This Trucker Is Loaded To Deliver Terrific Returns

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Lowered expectations, regardless of how slight, can have a devastating impact on a stock, as Wall Street flees in search of what it hopes are better opportunities. That wasn't the case with the shares of Knight Transportation (NYSE: KNX), however, with the price actually rising in the three days since management lowered its earnings guidance for 2013's second half. This resilience is illustrative of the company's many positive attributes and attractive valuations, in our view, and we believe the relatively unknown mid-cap ($1.3 billion) merits consideration by investors.

Knight Transportation, Inc. is one of North America's largest truckload transportation providers, offering a broad range of truckload services through a nationwide network of service centers, one of the country's largest company-owned tractor fleets, and contractual access to the fleets of thousands of third-party equipment providers. The 24-year-old company has grown substantially by increasing the geographic reach of its service center network and by expanding the breadth of services. This growth is reflected in a revenue base that's increased from about $13 million in 1991 to $936 million in 2012, and a fleet that has expanded from just a handful to more than 3,500 tractors. Equally impressive, Knight has been solidly profitable throughout its history, adeptly managing to stay in the black through multiple economic cycles. Indeed, unlike many poorer-capitalized rivals, the trucker fared reasonably well even during the "Great Recession," although per-share earnings did slip modestly during that difficult period.

Knight Transportation has been profitable every year since it went public in October 1994. That's not all, both revenues and share net have compounded at a double-digit annual rate since then, with the latter rising every year but three (2007, 2008, and 2009). Management has been able to adapt quickly to changing economic circumstance and have kept operating ratios consistently in the mid- to low-80% range, thereby allowing the company to generate a profit year after year. A rock-solid balance sheet, with stockholder equity of $518.0 million as of June 30, 2013, compared with debt of just $26.0 million, and a healthy (and dependable) cash flow have certainly helped, too, supporting both the continual upgrade of equipment, which appeals to shippers and drivers, and the occasional opportunistic acquisition. Looking forward, we think Knight will be able to maintain the earnings rebound that began 2010, and resulted in record share net in 2012 (albeit by a mere penny), well into the future. Our optimism is based on the expectation that the U.S. economy will continue to revive gradually, while noting that difficult operating conditions give stronger operators like Knight the opportunities to gain market share from rivals that don't have the financial and competitive staying power. Our long-term earnings projections also assume operating margins will regain some three to four percentage points over the next three to five years; margins were consistently above 30% before the financial crisis but have been closer to 20% in recent years. Finally, the bottom line should benefit from a stock buyback authorization that still has 7.4 million shares remaining for repurchase; this is probably subject to an ongoing effort to acquire USA Truck, which is discussed below.

In addition to be highly competent, Knight's management is shareholder friendly, returning more than $80 million in the past two-and-a-half years through stock repurchases and dividends. With respect to the latter, although the indicated yield is 1.4%, the company distributed special dividends of $0.75 and $0.50 a share in the fourth quarter of 2010 and 2012, respectively. The stock, meantime, looks quite attractive, selling at valuation levels that are very low on a historical basis, reflecting earnings that have risen while the stock has traded in a relatively narrow price range for almost eight full years. The dividend yield is near all-time highs, while price-to-book value and price-to-cash flow are near all-time lows. And perhaps most important, the current price earnings ratio of 18.8 is considerably below the 24.7 average of the past 15 years; the data points for the average range from a low of 14.3 to a high of 27.7, and the average in 10 years exceeded 23.0. Knight Transportation has been on Forbes Magazine's list of Top 200 Best Small Companies for 15 years in a row, and we think its stock will outperform most others over the next three to five years - about doubling in price.

The Company

Knight Transportation, Inc. is a leading provider of multiple truckload transportation services, generally involving the movement of full trailer or container loads of freight from origin to final destination for a single customer. The company was founded in 1989 as a provider of dry van truckload services but diversified over the years to also provide temperature-controlled truckload (through Knight Refrigerated, LLC), dedicated truckload, drayage (Knight Port Services, LLC), intermodal, and truckload freight brokerage services. Through its multiple service offerings and transportation modes, the Phoenix, Arizona-headquartered concern is able to transport, or arrange for the transportation of, general commodities for customers throughout the United States and parts of Canada and Mexico; revenues generated in the North American neighbors are minimal. Although operations are conducted through five segments, there is only one reportable segment, since all of the businesses have similar economic characteristics and are exposed to the same competitive, operating, financial, and other risk factors.

