Investors sold off XPO Logistics (NYSE:XPO) harshly, incurring a loss of almost 20% in just two trading sessions. The selloff was likely due to the triple whammy of:
- a $125M convertible notes offering,
- a preview of revenue and operating income that missed the consensus expectation, and
- the litigation with C.H. Robinson Worldwide (Nasdaq:CHRW) involving certain key employee hires.
Here I'm going to both analyze the recent events and take a longer-term look that hopefully will help determine if the selloff is a buying opportunity.
But before I start, I would like to provide some brief background information for those who are not familiar with this company.
XPO Logistics is a non-asset-based freight broker controlled and run by investor and legendary entrepreneur Mr. Bradley Jacobs. Jacobs took control of the company in September 2011.
Before XPO, Jacobs has successfully built four multi-billion-dollar companies in three different industries from scratch. Each of the companies reached the billion-dollar mark within a few short years. The two most recent companies he built were United Waste Systems and United Rentals (NYSE:URI). The former grew to be the fifth largest solid waste management company in North America, before being sold for $2.5 billion to Waste Management (NYSE:WM). The latter has become the largest equipment rental company in the world.
So, XPO is Jacobs' fifth venture to build a multi-billion-dollar enterprise. He chose the company because logistics industry is large, fast growing and fragmented.
In U.S., logistics is a $1 trillion industry and trucking alone is about $350 billion. Freight brokerage has been growing at about two to three times the pace of GDP over the last decade. And yet, truck brokerage, which is XPO's main focus, has so far only penetrated about 15% of the trucking industry. Jacobs believes the penetration can eventually grow to up to 50% level.
There are more than 10,000 licensed brokers in the country, all but 25 of which have revenue of $200M or less. This creates a great opportunity for consolidation. And that's precisely why acquisitions are an important component of Jacobs' three-pronged growth strategy. The other two components are cold starts and optimization of operations.
More information can be found in the following links:
- XPO Investor Presentation
- XPO Logistics' CEO Presents at the Deutsche Bank 2012 Aviation and Transportation Conference (Transcript)
- The big bet of Brad Jacobs
- Brad Jacobs: a U.S. transport "serial acquirer"
- XPO website
- XPO Logistics: Eyeing A Huge Return Over The Next Few Years
- XPO Logistics: The Best Idea For The Next 3 Years
Q3 Miss and Year-End Revenue Target
Management now sees Q3 revenue coming in the range of $68 to $72M, short of the consensus estimate of $81.5M. Management's goal for FY12 (ending Dec. 31) is to reach a revenue run rate of $500M by the end of year, compared to the actual whole-year revenue of $177M in FY11. With the Q3 miss, investors naturally wonder if the year-end target is still achievable.
Half of the year-end $500M revenue run rate target is planned to be from acquisitions while the other half from the existing operations plus cold starts.
So far this year, the company has completed two acquisitions (Continental Freight Services and Kelron) with a combined annual revenue of $122M, almost half way through its $250M target. With more than a whole quarter left, it still looks likely for the company to bring in another $128M to close the gap.
On the existing operations and cold starts, to attain the $250M run rate by year end means the company's Q4 revenue should reach $62.5M. If we assume that Continental and Kelron performed at the same run rate as before being acquired and also factor in that Kelron contributed a little short of two months of revenue in Q3, the Q3 total revenue of $68-72M would translate into roughly $47-51M contribution from the existing operations and cold starts. The company would need to grow this part of operation sequentially by $11.5-15.5M in Q4 to hit the target.
Again if Continental and Kelron performed at the same run rate as before being acquired, the "cold starts & existing" revenue would have had a $6.6M sequential growth in Q2 while remaining largely flattish in Q3. So, judging from this trend, whether this part of business can hit its target of $62.5M run rate in Q4 is not that clear to me. Market might as well have been fretting about this uncertainty.
However, it is certainly possible for management to add more than $128M revenue via acquisitions before year end, which will then serve to offset any shortfall on the "cold starts & existing" revenue.
So overall, it is still possible and likely for the company to meet its own year-end target of $500M revenue run rate.
Implication of the Convertible Offering
The most obvious consequence of this convertible notes offering is that it confuses the investing public because the company has ample liquidity to meet its operational needs, including acquisitions, cold starts, and infrastructure build-out.
Before this convertible offering, the company already raised combined net proceeds of $209M through Jacobs' investment last year and a public offering in March. The Continental and Kelron acquisitions cost $11.5M, a mere change compared to the capital raised. As of the end of Q2, the company had $190.7M cash on hand.
Management has in fact made clear to investors on the company's ample cash position. So this sudden massive convertible offering really had investors scratching their heads wondering what had just happened.
