 2018. Several top-tier TL carriers we cover, like Werner, could see revenue per mile (excluding fuel) flat to up slightly on superior yield management relative to the broader marketplace. Our long-term steady-state pricing growth assumption for the broader industry falls back to the historical average of about 2%. Although it will take longer for TL capacity to adjust to healthy demand than in previous cycles because of ELD-related productivity losses and limited driver availability, it will eventually happen; capacity won’t stay tight forever.

ELDs Will Constrain Capacity and Driver Shortage Prevents a Quick Fix In late 2015, the Federal Motor Carrier Safety Administration ruled that interstate truckers must install compliant electronic logging devices by Dec. 18, 2017, with full enforcement as of April 1, 2018. We estimate widespread ELD adoption will reduce truckload industry capacity by 2%-3% by the end of 2018. Accelerating demand growth, carriers' fleet-reduction efforts, and weather disruptions have brought the TL industry out of an approximate two-year capacity glut into a period of tight supply in which providers are seeing a solid secular uptick in pricing power. We expect the impact of ELDs to keep the supply/demand equation tight in the year ahead against a backdrop of healthy freight demand and a limited driver pool, which will constrain industry fleet growth.

ELDs track drivers’ duty status in real time and more precisely enforce hours-of-service compliance relative to paper logs, which use 15-minute intervals. Small fleets and owner-operators egregiously distorting their paper logs are certain to see the biggest hit to productivity (via lower utilization, or miles per tractor) upon adopting ELDs, but even the most stringent adherents to HOS rules will see a reduction. Large sophisticated truckload carriers, like Werner, saw a 4%-5% productivity hit upon installing ELDs in years past. We assume small fleets stand to lose in the ballpark of 7% of their productivity on average--a few percentage points above the level many large truckers have reported because small fleets have limited options (in terms of network scale and IT) to mitigate the impact. If a large proportion of small carriers were egregiously cheating with paper logs, that metric will be higher.

Essentially all the large TL carriers (those with more than 250 trucks) had installed ELDs by the end of 2017; most adopted some form of the technology years ago. But a large proportion of small and midsize truckers, which make up 99% of the TL carrier base, had yet to do so. In an analysis we conducted last September, we calculated that roughly 42% of the TL tractor fleet (trucks, not firms) was noncompliant. We estimate that implies a potential TL industry productivity/capacity hit of 2%-3% in 2018 as small truckers install ELDs.

The limited driver pool remains a headwind to industry fleet growth. As widespread ELD adoption tempers TL capacity in the year ahead, we think driver recruiting challenges will restrain most carriers’ attempts to quickly offset lost miles via fleet growth. This should keep supply tight for longer, which bodes well for industry pricing. The driver pool is limited for a host of reasons: A large number of drivers left the industry during the previous downturn, new entrants have long been inadequate (it’s not a glamorous lifestyle, and attracting young prospects is a challenge), and it’s a rapidly aging group (the average age of an owner-operator is in the ballpark of 55, with many retiring).

Market Appears Too Optimistic Despite sluggish demand and abundant truckload capacity throughout 2016, TL and LTL stocks on our coverage list launched into an unusually strong upward climb, with a meaningful jump in November 2016, rooted in the U.S. presidential election and the prospect of U.S. tax reform. Trucking valuations saw another drive upward in the second half of 2017 linked to investor optimism over vastly improving spot rates, which started spiking as truckload capacity rapidly firmed on rebounding retail end-market demand and disruption from the landfall of two hurricanes, Harvey and Irma. The increasing likelihood that capacity will remain tight in 2018 as a result of the impact of widespread ELD adoption among TL carriers, along with U.S. lawmakers' solidifying tax reform, also played a role. Capacity across the LTL landscape is relatively balanced, but providers nonetheless benefit from a supply-constrained TL sector in the form of spillover freight and yield gains, and investors know that. Overall, these factors have created substantial investor optimism, and we caution that many trucking names have moved back into highly overvalued territory, even despite the pullback in March. Downside risk is elevated, in our view. We would wait on the sidelines despite the lure of likely solid operating conditions in the year ahead.

We’ve seen this valuation dynamic before in trucking. In late 2014 and early 2015, we considered most TL and LTL carriers we cover to be overvalued, very likely because of overly optimistic assumptions surrounding longer-term core pricing gains (excluding fuel) and fleet growth (which drives load growth for TL carriers). As operating conditions normalized and softened, however, those valuations fell back to earth by early 2016 as reality set in. We think a robust pricing environment (perhaps the strongest in more than a decade) and the prospect of continued momentum into 2018 and 2019 stand behind truckers’ return to high valuations. Overall, the near-term outlook is robust, but investors seem to have forgotten the cyclicality of asset-intensive trucking stocks.

The TL and LTL carriers we cover are trading at roughly a 28% premium to our fair value estimates on average. Because Werner ranks as one of the largest TL carriers and its performance metrics aren’t muddied by acquisitions, it provides a helpful illustration for the overly optimistic growth assumptions that we think are baked into most trucking stocks. In early March, to get a sense of what the market was implying, we backed into the market price in our discounted cash flow model by adjusting several key assumptions. At the time, Werner’s stock price was about 34% above our $28 fair value estimate. It’s now at a 30% premium following the recent pullback in trucking stocks, but our analysis still provides perspective. For this scenario, we assumed Werner manages to defy the driver shortage and expand its tractor count by 4% on average over the next five years, with unusually robust increases of 5%-6% in both 2018 and 2019. In terms of pricing, we used unprecedented revenue-per-mile gains (net of fuel surcharges) of 9% in 2018 and 7% in 2019, tapering off to 3% in the out years. This implies average rate gains of 5% over the next five years. With these pricing and volume assumptions in play, organic trucking segment revenue growth (net of fuel surcharges) would average 9.5% over the next five years, including 13%-14% expansion in 2018 and 2019.

