Times are starting to get tough in the trucking industry. High channel inventories and weakening end-user demand are undermining the demand side of the equation and there is now significantly more capacity in the market. With that, spot rates are falling and are likely to collide with (and then briefly go below) spot rates in 2023, or possibly sooner.
That’s not a great set-up for any trucking company, but Heartland Express (NASDAQ:HTLD) is more than just any trucking company. Heartland has a strong operating track record and a solid core of drivers and equipment that stand out in the industry, not to mention long-standing customer relationship. The company also has M&A synergy levers to pull in 2023 that I believe can help offset some of the sector pressures coming in 2023.
Heartland shares have slipped about 4% since my last update, outperforming Knight-Swift (KNX) and Werner (WERN) by about 5%, as well as outperforming the broader transportation sector (the DJT is down about 16% over that time). I don’t prefer Heartland to Knight-Swift, which I recently wrote about here, but I do see Heartland as undervalued and possessing some counter-cyclical attributes that could help over the next six to 12 months.
Heartland reported 80% revenue growth, or about 70% growth excluding fuel surcharges, and total revenue exceeded expectations by 11%. Given how little information management provides, it’s hard to dial in the source of the beat; it’s plausible that Heartland’s volumes and pricing held up better than expected, but it’s also plausible that the sell-side had mis-modeled the contributions from M&A (Smith Transport & CFI).
Operating income rose 4%, or 9% on an adjusted basis, with reported operating ratio worsening by 910bp to 87.3% and adjusted operating ratio worsening by 920bp to 83.7%. Heartland missed OR expectations by about 100bp, but operating income would have beaten expectations by 9% without costs related to the M&A deals. Heartland still managed to meet EPS expectations even with a greater than expected 20% sequential decline in gains on sales of used trucks (an ongoing item/business for Heartland).
Management said that they still see demand ahead of capacity, and that they expect single-digit contract rate increases in 2023, but that demand is softening and this year’s peak season is muted at best (both Knight and J.B. Hunt (JBHT) have basically said “what peak?” in reference to the typical Q4 seasonal peak).
Truck tonnage has remained healthy, up 9% in August and up 5% in September (non-seasonally-adjusted), but cracks are emerging. Spot rates are now down close to 30% year-to-date, and are less than 10% above operating costs per mile. In fact, the most recent dry van spot rate quote I’ve seen was a bit below 2019 levels and a couple of percentage points below the seven-year average.
There are other signs of impending trouble. The Logistics Manager Index was 61.4 in September and 57.5 in October, while the Transportation Capacity metric came in at 73.1, the highest-ever reading. Basically, inventory levels are very high now, particularly downstream of warehouses, demand for freight is declining, and there’s still a lot of trucking capacity out there. With that, tender rejections are now at a four-year low and in the single-digits (meaning that truckers are no longer turning down freight like they were a year ago).
Given all of that, I think Heartland’s projection of single-digit contract rate increases could be optimistic. Heartland management knows the business well, but given the weakness in the spot market, it’s hard for me to see how more of that doesn’t translate/transfer into contract rates in 2023.
Heartland has long been an acquisitive company, but the recent track record of deal integration has been mixed. The basic rationale is sound – acquire companies to build a national network of terminals and diversify the customer base, while taking advantage of cost synergy opportunities (since Heartland is one of the lowest-cost operators) – but synergy realization in some of the more recent deals has taken longer than initially expected.
Heartland acquired Smith Transport earlier this year for $170M, adding 850 tractors, and then announced the $525M acquisition of TFI International’s (TFII) Contract Freighters Inc. (or CFI) non-dedicated U.S. dry van and temperature-controlled assets and the CFI Logistica Mexican operations.
The CFI deal pushes Heartland into the top-ten among truckload carriers (#8) and boosts the tractor count to 5,550, while also adding more Midwestern exposure (particularly the north-south corridor), temp-controlled exposure, and Mexican logistics capabilities that include truckload, less-than-truckload, brokerage, and freight consolidation services. I’d also note that this wasn’t the first time Heartland tried to acquire CFI, so it’s a business that Heartland knows and wanted for some time.
At the simplest level, acquiring two businesses with operating ratios in the low-90%’s gives Heartland familiar expense leverage/synergy opportunities as they will work to drive ORs into the mid-to-low-80%’s over the next three years. Beyond that, I like the further diversification and expansion of the truckload operations, as well as the expansion into Mexican logistics. This is more of a step into the unknown for the company, but should be a significant growth opportunity given the ongoing growth in cross-border traffic.
With the added revenue from M&A, Heartland should see significant reported revenue growth next year, although I do see risks to the core business (rev/mile and loaded miles) given the aforementioned pressures on truckload operators. Longer term, I expect low single-digit core revenue growth, but there could be upside here if Heartland decides to expand further into logistics (something many other truckload carriers have done in recent years).
I do expect Heartland to drive expense synergies from its acquisitions over time, and I expect FCF margins to move toward the mid-teens over time, driving mid-single-digit FCF growth.
Between discounted cash flow and a multiples-based valuation approach, Heartland shares look undervalued. Discounted cash flow suggests a long-term total annualized return in the double-digits, while a 7x multiple (in line with sector norms) on my ’23 EBITDA estimate and a 15x trough multiple on my 2022 EPS (peak) estimate both give me fair value estimates around $16.
I like Knight-Swift better, but I do see legitimate counter-cyclical positives to Heartland, and the valuation doesn’t look demanding. I’m concerned that company and sell-side expectations for 2023 could still be too high, and buying into the start of a cyclical downturn brings above-average risk, but this is a name that is looking more interesting to me as a contrarian play.
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