The 3PL sector is healthy but suffering under the weight of stable contract rates and rising spot rates, and C.H. Robinson is feeling that impact.
That’s one of the main conclusions from the Wall Street research firm of Evercore ISI, which launched coverage of the sector in a report this week that stretches toward 140 pages.
While the headline of the report focuses on its initial recommendations on the stocks of C.H. Robinson (NASDAQ: CHRW) and Landstar (NASDAQ: LSTR) — both get an “in-line” rating, the middle of the company’s three grades — the broader report focuses on how 3PLs face headwinds in a rip-roaring freight market with spot rates that have been climbing and contractual negotiations that haven’t locked in those higher rates.
“Prolonged elevation of spot rates has reverberated throughout multiple outlets within the trucking industry, with dire implications to brokerage spreads, which have suffered from a contract market that refuses to match current spikes in spot,” the Evercore report said. “With spreads likely to remain under pressure for the foreseeable future, further margin compression is the likely outcome.”
That margins are down is not just the view of Evercore. In its second-quarter report, the Transportation Intermediaries Association reported that the average margin that quarter for loads brokered by 3PLs was 12.6%, down from 13.2% in the first quarter.
And in the company’s second-quarter earnings call, C.H. Robinson CEO Robert Biesterfeld described the margin environment facing the company on many of its loads. Biesterfeld said the company was “honoring its contractual commitments with strategic customers, which is still resulting in a higher-than-normal percentage of loads with negative adjusted gross profit margins due to ongoing increases in the cost of purchased transportation.”
(However, the C.H. Robinson quarterly earnings report said the company’s North American truck margins were 10 basis points less than in the corresponding quarter of 2020.)
Evercore said the “unprecedented” current market has led to record revenues and profits in the 3PL industry. But it has come at “the cost of compressed brokerage margins, delayed contract repricing and increased volatility within the underlying trucking market.”
Brokerage spreads, according to Evercore, are in their 14th consecutive month in “negative territory.” “Few catalysts exist to suggest any type of near-term reversal,” Evercore said.
Brokerage houses that are seeking new contract rates are finding that shippers are resisting long-term deals given the current level of rates, according to Evercore. In place of the traditional contracts, the report said, deals have been more along the lines of “bridge financing, mini-bids and other short-term arrangements.”
Given that situation, the problem for a 3PL going forward is that it might not benefit from the usual end of a strong cycle, according to Evercore. That end of cycle is usually lucrative for a 3PL, with spot rates falling while earlier agreed-upon contract rates are held in place. When the 3PL goes to secure capacity, it’s at the lower rate to serve a customer that has a higher contract rate.
But now, “shippers continue to push back on entering into contracts amid historic levels of capacity tightening, while the bottlenecks that have capped supply from adequately meeting demand lack any near-term solutions,” Evercore wrote.
The Evercore prediction: “We view brokerage spreads remaining in negative territory for the remainder of 2021, with partial relief coming in the form of seasonal loosening in January following the holiday season.”
A more optimistic outlook was presented by CHRW CFO Michael Zechmeister on the company’s earnings call in late July. Referring to high spot rates, he projected that “at some point, if the costs start coming back to five-year averages, or 10-year averages, that’s when those margins start widening for Robinson.”
Given that the Evercore report looks at both C.H. Robinson and Landstar, a comparison of the issues that CHRW faces in the market compared to Landstar is inevitable. The two companies are often considered peers, but as the Evercore report notes, the models are significantly different.
The “unique” model of Landstar — with its business capacity owners (BCOs), independent agents and network of trailers — contrasts with the “principal-agency relationship inherent in the asset-light model,” Evercore wrote.
Instead, the Landstar structure is one in which compensation of BCOs and agents is “aligned with LSTR’s economic interest via contractually agreed upon percentages of revenue and gross profits that incentivize profit maximization while providing margin stability relative to typical 3PLs,” which are more at the mercy of where spot rates are sitting. BCO compensation also includes savings for drivers on fuel, insurance, tires and equipment.
The model, as the Evercore report notes, means that Landstar’s performance does have a high correlation to a spot market but without the “contractual headaches” the report laid out separately for more traditional 3PLs.
The “limited contractual market exposure and margin stability provided by BCOs have led to ideal operating conditions,” the report said.
When the market tightens like it has in 2020-2021, Landstar turns more to independent owner-operators to move freight. These are not BCOs, and when they are called upon in greater numbers, the report said, “gross margins decline resulting from a higher denominator in the form of stronger spot rates, but operating margins improve as insurance, equipment and other benefits provided to BCOs make up a lesser percentage of indirect costs.”
While that helps a company like Landstar get through a market with high spot rates, it also means that the sort of “late-cycle” decline in spot rates that benefits a company like C.H. Robinson isn’t a boon to Landstar. “Current conditions for Landstar represent peak profitability with limited upside relative to traditional peers given the uncertainty surrounding the future of the current cycle,” Evercore said.
The BCO model has another possible pitfall: rising insurance rates. Landstar provides its BCOs with insurance that covers a single-incident loss of $5 million and higher coverage over a three-year period. It also provides excess coverage, all through third-party providers.
“[Landstar] management has expressed concern over the diminishing availability of third-party insurance,” the report said. The problem is serious enough that “we view rising insurance costs as a threat to LSTR’s unique capacity structure.” It could push capacity away from BCOs, who receive that insurance coverage, and on to independent owner-operators, who do not.
That development, according to the report, would “[reduce] the stability provided by BCOs and potentially [erode] LSTR’s unique capacity advantages.”