Leverage from robust revenue growth in this market-based scenario would provide a solid boost to total operating margin, and in this optimistic scenario we assumed Werner can achieve a record-low midcycle operating ratio (expenses/revenue, net of fuel surcharges) near 89% by 2022. Implied incremental operating margins in this scenario are in the high teens, versus a low teens average run rate reflected in the base-case assumptions supporting our current fair value estimate.

However, the aforementioned market-implied assumptions are too optimistic, in our view. In terms of tractor growth, we believe 5%-6% in 2018 and 2019 (4% long term) is quite unlikely. Freight demand should prove healthy over the next two years, considering consensus GDP growth estimates are 2.9% and 2.4% for 2018 and 2019, respectively. Trucking is a GDP growth business, tracking a wide array of industrial, manufacturing, and retail end-market activity. Economic growth and opportunities for top-tier carriers like Werner to take share during this phase of constrained capacity (on superior service and shippers’ preference for providers with proven record of using ELDs) provide reason to think Werner and its peers will enjoy demand capable of supporting mid- to high-single-digit fleet growth. However, headwinds from the limited driver pool make strong tractor growth unlikely; we saw that happen in 2014.

Even for carriers with well-funded recruiting programs, flexible (driver-friendly) network capabilities, and resources to boost driver pay, our 3%-4% base case average fleet growth assumption for 2018 and 2019 (2% long term) could still prove optimistic. High driver turnover will keep the threat of unseated tractors in constant play, even for the market leaders. Unseated tractors compress utilization (miles per tractor) and thus productivity (revenue per tractor), and most of the public carriers reported low-single-digit utilization declines for that reason in 2017. We expect utilization to be flat to up slightly over the next few years among the TL carriers we cover, as periodic bouts with driver churn offset efficiency gains. For those that fall short on the recruiting front, utilization will decline.

For these reasons, truckers like Werner will probably remain reluctant to take on substantial fleet growth risk in the quarters ahead. In fact, the public TL carriers we cover have yet to announce meaningful tractor expansion plans. Equipment investment is gaining momentum due to support from robust rate gains and extra cash from tax reform, but it’s heavily weighted to refresh programs. As in 2014-15, when TL pricing flourished, we do expect the large TL carriers to adopt more of a growth posture as 2018 progresses, but the magnitude remains uncertain.

We think high-single-digit average rate gains (excluding fuel) in 2018 and 2019--implied in our market-based scenario--would be a stretch for Werner or its peers. Average increases of 8%-9% across the TL industry aren’t out for the question this year, especially for top-tier carriers with strong service capabilities, given that tight capacity should persist on the back of widespread ELD adoption and limited fleet growth. However, we don’t expect such robust gains to repeat in 2019. A repeat is possible if U.S. macroeconomic growth finds a way to accelerate beyond current expectations. However, year-over-year comparisons will become exceedingly difficult by the end of this year because of the meteoric spike in TL spot rates beginning in late 2017 and upcoming sharp rise in contract rates as the 2018 bidding season ensues. Further, over the next five years 5%-plus average long-term pricing gains are doubtful. That would be quite high on a historical basis; average increases for the TL industry have been closer to 2% since 2006.

Difficult to Drive a Moat in Trucking We do not award economic moats to any of the pure-play TL or LTL carriers we cover. We see few opportunities for even the most efficient providers to construct a lasting competitive edge via the key economic moat sources: cost advantage, efficient scale, intangible assets, switching costs, or network effect. Furthermore, in trucking, operational routines capable of maximizing productivity (strong IT, short-haul/regional focus, serving higher yielding outbound-imbalanced markets, low claims) can be replicated by well-capitalized competitors over time.

In TL shipping, in particular, barriers to entry are largely nonexistent because a licensed driver needs simply to borrow sufficient funds to buy a tractor to begin hauling customers’ freight. In terms of cost advantage, increasing fleet size doesn’t automatically translate into lower costs. This is partly because a truckload carrier can’t boost route density by adding customers, as by definition it hauls a full-trailer load from point A to point B for one customer at a time. Rather, to boost volume, a carrier must buy another truck and hire another driver. This is why in the current driver-constrained market, it’s hard for TL carriers to boost fleet size. There is a minimum utilization (miles per tractor) that’s needed to be reasonably profitable, but that can only go so far, and most large truckers are already on top of maximizing network optimization.

In the LTL niche, entry barriers are greater than those in the more fragmented TL space because of the need for a broad network of hundreds of consolidation terminals, sophisticated load path planning software, and material IT capabilities. At first glance, it might appear that the high-fixed-cost nature of LTL operations should allow for enduring scale-based cost advantages, or perhaps benefits from superior internal processes that optimize linehaul and pickup and delivery efficiency. However, over time well-capitalized competitors can replicate routines capable of maximizing productivity, and scale economies have largely proved insufficient across the industry. The near-bankruptcy of industry behemoth YRC Worldwide following the 2009 freight recession stands as a prime example.

We are by no means suggesting that investors avoid TL or LTL stocks under the right circumstances, and we wouldn’t hesitate to recommend most of the names we cover if they traded with an adequate margin of safety to our fair value estimate. But the lack of economic moats highlights the need for investors to be mindful of the cyclical nature of this capital-intensive industry. It is true that the industry is experiencing the strongest pricing power in more than a decade because of severe capacity constraints, but we do not overlook the fact that during the 2009 downturn, most TL and LTL carriers slashed rates to unsustainable levels in an attempt to maintain utilization or grab share from weaker peers.