Judging trucking by financial community standards

Sept. 1, 2002
Although many carriers think they see minor improvement in the trucking environment, theirs is not the only opinion that counts. While most truckload

Although many carriers think they see minor improvement in the trucking environment, theirs is not the only opinion that counts. While most truckload carriers are privately owned, the public financial markets still help determine a trucking firm's chances for success. This is particularly true for the credit and insurance markets.

Speaking to the opening session of the annual meeting of the Refrigerated Division of the Truckload Carriers Association, John “Chip” Grayson attempted to place the economics of trucking into the larger context of formal financial markets. Grayson is managing partner for the transportation/logistics group of Morgan Keegan & Company, an investment-banking house in Memphis, Tennessee. The Refrigerated Division met July 10 to 12, 2002, in Bernalillo, New Mexico.

At the outset, Grayson disclaimed any expertise on the technical aspects of trucking, saying that he had never driven, loaded, or dispatched a truck, run or worked for a trucking company — but that he had eaten meals in truckstops. In fact, he characterized his background as that of a recovering lawyer. In a serious vein, he noted that Morgan Keegan is the second-largest investment-banking house dealing with trucking securities, trailing only Deutsche Banc Alex Brown. It has underwritten the public offerings of truckload carriers such as Heartland Express, Knight Transportation, Swift, and M S Carriers. As a mergers and acquisitions advisor, Morgan Keegan has been involved in the sale of TLC Lines to Landstar and KLLM to High Road Acquisition Corp, a purchasing group formed by the management of KLLM when the company decided to revert from a public stock company to a private firm.

Working with Simon

In particular, Morgan Keegan has long had a hand in the affairs of Dick Simon Trucking. First, Grayson said, the firm underwrote the initial stock sale in 1995, followed by a secondary offering in 1997. The initial public offering raised $9 per share, and the secondary offering sold for $16 per share. “Our last work for Simon was selling the company out of bankruptcy earlier this year,” he said.

Dick Simon Trucking is a perfect example of how difficult the environment can be for refrigerated carriers in the financial markets. In August 2000, Jerry Moyes of Swift purchased enough Simon stock to take control of the company. In the ensuing 18 months, the stock price stayed on a downward trend as company performance suffered in a poor economy. Eventually, the company declared bankruptcy, and its assets were purchased by Central Freight, another trucking company controlled by Jerry Moyes. This has led some observers to suggest that Moyes liked the opportunities in refrigerated trucking so much that he bought Simon Trucking twice, Grayson said. “It looks as though the fleet has been reduced to a manageable size, and I think we will see Moyes begin to do great things with that company, just as he has done with other acquisitions,” he said.

Moyes is not the only investor to buy into refrigerated trucking with less than stellar results. In 2000, Bernie Ebbers, then Chief Executive Officer (CEO) of WorldCom, was a partner in High Road Acquisition, purchaser of KLLM. While KLLM has performed with some stability since becoming a private company, the same cannot be said of WorldCom, Grayson said.

The investment community is cautious about temperature-controlled trucking. In general, investors believe that refrigerated trucking is less cyclical than the general truckload business, Grayson said. They think that people will continue to eat, even in a bad economy. Sometimes, it looks as though they eat less or at least spend less on food in recessions, he said.

Excess trucking capacity

Investors think that refrigerated trucking is prone to excess capacity, and that excess capacity is brought about by low barriers to entry. Although it is an easy business to enter, operating costs are high, Grayson said. In addition, rates remain generally low, resulting in low operating margins and a low return on assets. Perhaps most importantly, investors think that shippers have more leverage over refrigerated carriers than they have with dry van carriers. “Shippers beat carriers up too much, keeping rates too low for optimum financial performance,” he said.

A look at the two remaining publicly owned refrigerated carriers gives some credence to these opinions, Grayson said. The publicly owned reefer carriers, when they included KLLM and Simon, have underperformed the S&P 500 stock index for the past two years, except for Marten Transport. In the past year, Marten gained 26% while the S&P dropped almost 21%. FFE Transportation outperformed the S&P as well, but only because it dropped less than the stock index. Other carriers such as Werner Enterprises that have refrigerated divisions have done as well or better.

Trucking is not always a bad investment. Most investors, given the choice five years ago between Microsoft and Knight Transportation, would have picked Microsoft, Grayson said. That choice would have been a mistake, because Microsoft has appreciated only 11.8% over five years compared with 35.3% at Knight, he said. Over the same five years, the S&P 500 has gained only 1.9%. Heartland Express also has outperformed Microsoft and the S&P 500 for the past five years. However, both Knight and Heartland are dry van carriers, although Knight has operated some small dedicated refrigerated fleets, Grayson said.

P/E ratios fall short

Investors tend to judge companies by their price-to-earnings ratios with the greatest values being assigned to those with the highest P/E ratios. Again some trucking companies — particularly Knight, Swift, and Heartland — have performed well, Grayson said. For instance, the P/E ratio of General Electric is 21 compared with 39.4 for Swift, 31.2 for Knight, and 30 for Heartland. None of these approach the 42.9 of Microsoft or the 41.2 assigned to the S&P 500 index. However, Marten falls far behind at only 15.4, he said.

