Stefonlinton
Looking at Werner Enterprises (NASDAQ:WERN) back in March of this year, I thought that the company’s stronger skew to the more stable dedicated carrier business (contracted truckload trucking for customers like retailers) would serve the company in good stead as the freight cycle peaked and then rolled over, sending volume expectations and spot rates lower. Well, the cycle has rolled over, but Werner hasn’t been quite as defensive as I’d hoped – the shares have dropped about 10% since then, a little worse than Heartland Express (HTLD), which typically has some counter-cyclical appeal, and a little better than Knight-Swift (KNX).
At the risk of sounding a little flippant, it’s the rare trucking stock that doesn’t look cheap to me today, leading me to wonder whether my assumptions for the next three years (and beyond) are simply too bullish or whether the Street is doing what it often does with cyclical stocks – dumping them almost irrespective of longer-term value in favor of stocks more likely to show earnings growth and margin leverage over the next year or two.
I think it’s the latter, and Werner does still look undervalued to me. It’s a more defensive name, and this would seem like a better time to think of defense first, but investors should remember that cyclical plays are meant as trades (not long-term buy-and-holds) and there will come a time when a shift to more aggressive carriers will be in order.
An Operating Miss Driven By Familiar Drivers
Even allowing that Werner’s business mix is different than many carriers (dedicated trucking is almost twice as large as percentage of revenue here versus Knight-Swift), the primary drivers of Werner’s third quarter results were nonetheless familiar – slowing freight demand, rising freight costs, and weaker logistics revenue tied to spot business.
Revenue rose 18% as reported, good for a modest beat. Trucking revenue was up 18%, with revenue excluding fuel surcharges up 9%. The One-Way business was flat this quarter, while the Dedicated business saw 16% growth on top of 9% underlying growth in revenue per tractor per week (that metric was down 4% for the One-Way business). Logistics revenue rose 18%, with almost a third of the growth coming from the small Final mile business, while brokerage rose 4% and intermodal rose 10%.
Operating income is always messy because of the impact of fuel surcharges, gains on equipment sales, and insurance receipts. Reported operating income rose 8%, missing by about 8%, with Logistics driving that miss. Looking at trucking ex-fuel, profits rose 17%, with operating ratio improving by a point to 84.8% (though if you exclude gains on sale, the operating ratio worsened 330 to 89.3%). Logistics profits declined 26%, with an operating ratio of 97% versus 95.2% a year ago.
As I said, while results were below expectations (a “surprise” by definition), it’s not so surprising now in the context of other company reports. Higher operating costs are an issue across the trucking sector, and likewise, most brokerage operators with significant spot exposure saw weaker sequential profitability (which happens as capacity crunches ease).
Freight Will Get Worse, But How Much Will It Impact Werner?
Now for the big question – what happens from here?
I had previously said that I expected truckload spot rates to fall 25%-30%, and we’re pretty much at that 30% level. I now expect further erosion, and I think Werner management’s commentary that spot rates are near the bottom could prove optimistic. At this point, there’s abundant capacity (the Transportation Capacity metric reported by the Logistics Manager Index is at a record level) and inventory levels are quite a bit higher, leading to much less urgency with shipping demand. To that end, many companies have talked about the absence of a real season peak this year, and Werner quantified that – a 60% year-over-year decline.
The “but” here is that Werner has such a sizable Dedicated business. These contracts often run for three to five years and I believe it has been over five years since Werner has posted a year-over-year decline in yields from this business. Moreover, with strong leverage to discount retailers and dollar stores, Werner’s customer base is already aligned with a weaker 2023 outlook.
Still, that does leave a One-Way business that contributed around 20% of third quarter revenue. This business tends to be more specialized (temperature-controlled, expedited, and so on), so it should hold up better, but 30%-plus spot rate erosion is still going to have an impact, and particularly so when operating costs are higher. As an aside for those readers expecting or hoping that operating costs will provide a floor for spot rates – they do over the longer term, but in the short term, it’s common in downcycles for spot rates to break through the average per-mile operating cost (and it forces less efficient operators out).
I also expect weaker trends in the logistics business. Intermodal and last-mile will slow with weaker demand volume and surplus capacity, but I expect more noticeable weakness in brokerage as capacity is abundant and rates are falling. Management is looking to shift more of its brokerage business to contract (versus spot), but then so is just about everybody else, so I’d expect margin pressure on the contract side as well, as customers will have a lot of competition for their business.
Expanding Through M&A
Werner has been busy of late on the M&A front, and this is something I expect to see in downcycles, though this strikes me as a bit early. In any case, the company acquired Baylor Trucking, expanding its tractor fleet by about 2% and adding more expedited (40% of revenue) and non-consumer exposure.
Most recently, the company announced it was spending about $112M to acquire ReedTMS Transport Services. This is predominantly a truck brokerage (90% of revenue), with a heavy focus on the food/beverage industry (two-thirds of the business), contract over spot (65%-35%), and more specialized assets (47% temperature-controlled). The remainder is a small (130 trucks) truckload trucking business.
I like the ReedTMS deal to a point. Broadening out to food/beverage and adding more temp-controlled exposure (as well as more contract coverage) makes sense, and I see some synergies and cross-selling opportunities here. That said, as Wells Fargo analyst Allison Poliniak-Cusic noted, using the same cash for a share buyback would have produced double the EPS accretion.
The Outlook
It doesn’t really fit elsewhere into this discussion, but I wanted to mention that while Werner has strong defensive characteristics given its Dedicated focus, this isn’t a company sleeping on the future. Werner has been quite active in partnering with companies involved in autonomous driving, including Aurora (AUR), TuSimple (TSP), and Kodiak Robotics. I’d also note that the company committed to purchasing 500 hydrogen-fueled engines from Cummins (CMI).
I was looking for a modest (low single-digit) revenue decline next year, but with the M&A activity, I’m expecting around 9% reported growth. Longer term, I expect mid-single-digit revenue growth as the company continues to gain share in the highly fragmented truckload industry and expands operations in areas like brokerage, intermodal, and last-mile logistics. On the margin side, I’m expecting FCF margins to move up from the lower end of the mid-single-digits toward the higher end, helping to drive high single-digit long-term FCF growth.
As far as valuation goes, discounted cash flow suggests Werner is now priced for a long-term total annualized return in the double-digits. Using past trough P/E’s and 2022 EPS, I get a near-term fair value of almost $48, while a 6.5x forward EBITDA multiple on my ’23 number gets me into the mid-$50’s. I think 6.5x is a fair discount (the long-term norm is closer to 8x), but clearly the market disagrees.
The Bottom Line
It’s almost cut-and-paste at this point, but if you’ve read my other articles on the trucking sector, you know that I believe the Street seems to be pricing in a pretty sharp downturn in the business. I was conservative relative to the Street earlier this year expecting the declines in spot rates, so I’m not really sure what to make of this. At a minimum, it just supports my general caution about buying into cheap-looking stocks at the start of a cyclical downturn. Specific to Werner, I really like how management is running this company, and though I see both sentiment and macro conditions as meaningful risks, it’s a name still worth considering in an out-of-favor sector.
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