By
Morningstar
:
By Matthew Young, CFA
Demand is under pressure, but long-term opportunities remain at
these wide-moat logistics firms.
The broader third-party logistics industry enjoys favorable
top-line growth dynamics and, over the long run, should continue to
expand at a faster pace than the underlying domestic transportation
market. Most of the 3PLs we cover benefit from robust economic
moats supported by the network effect, and the asset-light nature
of these businesses allows for low capital intensity and high
returns on capital. Two top-tier 3PLs--international forwarder
Expeditors International of Washington
(
EXPD
) and domestic truck broker
C.H. Robinson Worldwide
(
CHRW
)--are trading at attractive discounts to our fair value estimates,
in part because of near-term headwinds.
Third-party logistics firms are essentially travel agents for
freight. They generally do not own transportation equipment, but
rather buy capacity from truckers, railroads, steamship lines, or
cargo airlines, then resell it to shippers for a spread. The 3PLs
we cover generally boast variable-cost, non-asset (or at least
asset-light) models that exhibit less cyclicality and generate
higher capital returns than most traditional transportation
providers. Truck brokers and international forwarders have an added
buffer by way of their gross margin dynamics (net revenue over
gross revenue). The cost of purchased transportation is highly
variable because these firms primarily buy capacity in the spot
market. As a result, in periods of macroeconomic weakness when
capacity loosens and carrier pricing falls, providers can pass
those declines to shippers on a lag, thereby expanding gross
margins. Illustrating the resiliency of the 3PL business model,
truck broker C.H. Robinson posted gross margin expansion in 2009
during the freight recession, with operating margins (off net
revenue) actually rising. Furthermore, in 2009, average returns on
capital across our 3PL coverage universe fell to roughly 15%,
compared with 5% for the asset-based truckers. On the flip side,
when freight demand strengthens or carrier rates rise because of
tight capacity, gross margin compression will usually temper net
revenue growth--a common theme throughout the brokerage industry
this year.
North American 3PLs operate in several market niches, including
domestic transportation management (highway and rail brokerage),
air and ocean freight forwarding, and contract logistics (largely
warehousing and distribution). Within our coverage universe, the
pure-play freight brokers are C.H. Robinson, Landstar (
LSTR
), and Echo Global Logistics (
ECHO
). Asset-light intermodal marketing firms Hub Group (
HUBG
) and Pacer (PACR) also operate sizable highway brokerage
operations. The major freight forwarders on our list are Expeditors
International and UTi Worldwide (UTIW). While there is overlap,
most of the 3PLs we cover specialize in either domestic brokerage
or international shipping, though forwarders often bundle contract
logistics into their service offering.
Network Effect Makes for Moats
Most of the 3PL providers we cover benefit from narrow or wide
economic moats, supported in part by the network effect: As a
provider's network of shippers and carriers expands, its value
proposition to both parties deepens and becomes harder to replicate
(especially by small, less sophisticated operations).
Top-tier truck broker C.H. Robinson enjoys an immense customer
base that affords significant buying power--it can procure capacity
at lower rates than shippers can generally obtain directly with
carriers. Additionally, Robinson's large network of carriers is
attractive to shippers seeking access to reliable capacity, as well
as those looking to outsource the burden of managing hundreds of
carrier relationships. From the carrier perspective, Robinson
aggregates highly fragmented market demand, offering a valuable
source of freight opportunities capable of reducing empty
miles.
The network effect is similar for international forwarders like
Expeditors. For shippers moving goods overseas, Expeditors can
aggregate its buying power (in this case with cargo airlines and
ocean carriers), providing more attractive rates than a shipper
going directly to the asset-owning carrier. The vast majority of
air cargo is transacted through the forwarders (with few direct
shipper-carrier relationships), though shippers with sufficient
scale to fill entire containers often work directly with ocean
liners. As is the case with over-the-road truckers in the brokerage
industry, air and ocean carriers gain access to a deep reservoir of
freight that increases in value as the forwarder aggregates
customers.
