Buying Some More Knight-Swift Stock (NYSE:KNX)

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Since I published my bullish piece on Knight-Swift Transportation Holdings Inc. (NYSE:KNX) a little over 14 months ago, the shares have returned about 14.6% against a gain of about 20% for the S&P 500. They’ve underperformed recently, though, so I thought I’d check back on the business to see if I should reconsider my bullish take here. As is frequently the case, I’ll make that determination by looking at the most recent financial history, paying particular attention to the dividend. I’m also going to look at the stock as a thing distinct from the business. Finally, I gotta be me, so I’m going to give you yet another lecture on the risk reducing, yield enhancing potential of short put options, using my history with Knight-Swift as an example.

I’ve heard many times that not just my writing, but my whole being, can be “a bit tough to take.” It’s for that reason that each of my articles comes with a bit of a public service up front. I give you the highlights of my argument in a single paragraph so that you have the means to insulate yourself from the tedium of a whole “Doyle experience.” I do this extra work so you have the means to gird yourself from any emotional trauma my stuff inflicts. You’re welcome. I think the recent drop in price is a gift to long term investors because I think the dividend is well covered here. The shares are trading at near record low valuations, in spite of a spectacular 2021, and the dividend is very near a 5-year high. In addition to buying some more shares, I’ll be selling more puts. I’ve made a successful habit of this in the past, and I see no reason to change now. In particular, I’m selling the January 2023 puts with a strike of $30. I would recommend this or a similar trade for people who are comfortable with put options. There you have it. That’s my argument in a nutshell. If you read on from here, any pain you feel as a result is entirely on you.

Financial Snapshot

I think it’s pretty plain that the year that just ended was good to Knight-Swift. The top line was up by about 28%, and net income was higher by about 81%. In fact, the most recent year was a multi year best for the firm, handily beating the great results it achieved in 2018. Also, to avoid any accusations that I’m comparing the most recent year to a very weak one to make results look better than they “really” are, I’d say that the performance in 2021 was good relative to 2019 also. Sales were just under 24% higher, and net income more than doubled, up 140%.

Nothing’s perfect, though, and Knight-Swift is no exception. The level of indebtedness has skyrocketed, up by $860 million, and that’s never a plus in my world. I understand that it’s a necessary evil to fund acquisitions, for instance, but a necessary evil’s still an evil in my view. You may (likely do) disagree with me on this, dear readers, but I think higher debt always increases risk. In fairness, though, I don’t think the debt level is sufficiently bad to threaten the dividend.

Dividend Sustainability

In my experience, financial history is a pretty “niche” subset of the broader community of people who like learning about the human past. The future is much more compelling to investors for pretty obvious reasons. In particular, we’re interested in dividend sustainability for two reasons. First, we want some sense of the cash flow that our investments will spin off over time. Second, a dividend that’s sustainable is supportive of stock price, and a dividend that’s in danger of being cut is likely to cause the stock price to drop. This is why I want to try to understand how sustainable (or not) a given dividend is. As my regulars know, when it comes to looking at dividends, I remove my “accrual accounting” hat, and put on my “cash accounting” helmet, because I think dividends are all about cash. I specifically compare the size and timing of future obligations to the current and likely future sources of cash.

I’m afraid I can’t offer you a single table plucked from the pages of the latest 10-K that is simultaneously “handy”, and “dandy”, but I have done the next best thing I think. I’ve poured through the notes to the financial statements and have identified what I think are the most significant contractual obligations the company will face over the coming years. I’ve lumped the operating and finance leases together here because, for our purposes at the moment, it doesn’t really matter if $1 is spent on operating or finance leases. We see from the table that in 2022, the company will spend about $293 million, and will spend ~$76.4 million next year, and just under $306 million in 2024.

If you’d like to review these obligations in greater depth, I would invite you to check out the latest 10-K, starting on page 98. In my view, it was a real page turner.

The size and timing of Knight Swift

Knight-Swift Debt and Lease Obligations (Knight-Swift latest 10-K)

Turning now to the cash and cash generating capacity, the company has about $261 million in cash on the books as of the latest 10-K. In addition, they’ve generated an average of ~$983 million in cash from operations over the past three years while spending an average of $960 million in cash from investing activities. Please note, though, that the CFI figure is massively goosed by the $1.496 billion acquisition costs in 2021. If we strip this out, a more typical average CFI figure of $461 million emerges. Given the above, I’m of the view that the dividend of ~$63.5 million is well covered, and for that reason I’d be happy to buy more of this stock at the right price.

A financial history of Knight-Swift from 2014 to the present

Knight-Swift Financial History (Knight-Swift investor relations)

The Stock

Some of you who follow me regularly for some very odd reason know that it’s at this point in the article where I turn into a real “killjoy” because it’s here that I remind everyone not to get too excited about great financial results. The phrase “at the right price” has disqualified many great businesses from consideration when their stocks are trading excessively. The company can make a great deal of money, as Knight-Swift is doing, but the investment can still be a terrible one if the shares are too richly priced. This is because Knight-Swift is an organisation that sells for a profit. The stock is a proxy whose changing prices reflect more the mood of the crowd than anything to do with the business. In particular, the stock price changes are capricious and reflect the changing views about the very long term future of the company than anything to do with the business. This is why I look at stocks as things apart from the underlying business.

