It doesn't feel like a stretch to say that Wall Street loves logistics. From FedEx (NYSE:FDX) to Hub Group (NASDAQ:HUBG), from Landstar (NASDAQ:LSTR) to JB Hunt (NASDAQ:JBHT), most of this sector is trading very close to 52-week highs, even though economic activity in the U.S. has been pretty "meh" recently. While CH Robinson (NASDAQ:CHRW) and XPO Logistics (NYSEMKT:XPO) are a bit further removed from their highs, I think the latter could be a very interesting opportunity even at these levels.
The ambitions of the XPO management team are nothing short of extraordinary - they aim to take a company that sits around the #20 spot in the U.S. truck brokerage with $280 million in revenue and grow it into the #2 player by 2016, with revenue in the range of $4 billion to $6 billion. That's an incredible goal and frankly Wall Street isn't buying it - or at least not showing a willingness to assume that XPO can grow at that rate and generate any sort of real free cash flow. If the Street is wrong and management is right, shareholders could be looking at a future multi-bagger here.
Freight Brokerage - A Growth Opportunity In Transport
While the transportation sector on the whole doesn't generally grow much faster than GDP, sub-sectors can and do grow much faster, and that has proven to be the case with truck brokerage. Penetration has increased significantly over the past decade, and stands at about 15% of the trucking industry - good for a market opportunity of around $40 billion to $50 billion, growing at a rate more than twice that of GDP.
Truck brokerage is a relatively simple business on the surface. Truck brokers essentially match freight with truck capacity - companies don't always have the resources or desire to hunt around getting quotes for shipments, and many trucking companies lack the capacity to actively hunt for business. As a middleman, then, the broker makes the arrangements and collects a percentage of the shipment cost (the difference between what the truck company charges and what the client actually pays).
While $50 billion makes truck brokerage a sizable market, it's highly fragmented. There are literally thousands of licensed brokers in the U.S., maybe more than 10,000, and the top 25 represent less than 40% of the industry's revenue. That's particularly relevant to XPO and its growth plans, as the company is actively looking to roll up smaller players - players that may find that the increasing technology and working capital demands of the industry make it uneconomical to stay independent.
Although I do see the rate of growth slowing in the truck brokerage industry, I believe it will still be in excess of GDP growth for the next five years. Simply put, it's just too convenient both for companies like Old Dominion (NASDAQ:ODFL) and Arkansas Best (ABFS) on the trucking side and the customers. While lower truck-based cargo would be a risk, I think it's a small one - there are routes that railroads simply cannot run.
XPO's Strategy Is Proven, Albeit Risky
Right now, XPO is a three-part business. Freight brokerage is more than half of the company's revenue, but the company also engages in expedited transportation (where it's the #5 player in ground behind FedEx, Arkansas Best's Panther, UPS (NYSE:UPS), and Landstar), and freight forwarding. It is the freight/truck brokerage business that will drive the company's ambitions over the next four or five years.
XPO is looking to grow organically (cold starts) by establishing branches in new markets, and it looks like about 25% to 33% of the targeted growth will come from this opportunity. The formula here is pretty simple - identify attractive markets, find the right people to run the location, and invest a relatively moderate amount of capital to open the office. As an asset-light logistics service provider, XPO doesn't need much in the way of equipment.
The bigger source of revenue will be from acquisitions. As mentioned before, there are thousands of potential targets, though management has been focusing on companies with credible brokerage revenue today, with recent deals running from $27 million in revenue to $100 million. The company has done six deals in the past 14 months, and the company will have to do many more (or increasingly large) deals to get to its target revenue in 2016.
To the extent that it can ease investors' fears about the attendant risks of roll-up stories, management here has been through this before. The company's CEO (Brad Jacobs) led the construction of United Waste Systems, which he eventually sold to USA Waste Services (which then bought Waste Management (NYSE:WM)) at a solid profit, and then set out to found and build United Rentals (NYSE:URI). In both cases, M&A within highly fragmented and inefficient industries was a major feature of the story.
Not Just About Growth
Expansion and M&A are not the only ways that XPO can succeed and grow, though. Clearly, buying businesses does little long-term good if XPO cannot run them as well or better. To that end, I think XPO management has built an infrastructure that could support a successful long-term outcome.
