Jeff Borack's  Instablog

Barbie was conceived as the all-American girl.  In truth, she never was: at her inception, in 1959, Mattel Corp. arranged to make her at a factory in Japan.  A few years later it added a plant in Taiwan, along with a large cadre of Taiwanese women who sewed Barbie’s clothes in their homes.  By the middle of the 1990s, Barbie’s citizenship had become even less distinct.  Workers in China produced her statuesque figure, using molds from the United States and other machines from Japan and Europe.  Her nylon hair was Japanese, the plastic in her body from Taiwan, the pigments American, the cotton clothing from China.  Barbie, simple girl though she is, had developed her very own global supply chain.
    Supply chains like Barbie’s are a direct result of the changes wrought by the rise of container shipping.  They were unheard-of back in 1956… and in 1976 when oil prices brought sky-high freight costs that stifled the flow of world trade.  Until then, vertical integration was the norm in manufacturing; a company would obtain raw materials, sometimes from its own mines or oil wells, move them to its factories, sometimes with its own trucks or ships or railroad; and put them through a series of processes to turn them into finished products.  As freight costs plummeted starting in the late 1970s and as the rapid exchange of cargo from one transportation carrier to another became routine, manufacturers discovered that they no longer needed to do everything themselves.  They would contract with other companies for raw materials and components, locking in supplies, and then sign transportation contracts to assure that their inputs would arrive when needed.  Integrated production yielded to disintegrated production.  Each supplier, specializing in a narrow range of products, would take advantage of the latest technological developments in its industry and gain economies of scale in its particular product lines.  Low transport costs helped make it economically sensible for a factory in China to produce Barbie dolls with Japanese hair, Taiwanese plastics, and American colorants, and ship them off to eager girls all over the world.

-Marc Levinson, The Box

Introduction

Pacer International (PACR) stock is trading below intrinsic value even if we assume that a highly pessimistic scenario unfolds.  The threat of an unfavorable UNP contract renewal and the loss of business from a weak automotive sector, the two most major investor concerns, have more than fully been priced into PACR shares.  Also, the possibility of busting a leverage ratio covenant entered the picture in the first quarter of ’09.  This is entirely the result of the lenders definition of “leverage”, and only affects Pacer insofar as they may have to resort to raising capital in the equity markets.  All of these threats have been fully worked into the current share price, leaving investors with substantial room to profit from any sort of a return to normalcy.

My remaining concern is Pacer’s falling revenue.  Superficially glancing at the income statement shows rising revenue from at least 2002 (didn’t look further back) through 2008.  However, if we subtract fuel surcharges out, we find revenue peaked in 2003.  The declining trend in Pacer’s revenue leads me to believe that there are more serious fundamental problems that have been building for a few years, and it makes me hesitant to endorse PACR stock despite how oversold it appears to be.

That being said, I strongly believe that it’s worth learning about to follow the situation as it unfolds.  At share prices around $3, limited downside liability and upside profit potential make PACR stock almost like an option.  Bankruptcy risk is negligible and there is always the possibility of a takeover, arguably giving PACR good short-term investment characteristics as well as long-term.

Background

Pacer is a transportation logistics and brokerage business focusing on intermodal railroad traffic.  I touched on many of the fundamental drivers of this industry in my report on Trinity Industries (TRN), but I believe PACR is more immune to system-wide pricing shocks than TRN.  As an asset-light operator, PACR generally avoids owning property or equipment that needs to be kept in productive use.  Operating leverage should be low, allowing CoGS to vary with revenue.  On a quarter-to-quarter basis, PACR could have some trouble perfectly matching leasing obligations to client needs, but in the long run they should only take business that earns a spread.

Pacer is segmented by management as follows:

• Intermodal (transporting goods using more than one mode of transportation)
  • o Rail Brokerage
  • o Stacktrain (railcars that stack shipping containers two high)
  • 3rd Party Domestic
  • Automotive
  • International
  • Local Cartage
• Logistics
  • Highway Brokerage
  • Truck Services
  • International Freight Forwarding & Non-vessel Operating Common Carrier
  • Warehousing & Distribution
  • Supply Chain Management

If you’re interested in learning more about what they do, I recommend reading the 10k.  It’s 90% of what I know and 100% of what I would consider important enough to write about.  It’s straightforward and there’s nothing interesting for me to add.

