by Keith Schoonmaker
Concerns about a global economic slowdown may have the market wondering just how much freight needs to be moved around the world. But even with declining trade volume, companies still need to ship their goods in the most efficient, cost-effective manner possible. This is where third-party logistics firms come in.
Third-party logistics--or 3PL--firms are travel agents for freight. They coordinate shipments for customers, generally hiring asset-owning transportation firms to move pallets and containers. They arrange truck, railroad, airplane, and steamship passage to points around the globe, wielding buyer power to negotiate better rates than customers could obtain on their own.
These providers benefit from globalization and increasingly outsourced shipping functions. Shippers outsource traffic management to capable 3PL experts to reduce transportation costs, decrease fixed assets, reduce inventory expenses, improve shipping accuracy, and in general, eliminate distraction from running their main business.
Several 3PL firms have economic moats guarding future profits from competitors' intrusions. Typically, 3PL firms deliver tremendous returns on invested capital, since their business models demand little investment compared with asset-based firms like truckers, railroads, or integrated shippers.
Most publicly traded 3PL firms are well managed and in excellent financial health, with low or no net debt. While these firms are often richly valued by the market, three logistics firms' shares are presently trading far enough below our fair value estimates to be rated 5 stars: market darling Expeditors International of Washington (EXPD), and turnarounds UTi Worldwide (UTIW)and Pacer (PACR).
Expeditors Is On Sale
Expeditors International of Washington sets the 3PL standard of excellence. Among transportation stocks, there's no higher-quality name than this wide-moat firm. We point to Expeditors' attractive outsourced logistics industry, nonasset model, leading margins, and outstanding net revenue and earnings growth. Management focuses on the long term-- no employees were laid off during the recession, to stay ready for the recovery--and is fiercely independent. Moreover, the bulletproof balance sheet boasts $1.2 billion in cash ($5.68 per share) and no debt.
Expeditors' normally rich shares look on sale to us, trading at a 35% discount to our $61 fair value estimate. We think the market is focusing excessively on near-term demand that is lower than prior expectations. Nothing has compromised Expeditors' model. In fact, the firm achieved record second-quarter earnings this year. In our view, the only recently changed factor is a lower expectation for freight forwarding volume, based primarily on Expeditors' report that second-quarter airfreight tonnage declined 1% and ocean freight volume was flat with the prior-year period.
While demand does indeed appear to be softening, market-implied assumptions seem overly pessimistic to us. Our fair value estimate of $61 per share assumes double-digit net revenue growth in 2011--it was 19% in the first half--and 12% in 2012, in line with the firm's 10-year compound annual growth rate. The current market price appears to assume that all segments have flat second-half gross revenue and Asia gross revenue continues to decline 7%, followed by no gross revenue growth in 2012 before resuming typical 12% annual top-line expansion. This is far different from what's likely to occur in reality, given Expeditors' sharp recovery from the last recession: After gross revenue slipped 27% in 2009, it recovered 46% in the following year. Also, to reach today's market price, one must assume transportation costs remain at about 70% of gross revenue, as they were in 2010-11, rather than the favorable 66% in 2009, as carriers (Expeditors' suppliers) bid down rates to maintain asset utilization.
UTi Has Room To Improve
Turnaround candidate UTi Worldwide is trading well below our $24 fair value estimate, chiefly because it is operating below its potential, in our opinion. Also, there is greater uncertainty surrounding the timing of improved results. While UTi's business model historically has generated returns on invested capital slightly greater than the firm's cost of capital, we think the practice of keeping acquisitions separate rather than integrating them into a single operating entity has suppressed profitability. In our opinion, the firm also failed to clean up numerous basic best-practice deficiencies until the current CEO took the reins in January 2009.
Consolidating labor-intensive operations into companywide uniform standard procedures and one IT system will be a critical step in margin improvement, but UTi is moving toward a more centralized organizational structure as well. It is working to better its purchasing power by consolidating more volume at fewer air and ocean carriers. We expect improved practices across the board to contribute to margin improvement, even early in new customer relationships. In the past, adding clients often necessitated IT spending on custom programming or, at minimum, additional server capacity. The new proprietary system is being designed specifically for freight forwarding and should require minimal custom programming after full implementation.
However, we think the market is still concerned about the time frame for UTi's internal operational improvement, as well as slowing shipping demand. Also, comparisons with Expeditors are natural, and that's a tough comp for any firm.
Pacer's Picking Up the Pace
Intermodal marketing company Pacer is another turnaround in progress. Pacer's wholesale business, which supplies containers and intermodal dock-to-dock capacity to other intermodal marketing companies, shrank significantly when the firm cashed in its Union Pacific pricing contract in November 2009. The intermodal market has recovered from recession lows, and we remain bullish on the future of shipping via multiple modes. High fuel prices will accelerate shippers' modal shift to rail from trucks, but we think that over the long run, intermodal's labor and emissions reduction advantages will attract volume even if diesel prices decline.
Pacer is extending its reach via international forwarding operations. In its current model, the firm arranges shipments not just for the railroad portion of a haul, but also includes pickup at the origination truck dock, rail shipping, and truck delivery when needed to the destination truck dock, serving retail clients by arranging drayage for door-to-door shipping.
Also, Pacer has recrafted its leadership team with industry veterans who will raise the bar for its operations by having worked at other, high-performance firms. Pacer already has eliminated significant costs by slashing head count and moving its headquarters to a thriftier locale. Its new IT systems will be crucial to margin improvement.
We think these shares remain undervalued, trading at less than half of our $8.50 fair value estimate, but uncertainty surrounding Pacer's outcome is greater than at firms that do not need to rebuild a material portion of their franchise. We think Pacer currently has no economic moat, but its leaner cost structure and new IT systems set the moat trend on a positive trajectory, given its potential benefit from the network effect and the attractive aspects of intermodal shipping.
The Road Ahead
We project 3PLs will continue to increase revenue at 2-3 times the rate of global GDP expansion, based on our expectation that more goods will be shipped with growing global production and that 3PLs will capture a greater share of customers' transportation wallets. Investors can take advantage of this opportunity by watching for logistics firms like Expeditors, UTi, and Pacer to go on sale.
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