What drives consolidation in trucking?
2017 was an active year for mergers and acquisitions in American trucking: Heartland Express closed another one of its cash acquisitions, picking up Interstate Distributor Co. for $114M. Daseke Inc. used capital raised from its February IPO to add munitions and explosives haulers R&R Trucking and the Roadmaster Group, flatbed carriers The Steelman Cos and Tennessee Steel Haulers & Co., and commercial glass transporter Moore Freight Service to its flatbed/heavy specialized carrier group. “The consolidation opportunity is exciting for years to come,” said Don Daseke, founder of Daseke Inc.
But the biggest 2017 story in consolidation had to be the Knight-Swift merger announced in April that created a leviathan with 23,000 trucks and $5B annual revenue. FreightWaves spoke to veteran industry consultant Lee Clair, Managing Partner of Transportation and Logistics Advisors, to better understand the significance of the Knight-Swift mega-merger in the highly fragmented trucking industry. “There’s been lots of M&A and it will continue, but when it’s over, it won’t change the structure of the industry,” Clair explained. Why?
“There’s virtually no economies of scale in trucking over $250M revenue,” Clair continued, “but you have synergies of size—you can balance flows, run in more lanes, deal with one-off issues and problems. You can offer more to your customers. At a certain size, you go past that, and it actually costs you more. In the 1980s, that was $1B; if you went over a billion, you were gonna have your hands full. Then technology showed up, and you could run something much bigger, with the same span of control, very effectively, up to $2B. Knight’s play with Swift is betting that the tech has advanced so much that you can move that number much higher. Knight’s one of the best run companies around. Swift has been big and mediocre for a long time, but they’ve gotten significantly better: their management team has come a long way, and performance has really improved. Swift was significantly hampered by their debt load; they’ve worked at bringing that down, but it was incremental. The new company is better positioned to grow.”
Only the better-run companies, Clair said, would be able to operate efficiently at the biggest scales. There are several companies in a position to make deals of that size, but a large part of getting buyers and sellers to ‘yes’ depends on prevailing economic conditions. The growth rate of the overall economy is key for both buyers and sellers: healthy GDP growth boosts buyers’ confidence and encourages them to spend money on capital outlays; a solid economy also reassures sellers that they will be able to get a fair valuation in the market. The economy has been chugging along at 3% growth with low unemployment and rising workforce participation—these strong fundamentals brighten the outlook for trucking M&A deals in 2018. If Trump signs the Republican tax bill into law, the influx of cash to corporations of all types will encourage economic activity and free up liquidity for major acquisitions.
“There’s a plethora of capital out there, and plenty of firms are acquirable,” said John Engstrom, CFA, from Stifel Financial Corp, in a phone interview with FreightWaves. “If I’m a buyer, I want to be confident that I can make the asset look better the year after I buy, and outside of any public releases will be thinking about my next twelve month multiple as much as the market looks at the reported trailing twelve month multiple. If I’m a seller, I’ve seen my business firm up after some tough years. I might be thinking, ‘rates were strong in 2017, but I still remember 2016’s abysmal truckload market when I was running around with my hair on fire, trying not to go bankrupt.’ I might be ready to get out while the getting’s good.”
But investors giddy over the ‘Trump economy’ may have pushed stocks high enough to discourage big acquisitions. “We don’t expect the stronger market environment to drive trucking mega-mergers in 2018, as valuations are high and economies of scale for larger fleets tend to be low,” wrote Bascome Majors, CFA, of Susquehanna Financial Group (SIG), in an email interview with FreightWaves. Majors is right—truckload carriers’ P/E ratios are running about 130% of the S&P 500’s average. That means that the market’s high expectations for trucking companies’ performances in 2018 may already be priced in, and if that’s the case, would-be buyers will balk at paying a premium for the smaller carriers they’re trying to acquire.
Matthew Grayhack from Fitch Analytics agreed, saying “I think one of the things to remember is that when things look better, there’s a premium in the market; equities are up by double-digit percentages. There was talk that there might be more bidders looking to acquire in the market, and there’s higher cash flow, but I think you’re going to have to be willing to pay a premium.”
Even with sky-high carrier valuations, buyers may still be able to find ways to make a deal. Steve Brown from Fitch said, “Has the market’s appetite to put debt on these companies changed over the years? Historically, you didn’t see a lot of debt in the industry. And when you did, it was companies like YRC that got out over their skis a little bit… they had to restructure debt and wipe out shareholders and it was almost tantamount to a bankruptcy—a distressed debt exchange. As the carriers get larger, there may be more appetite for debt. The kind of leverage XPO is carrying now, we haven’t seen that historically. We’ll see how the market reacts to these bigger guys.”
There are a few ways that TL carriers’ P/E ratios could come back down—the most favorable for an active year of M&A would be if the tax cut ended up increasing the carriers’ earnings more quickly than their stock prices rose. That would lower the P/E ratio and make them more attractive to potential buyers. Buyers are trying to time their acquisitions to market upswings—they don’t want to buy at the market peak, but somewhere before that point. Morgan Stanley, on the other hand, does not think that truckload carriers’ P/E ratios are unusually high; they wrote in a Dec. 13 research note that carrier P/Es 130% of the market average track closely with the 10 year historical trend. Carrier P/E ratios only seem high because the stock market as a whole is priced high. Moreover, the high valuations for truckload companies are justified due to the benefits large carriers stand to gain when the ELD mandate begins removing capacity from the market and the tax cut unleashes a torrent of cash into corporate coffers.
So how long will the current capacity shortage and its associated high rates last? “The first thing is—what do we mean by ‘shortage’? When everybody’s screaming there’s a shortage, there’s never a time when everyone’s freight didn’t move. We’re short 15,000 drivers? Everyone’s freight is moving anyway,” said Lee Clair. “The second thing is, if anybody knows how long it’s going to last, they’re retired and on the beach. But right now, capacity is as tight as it’s ever been, and it’s much more likely that it will get tighter before it loosens back up.”
The strong labor market, and the corresponding difficulty carriers are having retaining drivers, might spur some acquisitions. “We have to consider the importance of finding [acquisition] targets with a lot of qualified drivers. If a company has a low turnover rate, that’s probably attractive to a larger firm,” said Grayhack.
Production and sales of new Class 8 trucks collapsed in 2016 and were weak to begin 2017, but slowly picked up steam. 2017 will end with several consecutive months of 30% year-over-year growth in new truck deliveries. Truckload carriers, wary of getting burned by a sudden downtown, are typically very cautious about expanding their capacity, so these figures indicate a robust confidence in 2018, which, again, seems grounded by very favorable market fundamentals. Since the Great Recession of 2009, there have been two boom-and-bust cycles in truck production: the first cycle saw a year of tepid growth (2010) followed by a year of rapid growth (2011) and then a year of plateauing growth (2012); the second cycle, after a small contraction in 2013, saw modest but sustained growth for two years (2014-5) before a large contraction in 2016. The first cycle saw a three year long upswing and the second cycle saw a two year long upswing, indicating that it is reasonable to expect at least one more year of growth after 2017.
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