UNP Contract

The UNP contract has been a serious concern for investors in PACR for a long time.  In an analyst report from Baird published February 12, 2009, the analysts stated “all else being equal, a 10-20% price increase to a renewed UNP contract equates to $0.60-$1.20/share incremental expense beyond 2011, which is potentially greater than our downwardly revised 2009/2010 EPS estimates of $0.93/1.20”.  The key qualifier in this sentence is “all else being equal” because all else remaining equal in light of a 10-20% price increase from UNP is unrealistic and the EPS changes are misleading.  Would it make sense for management to continue utilizing the UNP railways at negative margins, wiping out all other PACR profit for the year?  Clearly PACR would either:

a) divert traffic to cheaper lines
b) increase costs to customers, or
c) loose business. 

Scenario (a) results in similar revenue, margins, and profit, scenario (b) results in higher revenue, lower margins and similar profit, and scenario (c) results in decreased revenue, similar margins, and decreased profit.  Even in scenario (c), which is clearly the worst, there is no reason to expect PACR to cannibalize all their profits to continue running the same volume through UNP lines.  In reality, a combination of these scenarios will probably play out, but no combination results in $0.00 EPS for PACR post 2011.  Also, saying that the losses are potentially greater than the revised EPS estimates is circular logic if knowledge of these potential losses is included in the EPS estimates.  We realize that these UNP contract losses might occur, so we reduce our EPS estimates, which makes our losses from the UNP contract more significant, so we reduce our EPS estimate further, and so on…

These same analysts estimate that “50% of the $1.2 billion in intermodal purchased transportation is related to UNP contracted business (of which) 60% is on the legacy UNP contract”.  If 30% (0.5*0.6) of PACR’s intermodal business in 2008 was UNP related, and we take this down to the EBIT line of 113.3 million, PACR would loose $40 million of EBIT.  After 35% tax, this would result in a loss of $0.75/share moving forward.
Just to be clear, in the worst-case scenario where PACR looses all business now running through the legacy UNP contract because UNP gives PACR terms so terrible that it doesn’t pay to run any volume on UNP lines, 2008 earnings per share (not including impairments) would be down to $1.31, meaning shares are trading today around 3.5x earnings, yielding 30% to shareholders.

Automotive Segment

Another concern for investors in PACR is reliance on the strength of the automotive sector for continued volume.  Management states in the risk factor section that 20% of revenue in 2008 is connected to the automotive industry.  Worst-case scenario… no cars are ever transported by PACR again.  20% if 2008 EBIT is $17.9 million, which would result in an after tax loss of $0.34/share.  If we want to combine this with the UNP contract losses above, we have to take into consideration that some of this volume will overlap.  78% of 2008 revenue was from the intermodal segment, but effectively all 2008 EBIT was from this segment.  30% disappears with the UNP contract and 20% disappears with the automotive segment, but the overlap should be about 6%, leaving us with 56% of PACR business as continuing.  This $1.15/share puts PACR at a forward multiple of 4.2x earnings or a 24% yield to shareholders. 

Fixed vs. Variable Cost Assumptions

The above paragraphs depend on a number of assumptions most of which are not that important given the pessimism of the forecasts.  However, the assumption that costs are variable is important to consider.  The more costs are fixed, at least in the short term, the more slowly PACR will be able to bring costs down to match decreased revenue.  A 100% variable cost assumption is admittedly unrealistic in the short term, but it helps to get a feel for the long-run outlook in a market that is permanently impaired as suggested by the share price. 

The variable cost assumption is particularly appropriate given the asset-light nature of Pacer’s business and the low level of debt.  However, the short-term expectations might still be a legitimate concern for investors as discussed in the covenant section below.

Debt Covenants

I’ve been working on this company for well over a month now, and I’m glad that I waited for 1Q09 results to come out.  Although I generally don’t care what happens in terms of performance in any given quarter, this most recent quarter was bad enough that PACR had to draw on the revolver for $35 million.  From an interest coverage point of view, this shouldn’t a problem even in the short term.  PACR would generally have no problem meeting their obligations.  However, management mentioned that they are dangerously close to busting a covenant and are in the process of renegotiation.  I checked the indenture, and there are two financial covenants:

1) A consolidated interest coverage ratio of 3.0x must be maintained, with interest coverage defined as EBITDA (excluding one-time non-cash charges) divided by interest charges for any 4-quarter period.  The LTM multiple is 28x.

