By Matthew Young, CFA
Demand is under pressure, but long-term opportunities remain at these wide-moat logistics firms.
The broader third-party logistics industry enjoys favorable top-line growth dynamics and, over the long run, should continue to expand at a faster pace than the underlying domestic transportation market. Most of the 3PLs we cover benefit from robust economic moats supported by the network effect, and the asset-light nature of these businesses allows for low capital intensity and high returns on capital. Two top-tier 3PLs--international forwarder Expeditors International of Washington (EXPD) and domestic truck broker C.H. Robinson Worldwide (CHRW)--are trading at attractive discounts to our fair value estimates, in part because of near-term headwinds.
Third-party logistics firms are essentially travel agents for freight. They generally do not own transportation equipment, but rather buy capacity from truckers, railroads, steamship lines, or cargo airlines, then resell it to shippers for a spread. The 3PLs we cover generally boast variable-cost, non-asset (or at least asset-light) models that exhibit less cyclicality and generate higher capital returns than most traditional transportation providers. Truck brokers and international forwarders have an added buffer by way of their gross margin dynamics (net revenue over gross revenue). The cost of purchased transportation is highly variable because these firms primarily buy capacity in the spot market. As a result, in periods of macroeconomic weakness when capacity loosens and carrier pricing falls, providers can pass those declines to shippers on a lag, thereby expanding gross margins. Illustrating the resiliency of the 3PL business model, truck broker C.H. Robinson posted gross margin expansion in 2009 during the freight recession, with operating margins (off net revenue) actually rising. Furthermore, in 2009, average returns on capital across our 3PL coverage universe fell to roughly 15%, compared with 5% for the asset-based truckers. On the flip side, when freight demand strengthens or carrier rates rise because of tight capacity, gross margin compression will usually temper net revenue growth--a common theme throughout the brokerage industry this year.
North American 3PLs operate in several market niches, including domestic transportation management (highway and rail brokerage), air and ocean freight forwarding, and contract logistics (largely warehousing and distribution). Within our coverage universe, the pure-play freight brokers are C.H. Robinson, Landstar (LSTR), and Echo Global Logistics (ECHO). Asset-light intermodal marketing firms Hub Group (HUBG) and Pacer (PACR) also operate sizable highway brokerage operations. The major freight forwarders on our list are Expeditors International and UTi Worldwide (UTIW). While there is overlap, most of the 3PLs we cover specialize in either domestic brokerage or international shipping, though forwarders often bundle contract logistics into their service offering.
Network Effect Makes for Moats
Most of the 3PL providers we cover benefit from narrow or wide economic moats, supported in part by the network effect: As a provider's network of shippers and carriers expands, its value proposition to both parties deepens and becomes harder to replicate (especially by small, less sophisticated operations).
Top-tier truck broker C.H. Robinson enjoys an immense customer base that affords significant buying power--it can procure capacity at lower rates than shippers can generally obtain directly with carriers. Additionally, Robinson's large network of carriers is attractive to shippers seeking access to reliable capacity, as well as those looking to outsource the burden of managing hundreds of carrier relationships. From the carrier perspective, Robinson aggregates highly fragmented market demand, offering a valuable source of freight opportunities capable of reducing empty miles.
The network effect is similar for international forwarders like Expeditors. For shippers moving goods overseas, Expeditors can aggregate its buying power (in this case with cargo airlines and ocean carriers), providing more attractive rates than a shipper going directly to the asset-owning carrier. The vast majority of air cargo is transacted through the forwarders (with few direct shipper-carrier relationships), though shippers with sufficient scale to fill entire containers often work directly with ocean liners. As is the case with over-the-road truckers in the brokerage industry, air and ocean carriers gain access to a deep reservoir of freight that increases in value as the forwarder aggregates customers.
Overall, thanks to the asset-light nature of the business and benefits from the network effect, average returns on invested capital among the 3PLs rank among the highest in our coverage universe and usually exceed the cost of capital by a wide margin--a hallmark of moaty operations.
3PL Industry Growth Should Surpass That of Underlying Transportation Market
The 3PL industry has seen impressive expansion over the past few decades, with average annual growth of more than 10% between 1996 and 2011, based on data from Armstrong & Associates. This is well ahead of growth in the broader for-hire trucking and rail intermodal markets, which were up only 3% on average over that period. We expect industry growth to remain healthy, increasing at a slightly faster pace than domestic transportation spending. Key drivers of stronger 3PL industry expansion include incremental logistics outsourcing among shippers and share gains from asset-based carriers. Moreover, we expect the top-tier 3PLs to enjoy a sizable boost from market consolidation (via share gains and acquisitions) as smaller, less sophisticated providers find it harder to keep up with rising demand for global network capabilities and sophisticated IT.