Overall, thanks to the asset-light nature of the business and
benefits from the network effect, average returns on invested
capital among the 3PLs rank among the highest in our coverage
universe and usually exceed the cost of capital by a wide margin--a
hallmark of moaty operations.
3PL Industry Growth Should Surpass That of Underlying
Transportation Market
The 3PL industry has seen impressive expansion over the past few
decades, with average annual growth of more than 10% between 1996
and 2011, based on data from Armstrong & Associates. This is
well ahead of growth in the broader for-hire trucking and rail
intermodal markets, which were up only 3% on average over that
period. We expect industry growth to remain healthy, increasing at
a slightly faster pace than domestic transportation spending. Key
drivers of stronger 3PL industry expansion include incremental
logistics outsourcing among shippers and share gains from
asset-based carriers. Moreover, we expect the top-tier 3PLs to
enjoy a sizable boost from market consolidation (via share gains
and acquisitions) as smaller, less sophisticated providers find it
harder to keep up with rising demand for global network
capabilities and sophisticated IT.
Expeditors International Is Positioned for a
Recovery
Persistently weak air freight conditions and rising ocean
carrier rates are likely to temper growth in the quarters ahead,
and we think negative sentiment has reduced Expeditors' equity
valuation to attractive levels. The stock is trading at a roughly
29% discount to our $51 fair value estimate and 19 times 2013
consensus earnings per share. This compares with a historical
average forward price/earnings ratio of about 29. In terms of the
assumptions behind our fair value estimate, we model average annual
net revenue growth in the high single digits through 2016,
supported by a combination of recovery in air freight conditions in
later years (we assume average air freight demand growth of 3%-4%),
solid market share gains, and benefits from third-party logistics
outsourcing. Industry air freight demand has been under pressure
since the middle of 2011. Air freight represents an important
business driver for Expeditors at roughly 47% of 2011 gross
revenue. Despite Expeditors' history of strong operational
execution and share gains, the firm is not immune to sluggish
industry demand. Expeditors' air freight volume trends tend to
reflect those of the industry, with some variation stemming from
Expeditors' special project business and end market mix.
Why has air freight traffic been so weak? Although GDP expanded
in both the United States and Europe in 2011, escalation of the
European debt crisis and concerns about slowing macroeconomic
conditions in the U.S. (including weak employment trends) weighed
heavily on business and consumer confidence in the West. By the
middle of last year, shippers began aggressively managing inventory
to increasingly uncertain end market conditions for their own
goods. This has tempered world trade growth (especially eurozone
imports from Asia) and demand for key air freight cargo,
particularly high-value goods from the high-tech and telecom
sectors.
Also, shippers have been downshifting to less costly (albeit
slower) ocean freight. We think some of this is related to a
gradual, secular shift driven by improving ocean-liner service
levels, gains in supply chain technology (mode optimization), and
declines in the value per pound of certain cargo, such as LCD
televisions. However, we also believe a portion is tactical. During
periods of heightened economic uncertainty, shippers are more
likely to turn to slower, less expensive transportation options
when possible, even for cargo that normally moves via air (such as
high-fashion apparel, certain pharmaceuticals, and high-tech
goods)--air freight costs can exceed 10 times the cost of ocean
freight, especially during periods of elevated fuel prices. Given
soft consumer demand and low business confidence in the U.S. and
especially Europe, shippers have an incentive to keep inventory on
ships (which essentially act as floating warehouses) for several
weeks. Low interest rates are also making this option attractive by
driving down the cost of capital.
Despite lackluster air freight conditions, however, we think
Expeditors can generate average net revenue growth in the high
single digits over the long run. Expeditors is one of the
highest-quality transportation firms we cover. It enjoys a history
of impressive financial performance and shareholder value creation,
including freight forwarding margins almost double those of close
competitor UTi Worldwide. Expeditors also maintains a pristine
balance sheet with no debt and a mountain of cash ($1.4 billion as
of the third quarter). Over the past decade, the firm has posted
average annual growth of 13% for net revenue (gross revenue less
purchased transportation) and slightly more than 15% for earnings
per share, as a wide economic moat and strong operational execution
have enabled the firm to capitalize on healthy 3PL industry
expansion.