I have emailed company IR regarding this offering. If I ever get a reply in the near future, I will post it under the Comments area. I urge investors to complain to management about their poor investor communication because this has caused unnecessary concern that impacts the stock performance.
A second negative of the convertible offering is that throughout the converts' lifetime, net income will be reduced by a combination of (a) interest expense, and (b) the amortization of the discount associated with the equity component of the converts.
That said, given CEO Brad Jacobs is business savvy, one also has to wonder if this unexpected debt offering foretells a much more aggressive expansion plan for the rest of year, into FY13 and beyond.
Corporate history is littered with examples of acquisitions and expansions gone awry. But Jacobs has distinguished himself from the average corporate executive by setting a high bar on the return of any investment he made. In the case of XPO, he is mainly interested in small investments that will multiply through integration, IT and capacity sharing, and operation optimization.
Cold starts fit his thinking nicely, because they have very small capital requirements and can be quickly ramped up in a few years to generate a return that is a high multiple of the invested capital.
As for acquisitions, Jacobs mainly targets small freight brokers in the annual revenue range of $20 to $200M. These companies can be bought out at a low price/sales (P/S) multiple, integrated and expanded quickly through IT, capacity sharing and sales force upgrade.
Take the two acquisitions (Continental and Kelron) made so far this year as an example. The combined annual revenue of $122M has cost just $11.5M, giving rise to an aggregated P/S ratio of only 0.09.
Although these two acquisitions might not necessarily be indicative of future direction, I expect the low P/S multiple to remain a theme as Jacobs mostly sticks to his target $20-200M annual revenue range. I see the P/S multiple to typically remain at 1/3 or below with only rare exceptions.
Jacobs' acquisitions create shareholder value through a two-pronged strategy.
First, the entities being acquired typically are not able to scale on their own, underperform and often are in need of working capital. This dictates that their market value is generally on the cheap end, thus the low P/S multiple mentioned.
Second, XPO has the infrastructure and resources in place to quickly unlock and greatly increase the value of the acquired units through IT, capacity sharing and sales force upgrade.
In other words, unlocking value brings the originally depressed P/S multiple up to par. In addition, the operation upgrade adds value and increases the P/S multiple even further.
My prediction of the average acquisition P/S multiple of 1/3 or below appears reasonable when using Echo Global Logistics (Nasdaq:ECHO) as a reference. ECHO is a proven fast-growing freight broker and industry leader, having grown revenue from $7.3M in 2005 all the way to $603M in 2011. Yet, it was valued at 0.59x past-twelve-month sales as of Friday, 9/21/2012.
So, for the generally weaker or much-weaker freight brokers XPO is acquiring, there is no reason for the P/S multiple to come anywhere close to 0.59x. Of course, I do not rule out exceptions where some stars in the industry get acquired due to their strategic significance. But those should just be exception rather than norm.
This line of reasoning explains why XPO investors actually crave for more acquisitions than worrying about them. It also explains why Jacobs has appeared to be a little slow on acquisitions. He has a lot to weigh in a deal, e.g., size and growth versus price tag. I tend to regard this "slowness" as a reflection that he is prudent and savvy. You can't be savvy while being reckless, can you?
Therefore, if this convertible offering really forebodes somewhat expedited acquisition pace (along with accelerated cold starts and operation upgrades/expansions) going forward, the stock will likely have a catalyst to rally in the future.
C.H. Robinson Worldwide Lawsuit
It is hard to comment on this one until more details are released. However, it is not unusual for competitors to sue each other for inducing and abetting breaches of contract and misappropriating trade secrets when key employees jump ship. CHRW might have got nervous that a formidable opponent is suddenly emerging on the horizon and felt necessary to throw around a few roadblocks.
Valuation, Potential and Longer-Term Price Target
XPO is still in its infancy but fast growing. It is not expected to be profitable until late 2013. As such, conventional metrics such as EPS and the revenue ttm are not good ways to measure this company. One can actually argue that EPS, net income, and the actual revenue at this stage are largely irrelevant.
As noted above, XPO's revenue in FY11 was $177M. But by the end of this year, the annual revenue run rate is likely to hit the $500M mark. After completion of the current convertible offering, the company will have some $300M of cash in hand, which gives it a lot of firepower for future expansions.
At a P/S multiple of 1/3, the company needs $43M to close the "acquisition gap" of $128M (see above) for the rest of the year and reach the $500M target run rate. Following that, if the company spends another $150M for acquisitions (again at P/S = 1/3), that would mean $450M additional revenue, thus bringing the revenue run rate to $950M.
Such acquisitions would still leave the company with over $100M of cash available for new cold starts, ramping up the existing ones, the previously acquired units, and other existing operations. Adding the growth contribution from all these components, the company would attain a revenue run rate of well above the $1B mark.
Given the timing of the debt offering, it is reasonable to assume that all these can be achieved at around the year end of 2013.
