XPO Logistics - Profit Growth Still A Long Way Off

| About: XPO Logistics, (XPO)

Summary

Going forward in 2016, XPO Logistics is likely to continue to benefit from increased sales traction coming in from the recent Con-way acquisition.

Moreover, the company is anticipated to revert to profitability in the long-run due to cost savings and increased benefits of economies of scale, which will boost its profit margins.

Based on its fundamentals, the stock offers huge upside of 87% and therefore deserves a Buy recommendation.

XPO

XPO Logistics Inc (NYSE:XPO) is a provider of transportation logistics services and a provider of engineered, technology-enabled contract logistics in North America. The Company provides services for truckload transportation, truckload brokerage and transportation, last mile logistics, engineered supply chain solutions, warehousing and distribution, ground and air expedite, intermodal, drayage, global forwarding and managed transportation. The Company also offers truckload transportation services in North America.

In 3QCY15, the company delivered results that far exceed its targets. XPO increased gross revenue in the quarter by $1.7 billion, or 257% year-over-year. The increase in net revenue was even greater on a year-over-year basis, up 152%. This was due mainly to the acquisition of Norbert and margin expansion. Adjusted EBITDA was $166 million in the quarter, up 586% from last year. The increase was due to a mix of acquisitions and margin improvements.

By division, gross revenue for their transportation segment was up 128%. XPO has also completed the Con-way acquisition in late-October and all the acquired operations, which are all now operating under the single global brand of XPO Logistics. At the time that the Con-way acquisition deal was announced, management had said that they would improve profitability by at least $170 million to $210 million over two years, and they have already reduced more than $30 million of cost, primarily due to headcount reduction, adjustments in vendor contracts and the elimination of public company cost. Management is confident that XPO will hit its profit improvement target.

XPO increased net revenue margin in every single transportation business unit across the Company. Transportation net revenue margin was 22.6% versus 20.4% in the prior-year quarter. The increase in margin was due mainly to the expansion of their North American truck brokerage margins and the acquisition of a company called Norbert. In the North American brokerage and intermodal business, XPO increased gross revenue by 21%, generating strong volume and margin growth in truck brokerage. This was partially offset by weak volumes in intermodal, as it shed unprofitable accounts.

The intermodal market was also generally slower, due to lower fuel prices, which narrows the cost advantage of rail versus truck, especially when truck capacity is loose. Demand for home delivery of heavy goods continues to gain momentum, driven primarily by e-commerce sales. In this segment XPO increased gross revenue by 50%, and net revenue margin increased 165 basis points over last year, due to operational improvements in its field operations.

As we look into 2016, the company expects to continue to improve its North American transportation margin as it gains scale and as its sales reps increase in tenure. This is all in addition to the secular growth offered by its end markets. So XPO has many avenues to grow its profits and it's in a strong position to drive that growth in any operating environment. Historically, the company has met or exceeded every financial goal they've announced over the last four years and thus it seems likely that its long-term financial targets would be met or exceeded in similar fashion.

Financial Valuation:

Here is an excerpt of the company's past performance. Every metric is presented in millions of dollars, except for percentages and ratios.

XPO (USD Mil.)

CY10

CY11

CY12

CY13

CY14

Sales

158

177

279

702

2,357

Sales Growth

58%

12%

57%

152%

236%

Operating Profit

8.45

1.72

(27.96)

(52.30)

(40.90)

Operating Profit Growth

166%

-80%

-1722%

87%

-22%

Operating Margin

5.3%

1.0%

-10.0%

-7.4%

-1.7%

Net Margin

3.1%

0.4%

-7.3%

-6.9%

-2.7%

PAT Growth

187%

-84%

N/M

138%

31%

ROE

16%

1%

-12%

-14%

-6%

Total Assets/Total Equity

1.7

2.0

2.0

1.9

1.7

CFO/Net Income

0.5

8.7

1.2

1.4

0.3

Click to enlarge

Source: Reuters

As shown in the table above, sales growth has been highly volatile, reflecting the frequent acquisitions the company has made in the past, in an attempt to enhance operational footprint and its earnings. However, this rapid and inorganic growth has come at the cost of high volatility in the quantum of its operating profits (which have, on occasion, slipped into the red too). Furthermore, the impact of the acquisitions has also dented its operating profit margins which are likely to have reflected the one-off impacts of the various acquisitions. The unstable trend witnessed in the company's PAT growth and its net margins tell a similar story, with a follow-on impact on the company's return on equity (ROE) as well. ROE has historically fluctuated in the wide range of negative 12% to +16% over the past 5 years. Rapid expansion has facilities the need to retain cash within the company, and therefore, we can see that the company has not paid a single cash dividend since 2005 at least, and we do not expect this trend to change in the year ahead.

Going forward in 2016, XPO is likely to continue to benefit from increased sales traction coming in from the recent Con-way acquisition. We expect sales for next year to clock in at $6.64 billion, reflecting the impact of the acquisition. Net margins are likely to remain negative as the company is expected to incur large interest costs in the range of $340-360 million in CY16. Thus, in the near term, we expect the company to post an annual EPS of negative $1.51. However, beyond that we expect the company's sales will grow at an organic rate of 2.6% per annum, in line with the expected rate of US GDP growth. The company is likely to revert to profitability in the long-run due to cost savings and increased benefits of economies of scale, which will boost its profit margins.

The table below summarizes the projections until 2019.

XPO - Forecast Assumptions

CY15F

CY16F

CY17F

CY18F

CY19F

Sales

6,643

9,694

9,946

10,205

10,470

Sales Growth

181.9%

45.9%

2.6%

2.6%

2.6%

Operating Profit

54

194

285

380

480

Operating Profit Growth

N/M

262%

47%

34%

26%

Operating Margin

0.8%

2.0%

2.9%

3.7%

4.6%

Net Margin

-2.5%

-1.6%

0.0%

1.5%

2.9%

PAT Growth

158%

-5%

N/M

N/M

93%

ROE

-10%

-11%

0%

11%

18%

CFO/Net Income

0.5

0.6

0.7

0.8

1.0

Click to enlarge

We have valued this stock based on Free Cash Flow to Firm (FCFF) basis, with valuation parameters presented below:

Beta

2.15

MRP

4.40%

Risk Free Rate

2.24%

Terminal Growth

2.00%

Cost of equity

11.70%

Cost of debt

10.1%

Tax rate

20.0%

After tax cost of debt

8.0%

Debt Weight

38.5%

Equity Weight

61.5%

WACC

10.3%

Click to enlarge

By assuming terminal FCFF growth of 2.00% and applying discounted cash flow (DCF) valuation method, the equity value comes out to be $4.33 billion, resulting in a target price of $40.00 per share, offering a huge upside of 87.3% from the last closing price of $21.36 per share.

Conclusion:

XPO has underperformed the market over the past 12 months, falling by 43.5% (as of 22nd January closing) and underperforming the S&P 500 Index which fell by just 7.1% over the same period. While the company's near term earnings are likely to remain suppressed due to the high interest costs incurred to finance the Con-way acquisition, in the long-term, the company's bottom-line should yield benefits from the deleveraging of its balance sheet and higher profit margins from increased economies of scale.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.