Morgan Stanley—bullish on TL carriers, bearish on 3PLs
SIG—tax reform will improve TL carriers’ FCF yields and bring P/E ratios back to earth
According to several industry-wide surveys, the ELD mandate is expected to remove capacity from the truckload market as small carriers struggle to comply with the new regulations, especially when the ‘hard enforcement’ period begins in April 2018. No one knows exactly how much capacity will exit, but as the deadline approaches, survey respondents have been revising their estimates upwards. In August, 39% of respondents expected a capacity loss greater than 3% (31% expected a reduction of 4-6%, 6% expected a reduction of 7-9%, and 2% expected a reduction of 10% or greater), but by November, 44% of respondents expected a capacity loss greater than 3% (30% expected a reduction of 4-6%, 9% expected a reduction of 7-9%, and 5% expected a reduction of 10% or greater).
Large truckload fleets stand to benefit from the ELD mandate: a capacity shortage means higher rates, and smaller fleets might look to sell assets to larger fleets at prices favorable to both sides. Morgan Stanley, in their report “How to Play the ELD Mandate?” dated Dec. 13, calls for a larger-than-consensus impact on capacity and therefore a larger-than-consensus benefit to the big truckload carriers. Truckload carrier market valuations are already elevated—the sector’s average price over earnings ratio (P/E) is about 125% of the S&P 500’s average, which means that investors expect strong growth from truckload carriers relative to other sectors. But Morgan Stanley has argued that the elevated P/E ratios enjoyed by truckload carriers track very closely with their historical 10 year averages, and those high valuations are justified because of all the benefits those companies stand to gain from technological innovations and policy changes.
In Morgan Stanley’s bullish scenario for TL stocks, if corporate tax rates are cut by at least 10% (and it looks like they will be cut by ~17%), revenue growth for the largest carriers, like Knight-Swift Transportation Holdings, could accelerate to double digits for both 2018 and 2019.
On the other hand, a volatile and tightening spot market could hurt brokerages like C.H. Robinson—Morgan Stanley writes that “As the temporary impact from the hurricane has receded and we move into more structural price inflation as a result of the ELD mandate into 4Q, we expect pressure on gross margins at CHRW as spot rates inflate faster than contract rates.” Morgan Stanley also reports that the shippers they’ve spoken with, anticipating inevitable price inflation in 2018, plan to reduce their overall brokerage spend because, firstly, contracted asset-based capacity is cheaper, and secondly, they think that having contracts with asset-based carriers will guarantee a truck more than using a broker. “The former will be a headwind to price/margins and the latter will be a headwind to volumes, in our view,” the analysts wrote.
Susquehanna International Group (SIG) also thinks that large truckload carriers are in a good position headed into 2018. In a Logistics & Trucking Industry Update released this morning, SIG analysts considered the impact of the Republicans’ US tax reform bill—as currently written—on carrier valuations. SIG thinks the massive injection of cash the corporate tax cuts represent would make “P/E multiples look more grounded” and also improve free cash flow (FCF) yields.
The bottom line is that both Morgan Stanley and SIG think that truckload carriers are a good buy going into 2018, but for different reasons—the sector will be buoyed by very strong cyclical fundamentals, and secular changes like technology diffusion and tax reform will create generate further tailwinds for these companies’ valuations.
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