Knight has one of the largest company-owned tractor fleets in the country, operating out of a nationwide network of (29) service centers. As of December 31, 2012, it operated 3,627 company-owned tractors, with an average age of 1.9 years, and had under contract 507 tractors owned and operated by independent contractors. The trailer fleet consisted of 9,564 53-foot long trailers, with an average age of 5.5 years, and included 1,092 temperature controlled trailers. The trucker also has access to the fleets of thousands of third-party equipment providers. At the end of last year, the company had 5,176 employees, of which 4,197 were drivers, none of them unionized. Knight's diverse and premium services support a diversified customer base. In 2012, the top 25 customers represented approximately 38% of total revenues, and the top 10 accounted for about 23%. No single customer represented more than 4% of aggregate revenues.

Operating Strategy

Management seeks to grow truckload market share by leveraging its diverse service offerings, extensive relationships, and nationwide service center network, and to improve asset productivity through enhanced technology and market knowledge, while maintaining a tight focus on cost. To achieve these goals, it operates primarily in high-density, predictable freight lanes in select geographic regions, and attempts to develop and expand the customer base around each of its service centers by providing multiple truckload alternatives to customers. This allows the company to take advantage of the large amount of truckload freight transported in regional markets. The decentralized service centers, meanwhile, enable both better customer support and drivers to stay closer to home. Knight's operating strategy is also supported by a modern fleet and state-of-the-art information technology, which also appeals to drivers and customers, reduces maintenance expenses and downtime, and enhances operating efficiencies.

Multi-Pronged Growth Strategy

Knight Transportation's revenues have expanded robustly through most of its history, including at a decent double-digit rate over the past 10 years. Historically, a substantial portion of the expansion has derived from entry into new geographic regions through the opening of additional service centers. A broadening of service offerings has certainly aided the top-line advance. And the internally generated growth has been augmented by multiple acquisitions; since 1999, four short-to-medium haul truckload carriers or all of their trucking assets have been acquired. Management's current growth strategy revolves around the following five areas, in addition to continuing to seek opportunities to open more service centers:

Ø Expand existing service centers - focus on developing and expanding existing service centers by strengthening customer relationships, recruiting quality drivers, adding new customers, and expanding the range of truckload solutions offered from these service centers.

Ø Improve asset productivity - focus on improving the revenue generated by each tractor and trailer, meaning maximize both miles driven and rates charged.

Ø Strengthen customer relationships - focus on marketing services to both existing and new customers in freight lanes that complement the company's existing operations. To existing customers, the goal is to have them use as many of Knight's services as possible.

Ø Diversify service offerings - each of the company's complementary truckload service offerings produced revenue growth in 2012, and management is looking to continue investing resources to build on the range of solutions to offer its customers.

Ø Acquire selectively - as noted above, the company has a history of supplementing internal growth through extraordinary transactions, and more are likely going forward.

Significantly, Knight is one of the few large-scale truckload transportation providers that have established a foundation that can support substantial growth. The foundation extends to the geographically diverse service center network, which could support an appreciable increase in freight volume, regional management talent, which is fostered by a decentralized organizational structure, and a state-of-the-art nationwide communications and information infrastructure. At the same time, the company also benefits from the economies of scale that derive from the centralization of certain business functions.

Key Revenue and Expense Variables

Knight generates most of its revenue by transporting freight for its customers. The company is generally paid a predetermined rate per mile or per load for its services. Additional revenues are derived from charging for tractor and trailer detention, loading and unloading activities, and other specialized services. The collection of fuel surcharges to mitigate the impact of increases in the cost of fuel also adds to the top line. The main variables that affect revenue are the rate per mile received from the customers, the percentage of miles for which it is compensated, and the number of loaded miles generated by the trucker's equipment. These factors, in turn, are influenced by general economic conditions in the United States, customer inventory levels, specific customer demand, the level of capacity in the trucking industry, and driver availability.

The most significant expenses in Knight's business include fuel, driver-related expenses (such as wages, benefits, training, and recruitment), and costs associated with independent contractors and third-party equipment providers. Other significant expenses include maintenance and tire expense and the cost of insurance and claims. These expenses generally vary with the miles traveled, but they also have a controllable component based on safety, fleet age, efficiency, and other factors. The company's primary fixed costs are the acquisition and depreciation of long-term assets, such as revenue-generating equipment, service centers, and the compensation of non-driver personnel. In 2012, labor-related outlays constituted 25.5% (25.3% in 2011) of total revenues including fuel surcharges, while fuel, depreciation/amortization, and purchased transportation costs accounted for 24.6% (26.1%), 9.1% (8.8%), and 15.8% (14.9%), respectively. On a revenue before fuel surcharge basis, the comparable figures are 31.7% (31.3%), 6.2% (8.3%), 11.3% (10.9%), and 19.7% (18.5%).