Expeditors International Is Positioned for a Recovery
Persistently weak air freight conditions and rising ocean carrier rates are likely to temper growth in the quarters ahead, and we think negative sentiment has reduced Expeditors' equity valuation to attractive levels. The stock is trading at a roughly 29% discount to our $51 fair value estimate and 19 times 2013 consensus earnings per share. This compares with a historical average forward price/earnings ratio of about 29. In terms of the assumptions behind our fair value estimate, we model average annual net revenue growth in the high single digits through 2016, supported by a combination of recovery in air freight conditions in later years (we assume average air freight demand growth of 3%-4%), solid market share gains, and benefits from third-party logistics outsourcing. Industry air freight demand has been under pressure since the middle of 2011. Air freight represents an important business driver for Expeditors at roughly 47% of 2011 gross revenue. Despite Expeditors' history of strong operational execution and share gains, the firm is not immune to sluggish industry demand. Expeditors' air freight volume trends tend to reflect those of the industry, with some variation stemming from Expeditors' special project business and end market mix.
Why has air freight traffic been so weak? Although GDP expanded in both the United States and Europe in 2011, escalation of the European debt crisis and concerns about slowing macroeconomic conditions in the U.S. (including weak employment trends) weighed heavily on business and consumer confidence in the West. By the middle of last year, shippers began aggressively managing inventory to increasingly uncertain end market conditions for their own goods. This has tempered world trade growth (especially eurozone imports from Asia) and demand for key air freight cargo, particularly high-value goods from the high-tech and telecom sectors.
Also, shippers have been downshifting to less costly (albeit slower) ocean freight. We think some of this is related to a gradual, secular shift driven by improving ocean-liner service levels, gains in supply chain technology (mode optimization), and declines in the value per pound of certain cargo, such as LCD televisions. However, we also believe a portion is tactical. During periods of heightened economic uncertainty, shippers are more likely to turn to slower, less expensive transportation options when possible, even for cargo that normally moves via air (such as high-fashion apparel, certain pharmaceuticals, and high-tech goods)--air freight costs can exceed 10 times the cost of ocean freight, especially during periods of elevated fuel prices. Given soft consumer demand and low business confidence in the U.S. and especially Europe, shippers have an incentive to keep inventory on ships (which essentially act as floating warehouses) for several weeks. Low interest rates are also making this option attractive by driving down the cost of capital.
Despite lackluster air freight conditions, however, we think Expeditors can generate average net revenue growth in the high single digits over the long run. Expeditors is one of the highest-quality transportation firms we cover. It enjoys a history of impressive financial performance and shareholder value creation, including freight forwarding margins almost double those of close competitor UTi Worldwide. Expeditors also maintains a pristine balance sheet with no debt and a mountain of cash ($1.4 billion as of the third quarter). Over the past decade, the firm has posted average annual growth of 13% for net revenue (gross revenue less purchased transportation) and slightly more than 15% for earnings per share, as a wide economic moat and strong operational execution have enabled the firm to capitalize on healthy 3PL industry expansion.
We think the firm's entrepreneurial culture and steadfast focus on long-term performance are key drivers of its unusually strong execution. During the 2008-09 freight recession, Expeditors avoided layoffs to preserve its robust network service capabilities. Consequently, the company was able to grab market share as international freight demand recovered near the end of 2009 (and into 2010) and shippers scrambled to find access to capacity as they restocked inventory--Expeditors' air freight volume jumped an average of 37% (year over year) between the first quarter of 2009 and the second quarter of 2010. We expect successful execution once again when forwarding markets improve this time around. Salesforce compensation is predominantly commission-based (with below-average base salaries), and managers' bonuses are pegged to net revenue and operating profit trends of individual branches--factors that make for a profit-conscious setting. This entrepreneurial culture does not drive our wide moat rating, because it can be replicated. However, we believe Expeditors leads its peers in terms of executing this strategy.
Its large network of shippers and carriers supports a wide economic moat, and we think this moat is capable of defending long-run economic profits, especially from smaller competitors. As evidence of its wide moat, the firm has generated returns on invested capital in excess of 25% over the past decade, well above our 10% cost of capital estimate. We also think Expeditors' moat is sustainable since the market remains fragmented and share gains are accruing to top-tier 3PLs. We expect returns on capital to remain in the high 20s on average over the next five years.
We think low-single-digit global air freight expansion over the long run is a reasonable assumption. We believe industry growth in the years ahead will probably remain below the 6% long-run historical average, given likely sluggish economic growth in the West, particularly in Europe, and a migration to near-sourcing among some North American shippers. That said, air freight will remain an indispensable component of shippers' supply chains and critical means of rapid overseas transport. This is particularly the case for high-value, low-weight cargo (high-tech goods with short life cycles), perishables, and time-critical cargo linked to just-in-time inventory replenishment. Once global economic activity enters a cyclical upturn or even a period of stability, we expect demand for air freighted cargo to recover.