2) A consolidated leverage ratio of 3.0x may not be exceeded, with leverage defined as total indebtedness divided by EBITDA (again excluding one-time charges).  In the first quarter, the LTM leverage ratio grew to 1.78x from 0.62x at the end of ’08.  This is really an interest coverage ratio in disguise, and it’s particularly lethal for PACR in the present situation.  EBITDA is measured over the current 4 quarters, whereas total indebtedness is a snapshot view of the balance sheet.

The odds of triggering the leverage ratio covenant are difficult to predict.  In the conference call, management said their concerns are due to “current revenue and expense projections”.  However, the COO also said in reference to the retail door-to-door business “our volumes steadily improved throughout the quarter and actually in April our volumes are flat with last year”.  Later the CFO also stated “we've seen some stabilization in the volumes as the period has gone on, on the wholesale domestic side”.  Regardless of second quarter results, management expects earnings to be positive by the second half of ’09 based solely on cost reductions with no turnaround in the economy.  I’m guilty of cherry-picking the not-bad news here, but I do think there are some signs of light at the end of the tunnel.

In the worst case scenario, PACR will not be able to renegotiate on favorable terms and will bust that covenant, forcing management to raise capital in the equity markets.  This creates an interesting situation where a low share price today actually increases the dilution effect of issuing new shares, so a falling share price makes the stock less valuable, and a rising share price makes the stock more valuable.  This is textbook reflexivity ala Soros, and has interesting implications for my model.

Comparison/Competition

Asset-light logistics is a crowded space and PACR is not the largest player.  I didn’t spend as much time comparing PACR to its peers as I usually do because PACR is blatantly the most heavily discounted, but my optimism for the industry makes it difficult to really consider any of these companies as a short.

The Hub Group is probably the best company to compare to Pacer.  They operate in exactly the same market, have been competitors for a long time, and generate a similar amount of revenue.   Not taking into account fuel surcharges, intermodal revenue grew by 10% and 3% in 2008 and 2007 respectively.  EBIT for the intermodal segment isn’t clearly broken out, but total EBIT growth was 5% and 17% in 2008 and 2007.  This compares to only about 4% growths in revenue and a flat EBIT for Pacer from its intermodal segment over the same time period.

JB Hunt has traditionally been more of a trucking company, but in the past ten years it has transitioned to focus more heavily in the intermodal railroad logistics and brokerage market.  Management separates out the performance of the JBI segment, which is Pacer’s most direct competitor.  This segment has experienced explosive growth in the past few years, growing revenue by 18% and 16% in ’08 and ’07 respectively, and EBIT by 6% and 31% over the same years.

CH Robinson traces its roots to a produce distributor.  Of the comparison group I compiled, it’s obviously the largest player, but it’s also the least heavily weighted towards intermodal rail traffic.  Only 4% of transportation-related gross profit is attributed to intermodal traffic, with the bulk coming from truck shipping.  On top of this, CHRW also earns 22% of total gross profits from information based services.

In general, it’s difficult for me to get a sense for how much of Pacer’s underperformance in the last few years is just bad luck (bad economy) and how much might be the result of inferior service.  One piece of the puzzle is fuel-costs, which are spoken about by management and analysts in the conference calls.  The takeaway is that fuel costs are covered by surcharges, but that accounting mechanisms result in lagging pressure on margins when fuel costs rise, and a lagging decrease in pressure if they fall.  And these surcharges are significant, peaking at 41.4% of revenue in 3Q08.  These surcharges have been masking declining revenue at Pacer for a number of years.  What I would like to see in coming quarters is both a relative outperformance of PACR to its peers and an absolute growth in surcharge-adjusted revenue.  Pacer needs at least to maintain historic levels of business at equally attractive margins for me to be confident this is a home-run.  Especially considering management cut dividends, and they might dilute shareholders in the near future, I don’t see how PACR will return value to shareholders if they’re in a permanently declining business.  Again, this isn’t a recession problem or something that happened in a recent quarter, this has been going on since at least 2004.

