When I last wrote on XPO Logistics (XPO) roughly a year ago, I wasn't all that interested in the shares due to what I thought was an overheated valuation. Little did I expect the chaos that would ensue, including a large M&A transaction that never happened, the loss of a significant chunk of business from Amazon (AMZN), significant high-level executive turnover, multiple EBITDA misses, and persistent questions regarding the company's working capital management and intrinsic growth capacity.
Although I still like XPO's less-than-truckload (LTL) trucking operations and I believe the contract logistics business may be underappreciated on its long-term leverage to e-commerce fulfillment, I don't like the debt-funded share buybacks, and I think the macro picture is getting more challenging. On the other hand, there's a sizable short position here and the market could reward performance that simply meets expectations in 2019. On top of that, today's valuation seems to only be anticipating low single-digit long-term FCF growth.
Results Still Showing Some Stress In The First Quarter
XPO's first quarter results weren't as much of an improvement from the recent trend as I'd hoped to see. Revenue missed by about 3% and while reported adjusted EBITDA beat by 2%, results were inflated by a gain on sale and the underlying result was a 4% miss.
Revenue rose about 2% on an organic basis, with 8% growth in logistics offsetting 4% contraction in transportation. Freight brokerage declined by 13%, managed transport declined by 9%, last mile declined by 6%, and global forwarding declined by 6%, while Europe was up 1% on a reported basis. Less-than-truckload was a relative bright spot, rising 1%, though underperforming the better than 6% growth rate of Old Dominion (ODFL); both had a similar performance in tonnage, but ODFL did much better with realized pricing.
Gross margin improved by more than two points, helping drive 4% growth in adjusted EBITDA (and 40bp of margin expansion). By segment, transportation EBITDA rose 3% (70bp of margin expansion), while logistics grew 4% with 10bp of margin expansion. For the LTL business, operating ratio improved 20bp qoq (versus a 130bp deterioration at ODFL), but XPO still lags this rival by about eight points.
New business grew 15% in the quarter and management reiterated its revenue and EBITDA growth guidance for the year, a welcome note of stability after two relatively rapid downward revisions in December and February.
Growth Headwinds Not Getting Any Lighter
XPO surprised the Street in the fourth quarter with the announcement that it lost roughly $600 million in business from Amazon for postal injection services - while I don't believe XPO has ever explicitly identified Amazon as the customer, there really isn't another company that could have been doing that much postal injection business with XPO. With the company announcing that it is discontinuing postal injection, the prospects for this business coming back seem virtually nil.
Amazon's move may have been motivated by XPO's increasingly explicit efforts to offer e-commerce and retail customers logistics and fulfillment services directly in competition with Amazon's logistics services. Whatever the case, it represents the loss of a sizable piece of relatively profitable business, and it comes at a time when replacing that business is getting more challenging.
The outlook for Europe is uncertain at best; several multi-industrials reported in the first quarter earnings cycle that conditions were deteriorating there, and the stresses from Brexit in the U.K. and weaker GDP in France aren't abating.
In the U.S., freight markets are definitely slowing. ODFL and other LTLs have seen inarguable fading momentum in tonnage (for XPO, tonnage was down 3% in Q1, down 0.3% in Q4, down 0.6% in Q3, and up 0.1% in Q2), and ODFL has talked about more competition in pricing. For XPO's part, the company noted pressure on renewal rates, with contracted pricing rising 3.7% in Q1 after rising 4.9% in Q4'18. If and when the U.S. economy slows further, it will pressure demand for trucking, brokerage, and other XPO services.
Longer term, though, I do still think highly of XPO's last-mile and logistics opportunities. XPO is building up a respectable alternative to Amazon for e-commerce companies, and with an "arms race" in terms of next-day/two-day shipping, smaller players who can't afford their own logistics infrastructure could turn to XPO to stay competitive. XPO also continues to invest in technology, including a cloud-based digital marketplace (XPO Connect) and cobots - the latter can improve pick rates by 3x or more, with lower error rates.
More Than A Few Questions Linger
XPO has always been a controversial name, and management has yet to put that behind it. While the company had spent most of the first half of 2018 talking up its plans for a large, transformative M&A transaction, nothing ever happened and when the share price collapsed in the fourth quarter of 2018, management instead launched a huge buyback effort well in excess of what it could support with current cash flow (in other words, it borrowed to buy back shares).
Management turnover has fueled concerns, as the company saw four executives leave in a relatively short period - including the head of the LTL business, the CFO, and the Chief Strategy Officer. More bizarre was the COO situation. XPO's hiring of Kenny Wagers from Amazon in April of 2018 was considered a coup at the time, and there was some speculation that Amazon's cancellation of its postal injection business with XPO was a retaliatory move, but then the company fired him (without cause) in mid-March, claiming that the role had been created in anticipation of that large M&A move and that the position wasn't needed without that deal in place.
On top of that, management's policy of funding growth (particularly in Europe) by factoring and securitizing accounts receivable remains controversial (even though it's pretty common in European logistics), and there's some worry about the entrance of J.B. Hunt (JBHT) and Ryder (R) into the last-mile logistics market, though I agree with management that they're likely to be more responsible competitors over time than the smaller, fragmented players that lack scale.
For all of the chaos in 2018, XPO's final performance wasn't so different than I'd expected - full-year revenue was within $21 million of my estimate (a 0.1% difference), EBITDA was 3.5% below my expectation, and FCF was about 7% better than I'd modeled. Even so, I'm choosing to lower my near-term expectations on growing macro stress/headwinds, and lowering my longer-term revenue growth expectations on what I believe will be a more conservative plan from here (I don't normally model M&A, but XPO had been an exception).
With those changes, I'm expecting long-term revenue growth on the lower end of the mid-single-digits and FCF growth on the higher end of the mid-single-digits. Those assumptions support a fair value well above today's price. Turning to EV/EBITDA, I've chosen to go away from historical norms for logistics businesses (a sum-of-the-parts of comparable historical multiples for forwarders, logistics, LTLs, and so on) and instead base my EBITDA multiple on three-to-five year expected EBITDA growth. With that, my multiple falls to 7.5x, leading to a fair value of around $67.50 today.
The Bottom Line
There's plenty of room to debate how much of a public company management's time and energy should be spent addressing investor worries as opposed to managing the business how they think best. In the case of XPO, there have been worries and doubts about this business from day one, even though I'd argue that the company's efforts in logistics and LTL trucking show it can execute and run these businesses well. Without a steady run of clean results, those doubts won't go away, but I believe today's valuation offers pretty interesting upside even with growing macro worries.
Disclosure: I/we 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.