Technology is important to this company. Pricing loads is a real challenge for many brokers, as it can be difficult to forecast carrier pricing for unfamiliar/uncommon roads. XPO, though, has invested in processes that collect and analyze substantial volumes of data to generate more accurate prices. Likewise, the company leverages its systems to source capacity more efficiently and also has "Big Brother" systems in place to track the actions and performance of its sales reps.
All told, I believe this is where XPO wins or loses the long-term battle. Pricing isn't exactly standardized in truck brokerage, but there's not that much wiggle room (and it's not a high-margin business). Larger companies like CH Robinson, Landstar, and JB Hunt have used technology to good effect, and I believe XPO is following that same path. What's more, as I mentioned earlier, technology is an area where smaller brokers are likely to struggle to keep up - the costs of IT may be coming down, but not fast enough. Consequently, more and more potential acquisition targets may simply not be able to keep up.
Many Things Could Go Wrong
Any time a company talks about growing from less than $300 million to over $4 billion in gross revenue, it's wise to be suspicious. To that end, there is a long and inglorious list of companies that tried an aggressive M&A roll-up strategy only to go bust - whether it was from overstretching the balance sheet, buying too many bad businesses, or losing sight of actual operational performance while hunting the next deal.
M&A tends to create complications in accounting, and disreputable companies have exploited that to hide underlying problems in the business. Likewise, XPO has a pretty solid balance sheet today, but will almost certainly need to lever up to buy more growth.
In the case of XPO, though, I also worry about focus. During the fourth quarter, the company opened not only eight new truck brokerage offices, but eight new freight forwarding offices and an office for the expediting business. Likewise, one of the recent acquisitions was East Coast Air Charter - a non-asset air charter brokerage business. While I'm glad that company isn't letting the non-truck brokerage business wither, and air charter brokerage could be a good business, I do worry about bandwidth. Juggling a couple of balls or clubs is manageable, but each additional club makes things nearly exponentially more difficult. It would be a shame if XPO's management derailed the truck brokerage growth plan by trying to do too much.
That said, management eats its own cooking (managers and directors own more than half the shares). What's more, I appreciate that the company does not hide or understate the significant dilution that will come from preferred stock, warrants, and a convertible note - while the stated share count is around 17 million, the real count is more like 43 million.
Can They Hit The Target?
Modeling is always a subjective process, but I have to admit I frankly don't know how you model a revenue ramp from about $300 million to $4 billion-plus, particularly when so much of that growth will come from acquisitions. There's definitely business out there - of the $50 billion market, CH Robinson is the largest player with over $9 billion in truck brokerage revenue (good for about 17%) share, and both Landstar and Total Quality are above the $1 billion threshold.
To a large extent, then, this is a binary model/valuation exercise - you either believe, or you don't. I'm going with slightly below-Street numbers, estimating that the company will reach $4.4 billion in revenue in 2016 and grow at an overall rate of nearly 40% over the next decade.
The margin side of the model is likewise a patchwork of guesses. Companies like CH Robinson, Landstar, and Hub Group can give you some idea of potential margin structures, but acquisitions usually depress margins for at least a year or two post-close. With that in mind, I believe XPO will post pretty unimpressive free cash flow margins over the next five years (between 0% and 1%), and may even go negative more than once. Longer term, I think the company will generate margins of around 2.5% - below the likes of JB Hunt and Hub Group due to what I believe will be legacy inefficiencies from the M&A binge. On a "longer long-term" basis, though, I think XPO could do better - particularly if the company's technology platform delivers the advertised benefits.
The Bottom Line
Analysts like to value logistics companies on EV/EBITDA, but that's difficult for XPO right now as the company's trailing EBITDA is negative and probably won't be positive until 2014. On a cash flow basis, though, that scenario I laid out above suggests a fair value around $25, even with the significant future dilution. Do remember, though, that the company will likely need to raise funds throughout this growth spurt, and that will alter the long-term fair value.
Clearly this is a very risky investment idea, with a large number of unknowns. More than anything, that's probably why the stock looks cheap today - you're taking on a lot of risk and uncertainty for what could be a remarkable growth story…or another lesson - the folly of trying to grow by aggressive M&A. While I don't own the shares myself yet, I have to admit that this stock looks more interesting than I expected, and it just may have a place in my portfolio as a speculative play on a sector that I've long liked but have struggled to find value-priced investment options.
Disclosure: I 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.