In addition to an eventual recovery in air freight demand, we expect share gains from small, less sophisticated providers to remain a key growth driver. The freight forwarding market is still fragmented, with the top 10 providers constituting only 44% of the industry. Outside this group are thousands of small and midsize operations. Because of escalating supply chain complexity (driven in part by high levels of foreign sourcing and low macroeconomic visibility), demand for 3PLs with robust local market knowledge, vertical expertise, and sophisticated IT continues to expand. Overall, we think a long runway of opportunity exists for Expeditors to grab share from smaller, less capable firms that lack the resources to keep up. The data appear to bear out this thinking as the top providers have increased their portion of the market from 40% in 2006, according to Transport Intelligence.
We also expect an incremental boost from logistics outsourcing among shippers. With heightened global economic uncertainty and the prospect of a prolonged period of sluggish growth, retailers and manufacturers in the West are managing with tight inventory levels and aggressively seeking ways to boost profitability. Consequently, the supply chain has morphed into a critical source of cost savings and competitive differentiation. We think large shippers that work directly with ocean carriers represent a key opportunity for top-tier forwarders like Expeditors. Over the past few years, most ocean liners have been posting losses because of the capacity glut and related pressure on pricing. Despite rate progress thus far in 2012 (driven by efforts to limit capacity via slow steaming), liners are still struggling to stay out of the red. Given carriers' limited resources, coupled with forwarders' ability to provide redundancy and flexibility by contracting with multiple carriers, forwarders have been taking a bigger slice of the market. Overall, we think logistics outsourcing remains a favorable trend. A recent study conducted by consultant CapGemini suggests two thirds of large shippers are increasing their use of 3PLs, while approximately 60% are consolidating the number of providers used--factors that bode well for top forwarders like Expeditors.
C.H. Robinson's Margins Are Down, but the Business Model Isn't Broken
Truck brokerage specialist C.H. Robinson is seeing persistent gross margin compression due in part to tight trucking industry capacity (enabling carriers to increase rates) and an elevated mix of price-committed business. This has weighed on net revenue growth and investor sentiment. That said, we think the gross margin pressure is a cyclical dynamic and long-term growth opportunities remain attractive. Robinson enjoys a wide economic moat supported by the network effect, and we expect it to continue gaining share from asset-based carriers and small, less sophisticated providers.
The shares are trading at an 18% discount to our $73 fair value estimate and 19 times 2013 consensus EPS. This compares with a historical average forward P/E of about 27. We expect annual net revenue growth in the high single digits on average over the next five years as Robinson capitalizes on attractive secular trends in the 3PL industry and continues to garner share from both asset-based trucking companies and small freight brokers.
Carrier rates have been rising faster than pricing to customers, with Robinson's transportation segment gross margin hitting a record low in the second quarter (14.9% versus a 10-year average of 17%). As a result, net revenue (gross revenue less purchased transportation) has increased only 3% year over year thus far in 2012, compared with a 9% rise in gross revenue. We get the sense that many investors are concerned that this prolonged yield pressure is evidence of a secular, unfavorable shift in the competitive dynamics of brokerage. But strong competition is nothing new--the prospect of high returns on invested capital has been attracting newcomers to asset-light brokerage for more than a decade. We also think it is unlikely a few aggressive entrants are behind Robinson's recent margin squeeze, since the market remains highly fragmented, and share gains should continue accruing to sophisticated providers with scale as the market consolidates.
Rather, we think the depressed gross margins are the result of unusual supply/demand dynamics. Robinson's gross margins are historically countercyclical because of the time lag in passing along higher capacity rates to customers. Contraction usually occurs when industry freight demand expands, capacity tightens, and carriers raise rates. The opposite occurs when demand falls off, as seen in 2009 when Robinson's transportation segment gross margins increased more than 300 basis points despite lower freight volume. More recently, however, capacity has been tightening not so much because of robust freight demand, but because of a combination of the driver shortage and limited carrier fleet growth. With supply and demand roughly in balance, carriers are enjoying decent pricing power and Robinson is paying more for capacity in the spot market. At the same time, the firm's pricing to truckload shippers has been a bit sluggish. Because economic conditions are lackluster, Robinson is seeing softer spot market activity and less unplanned freight from existing customers, which carry better pricing dynamics. More important, Robinson's mix of contractual business has increased as the firm has pushed to become more of a core carrier to larger shippers. As a result, more of the business is subject to a time lag in terms of passing along higher capacity rates to shippers.