We think the firm's entrepreneurial culture and steadfast focus
on long-term performance are key drivers of its unusually strong
execution. During the 2008-09 freight recession, Expeditors avoided
layoffs to preserve its robust network service capabilities.
Consequently, the company was able to grab market share as
international freight demand recovered near the end of 2009 (and
into 2010) and shippers scrambled to find access to capacity as
they restocked inventory--Expeditors' air freight volume jumped an
average of 37% (year over year) between the first quarter of 2009
and the second quarter of 2010. We expect successful execution once
again when forwarding markets improve this time around. Salesforce
compensation is predominantly commission-based (with below-average
base salaries), and managers' bonuses are pegged to net revenue and
operating profit trends of individual branches--factors that make
for a profit-conscious setting. This entrepreneurial culture does
not drive our wide moat rating, because it can be replicated.
However, we believe Expeditors leads its peers in terms of
executing this strategy.
Its large network of shippers and carriers supports a wide
economic moat, and we think this moat is capable of defending
long-run economic profits, especially from smaller competitors. As
evidence of its wide moat, the firm has generated returns on
invested capital in excess of 25% over the past decade, well above
our 10% cost of capital estimate. We also think Expeditors' moat is
sustainable since the market remains fragmented and share gains are
accruing to top-tier 3PLs. We expect returns on capital to remain
in the high 20s on average over the next five years.
We think low-single-digit global air freight expansion over the
long run is a reasonable assumption. We believe industry growth in
the years ahead will probably remain below the 6% long-run
historical average, given likely sluggish economic growth in the
West, particularly in Europe, and a migration to near-sourcing
among some North American shippers. That said, air freight will
remain an indispensable component of shippers' supply chains and
critical means of rapid overseas transport. This is particularly
the case for high-value, low-weight cargo (high-tech goods with
short life cycles), perishables, and time-critical cargo linked to
just-in-time inventory replenishment. Once global economic activity
enters a cyclical upturn or even a period of stability, we expect
demand for air freighted cargo to recover.
In addition to an eventual recovery in air freight demand, we
expect share gains from small, less sophisticated providers to
remain a key growth driver. The freight forwarding market is still
fragmented, with the top 10 providers constituting only 44% of the
industry. Outside this group are thousands of small and midsize
operations. Because of escalating supply chain complexity (driven
in part by high levels of foreign sourcing and low macroeconomic
visibility), demand for 3PLs with robust local market knowledge,
vertical expertise, and sophisticated IT continues to expand.
Overall, we think a long runway of opportunity exists for
Expeditors to grab share from smaller, less capable firms that lack
the resources to keep up. The data appear to bear out this thinking
as the top providers have increased their portion of the market
from 40% in 2006, according to Transport Intelligence.
We also expect an incremental boost from logistics outsourcing
among shippers. With heightened global economic uncertainty and the
prospect of a prolonged period of sluggish growth, retailers and
manufacturers in the West are managing with tight inventory levels
and aggressively seeking ways to boost profitability. Consequently,
the supply chain has morphed into a critical source of cost savings
and competitive differentiation. We think large shippers that work
directly with ocean carriers represent a key opportunity for
top-tier forwarders like Expeditors. Over the past few years, most
ocean liners have been posting losses because of the capacity glut
and related pressure on pricing. Despite rate progress thus far in
2012 (driven by efforts to limit capacity via slow steaming),
liners are still struggling to stay out of the red. Given carriers'
limited resources, coupled with forwarders' ability to provide
redundancy and flexibility by contracting with multiple carriers,
forwarders have been taking a bigger slice of the market. Overall,
we think logistics outsourcing remains a favorable trend. A recent
study conducted by consultant CapGemini suggests two thirds of
large shippers are increasing their use of 3PLs, while
approximately 60% are consolidating the number of providers
used--factors that bode well for top forwarders like
Expeditors.
