Refrigerated carriers anticipate better returns

Sept. 1, 2004
The stock market loves trucking stocks, John Larkin told a general session of the annual meeting of the Refrigerated Division of the Truckload Carriers

The stock market loves trucking stocks, John Larkin told a general session of the annual meeting of the Refrigerated Division of the Truckload Carriers Association. Larkin is managing director of Legg Mason Wood Walker, an investment-banking firm in Baltimore, Maryland. The Refrigerated Division meeting was held July 14 to 16, 2004, in Rockport, Maine.

However, an increase in interest rates is a classic signal to begin selling, he said. “Higher interest rates mean that trucking stocks have peaked and that things can't get any better,” Larkin said. “Things, however, may be a little different with this increase in interest rates. In the past 20 years, truckload stocks have increased in value by roughly 15% per year compound interest. In contrast, the S&P 500 index has grown only 10% per year during the same 20 years. Truckload stocks have consistently outperformed the market.”

Truckload stocks are trading at almost 20 times their projected earnings for calendar year 2004, Larkin said. That is a premium of almost 5% above the overall S&P 500 and the stock market in general. “That makes valuations for truckload stocks high and that they will remain high for the foreseeable future,” he said. “Recent results show this. For instance, J B Hunt reported an operating ratio of 87.5 for the second quarter.”

Supply and demand changes

Changing interest rates should not affect the value of trucking stocks, because the market has altered its view of supply and demand compared to lending rates, Larkin said. One reason for this is a lack of new capital moving into the trucking industry. Few companies have made stock offerings recently. In contrast, truckload carriers have kept fleets stable and have used the returns to pay down debt.

The lack of capital for expansion has not made a big difference in the industry, because carriers have such a difficult time finding drivers. “It almost seems as if every American who could qualify for a CDL and has a clean record is already driving a truck,” Larkin said. “I don't think that a lot more drivers are lurking in the shadows somewhere. Opening the Mexican border will not be a solution. Intermodal transportation could possibly take some pressure off the driver situation, but the rails have their own problems, particularly congested handling facilities. Short of increasing driver pay 50% to 60%, we may not solve the driver shortage any time soon.”

One of the external factors looming for truckload carriers is the next round of EPA regulations for engine exhaust emissions. “I think that many of the truckload carriers will use the strength of their balance sheets to move aggressively toward reducing the average age of their fleets before those regulations take effect in 2007,” Larkin said. “Buying ahead of the effective date will allow some truckload carriers to run their business while somebody else acts as the guinea pig for those new engines.”

Strict carrier selection criteria

Shippers are using strict standards in choosing carriers, Larkin said. In an economy with low inventory levels, many shippers are willing to pay slightly higher rates in return for guaranteed service levels. This allows carriers to focus on the return on their invested capital. “Unlike the mid 1990s, carriers seem much more interested in generating profits than on unrestrained growth,” he said.

All these factors work in favor of the larger carriers, Larkin said. The economy puts pressure on the smaller carriers and increases the competitive advantage enjoyed by the larger, well-capitalized carriers.

Although interest rates are up slightly, they remain at historically low levels, Larkin said. That has had a positive impact on the economy. In addition, the effects of the Bush tax cut have begun to take hold and stimulate the economy. Just about every indicator of economic activity looks positive, he said.

Trucking capacity is down — bad news for the carriers that failed, but good news for the survivors, Larkin said. The rate of financial failure is slowing. Surviving carriers have adopted a slow-growth strategy to retain the advantages of limited trucking capacity.

Replacing older trucks

Some analysts have looked at recent truck sales trends and concluded that carriers are about to build capacity rapidly. A more realistic view is that carriers have become comfortable with the 2002 engines and are beginning to replace the trucks they purchased during the Freightliner give-away binge of 1997 to 1999, Larkin said. “Those trucks are aging, and the maintenance costs are eating up any saving that might be available by staying away from new technology,” he said. “Replacing trucks now will allow carriers to approach 2007 with relatively young fleets so that they can deal cautiously with the next round of regulations.”

The strategy of most retailers plays to the strength of truckload carriers, Larkin said. Large retailers — Wal-Mart — build their systems around truckloads from manufacturers to distribution centers and truckloads from distribution centers to stores. “Some retailers have begun to visit carriers, almost begging for more capacity,” he said.

The outlook for truckload carriers is good, and refrigerated carriers are seeing the benefits of recent trends just like their dry van colleagues, but at a slower pace, Larkin said. Rates are going up, but not as fast as the increases available to dry van carriers. J B Hunt has recently announced revenue per loaded mile of $1.62, excluding fuel surcharges. “In contrast, Marten, one of only two publicly traded refrigerated carriers, reports $1.35 per mile,” he said.

Rates for refrigerated carriers lag dry van carriers, because most food plants seem to have a favorite house carrier that gets an attractive rate for the outbound freight, Larkin said. That same carrier avoids sales cost by using a third party logistics firm to find return loads. In addition, the food business is more stable than the general freight business, so rates do not change as much. One other factor in lower refrigerated rates could be that the tightening of capacity is only now beginning to show for those carriers, he said.

Consolidation among refrigerated carriers will continue with weaker carriers failing, Larkin said. If the economy stalls, freight will gravitate toward the big, healthy carriers, assuming they can find drivers. However, the industry will not change much in terms of mergers and acquisitions. The carriers that grow will do so through internal expansion, not by purchasing other carriers, he said.

To reach rate parity with dry van carriers, refrigerated carriers will need to increase rates about 4% beyond the increases received by dry carriers, Larkin said. That will require double digit rate increases just to get the same returns reported by dry carriers. “However, the economic recovery seems to be in full swing, and refrigerated carriers can anticipate better times,” he said. “Costs such as pallet exchange and lumper fees are going down. If these costs are not falling, they are beginning to be reflected in carrier rates. In fact, the next two to four years have the potential to be the best for refrigerated carriers in the past 20 years.”

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