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• Higher oil prices continue to raise costs for retailers relying on overland shipping.
• Trucking is one of the most expedient, but also one of the most inefficient modes of freight transportation.
• Equities in this sector have been bid higher as investors buy into the economic recovery and fail to discount risks from higher fuel costs.
• Three trucking companies are vulnerable to a sharp decline as investors begin to take stock of mounting risks:
- Old Dominion Freight Line (ODFL)
- Landstar System (LSTR)
- Werner Enterprises (WERN)
It’s no secret that oil prices have been climbing – increasing transportation costs for consumers and businesses alike.
To a certain extent, this dynamic has been largely glossed over by Wall Street. At this point, the majority of fund managers and institutional investors are buying into the recovery thesis. After all, the Fed has been flooding the economy with cheap capital and we have essentially bought our way out of the financial crisis.
But the big question is at what cost? Sure, we may have manufactured a few percentage points of GDP growth. But the taxpayers (present and future) have ponied up trillions of dollars to generate this feeble recovery.
More importantly, the flood of capital along with increasing demand from emerging markets has generated significant inflation for key commodities. The CPI numbers fail to show the true effect, but looking just at the costs for agricultural and energy commodities, we can see a significant inflationary effect.
This inflationary effect has been a significant challenge for emerging markets where food, housing, and energy costs make up a material portion of monthly income. The effects have been muted in developed nations because of our higher level of discretionary spending. But that doesn’t mean inflation won’t eventually cause much more severe challenges.
For retailers, higher energy costs are beginning to affect business from two primary angles:
- First, higher energy prices cut into discretionary consumer spending. This is a well known issue and has been discussed by plenty of financial commentaries.
- Second, higher energy prices translate into higher manufacturing and distribution costs – compressing profit margins and eventually requiring price increases to offset spiraling costs.
It seems that this second issue has been largely ignored – possibly because higher manufacturing and distribution costs have been offset by lower labour expenses. Companies are getting more done with fewer people. And with high unemployment rates, wage pressures are virtually nonexistent.
Fuel Costs and the Trucking Industry
Higher fuel prices don’t automatically translate directly to lower profits for the trucking industry. Most fleets are able to pass fuel surcharges on to customers and materially offset rising costs.
But when fuel prices shift materially, it can cause retailers to begin rethinking their shipping priorities. Short-haul routs may still be a necessity, but when it comes to longer distance shipping, there are better alternatives.
Rail transportation is inherently less expensive in terms of fuel costs. For instance, in 2009, CSX averaged 468 miles per gallon per ton. Typically, it takes about three times as much fuel to move the same weight and distance by highway trucking.
For retailers that continue to move freight by truck, higher fuel costs will do one of two things. Either the retailer will accept lower profit margins as a result of higher transportation costs, or the retailer will raise prices for consumers. While lower profit margins may be a short-term solution, eventually, prices will have to rise across the board. And according the the laws of supply and demand, higher prices naturally lead to lower quantity demand.
As the inflationary effects of higher fuel prices evolve, truckers are going to have to face a choice similar to the retailers’ conflict. Passing on higher fuel costs in the form of fuel surcharges will eventually cause retailers to cut back on shipping. However, choosing NOT to pass on these higher costs will eat into profit margins. Either way, the environment is expected to become much more challenging for traditional trucking companies.
Vulnerable Stock Prices
Trucking stocks have been strong for the last several months. Relatively stable retail sales figures along with a slight improvement to jobless claims have been a bullish factor. Investors appear willing to believe in a growing recovery, and are paying higher earnings multiples for the cash-flow positive trucking companies.
But with this confidence comes additional risk. If optimistic assumptions are challenged, the price / earnings multiples will surely contract. Remember, the market hates uncertainty and right now, institutional investors are operating under the construct of false-certainty.
Employment strength is not as positive as the headlines imply. The labour participation rate has been dropping, meaning there are significantly more workers who are simply discouraged and choosing not to look for employment.
As the Fed begins to wind down stimulus measures, the feeble recovery (which is basically still on life support) will be required to sustain itself. The danger is that retailers begin to feel the pinch as both low-end consumers as well as affluent buyers continue to feel the effects of tighter policy, and increased inflation.
Up to this point, the lower-end consumers have been hit the hardest, while employment and income have remained stable for higher wage earners. A withdraw of stimulus could be the catalyst for lower spending from the affluent consumer, and in turn, smaller shipments for truckers to carry.
Price action will be most important variable when determining our trade timing, but we have three trucking stocks picked out as short candidates when the decline begins:
• Rich valuation implies a strong trucking environment for years to come.
• Equity offering may be the most efficient use of a high stock price, but dilutes current shareholders.
• Growing average length of haul puts the company in direct competition with the rail industry.
• Faltering chart is close to breaking through support – igniting bearish interest.
Old Dominion is trading at a premium valuation. Analysts expect the company to earn $1.77 per share this year, and the stock is trading near $34. A forward PE above 19 is well above the historical average for this capital-intensive business.
The premium price implies that investors are expecting significant long-term growth – and analyst expectations have been gradually increased over the last several months. In 2011, the expectation is for earnings growth of 31% despite the fact that revenue will only grow by about 18%.
For 2012, the growth assumptions are similar, with EPS expected to increase by 23%, with revenue growth decelerating to 12%. Following the logic on these assumptions, analysts are expecting profit margins to increase despite the fact that fuel costs are higher and likely to bite into both shipment volumes as well as the ability to pass elevated costs on to consumers.
In addition to the business concerns, equity investors also have to deal with a significant stock sale being enacted by the company. According to a press release issued in conjunction with the company’s fourth quarter earnings release, Old Dominion is attempting to sell $100 million worth of additional stock.
