Having recently finished reading the book The World is Flat by Thomas Friedman, I have found myself searching how to apply the “globalization paradigm” to my portfolio management process and how to incorporate these trends into a more thoughtful view of the investment landscape.
One clear observation I have made is that jobs and growth are headed overseas, so a forward thinking investor ought to position their portfolios to benefit from this inevitable shift of capital. That said, for the enterprising analyst, there are certainly pockets of opportunity within the US markets. One industry that arguably cannot be “outsourced” is transportation, you simply cannot outsource the infrastructure, assets, and human capital involved in delivering goods along American highways, waterways, and railroads. This realization has led me to focus my screening in that sector.
Using a disciplined screening process focused on valuation, return on capital, and growth, I discovered Pacer International, the worlds largest inter-modal transportation company. Pacer is an asset-light transport, meaning that it does not own hard assets, like trains and trucks, but instead, most of its assets are in information technology and deeply entrenched relationships with the railroads and shipping companies. This, by nature, leads to higher returns on capital, and positions them favorably at the end of economic cycle, when the asset heavy players see steep profitability declines as businesses become over-capitalized.
Inter-modal refers to the process of moving a container or trailer via more than one mode. Essentially, Pacers fleet of leased containers are able to be transported via rail or truck, eliminating the need to load and unload the vehicles. PACR also has a patented system known as “double-stacking” which, logically, allows containers to be stacked one on top of the other, enabling more goods to be transported along rail routes.
The value proposition that PACR presents is their economies of scale. PACR has the ability to contract large container volumes at discounted prices, and therefore offer customers more cost effective methods of sending and receiving goods. Smaller, regional chains do not have the buying power to realize such discounts and therefore use Pacers services. Furthermore the company handles the logistics and supply chain functions needed to transport the goods from the factory floor, to the retail level. Imagine a small sporting goods company that sells golf clubs. Golf clubs manufactured in China, will arrive via ship to the port of Los Angeles. PACR will handle getting the products through customs, warehouse the items, and using information technology, load items onto appropriate containers, based on varying levels of demand. From there, the goods will move via Pacer railroad containers to Atlanta, Chicago, New York, etc, and at this point the containers will seamlessly disperse, this time pulled by heavy duty trucks that bring the goods to their final, regional destinations.
The economies of scale, IT infrastructure, and entrenched relationships with suppliers (railroads) and customers (mostly retailers), provide a powerful competitive advantage for Pacer.
In addition to their strong competitive advantages within the inter-modal industry, the following trends should also act as a “wind in the sails” for PACR
1. Cost effectiveness (Fuel Costs) - Higher energy costs and increasingly higher trucking rates driven by labor shortages (do you know any 18 year olds clamoring for a truck-driving career)and regulatory changes have made this mode of transportation significantly more cost effective than Truckload and Less-than-Truckload transportation. For perspective, consider that transporting one ton of goods via rail is 40% cheaper than trucking the same amount of deliveries.
2. Container Imbalances - Asian Imports - An increasing amount of goods coming from Asia is creating an imbalance of containers, increasing the value of the service. Nearly 3 deliveries moves eastward across the US for every delivery that moves westward. Asian shippers do not want their containers traveling across the country only to come back empty. PACR on the other hand can use its extensive network of customers and delivery routes to more effectively utilize the volume.
3. Railroad Improvements - Improving service levels from railroad operators - a major criticism of the stock has been its reliance on habitually unreliable railroad companies. This is changing. The railroads have spent a tremendous amount of capex in recent years to incorporate technology that limits service interruptions and bottlenecks.
From a fundamental perspective, the investment looks compelling as well. PACR is expected to earn 2.00 next year, a 14x multiple, based on its current $28.00 handle. Other non-asset based transports are trading at over 25x, which is a historically wide discount for PACR. Based on a conservative DCF model, assuming 15% growth in free cash flow, and a 12% discount rate, the shares appear over 30% undervalued. The company should earn a 15% return on its capital this year and deliver over 100mm in free cash, about 10% of its market value. Furthermore, the company is expected to grow at a 14% rate, and judging by a recent string of positive earnings surprises, the consensus may be low.
Charts of key metrics are below; click to enlarge:
While most of the talking heads on CNBC will probably tell you this is a bad time to invest in cyclical transports, which typically under-perform at the end of an economic cycle, I would disagree. If I had a dollar for every portfolio manager that thought they could accurately predict the economic cycle I would be a rich man, I have yet to find someone who can consistently time these peaks and valleys. A more thoughtful investor however might use all this pessimism to find some bargains to add to their portfolio. PACR offers investors a reasonably priced stock, well positioned in a bottlenecked industry, with some very favorable long term trends that should enable them to sustain healthy growth. In an increasingly “flat” world that’s becoming more and more unpredictable, I’m using these dips to patiently construct a portfolio of well positioned companies in defensible markets, a strategy that should outpace the market over the long run.
Related: more long stock ideas.