A JB Hunt Deal With BNSF Or Norfolk Southern Could Be In Play

Jan.19.16 | About: J.B. Hunt (JBHT)

Summary

A merger between either BNSF or Norfolk Southern and JB Hunt is a possibility as consolidation in the freight industry continues.

The competitive landscape for intermodal services is changing across Class I rail operators, most notably through Union Pacific's Streamline service.

Intermodal rail traffic has been the better growth story versus carload traffic for Class I rail operators, as performance prior to and after the Great Recession has indicated.

Overview

JB Hunt Transport Services (NASDAQ:JBHT) is the largest intermodal truckload carrier in North America. To put this into perspective, JB Hunt generated over five times as many intermodal loads versus public peers through September 2015; 1.3 million loads reflecting an improvement of 3.5 percent from last year. In addition to intermodal, the company also offers dedicated contracted, truckload and capacity solutions services.

The key focus though is on the intermodal business which generated $2.7 billion in revenue during the first nine months of 2015. The intermodal story is directly tied to Class I rail operators so a quick overview for this group is in order. Intermodal has been the brightest story for Class I rail operators post the Great Recession. Carload traffic is still significantly below pre-recession levels, but intermodal traffic has achieved record levels to date.

Energy and other commodity prices have greatly impacted demand for Class I carload traffic in North America. Coal and petroleum products as well as sand, gravel and other inputs supporting petroleum products reflected between 26 and 58 percent of all carload traffic for Class I rail operators. Canadian National Railway (NYSE:CNI) and Kansas City Southern (NYSE:KSU) have the least amount of exposure to these commodities whereas BNSF (NYSE:BRK.B), Union Pacific (NYSE:UNP) and Norfolk Southern (NYSE:NSC) had the greatest exposure at 58, 42 and 41 percent of total carload traffic respectively.

Coal is going to be a tough ride for all rail operators over the long-term as further declines are inevitable. No one knows how rapid this decline will be 5, 10 or 30 years from now, but it is clear that traffic will most likely never get back to a long-term growth cycle. The same argument can be made for paper products to some extent.

Other commodities including petroleum products and sand, gravel and inputs supporting these products also face similar long-term uncertainties. However, in the near-term the bigger issue is volatility and the extremely short-term nature at which these volatile swings may occur. Many other commodities such as metal products, stone/clay/glass, waste and scrap, etc. are also exposed to volatile cycles due to supply and demand as well as currency fluctuations.

This brings us to one of the areas where Class I rail operators have all benefited, intermodal. One of the key reasons for this has been the economic recovery over the past six years. Housing, finished vehicles and many other retail consumer durable and non-durable products have been core drivers; transportation of these retail goods whether intermediary or as finished products has driven growth for intermodal business. As such, JB Hunt has reaped solid growth during this time along with Class I rail operator peers for the intermodal segment.

JB Hunt has evolved into one of the most successful, if not the most successful intermodal operations in North America, meriting the company being considered as a prime target for acquisition by a Class I rail operator. Such a deal would greatly improve the diversification for both near-term and long-term headwinds in the rail industry.

As other commodities weigh on Class I rail operators, pressure will continue to mount to make a move to gain competitive advantages. This move will most likely involve consolidation of intermodal services wherever possible. As the number one target for consolidation, JB Hunt will merit a premium regardless of the current stock price. The only questions that remain are the pros and cons of such a move by a Class I rail operator and how feasible would an actual deal be. Additionally, the timing of a deal is worth thinking about.

Pros & Cons

First, investors should realize that JB Hunt has contractual arrangements with many Class I rail operators. Specifically these arrangements are relied upon the most by BNSF and Norfolk Southern. As an example, it is not uncommon for a BNSF intermodal railyard to have a substantial portion of the traffic involving JB Hunt equipment including domestic containers and chassis. A similar statement can be made regarding Norfolk Southern's intermodal railyard facilities.

Second, investors need to realize that intermodal services from Class I rail operators has evolved to a point where both Union Pacific and CSX (NASDAQ:CSX) are growing their own separate marketing services internally. We have anecdotal evidence that CSX does still transport intermodal traffic via JB Hunt equipment, but this type of information does not seem to support a similar statement from Union Pacific's intermodal traffic.

Additionally, Union Pacific has its owned branded intermodal equipment via EMP and UMAX, as well as access to XPO Logistics (NYSE:XPO) and Hub Group (NASDAQ:HUBG) intermodal equipment. As a result, Union Pacific has exclusive access to a competitive scale of intermodal equipment to rival the BNSF, Norfolk Southern and JB Hunt combination.