Model

I modeled this company in an unusual way.  Normally I grow revenue into the future as a function of long-term assets including PP&E and some combination of goodwill, intangibles, and other assets.  However, PACR completely wrote-down goodwill and intangible asset values to 0.  Management stated that they “believe in the ongoing viability” of those assets, and that the impairment was triggered by a decline in PACR market capitalization.  Rather than adding it back in and estimating revenue as some asset turnover multiple, I simply input analyst expectations for revenue through 2012.  Since my model looks 5 years out, I assumed that 2013 revenue is the same as 2012, an assumption I believe is pessimistic and one that my model is sensitive to as my intrinsic value estimate for today is the discounted value of the share price in 2013 plus dividends between now and then.  The most major problem this creates is a decoupling of earnings reinvestment and expectations for future earnings.  It’s possible for my model to show increasing revenue (because it’s fixed) despite shrinking PP&E as cash flow fails to cover D&A expenses.  However, this luckily is not the case in my model.  PACR is able to resume dividends, repurchase shares, and spend reasonable CapEx to grow PP&E.

As with any company operating at a narrow margin (EBIT margins in the 4-6% range), earnings estimates are extremely sensitive to the cost side of the equation.  For the past seven years, CoGS (including fuel) as a function of revenue has been 84.2% with a standard deviation of only 1%, meaning 95% of years should have a CoGS at between 82-86%.  (I realize this is a small sample and it’s statistically insignificant, it’s just to demonstrate a point.)  The first quarters CoGS came in at 92.1% of revenue.  Results are similar if we include quarterly data for 2007 and 2008.  However, because we’re looking at the long-term prospects for this company, we will assume that costs are variable and therefore revert to the mean for the past seven years.

To deal with the revolver covenant situation, I have assumed the worst-case scenario.  PACR busts the leverage ratio covenant and is not able to renegotiate the terms of that agreement at all.  They have to repay the debt in full, and are only able to raise the necessary cash by taping the equity markets, selling shares at today’s deeply discounted price.  This raises the diluted share count from 34.9 million today to over 45 million at the end of the second quarter.  Because I also assume that PACR resumes their historic dividend yield in 2010, the increase in share count increases the cash-flow requirement and impairs Pacer’s ability to repurchase a large number of shares moving forward.  These factors make my model very sensitive to the current share price.  A low share price today increases dilution and has long-term negative consequences for PACR.  Therefore, if the share price goes up, the company actually becomes more valuable, and vice versa.  However, even at a present share price of $1, the current value per share is $3, compared to say $9.23 of value at a current price of $5.  So while the value falls due to a low current share price, the expected return on investment still rises (3x vs 2x).

Given the above assumptions and running off analyst forecasts for revenue, my model predicts EBIT, NI, and EPS figures significantly below analyst expectations as can be seen in the graph below.  Despite the extremely pessimistic nature of the assumptions I have made, and a very high discount rate of 15% for the next five years, my model still values PACR stock at twice it’s current value if at the end of 5 years PACR stock is trading at a 7-year average earnings multiple of 13.5x (a discount rate of 7.4% net of growth).  

The output of this model doesn’t take into account the effect of a failed UNP re-negotiation or the permanent loss of the automotive business.  It’s difficult to work those projections into a model using analyst projections because those concerns must be at least partially worked in.  Taking these losses into consideration, the simultaneous loss of the UNP and automotive business resulted in a 2008 EBIT of about $60 million, which can be compared to my modeled expectation for $58 million of EBIT in 2010.  For a present share value of $5 to be correct, PACR would still have to be stuck at the $60 million EBIT mark in 2014.

I want to make it clear that I don’t believe my model provides an accurate or even realistic expectation for the future of PACR.  It’s just a tool to work through the mechanics of some scenarios.  I do, however, think prospects for the intermodal rail brokerage business are extremely bright.  I’m just trying to demonstrate how absolutely terrible the next 5 years would have to be for PACR to be worth even $5/share today.

Conclusion

I like Pacer as a company, I like PACR as a stock, and I think current valuations are attractive.  However, I don’t think that investor concerns are baseless.  While these concerns seem to be more than fully worked into the current share price, there is still the possibility that Pacer will have continued difficulty competing with some of the industry heavyweights even in a favorable market.  Investors should get a better feel for this by watching the numbers as they’re reported over the next year or so.

Disclosure:  none