Despite these gross margin woes, we think Robinson's long-term growth opportunities still look attractive. The firm enjoys a long record of consistent net revenue expansion and robust profitability. It does not own transportation equipment, so it avoids capital intensity and employs minimal operating leverage. Additionally, the firm has historically maintained a debt-free balance sheet with plenty of cash. Over the past decade, the firm has generated average annual net revenue growth near 15%, with operating margins (off net revenue) expanding from 29% in 2001 to 42% by the end of 2011--and most of this has been done organically. We think Robinson's wide economic moat and best-in-class executional capabilities have enabled it to capitalize on healthy 3PL industry expansion, and we expect that to persist.
Robinson has carved out a wide economic moat, supported by the network effect. Its immense network of shippers and carriers generates a compelling value proposition with durable barriers to entry, since duplication would be a daunting task (particularly by small, less sophisticated providers with limited buying power and constrained IT infrastructure). In Robinson's core brokerage operations, its customer base of 37,000-plus shippers bestows significant buying scale. As a result, the company is able to negotiate lower buy rates for capacity than shippers can secure for themselves, providing customers with material cost savings. Larger shippers that outsource their internal logistics management functions (including personnel) also enjoy the added benefit of reducing fixed assets and making fixed transportation costs variable. Furthermore, Robinson's vast network of more than 53,000 carriers across most transport modes acts as an attractive source of capacity for shippers. This is an increasingly important attribute given the secular tightening of truckload capacity. Overall, Robinson has posted average returns on invested capital of about 36% over the past decade, handily exceeding our 10% cost of capital estimate.
We expect Robinson to continue to gain share from less capable domestic transportation managers. We do not consider its robust IT systems to be the foundation of its wide economic moat because competitors with sufficient capital can replicate technology. That said, we think IT provides differentiation from smaller providers with fewer resources, especially as supply chains become more complex and shippers increasingly demand sophisticated informational expertise. More than 10,000 registered freight brokers operate in the U.S., and while the top 15 make up more than 45% of industry sales, gross revenue for each of the remaining providers starts to fall off significantly beyond that point, and the market becomes vastly fragmented. Although 3PLs usually operate asset-light businesses with low capital intensity, IT and communications infrastructure requires significant up-front and maintenance outlays, placing providers with scale in an advantageous position. Robinson's IT-related expenditures run close to $100 million annually, and despite the sluggish brokerage environment, the firm has been maintaining and even increasing its IT investments in an attempt to stay ahead of the curve and maximize its value proposition. Relative to the broader North American 3PL industry, we estimate Robinson's share remains small, coming in somewhere around 3%-5%, depending on market definition.
Asset-based carriers also represent a source of market share gains. We think domestic transportation managers are still taking share from asset-based carriers (direct shipper relationships) while motivating large shippers to outsource more of their transportation management activities. First, outsourcing transportation execution to a top-tier broker like Robinson enables shippers to remove the administrative burden and risk of managing potentially hundreds of carrier relationships, particularly in terms of rate negotiation and quality control. Another compelling factor is the firm's ability to aggregate highly fragmented truckload industry supply (95% of truckers operate fewer than 20 trucks) through its industry-leading network of carrier relationships. This provides shippers across the size spectrum with efficient access to flexible capacity, since Robinson is more likely to have a piece of equipment available at the right place and at the right time, for a reasonable price. In recent quarters, trucking industry supply and demand has been roughly balanced, but an uptick in macroeconomic conditions or freight volume growth would probably drive capacity shortages on certain lanes, providing incremental opportunities for Robinson to substantiate its value proposition.
Second, Robinson can offer unbiased, multimodal solutions that help customers optimize the mix of intermodal versus over-the-road shipments because it does not own tractors or trailers. Demand for multimodal solutions is rising, driven in part by improving service levels from the rails, variability in fuel costs, and an intensifying focus on supply chain efficiency. Worries about capacity constraints among truckload carriers have also driven some freight to the rails. This dynamic should play well into the hands of providers like Robinson because, unlike asset-based carriers, 3PLs are not bound to maximizing asset utilization. Putting it all together, we estimate that only about 12% of the $340 billion spent on for-hire trucking and rail intermodal shipments flowed through asset-light domestic freight brokers in 2011.
Furthermore, the international freight forwarding business holds incremental opportunities. Robinson has been offering its customers air and ocean freight forwarding services for a few decades, but only to a small degree. However, that is about to change with its recent agreement to acquire Chicago-based air and ocean freight forwarder Phoenix International. Last year, Robinson generated $106 million in air and ocean forwarding net revenue; Phoenix will add $161 million to that run rate. The combined operations won't quite propel Robinson's forwarding business into the ranks of the top 25 global providers, but we expect the greater market presence to enhance its credibility with large customers--a segment to which Robinson has been gravitating on the domestic transportation front. The addition of Phoenix should also increase buying clout with air and ocean carriers, boosting segment gross margins, since Robinson can now aggregate demand from a much larger pool of shippers.