Lastly, JB Hunt recently has partnered with Canadian National to collaborate on a Canada to/from the U.S. continental service. It should be noted that Canadian National already owns one of the largest full-load trucking companies in Canada with extensive intermodal capabilities; yet the need to partner with JB Hunt is still lucrative. The same can be said for CSX.

These circumstances should trigger an alarm as there is a clear coast-to-coast connection between Union Pacific and CSX with intermodal equipment for services excluding JB Hunt. Union Pacific has even created a new brand entitled Streamline offering these products and services. This does not preclude capacity fulfillment from JB Hunt on CSX intermodal trains, but it again, is not clear as to whether Union Pacific uses such capacity solutions from JB Hunt as it appears that there is not a need.

The Union Pacific intermodal service is also utilized by other Class I rail operators including Canadian National and Canadian Pacific Railway (NYSE:CP), Norfolk Southern and Kansas City Southern.

As such, it would be in the best interest for BNSF and Norfolk Southern to consider acquisition strategies to incorporate JB Hunt into their operations in order to provide an equivalent competitive product and service to Union Pacific's growing services for intermodal. BNSF has the highest exposure to the highlighted commodities with near-term and long-term risks and Norfolk Southern also has high exposure. Acquiring JB Hunt would ensure that these two rail operators would have access to a more stable traffic generator over the long-term.

Other asset owners include Swift Transportation (NYSE:SWFT) and Schneider, but neither have the scale to substitute what JB Hunt has to offer. As both of these companies have multiple truckload services larger than their intermodal operations, it would not make as much sense to attempt to acquire either rather than JB Hunt.

To take the other position, investors should think back to the scale that JB Hunt has grown to. This scale has allowed the company to align itself with at least five of the seven Class I rail operators. This scale provides the shipping industries with options to choose from to get access to JB Hunt's intermodal services. Shippers can either go through JB Hunt directly, or any of the five Class I rail operators. From a freight rate standpoint, this allows for competition amongst these parties.

If JB Hunt were to be acquired, control of the company could fall to BNSF, who would most likely look to continue a partnership with both Norfolk Southern and CSX, but could have impacts for Kansas City Southern, Canadian National and Canadian Pacific. Union Pacific would be the clear focus of competition. If Norfolk Southern were to acquire the company, a similar expected arrangement with BNSF would most likely remain, with possibly similar impacts to other Class I rail operators; and a more clear focus of competition with Union Pacific and CSX.

Another point is that both BNSF and Norfolk Southern could maintain their growth through the existing contractual arrangements with JB Hunt without any merger. From this standpoint, JB Hunt itself could look to increase its scale through acquiring one of the other major truck intermodal companies listed above.

A deal with BNSF makes the most sense as it could be argued that it would add more competition against Union Pacific's Streamline service and also maintain the current contractual arrangement environment for shippers with other Class I rail operators. At any rate, the impetus for taking action for a merger is on the mentioned Class I rail operators rather than JB Hunt as the company is intertwined with the majority of Class I rail operators as its intermodal services extend throughout North America.

Merger Feasibility

There are three items to note in the event a merger attempt would occur with JB Hunt being targeted for acquisition. First, a premerger notification process would need to be undertaken to meet requirements for the Federal Transportation Commission, FTC and Department of Justice, DOJ.

Second, review from the Surface and Transportation Board, STB would be required. Lastly, investors should note that there are no risks related to the ownership of JB Hunt's stock that would discourage any potential takeover; so if agreed to by the board, structurally a merger would be feasible.

The Hart-Scott-Rodino Act, HSR Act established the federal premerger notification program, which provides the FTC and DOJ with information about large mergers and acquisitions before they occur. The parties to certain proposed transactions must submit premerger notification to the FTC and DOJ. The parties are not allowed to close the deal until the waiting period outlined in the HSR Act has passed, or the government has granted early termination of the waiting period.

This process would focus on ensuring that any potential outcomes of the deal would not result in a monopolizing effect for the rail industry. A primary focus from this perspective would entail a need to understand how the proposed merger would address the existing contractual relationships between JB Hunt and Class I rail operators.

The STB would scrutinize this type of deal as it would involve a Class I rail operator. The fact that the deal would be between an intermodal truckload company versus another Class I rail operator would impact the review, but it is unclear as to whether this would create any leeway. From a shipper perspective, concerns regarding freight rates would be the highest priority and the STB would take this into consideration in a serious fashion.

