While these are boom times for truckers from an available volume and pricing strength standpoint, actually taking advantage of the boom is a different matter. Driver shortages are a challenge across the industry, and it has led to actual year-over-year declines in revenue for Heartland Express (NASDAQ:HTLD) as it can’t operate its fleet at full capacity. On top of that, there are growing concerns that 2022 will be the peak year for the cycle, leading investors to leave the sector for greener pastures.
These shares are down about 10% since my last update, underperforming rival truckload carrier Knight-Swift (KNX) and the Dow Jones Transports by a wide margin (around 35% and 27%, respectively). Although I do think that the market may be already pricing in a conservative outlook for the trucking industry, and these shares are close to a 52-week low, if I were going to take the risk of entering the sector now, I think I’d rather own Knight-Swift.
A Tough Second Quarter Due To Capacity Limitations
The underlying operating environment in the second quarter was fine from a demand standpoint, with carriers like Knight-Swift and Old Dominion (ODFL) (a less-than-truckload, or LTL, carrier, but still relevant) reported mid-teens pricing improvements in contract business against a backdrop of 30%-plus year-over-year growth in spot rate (not an especially large business for Heartland).
The issue has been, and remains, the ability to recruit and retain enough drivers to keep all the trucks moving.
Revenue declined 4% in the second quarter, or 8% excluding fuel surcharges, missing Street expectations by about 6%. Management had to turn down even more loads around quarter-end (around 11,000 to 12,000 a week) than at the start of the quarter (9,000 to 10,000), and considering where pricing was for the quarter, it seems reasonable to conclude that volume fell by a pretty substantial extent, as Knight-Swift saw 8% ex-fuel growth in Trucking with 19% yield growth and 7% contraction in utilization.
Heartland recaptured a lot through better operating leverage, though, with an in-line EPS number. Because of the impact of fuel and gains on sale (which Heartland treats as a recurring operating income item), comparisons are a little more challenging. Operating income rose 10% as reported, with gains on sale coming in higher than expected and boosting operating income by around 5%. Excluding those gains, operating income declined 10%, but the company still did a good job on core operating expense items.
As Heartland reports, the operating ratio improved 220bp year over year to 82.3%, while the “adjusted” operating ratio improved 330bp to 79.7%. Excluding fuel surcharges from revenue and gains on equipment sales (my own calculations), the operating ratio worsened by 40bp to 85.2%.
Internal Improvement Efforts Are Still Material
Heartland does have a few internal drivers worth watching in the near term.
Management continues to work on improving the operations of Millis, a business that the company acquired back in 2019. Relative to legacy Heartland operating ratios that managed quoted at the “mid-to-high 70%’s” for the second quarter, Millis remains in the low-90%’s, but the company continues to target an operating ratio of 85% or better (lower) by the end of Q3’22 – three years after the deal.
While further improvements in the Millis operations could have a material impact on results, it’s going to take work to get there and a driver shortage isn’t helping. Moreover, it’s worth mentioning again that for as efficient as Heartland is with its own operations, their history of identifying good acquisition targets and then successfully integrating them is not particularly good. I think that turns up the pressure on management with respect to Millis, as the market may well be pricing in that Heartland management has to “earn” the right to do further M&A down the line.
The second internal driver relates to driver recruitment and retention. While Heartland pays well (among the best per-mile rates) and keeps their fleet young, it’s a demanding place to work, and driver attrition has been an issue with past acquisitions (not so much on an internal organic basis).
Management recently altered its pay mechanism to include a framework for minimum pay, and that should help with retention. The fact remains, though, that there aren’t enough drivers to go around these days. Commercial truck drivers as a group were already skewing older before the pandemic, and many drivers have since decided to retire or find other jobs. In addition, insurance companies are insisting on better safety records and the Drug and Alcohol Clearinghouse is effectively disqualifying tens of thousands of drivers.
Last and not least, there aren’t as many as many new entrants into driving schools seeking to become commercial truckers. Higher wages will likely eventually fill that gap, but it could take quite some time – it’s certainly not a short-term fix.
I think it’s entirely possible that between ongoing high demand for trucking (including ongoing growth in e-commerce and the possibility of more onshoring/near-shoring of manufacturing and supply lines) and driver shortages, the peak of the cycle could get pushed late into 2022 or into 2023, and/or that we may see more of a “plateau” than a traditional peak.
I can appreciate that that may sound a lot like an “it’s different this time” argument, and I don’t want to undersell the risk that a cyclical decline is not too far down the road. Still, it’s hard to see how pricing weakens substantially given the volume/capacity challenges from the driver shortages.
Heartland is having a harder time navigating this environment, though, and that does lead me to reduce my revenue and EBITDA expectations. The FCF outlook is more uncertain, though, as Heartland may well not have to spend as much on new equipment if it doesn’t have the drivers to operate it.
If Heartland can generate low single-digit long-term revenue growth (in line with its historical experience) and push FCF margins from the low-to-mid teens to the mid-teens, the shares do look somewhat interesting here with a potential high single-digit long-term annualized return.
Likewise, the shares do not look overvalued on a P/E or EV/EBITDA basis, with an 18.5x forward multiple (in line with past trough forward P/E’s, corresponding with peaking forward earnings) supporting a price target of around $18.50.
The Bottom Line
This stock may very well be bottoming out, and leading the sector in doing so, so I wouldn’t seriously think of going short, but I don’t have enough confidence in the bull story to want to take the risk about being wrong about the larger sector cycle. Not only has Heartland had issues with past M&A, I don’t see the same diversification in growth opportunities here, and clearly the driver shortage is hitting them harder. It’s a name to watch in case it really is bottoming out ahead of other truckers, but I’d really want to see more good news on revenue/driver availability to go along with any sort of value/multiple-based call.