It's time we discuss XPO Logistics, Inc. (NYSE:XPO) again. This transportation giant is looking to spin off its brokerage business this year to unlock more value in both its new business and its remaining less-than-truckload ("LTL") business. In March, I covered these opportunities and made the case that XPO was significantly undervalued. Since then, the stock has lost more than 30% of its value as the S&P 500 has come close to bear market territory. The problem, as usual, is that during these market moves, investors lose some sense of rationality as panic selling sets in.
The goal of this article is to re-assess the situation in light of a changing macroeconomic environment and to discuss the best ways to deal with (almost) obviously undervalued companies in times of high volatility and uncertainty.
So, bear with me!
Let's start with the economy, which triggered me to write this article as it influences the valuation so much. What we're dealing with is a mix of headwinds that are just too much for the (global) economy and investors' willingness to take risks.
The Wall Street Journal headline below sums it up quite well. Inflation and rising rates are doing a number on global growth at a time when supply chain issues remain persistent.
If we ignore unprecedented lockdowns in 2020, we're in one of the most challenging macro environments since the Great Financial Crisis. Consumer price inflation is above 8%, consumer sentiment is falling off a cliff, and supply chain issues are not fading as China started to lock down major cities again on top of the war in Ukraine, which is causing food prices to soar (among other factors).
Now, this is causing manufacturing expectations to drop. Using the average of the New York manufacturing index and the Philadelphia Fed manufacturing index, we see that manufacturing growth is expected to turn into contraction. This will more than likely result in a sub-50 ISM manufacturing index and lower orders.
Yesterday, I tweeted the results of the Richmond Fed manufacturing survey, which showed the risks (in this case) the U.S. economy is facing.
The manufacturing index fell from 14 to -9. In this case, new orders were down as well (from 6 to -16). New orders were the driving force of the economy since the end of the 2020 lockdowns. Back then, supply issues were the main problem. Now, demand is also an issue. Note that the backlog of orders is also contracting. One item that did not contract was "prices paid," which increased to a new high. That's the only thing that actually had to fall in order to give us at least some good news.
To make things worse, the Federal Reserve is now aggressively hiking rates to combat inflation. The market assigns a higher than 50% probability to the likely hood of the Fed rate coming in higher than 275 basis points on February 1, 2023.
Now, with that in mind, let's look at XPO Logistics.
One of the things I've often mentioned is the ability of the XPO stock price to inflict serious pain on investors whenever economic growth declines. Right now, the stock is roughly 45% below its all-time high, which makes it the fourth serious decline since the Great Financial Crisis. Back then, the stock fell as much as 80%. After that, three declines between 50% and 60% followed.
Incorporated in 2000, XPO was young when the Great Financial Crisis hit. After that, it accelerated acquisitions, which caused its debt load to rise. Hence, economic downturns lead to drawdowns of 50% to 60%. The pandemic saw a similar drawdown as demand imploded.
The graph below shows that sell-offs are not random. XPO perfectly follows the economic trend - in this case, represented by the manufacturing average I used earlier in this article.
Solely based on this (important) chart, it's fair to say that a lot of economic weakness has been priced
Now, the company is in a different spot.
The worst thing about XPO is that it's prone to selloffs during economic downturns. The best thing about XPO is that it's one of the best transportation companies in the world. A period of aggressive acquisitions has now led to XPO having one of the most advanced business models in its industry. The company is one of the largest providers of LTL transportation in North America, it is the fourth-largest truck broker in North America with more than 90% of its 2021 operating income coming from North American LTL and truck brokerage.
The company has 731 locations, employing more than 42,000 employees while serving more than 50,000 customers.
When including its financials, it's fair to say that XPO is a proven operator bringing a lot of value to the table. However, please be aware that the numbers below include the 2021 GXO Logistics (GXO) spin-off. If it weren't for that spin-off, the numbers would be higher. So, that's why the uptrend isn't steeper.
On May 9, 2022, the company reported record revenue while raising its guidance (back then, supply chains were already an issue):
"We're executing on multiple avenues for value creation - the spin-off of our tech-enabled brokered services platform, the sale or listing of our European business, our continued deleveraging, and company-specific initiatives for the ongoing transformation of our North American LTL business," CEO Brad Jacobs said. "We continue to expect our adjusted operating ratio to inflect to year-over-year improvement later this quarter, with an improvement of more than 100 basis points for the full year. We plan to drive hundreds of additional basis points of improvement in the coming years."