Controlling expenses effectively is a critical element of ensuring a trucking company's profitability. As such, the primary measure used to evaluate profitability is the operating ratio of the business, excluding the impact of fuel surcharge revenue (operating expenses, net of fuel surcharge, as a percentage of revenue, before fuel surcharge). Knight's focus since inception and an important element of its operating model has been on cost per mile. And this extreme focus on expenses extends to all its service offerings and in evaluating acquisition opportunities.

Competitive Dynamics

The freight transportation industry is highly competitive and fragmented. Competition comes mainly from other truckload carriers and logistics companies, but shippers can also have the option of using railroads and air freight providers. The principal competitive factors in the business are service, efficiency, pricing (or rates), the availability and configuration of equipment that satisfies customers' needs, and the ability to provide multiple solutions. Significantly, many truckload carriers are poorly managed, financially challenged, and operate aging fleets that are cost-inefficient.

The truckload market, meantime, has been difficult for some time, hurt by rising prices for diesel fuel, sluggish demand for freight, and pricing weakness, all of which are out of a trucker's control. A continuation of this operating environment should allow the better-managed, well-capitalized players, like Knight, to capture additional market share. Significantly, too, when conditions do ultimately improve, the survivors will be in a position to thrive in a market that will be characterized by reduced truckload capacity and increased freight demand.

A Pending Takeover Has Positive Implications

On September 26, 2013, Knight Transportation made a hostile bid for USA Truck Inc. (NASDAQ: USAK), having failed in the preceding four weeks to negotiate a friendly transaction. The suitor is offering $242 million, factoring in the troubled short-haul carrier's roughly $146 million in debt. Under the terms of the proposal, USA's equity holders would receive $9 per share in cash. This represents a 39% premium to the stock's closing price on the day before the public announcement of Knight's proposal and a 58% premium to the closing price on August 27th, the day before the proposal was initially made to USA's board of directors.

USA Truck has generated revenues of more than $500 million in each of the past two years and the top line will most likely exceed the half billion dollar mark this year too. Its bottom line has been in negative territory in each of the past three years, however, with losses totaling almost $32 million. Moreover, despite ongoing turnaround efforts, results for the September and December periods will probably mark the ninth and 10th consecutive quarters of red ink. The difficult operating environment is exacting a far steeper toll on USA Truck, vis-à-vis Knight, given its higher cost structure and far weaker financial position; Knight's consolidated operating ratio in 2013's first half was 85.3% while USA's was 101.7%; debt constituted 58% of USA's total capital at the end of June, a far cry from Knight's 19.9 to 1 equity to debt ratio.

The suitor has an 11.3% equity stake in the target and has expressed a willingness to raise the price modestly. USA Truck rebuffed another potential buyer, Celadon Group, in October, 2011, without even talking with the larger rival, so it's difficult to know whether a transaction will ultimately transpire. All that said, the acquisition, assuming it's concluded without the price rising too much, would undoubtedly have very positive implications for Knight. The two companies operate in complementary service lines and there's appreciable overlap in their service networks. Moreover, operational improvements and the benefits afforded by a stronger balance sheet - including cheaper credit - would probably allow the prospective addition to quickly be accretive to earnings. Last, increased capacity would certainly be welcome if the industry is indeed near an inflection point, in terms of better pricing fundamentals, as many believe. Note, though, that our earnings estimates and projections exclude the possible transaction, pending further developments.

A Solid Financial Record

Knight Transportation has been solidly profitable every single year since it went public in the fall of 1994. This period includes the recessionary years of 2001, 2007, 2008, and 2009. Revenues compounded at a double digit rate over the past 15 years, as did per-share earnings, which, excluding nonrecurring items and adjusted for four three-for-two stock splits, rose from $0.14 in 1997 to $0.85 in 2012. The bottom line advanced in all but three of those years, all of which were affected by the "Great Recession," and last year's tally marked an all-time record high. Noteworthy, too, is management's ability to quickly adjust to changing circumstances, as reflected in an operating ratio (excluding fuel surcharges) that didn't stray more 75 basis points from the 85.0% mark in any of the past five years.