The fact that BNSF or Norfolk Southern would not be primarily interested in the dedicated contracted, truckload or capacity solutions services, could lead to the sale of these assets as part of the deal. Additionally, as mentioned, Union Pacific's growth of its own service coast-to-coast would add justification for such a deal to occur to balance competition for shippers.

A deal involving BNSF would most likely appease the FTC and DOJ rather than Norfolk Southern. This would result from the fact that BNSF could maintain existing contractual arrangements as they stand today with Norfolk Southern and CSX, whereas Norfolk Southern would be inclined to reduce capacity for CSX to gain a competitive advantage. New agreements would most likely need to be updated to appease the other Class I rail operators.

BNSF also has the luxury of being owned by Berkshire Hathaway as well which would on a technicality, allow for a more diversified acquisition versus Norfolk Southern. Based upon these circumstances, it would seem possible for such a merger to be allowed; with a better chance than the recently suggested Canadian Pacific and Norfolk Southern deal.

Timing & Strategy

If we assume a BNSF merger led by Berkshire Hathaway, investors should focus on when BNSF was acquired by Berkshire Hathaway. The announcement took place during November 2009, a time period roughly eight months after the Great Recession's bottom.

Warren Buffet is strategic when it comes to mergers and does not want to make a move when things could get worse. Granted there were no guarantees during November 2009 and negotiations could have been ongoing throughout the year or even during 2008. If market volatility increases throughout the year, 2016 may or may not be the best time to make a deal. It would ultimately depend upon the negotiations.

However, JB Hunt's stock is down 24 percent from its close as of December 31, 2014. This equates to an enterprise value of $8.6 billion. From a fair value perspective, JB Hunt has consistently held a premium regarding the company's P/E and EV/EBITDA ratios. This has been consistent between market averages as well as within the truckload industry.

JB Hunt has consistently traded above 20 times earnings and near 10 times enterprise value to EBITDA since 2000. Today's valuation places these multiples near 18 and 10 respectively. Both JB Hunt's revenue and earnings growth has accelerated post the Great Recession while free cash flow has been steady. This has resulted in a slightly higher P/E ratio above 23 and EV/EBITDA ratio near 13.

Based upon this, JB Hunt is trading at discount. Uncertainties regarding freight rates and slowing traffic are mostly the cause. But long-term effects of hours of service rules, electronic logging devices and other regulatory mandates will also impact the entire truckload industry.

We know that Warren Buffet is interested in creating cash flow through dividends. JB Hunt has historically generated around $200 million in free cash flow so the company does offer Warren Buffet a stream of cash; currently a three percent return at today's price.

At $65 per share, JB Hunt could easily be acquired with a premium at or above 20 percent valuing the company near $10 billion; based upon a return to historal valuation levels. This would still allow for a 2.5% return on such a purchase price of which, Warren Buffet could pay out to Berkshire Hathaway.

As the business would be integrated into BNSF, this would add to the near $4 billion per year that gets distributed as dividends. Additionally, Warren Buffet would have the option of immediately creating more cash through the sale of the dedicated services, truckload and capacity solutions business segments. This could fetch near $4 billion.

Based upon these circumstances, investors should think about the current global economic environment. For 2016, there is no clear indication that rail traffic will recover. We know that traffic declined drastically during the fourth quarter of 2015 and that potentially the first quarter for 2016 will weigh on freight volumes. The first week of the year is off to a rough start for carload traffic, while intermodal traffic is up keeping with the earlier discussed trends.

Investor Perspective

First and foremost, investors should consider JB Hunt's business as a great way to get exposure to the rail industry without taking on the risks of the commodities discussed earlier. Additionally, JB Hunt has a strong growing dedicated contracted services segment and has expanded to include its own capacity solutions services to meet shipper needs when equipment supply becomes tighter and/or unavailable.

All freight industry stocks have been crushed from last year and through the beginning of this year. Freight demand indicators have displayed declining growth across the board including tonnage, shipments and loads. Intermodal has not been immune to these declines as the year has progressed. For these reasons, investors should be highly cautious and take a read from the market's early signals into 2016.

Predicting a merger is no easy task, and investors should think about buying a stock for many other reasons versus speculative propositions. However, by looking at the pieces of the intermodal puzzle in North America, a JB Hunt deal makes sense. I would suspect that BNSF would be the leading candidate for such a deal, but that Norfolk Southern would also entertain the idea.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in JBHT over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.