With that said, the company is on pace to do close to $580 million in free cash flow next year. This implies a free cash flow yield of almost 11% using the company's $5.5 billion market cap.
The company isn't paying a dividend, which means surplus money is used to reduce debt and occasionally buy back shares as the cash flow chart below shows.
As a result of accelerating free cash flow and a focus on streamlining the business instead of acquired growth is resulting in a steep downtrend in net debt. Excluding future spin-offs (I will discuss that in this article), the company is expected to lower net debt to less than $3.0 billion in 2022. That will likely imply 2.2x EBITDA. On April 9, 2022, the company redeemed $630 million of $1.15 billion in outstanding 6.250% Senior Notes due 2025. The company can now finally get rid of expensive debt, replace it with lower-yielding debt, and clean up its balance sheet.
Prior to the pandemic, the net leverage ratio was consistently close to 3.0x EBITDA. In 2024, this number could be 1.4x EBITDA, meaning its business opens up new possibilities to acquire new growth with more "in-house" funding, buying back shares on a consistent basis, or even paying a dividend.
With that said, the numbers above are prone to a major adjustment as the company is spinning off its brokerage business after spinning off its next-gen warehousing business in 2021 (GXO Logistics).
XPO Logistics will spin off its truck brokerage business, which will result in "RemainCo" being a pure-play LTL company with proprietary technology and other "company-specific" levers to enhance efficiency and growth.
In this case, it's a win for RemainCo and SpinCo as both get to focus on their core businesses, which comes with a higher valuation.
This is the spin-off valuation example I gave in my last article:
Let's assume a company is specialized in baking cakes for wholesale like Costco (COST). It's where 90% of its income comes from. However, the company is also building its own cake-making machines (I'm sorry for my very basic example) that allow producers of cakes, pastries, and bread to produce their products more efficiently. The total company is probably valued at 8x EBITDA because of its slow-growing business. This includes its high-tech machines that could change the industry. Now, if the company were to spin off its machinery segment, it could trade independently at a 15x EBITDA margin because it's fast-growing without a lot of competition.
The best thing is that XPO is criminally undervalued right now. The company has a market cap of $5.5 billion, $2.6 billion in expected 2022 net debt, and $120 million in pension-related obligations. This gives us an enterprise value of $8.2 billion. That's just 5.7x next year's expected EBITDA. The valuation has (almost) always bottomed close to 6x NTM EBITDA.
This valuation does not make sense the way XPO has shaped its business, and it most certainly doesn't make sense when it spins off its brokerage business. After all, at that point, investors can apply specific valuations to brokerage and LTL. Given the growth rates of both businesses, I have no doubt that both need to be valued at least 8-10x EBITDA. And that's conservative.
In my previous article, I made the case that the company should trade at 11x EBITDA and gave the stock 60% more upside until "fair" value.
That would imply a price of $115 per share. I'm sticking to that.
With that said, and to use the words of John Maynard Keynes:
Markets can stay irrational longer than you can stay solvent.
I don't know where the bottom is. What I do know is that markets will eventually give stocks the value they deserve. So, my advice remains to break up an initial investment into pieces. Buy, i.e., 25% now, and add regularly over time. If the stock falls further, investors can average down. If the stock takes off, investors have a foot in the door.
Either way, we're not dealing with a 2020 growth stock that is now more or less worthless, but a stock that suffers when economic growth declines. XPO's business remains as solid as ever and even slower than expected growth will not change the fact that this risk/reward is great.
In this article, I tried to achieve two things. First, to discuss why XPO is down, and what its performance means for the risk/reward. Because of a vicious mix of economic headwinds, investors are de-risking their portfolios. So far, this has pushed the XPO stock price roughly 45% below its all-time high.
Second, we looked at the company's financials and spin-off plans. Unlike a lot of poor-quality stocks that are currently suffering, XPO has a tremendous business behind the stock price. Free cash flow has accelerated, debt has become more than sustainable, and spin-off plans are about to unlock a lot more value - both in terms of operating efficiencies, and in terms of stock market valuations.
The only reason why I haven't bought XPO yet is my already high transportation exposure and the fact that I spent cash on long-term dividend investments in the past few weeks. Depending on my income in the next 2-3 months, I will buy XPO.
(Dis)agree? Let me know in the comments!
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
Additional disclosure: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.