In 2012, revenues, including fuel surcharges, increased 8.1%, year over year, to $936.0 million. Excluding the surcharge, the top line rose 7.9% to $752.2 million. Net income, meantime, excluding a five cent-a-share nonrecurring noncash charge, increased from $60.2 million to $68.0 million, representing a year-over-year gain of 12.9%. On a per share basis, earnings advanced from $0.74 to $0.85, up 14.9%, with the bottom-line comparison aided by treasury activities that reduced the number of diluted shares outstanding by 2.3%. Freight demand and industry-wide supply of tractors and trailers were in relative equilibrium during the year, but revenues got a boost from the occasional surges in freight demand that resulted in an overall increase in freight rates. An increase of 188 tractors (to 4,096) in the average number of tractors operated helped, too, as did gains generated by the company's non-asset based businesses, reflecting continued progress in management's efforts to expand the number of services utilized by its customers. The operating margin, meantime, widened by almost 80 basis points, bolstered by improvements in the freight mix and contract pricing.

Expectations for 2013 and Beyond

Knight's revenues in the first half of this year totaled $480.2 million, 5.3% higher than in last year's comparable six-month period. The total revenue included $90.5 million of fuel surcharge revenue, little changed from the $91.4 million tallied in the year-earlier period. Excluding the fuel surcharge, revenues were up 6.9%. Most of the trucker's growth in the year's first six months derived from its less capital intensive, non-asset based operations, such as brokerage and intermodal. In the second quarter, for example, the non-asset based service business, which now accounts for roughly 20% of aggregate revenues, generated growth of 64.2%. On the flip side, however, top-line contributions from the asset-based operations declined 2.5% in the quarter, reflecting both the sluggish freight environment and an increasingly competitive driver market. Per share earnings were up a mere 2.4% in the half, as the challenges - sluggish freight demand, pricing weakness, and a tough driver market - in the core business resulted in the consolidated operating ratio increasing by .6 percentage points, to 85.3%. It's important to note, too, that the non-asset based businesses generate inferior margins; they are improving, though.

On October 8th, management lowered its earnings guidance for this year's third and fourth quarters from $0.22-$0.24 and $0.22-$0.25, respectively, to $0.18-$0.20 and $0.20-$0.23, due to softer-than-anticipated freight demand and challenges related to recruiting drivers. Importantly, however, the company noted that there was some improvement in recent weeks, on both fronts. The lowered expectations indicate that share net for all of 2013 will be flattish to down a penny or two, vis-à-vis last year's tally.

Looking beyond this year, we expect demand for truckload freight to improve based on a moderately expanding economy. Moreover, the U.S. Department of Transportation Federal Motor Carrier Safety Administration's Compliance Safety Accountability ("CSA") program, which has imposed a series of new mandates, including hours-of service rules and pending electronic on-board recorders, could result in a reduction in effective trucking capacity to serve increased freight demand. As well, in an ironic twist, an improving macroeconomic environment could create a shortage of drivers, as some might find better employment opportunities elsewhere, disproportionately hurting the smaller weaker competitors and better positioning the upper tier operators. All things considered, the prevailing trends suggest Knight Transportation will in the years ahead have opportunities to grow market share and generate better yield. Our earnings estimate for 2014 is $1.05. Looking further out, we think the company could earn around $1.65 in the outer years of our three- to- five-year projection horizon. (Note: Our projections assume continued execution of the stock repurchase program. But success in acquiring USA Truck would undoubtedly result in a marked slowdown in this activity.)

The Final Word

The trucking business has been challenging in recent years and the long-anticipated improvement in shipping demand and pricing may materialize later than expected. As well, driver turnover, which is a long-standing problem, may be exacerbated by a strengthening economy that gives prospective hires superior alternatives. Significantly, though, the driver issue could prove to be a long-term positive for Knight, as it could end up shrinking industrywide capacity. A slower-than-expected revival in the industry's business fundamentals could prove a long-term positive for the Arizona-based trucker, too, since some of the weaker competitors may well be forced out of business. As for things that are more in the company's control, it's important to keep in mind that management has a long and impressive track record of generating profits even during difficult times. Knight has a well-developed nationwide infrastructure in place and a well-defined strategy for staying on a growth track. A strong balance sheet and ample borrowing capacity are additional pluses, as is the stock buyback authorization, which ought to provide the shares with some support. All things considered, we think KNX shares could about double in price over the next three to five years. Moreover, a successful acquisition of USA Truck would probably cause us to raise our price targets.

Disclosure: I am long KNX. 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.