C.H. Robinson's Margins Are Down, but the Business Model
Isn't Broken
Truck brokerage specialist C.H. Robinson is seeing persistent
gross margin compression due in part to tight trucking industry
capacity (enabling carriers to increase rates) and an elevated mix
of price-committed business. This has weighed on net revenue growth
and investor sentiment. That said, we think the gross margin
pressure is a cyclical dynamic and long-term growth opportunities
remain attractive. Robinson enjoys a wide economic moat supported
by the network effect, and we expect it to continue gaining share
from asset-based carriers and small, less sophisticated
providers.
The shares are trading at an 18% discount to our $73 fair value
estimate and 19 times 2013 consensus EPS. This compares with a
historical average forward P/E of about 27. We expect annual net
revenue growth in the high single digits on average over the next
five years as Robinson capitalizes on attractive secular trends in
the 3PL industry and continues to garner share from both
asset-based trucking companies and small freight brokers.
Carrier rates have been rising faster than pricing to customers,
with Robinson's transportation segment gross margin hitting a
record low in the second quarter (14.9% versus a 10-year average of
17%). As a result, net revenue (gross revenue less purchased
transportation) has increased only 3% year over year thus far in
2012, compared with a 9% rise in gross revenue. We get the sense
that many investors are concerned that this prolonged yield
pressure is evidence of a secular, unfavorable shift in the
competitive dynamics of brokerage. But strong competition is
nothing new--the prospect of high returns on invested capital has
been attracting newcomers to asset-light brokerage for more than a
decade. We also think it is unlikely a few aggressive entrants are
behind Robinson's recent margin squeeze, since the market remains
highly fragmented, and share gains should continue accruing to
sophisticated providers with scale as the market consolidates.
Rather, we think the depressed gross margins are the result of
unusual supply/demand dynamics. Robinson's gross margins are
historically countercyclical because of the time lag in passing
along higher capacity rates to customers. Contraction usually
occurs when industry freight demand expands, capacity tightens, and
carriers raise rates. The opposite occurs when demand falls off, as
seen in 2009 when Robinson's transportation segment gross margins
increased more than 300 basis points despite lower freight volume.
More recently, however, capacity has been tightening not so much
because of robust freight demand, but because of a combination of
the driver shortage and limited carrier fleet growth. With supply
and demand roughly in balance, carriers are enjoying decent pricing
power and Robinson is paying more for capacity in the spot market.
At the same time, the firm's pricing to truckload shippers has been
a bit sluggish. Because economic conditions are lackluster,
Robinson is seeing softer spot market activity and less unplanned
freight from existing customers, which carry better pricing
dynamics. More important, Robinson's mix of contractual business
has increased as the firm has pushed to become more of a core
carrier to larger shippers. As a result, more of the business is
subject to a time lag in terms of passing along higher capacity
rates to shippers.
Despite these gross margin woes, we think Robinson's long-term
growth opportunities still look attractive. The firm enjoys a long
record of consistent net revenue expansion and robust
profitability. It does not own transportation equipment, so it
avoids capital intensity and employs minimal operating leverage.
Additionally, the firm has historically maintained a debt-free
balance sheet with plenty of cash. Over the past decade, the firm
has generated average annual net revenue growth near 15%, with
operating margins (off net revenue) expanding from 29% in 2001 to
42% by the end of 2011--and most of this has been done organically.
We think Robinson's wide economic moat and best-in-class
executional capabilities have enabled it to capitalize on healthy
3PL industry expansion, and we expect that to persist.
Robinson has carved out a wide economic moat, supported by the
network effect. Its immense network of shippers and carriers
generates a compelling value proposition with durable barriers to
entry, since duplication would be a daunting task (particularly by
small, less sophisticated providers with limited buying power and
constrained IT infrastructure). In Robinson's core brokerage
operations, its customer base of 37,000-plus shippers bestows
significant buying scale. As a result, the company is able to
negotiate lower buy rates for capacity than shippers can secure for
themselves, providing customers with material cost savings. Larger
shippers that outsource their internal logistics management
functions (including personnel) also enjoy the added benefit of
reducing fixed assets and making fixed transportation costs
variable. Furthermore, Robinson's vast network of more than 53,000
carriers across most transport modes acts as an attractive source
of capacity for shippers. This is an increasingly important
attribute given the secular tightening of truckload capacity.