It’s time for me to belabour this point by using Knight-Swift itself to drive it home. The company released annual results on February 24th. If you bought this stock the next day, you’re down about 16% since then. If you waited until March 8th, to pick a date completely at random, you’re down about 9.5% since then. Not a great result either, but obviously, not enough changed at the firm over this short span of time to warrant a near 7% variance in returns. The differences in return came down entirely to the price paid. The investors who bought virtually identical shares more cheaply suffered less than those who bought the shares at a higher price. This is why I try to avoid overpaying for stocks.

My regulars know that I measure the cheapness (or not) of a stock in a few ways, ranging from the simple to the more complex. On the simple side, I look at the ratio of price to some measure of economic value like sales, earnings, free cash flow, and the like. Ideally, I want to see a stock trading at a discount to both its own history and the overall market. In my previous article, I became as excited as I ever get when the stock hit a price to earnings ratio of 16.67. The shares are now about 38% cheaper per the following:

Chart
Data by YCharts

While investors are paying less for $1 of future earnings, it seems that they’re getting “more” in terms of the yield. I think it’s relevant that the yield is very near a 5-year high.

Chart
Data by YCharts

In addition to simple ratios, I want to try to understand what the market is currently “assuming” about the future of this company. In order to do this, I turn to the work of Professor Stephen Penman and his book “Accounting for Value.” In this book, Penman walks investors through how they can apply the magic of high school algebra to a standard finance formula in order to work out what the market is “thinking” about a given company’s future growth. This involves isolating the “g” (growth) variable in the said formula. Applying this approach to Knight-Swift at the moment suggests the market is assuming that this company will grow at about 0.7% over the long term. This is very nicely pessimistic in my view. Given the valuation, and the fact that I think the dividend is reasonably secure, I’m going to add to my position here.

Options Update

My regulars know that I like to sell put options on great companies, because I consider these to be “win-win” trades. If the shares remain above the strike price, I’ll simply pocket the premium, which is never a hardship. If the shares fall in price, I’ll be obliged to buy, but will do so at a price that represents an even better entry price. Thus, “win-win.” In my previous missive on this name, I offered up a brief history of my short put option trades involving Knight-Swift. Shares were “put” to me in March of 2020 at a price of $28 as markets imploded globally. I then generated another $2.30 by selling two more batches of puts, one set for $1.40 each, one set for $0.90 each. I think my history with the puts on this company demonstrates, yet again, that put options can help reduce risk by lowering the adjusted cost base of a stock, and can improve returns by generating added cash flow.

I’m not the most creative fellow in the world, and so I’m the type to build a system and just keep working it. With that in mind, I’m going to take advantage of the latest price drop to sell some more puts. After all, when prices drop, we get closer to great strike prices.

In particular, I’m going to be selling some of the January 2023 puts with a strike of $30. These are currently bid at $0.90. If the shares remain above $30 over the next nine months, I’ll add the premium to my returns on this name. If the shares fall about 33% over that time, I’ll be obliged to buy more of this stock, but will do so at the equivalent of a 1.6% dividend yield, and a price to earnings of ~6.75 times. I’m comfortable with either outcome, and thus, “win-win.”

It’s that time again. Remember when I took the mood down a little bit by suggesting that a great company can be a terrible investment at the wrong price? I’m about to do so again, after getting you all excited about “win-win” trades. It’s all well and good for me to characterise these as “win-win” trades, but there’s risk with every investment, including short puts. I consider risks with these instruments to fall into two broad categories: the economic and the emotional.

Starting with the economic risks, I’d say that the short puts I advocate are a small subset of the total number of put options out there. I’m only ever willing to sell puts on companies I’d be willing to buy, and at prices I’d be willing to pay. So, don’t take what I write about short puts being “win-win” as an excuse to go out there selling puts both “willy” and “nilly.” Only ever sell puts on companies you want to own at (strike) prices you’d be willing to pay.

The two other risks associated with my short puts strategy are both emotional in nature. The first involves the emotional pain some people feel from missing out on upside. To use this trade as an example, let’s assume that the market really likes what’s happening at Knight-Swift, the shares turn around, and climb to $60 over the next several months. Obviously my puts will expire worthless, which is a great outcome in some ways. I will not catch any of the upside in the stock price, though. So, short put returns are capped by the premium received. This is emotionally painful for some, but not for me.

Secondly, it can be emotionally painful when the shares crash below your strike price. This has happened to me many times over the years. While it most often works out well, it is emotionally painful in the short term. The fact is that it’s not fun when the stock crashes well below the strike price. So, I can make a reasonable argument that Knight-Swift shares would be a bargain at a price of $30, but if it drops to $25, for instance, that will take an emotional toll, at least in the short run. I think people who sell puts should be aware of these emotional risks before selling.

While I think these investments will reduce risk, they won’t eliminate it. I think it’s proven to be an economically advantageous trade in the past, but we should enter it with our eyes open. I’ll be selling these puts, and if you’re comfortable accepting the risks described above, I would recommend you do the same.

Conclusion

I think the shares are reasonably priced, and I think the business is doing rather well. In addition, I think Knight-Swift’s dividend is secure, so I’ll be adding a few more shares. In addition, I’ll be selling the puts described above. If you’re comfortable with short put options, I’d recommend this or a similar trade, dear readers. If you’re not, I’d recommend taking advantage of the recent price weakness to buy some shares. They’re very near multi-year low valuations. I don’t think history necessarily repeats, but when people have bought at current valuations in the past, they’ve done well.

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