If this does come to fruition, we are looking at a company that grows from $177M actual revenue to above the $1B run rate in two years. And that's simply insane growth.
If we value XPO at 0.6x, the $1B revenue run rate at the end of 2013, this stock would be worth a market cap of $600M. The actual market cap as of last Friday (9/21/2012), at $12.50 a share, was about $518M.
The consensus estimate of 10 analysts for XPO's FY13 revenue is $816M (which is NOT inconsistent with a $1B revenue run rate at the year end). At $12.50 per share XPO was thus trading at 0.63x the FY13 consensus revenue estimate. This was lower than CHRW's 0.75x, but higher than ECHO's 0.43x (as of 9/21/2012).
So when XPO's high growth rate is considered, the stock is now trading at fair to attractive valuation.
You might have noted that XPO's recent market cap of $518M (as of Friday 9/21/2012) I gave above is more than twice the $221M widely quoted in the financial media. These other sources have ignored RSUs, in-the-money options and warrants and the eligible preferred share conversion. They are vastly understating XPO's market value. The discrepancy here is much more pronounced than even the notorious Facebook (Nasdaq:FB) case where the correct market cap as of 9/21/2012 should be $62.67B instead of $48.97B widely reported.
Perhaps even more important than the current valuation consideration is the future potential of this company. The determining factor of success in any equity investment lies in the future of the company you are investing in. And XPO is one that has a brighter future than most other stocks in the market.
Brad Jacobs aims for a revenue of $4B to $6B in the next few years. The reason you should believe him is his phenomenal credentials in the past three or so decades creating several multi-billion dollar enterprises. Follow the links I provided at the outset if you are not familiar with his track record.
To see the potential of this stock, let's assume XPO gets to a revenue of $5B in "a few" years. Whenever that's achieved, XPO should deserve a market cap of $4B assuming a P/S ratio of 0.8. For reference purposes, CHRW traded at 0.86x past twelve months' revenue as of last Friday, 9/21/2012.
In terms of the per-share price, of course, it will not be a simple linear relation to the market cap for this stock. This is because of the dilution that needs to take place to drive the growth as the market cap goes up.
How much dilution will be needed for the stock to eventually get to the $4B market cap? That's not a simple question to answer. However, a model I'm using puts the eventual common shares outstanding at 59M when the company reaches $5B top line. To that I also add a buffer of 6M shares to account for any extra dilution due to future employee stock-based compensation and unforeseen share issuances. So the total shares outstanding then would be 65M by my estimate.
At 65M common shares outstanding, the $4B market cap would translate into a share price of $61.5.
A common belief is that XPO will reach the $5B annual revenue in five years. So the share price of $61.5 can be taken as my tentative 5-year price target for this stock. Relative to the $12.50 share price last Friday, this represents a 392% return in 5 years.
The stock would apparently have more upside if my dilution model turns out to be too conservative. But as an investor, I do not want to get aggressive on my analysis.
Investing in XPO is basically a bet on its legendary Chairman and CEO Mr. Bradley Jacobs. Investors in Apple (Nasdaq:AAPL), Amazon.com (Nasdaq:AMZN) and Michael Kors (NYSE:KORS) can attest to how important a great captain is to the stock value in the long run.
Investors in the growth stocks just mentioned, or GOOG, YELP, Z, MELI, LULU, CMG, DDD, SSYS, WFM, CELG, CF, WPRT, TSLA, or even much smaller emerging plays like QUIK might find XPO a great addition for portfolio diversification purposes.
The major risk to this investment is the macro environment. The freight brokerage industry is currently experiencing the headwind from a soft economy. The Dow Jones Transport index has underperformed the general market lately, pointing to weakness in the entire transportation sector.
However, the macro softness should be somewhat mitigated by the company's fast market share gain in the future. A good way to think about this is to look at KORS. While luxury brands like Coach (COH), Burberry (UK:BRBY), and Fossil (FOSL) have all experienced impact from the soft economy, KORS just keeps on beating estimates and raising guidance. XPO and KORS are in different industries and have different growth strategies. However, the way company-specific growth outpaces, offsets or mitigates macro headwinds should probably work similarly.
On company-specific risks, I think volatility will remain high particularly as the need to dilute shares arises again in the future.
Equity investment is essentially a bet on a company's future. Whether a company has a great future depends largely on its management team.
XPO Logistics is a fast-growing small cap spearheaded by Bradley Jacobs who has decades of track record in creating a multi-billion dollar enterprise in just a few years. It has only been a year since Jacobs invested in and took over XPO. Recent short-term stock decline thus likely creates a great opportunity for investors to build a long-term position at an early stage of this company's growth.
I believe this stock can trade as high as $61.5 within five years, compared to $12.50 the stock traded on Friday.