A true complaint about refrigerated trucking is that carriers do not provide an adequate return on investment, Grayson said. To create value, a company must produce returns that exceed its cost of capital. The cost of equity capital at most trucking companies is 15% to 17%, depending on size. Microsoft pays approximately 17% for equity capital. For 2001, the return on equity at Microsoft was 15%, down from 25.9% in 1999. In comparison, return on equity was 16.4% at Knight for 2001, 17.2% at Heartland for the same year, and only 3.9% at Swift for 2001, down from 10.5% for 2000. Marten has performed the best for refrigerated carriers at 9.4% for 2001, down from 14.9% as recently as 1999. At the other end of the spectrum, FFE has had a negative return on equity for each of the past three years. “A company that earns only 13% to 14% on its equity simply is not earning enough to justify the risk of business,” he said.

Freight rates at dry van carriers are roughly the same as those at refrigerated carriers, Grayson said. At the same time, the cost of operating a dry van is much lower than that of a refrigerated trailer. As a result, the operating margins for van carriers are much higher than those of refrigerated carriers. The big dry van carriers such as Heartland, Knight, and Swift operate with margins much wider than those of the two remaining reefer carriers. “This includes Marten, the most profitable of the refrigerated carriers, which has averaged 92.8 as an operating ratio for the past four years,” he said.

Lower company values

This leads to a consideration of the pros and cons of refrigerated carrier valuation, Grayson said. The cons include poor stock performance and low valuations for privately owned carriers. This is particularly important for small carriers that might want some day to sell out. Poor overall segment performance leads to the conclusion that small carriers can sell only to other refrigerated carriers or to van carriers that already own refrigerated operations. In addition, the price paid in an acquisition probably will not be very high, he said.

On the pro side of the issues, refrigerated trucking doesn't have a huge pool of capital available for growth, Grayson said. As counterintuitive as that may sound, it could be good, because when Wall Street likes an industry, it throws so much money at it that the industry tends to fail from too much capacity. “The telecom industry is a great example,” he said. “Wall Street loved telecom and threw billions of dollars at it and killed it. Telecom developed too much capacity and many companies have failed. The same thing has happened in trucking and can happen again. In the past, a rapid flow of capital into trucking has led to fleet expansion followed by rate cutting to fill all those extra trailers. At the same time, carriers had to spend more money to find drivers to haul freight at lower rates. A love affair with Wall Street that increases capacity and depresses rates is not necessarily a good thing.”

Without easy access to capital for expansion, capacity in refrigerated trucking should remain stable or contract slightly, Grayson said. In an economy that is beginning to expand again, this should lead to higher rates.

Demand higher rates

For refrigerated carriers to thrive in the coming years, they must begin to demand reasonable rates to produce adequate returns on their investments, Grayson said. To determine a reasonable level for rates, carriers must know their costs so that they can price their services accurately, including appropriate profit margins. Rates need to reflect all the costs, both hard and soft, in the transportation transaction. If a fleet chooses to operate with new equipment, rates must reflect the higher cost of equipment. This portion of a rate needs to include the higher purchase price and operating costs for refrigerated equipment. Rates must also reflect driver wages and increasing insurance premiums. In addition, rates must cover variables such as waiting time and empty mileage to reposition equipment for paying loads, he said.

The key to generating reasonable rates is convincing shippers to pay a given rate. “Refrigerated carriers offer a premium service, so they should be paid a premium price,” Grayson said. “However, this won't stretch all that far, because in business, shippers will not ever pay any more than they have to.”

In any business, rates merely are a function of supply and demand. That's a basic rule, from which there is no escape, Grayson said. However, trucking capacity is down. In 2001, 4,300 trucking companies failed. In the past two years, more than 200,000 trucks have left the market, reducing total trucking capacity by more than 10%. The question is whether or not that capacity will return. “The probability is that it will,” he said, because barriers to entry are so low. A trucker just has to sign the note for a big loan, and a company is back in business. About the only things keeping new entries out of trucking are used-truck values, insurance costs, and scarce financing.”

Rates lag inflation

Rates in trucking are not keeping up with inflation, Grayson said. Over the past 10 years, the consumer price index has risen 25%, while truckload rates have risen only 10%. For the same 10 years, LTL rates have far exceeded inflation. “It's astonishing to me that truckload rates have been unable at least to remain in step with inflation,” he said. “The reason that LTL carriers have done so much better at maintaining rates is that they know their costs. That's one thing about their business that they understand really well, spending a lot of time and money making sure services are priced correctly.”

In the short term, things may be getting better for truckload carriers, because shippers are becoming worried about capacity. They are afraid of a transportation shortage going into the Christmas season, Grayson said. In an environment like that, refrigerated carriers can be extremely efficient because of the large spot market and low barriers to entry. The drawback is that demand does not exceed supply for long. As soon as shippers begin paying for service, carriers will pop up to serve them. “In that situation, it's time to move quickly and decisively to get rate increases while they are available,” he said.

With rate increases in hand, refrigerated carriers should be set to experience better results in 2003, Grayson said. However, better will not mean much easier. Carriers should expect continued pressure for high levels of service along with high insurance costs and tight credit markets all the way through 2003, he said.

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