From a business perspective, this sale actually makes a lot of sense. Management is using its elevated stock price as “currency” – raising capital to cover capital expenses and potentially make acquisitions.
But the strategic decision implies that management believes their stock price is at least somewhat overvalued – and they are attempting to take advantage of this premium valuation. Current stockholders will see their ownership of the company diluted, while management receives a $100 million blank check which may or may not be used productively.
One of the issues that makes Old Dominion particularly vulnerable is the increasing average length of haul. As of the last reporting period, ODFL’s average haul is 948 miles – a figure that has been growing annually for a number of years now.
Ironically, while longer hauls use less fuel per ton per mile, the increasing route distance also puts the company in more direct competition with the rail industry. Highway truckers simply can’t compete in terms of efficiency when compared to shipments by rail.
In the future, truckers are likely to be more profitable by charging premiums (per distance) for shorter routes, rather than competing with rail carriers to deliver the same service.
Technically, ODFL has been in a relatively strong bull market for a number of months now. But the stock is beginning to show signs of fatigue and could be a great short if it breaks down from this point.
In late March, ODFL broke out of a three-month base, only to run into resistance just above $36. Since that time, the stock has come back to test the breakout point, and considering the weakening market, that test may fail. If ODFL trades decisively below $34, it will also break the 50 EMA which could be a major sell signal for momentum traders.
Price action continues to be the key variable for pulling the trigger on a short position, but the components for an attractive reward-to-risk scenario are coming together.
Landstar System (LSTR)
• Billed as a diversified logistics and transportation company, LSTR receives the vast majority of revenue from trucking.
• Premium valuation is vulnerable considering industry challenges.
• Deceleration in revenue growth raises questions about expectations.
Take a peek at Landstar System’s website and you’ll naturally assume that the company is a leader in a number of different transportation business lines. The company’s tag line of “Providing Supply Chain Solutions and Complete Global and Domestic Transportation Services” sounds very impressive.
But in actuality, the company is a trucking firm – with 91% of revenues derived from independent business capacity owners (BCOs) and truck brokerage carriers.
There’s nothing wrong with being in one business and doing it well. But investors should realise that the company is first and foremost a trucking company – with all the risks and opportunities that come along with this business.
Questionable Growth Rates
The biggest risk that I see with Landstar right now is that investors are likely over-estimating the company’s potential growth, while failing to realise the industry risks which will directly affect this company.
For 2010, the company grew earnings by nearly 30%, an impressive feat as the economic recovery took hold. In 2011, analysts expect earnings growth to decelerate to 19%, and for next year growth is expected to come in 17% higher.
But looking carefully at the company’s traffic and revenue levels, there are some concerning issues rising.
For starters, the total number of company loads increased by only 10% last year. That’s all well and good when pricing power is at your back. But if LSTR is entering an environment with tighter pricing metrics and lighter retail shipments, the earnings growth could decelerate much more quickly than analysts currently expect.
More importantly, we are already seeing signs of deceleration in revenue growth. For the December quarter, the company grew revenues by only 7%, while still reporting a 35% increase in profit. The number of loads for the quarter actually decreased during this period, not a great sign for a company priced for growth.
At this time, Landstar’s stock is still tracking well above its 50 day average, and holding above a breakout level from early April. But over the last few weeks, volume has been decreasing – possibly a sign that institutions are backing off purchase programs.
Once again, we’re waiting for price action to signal trouble before committing capital on the short side. But given the high valuation, and growth concerns, LSTR could be an excellent plunge candidate when the market begins to lose momentum.
The company announces earnings Thursday (4/21) before the open. Certainly, this earnings announcement could turn out to be the initial catalyst, knocking shares out of their currently bullish pattern.
Werner Enterprises (WERN)
• Anemic revenue growth casts doubt on growth prospects.
• Optimistic valuation leaves plenty of room for disappointment.
• Breakout failure discourages momentum traders.
Over the past four quarters, Werner Enterprises has increased profits in a truly remarkable way. Despite the fact that average revenue growth has been in the single digits (less than 10% year-over-year), earnings per share have grown by 50%, 61%, 27% and finally 32%.
The impressive part of this growth is how the company has managed to manufacture efficiency gains for a significant amount of time. Investors have rewarded the company – especially in the last six months. The stock has rallied nearly 40% from its short-term low in August. Investors are now paying nearly $20 for every dollar the company earns as further growth is expected.
While efficiency gains are certainly impressive and worth striving for, earnings can only improve so much due to better internal margins. At some point, if the company is going to continue to grow, revenue has to appreciate – and appreciate by a material amount.
The risk with WERN right now is that investors may be overly confident when it comes to future growth, without fully discounting the risks of an economic setback.
Werner appears vulnerable from two distinct perspectives:
First, the company has become increasingly reliant on the retail industry. Over the past two years, retail merchandise has grown to represent 49% of the company’s revenue. More stable categories like grocery products and manufacturing shipments have declined as a portion of revenue.
This leaves Werner vulnerable to a slowdown in the retail market – a vulnerability that current investors appear to be glossing over.
Secondly, the company has been reducing its fleet of trucks. Reductions in maintenance costs have certainly helped the company become more efficient and profitable. But if investors are betting on future growth, one has to wonder how this growth will take place…
Cutting capacity is a short-term fix for growing earnings. But it doesn’t help much in terms of creating a long-term platform for growth.
Looking at the stock chart, WERN traded through a relatively tight consolidation into the second half of March. At the end of the month, the stock broke to new highs on robust volume. But within a week, the stock fell back into the range, disappointing breakout buyers.
If WERN violates the low end of this trading range (below $25.) the action would invite trend followers to place bearish bets, and would also leave breakout buyers trapped in a losing position. Given the company-specific and broad economic challenges, this break could offer an excellent inflection point for initiating a short position.