Overall, Robinson has posted average returns on invested capital of
about 36% over the past decade, handily exceeding our 10% cost of
capital estimate.
We expect Robinson to continue to gain share from less capable
domestic transportation managers. We do not consider its robust IT
systems to be the foundation of its wide economic moat because
competitors with sufficient capital can replicate technology. That
said, we think IT provides differentiation from smaller providers
with fewer resources, especially as supply chains become more
complex and shippers increasingly demand sophisticated
informational expertise. More than 10,000 registered freight
brokers operate in the U.S., and while the top 15 make up more than
45% of industry sales, gross revenue for each of the remaining
providers starts to fall off significantly beyond that point, and
the market becomes vastly fragmented. Although 3PLs usually operate
asset-light businesses with low capital intensity, IT and
communications infrastructure requires significant up-front and
maintenance outlays, placing providers with scale in an
advantageous position. Robinson's IT-related expenditures run close
to $100 million annually, and despite the sluggish brokerage
environment, the firm has been maintaining and even increasing its
IT investments in an attempt to stay ahead of the curve and
maximize its value proposition. Relative to the broader North
American 3PL industry, we estimate Robinson's share remains small,
coming in somewhere around 3%-5%, depending on market
definition.
Asset-based carriers also represent a source of market share
gains. We think domestic transportation managers are still taking
share from asset-based carriers (direct shipper relationships)
while motivating large shippers to outsource more of their
transportation management activities. First, outsourcing
transportation execution to a top-tier broker like Robinson enables
shippers to remove the administrative burden and risk of managing
potentially hundreds of carrier relationships, particularly in
terms of rate negotiation and quality control. Another compelling
factor is the firm's ability to aggregate highly fragmented
truckload industry supply (95% of truckers operate fewer than 20
trucks) through its industry-leading network of carrier
relationships. This provides shippers across the size spectrum with
efficient access to flexible capacity, since Robinson is more
likely to have a piece of equipment available at the right place
and at the right time, for a reasonable price. In recent quarters,
trucking industry supply and demand has been roughly balanced, but
an uptick in macroeconomic conditions or freight volume growth
would probably drive capacity shortages on certain lanes, providing
incremental opportunities for Robinson to substantiate its value
proposition.
Second, Robinson can offer unbiased, multimodal solutions that
help customers optimize the mix of intermodal versus over-the-road
shipments because it does not own tractors or trailers. Demand for
multimodal solutions is rising, driven in part by improving service
levels from the rails, variability in fuel costs, and an
intensifying focus on supply chain efficiency. Worries about
capacity constraints among truckload carriers have also driven some
freight to the rails. This dynamic should play well into the hands
of providers like Robinson because, unlike asset-based carriers,
3PLs are not bound to maximizing asset utilization. Putting it all
together, we estimate that only about 12% of the $340 billion spent
on for-hire trucking and rail intermodal shipments flowed through
asset-light domestic freight brokers in 2011.
Furthermore, the international freight forwarding business holds
incremental opportunities. Robinson has been offering its customers
air and ocean freight forwarding services for a few decades, but
only to a small degree. However, that is about to change with its
recent agreement to acquire Chicago-based air and ocean freight
forwarder Phoenix International. Last year, Robinson generated $106
million in air and ocean forwarding net revenue; Phoenix will add
$161 million to that run rate. The combined operations won't quite
propel Robinson's forwarding business into the ranks of the top 25
global providers, but we expect the greater market presence to
enhance its credibility with large customers--a segment to which
Robinson has been gravitating on the domestic transportation front.
The addition of Phoenix should also increase buying clout with air
and ocean carriers, boosting segment gross margins, since Robinson
can now aggregate demand from a much larger pool of shippers.
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