Morgan Stanley (NYSE: MS) transportation equity research analyst Ravi Shanker says “risk-reward” for the freight transportation industry is “looking more balanced.”
In a March 23 note to clients, he upgraded his outlook for the sector from “cautious” to “in-line.”
While he lowered his 2020 and 2021 earnings estimates across all transportation modes, he cited several reasons to justify the improved outlook, which has a bias towards trucking, for the sector.
Shanker said that transportation data points have “held up relatively well so far,” noting signs of improvement in trucking metrics as supply chains continue to respond to the spike in demand for food, grocery, cleaning supplies and other household items as coronavirus-related quarantines continue.
In recent weeks, the year-over-year (y/y) improvement in outbound tender volumes has widened as truckload (TL) demand has spiked. Volumes are currently running 28% higher y/y.
As TL volumes surge, excess truck capacity, which has weighed on TL rates for more than a year, has been quickly absorbed. The market has tightened meaningfully since the outbreak as evidenced by carriers being more selective with the loads they chose to haul. Currently, 16% of the loads tendered to carriers under contract with shippers are being rejected, according to FreightWaves data.
2020 was already expected to be a year of meaningful contraction in TL capacity. Many carriers were forced to close shop when rates sank in response to incremental truck capacity and sluggish volumes throughout late 2018 and most of 2019. Further, cost inflation across the carrier P&L, most notably on the insurance expense line, as well as added industry regulation were expected to drive market tightness and lift rates higher by the middle of the year. While this scenario may be temporarily pulled forward as the world awaits clarity on a potential resumption to normal, how long the recent uptick in TL fundamentals will last remains to be seen.
Shanker said that he views the transportation complex as having some defensive qualities, typically not the investment thesis for the transports, specifically calling out the trucking industry’s roughly 60% exposure to consumer staples. He also noted that sectors like manufacturing, airlines and hospitality are far greater exposed to the quarantines and at risk for a potential total shut down.
“Freight transportation will likely be at the forefront of a need to restock when supply chains are back up and running – in China now and in Europe and the U.S. in a few months’ time – leading to tightness in supply and significant potential rate inflation when that comes.”
Shanker took down his earnings estimates for all but one company he covers. The outlook for full-year 2020 TL earnings estimates was reduced in the high-single-digit percentage range with more muted reductions made in 2021.
“Fundamentals probably deteriorate before they get better, but volumes/pricing have held up so far, a sharp rebound could be a net tailwind, balance sheet risk is low and even bear-case valuations have normalized, which leads us to believe that risk reward for Freight Transportation is now balanced.”
Shanker said his base case forecast calls for “a short, sharp freight recession,” similar to the 2008 global financial crisis, but only lasting for three months. He said that this scenario would amount to a roughly 5% reduction in 2020 earnings.
Shanker’s bear case scenario calls for a 10% decline in earnings for 2020, a 35% decline from the 2018 peak. He said that the transportation industry “has already been through a recession in the last 18 months, which makes our starting point much lower than other sectors.”
His bull case assumes no material changes.
Morgan Stanley’s economists are expecting a 30% decline in second-quarter GDP with a 29% rebound in the fourth quarter. For the entirety of 2020, the firm expects a 3% y/y decline in GDP.
Shanker favors the “highest quality names in our group,” avoiding “high fixed cost businesses with high operating leverage.” Shanker cautioned, “names with negative secular catalysts and highly levered companies are not out of the woods yet.”
“The most obvious error we may be making is that we are too early in calling a bottom and that the unprecedented nature of the challenges facing us bring new lows – even below what we saw in 2008. We do not believe that this can be a base case at this time but we continue to constantly reevaluate the situation.”
The S&P 500 is off 32% since the market selloff began on February 24 as fears over the coronavirus intensified after a rapid outbreak in northern Italy prompted officials to lockdown several towns. In the same period, the Dow Jones Transportation Average is down 38%.