Several analysts believe the current trucking boom has legs to run further. Amit Mehrotra, Deutsche Bank’s (NYSE: DB) managing director and head of transportation and shipping research, is firmly in the bulls’ camp. In fact, in his almost 20 years of analyzing companies and industries, his outlook report for 2021 is the most bullish one he’s written.
During an interview with FreightWaves, Mehrotra laid out his rationale on trucking in 2021 and beyond. His positive thesis centers on continued consumer strength and a positive inflection in the industrial economy, both of which he believes will push earnings higher than current consensus forecasts. The following is an edited version of that conversation.
Runway for demand?
FreightWaves: There has been a great deal of conversation about a record peak season with strong freight flows extending from early summer through the holiday season. What’s your confidence level in freight demand now that we are in the first quarter, the seasonally weakest part of the year?
Mehrotra: “We have high confidence that demand trends in 2021 will surprise materially to the upside. It is our view that both the U.S. industrial and consumer economies will be firing on all cylinders this year. The industrial economy will be supported by demand growth for refined oil products, which has significant positive implications for the U.S. energy complex and in turn U.S. industrial activity.
“Auto production will be up by over 20%, and Boeing (NYSE: BA) will resume production of its 737 aircraft, which historically has accounted for 80% of total Boeing production (which is produced in Kansas and travels via rail to Washington state for final assembly). Also, we are forecasting a surge in consumer activity from a release in pent-up demand … not to mention the ongoing, and significant, need for inventory restocking.
“We would also point to over $100 billion of home equity that was cashed out by U.S. consumers in 2020 — $39 billion in the third quarter alone. This is still well below over $300 billion cashed out in 2006 … but speaks to the impact rising home values are having on consumer mindsets and spending.”
FreightWaves: Consumers have spent more on goods (versus services) as they are stuck at home, which has required an ongoing restocking of inventory. When do you see this ending and are there any other favorable demand catalysts for trucking in 2021?
Mehrotra: “Inventory balances at retailers are generally back to where they were pre-COVID, but same-store sales are significantly better, which is driving the need for restocking. For example, Target (NYSE: TGT) had inventory per store of $6.7 million at the end of October. While this was up 9.5% year-over-year, it’s in the context of same-store sales up 20.7%, implying a sales/inventory spread of over +1,100 basis points. This spread was +960 bps at Dollar Tree/Family Dollar (NASDAQ: DLTR), +720 bps at Walmart (NYSE: WMT) and +2,900 bps at Tractor Supply (NASDAQ: TSCO), underscoring the continued need for restocking.
“And we see potential for spreads to widen again as restrictions ultimately ease — reflecting release of pent-up demand. The bottom line is we see at least two quarters of volume just from inventory restocking, which is very positive when overlaid with our overall macro outlook for growth.”
Capacity headwinds to stick around
FreightWaves: There are several capacity constraints – the Drug & Alcohol Clearinghouse, a material decline in CDL issuances during 2020, lower driver school enrollment, rising insurance costs, etc. keeping a lid on truck availability. When do you see these headwinds correcting and which constraints do you see lingering longer?
Mehrotra: “All these constraints simply mean that barriers to entry are rising, not going away. In fragmented markets like truckload, there is always a clearing price to bring in more capacity. The capacity constraints you noted are very real and notable, but all they do is raise barriers to entry, not eliminate them. Truckload cycles will always be characterized by booms and busts, but higher barriers mean higher highs and higher lows cycle-over-cycle.”
FreightWaves: Do you think this truckload cycle is different? Why wouldn’t the industry overbuy capacity again and weaken the favorable supply-demand dynamic?
Mehrotra: “Trucking is among the most fragmented markets in the world, with the added characteristic of relatively low (albeit rising) barriers to entry. Given these characteristics, it’s never ‘different this time’; rather, a good market sows the seeds to the downturn (via overordering) and vice versa.
“We do believe truckload company earnings can be higher cycle-over-cycle, but we still project Knight-Swift’s (NYSE: KNX) earnings, for example, to decline 20% in 2022 versus 2021 (compared to consensus that still, we think incorrectly, has it up in 2022 year-over-year).
“And [in November] over 50,000 new units were ordered, representing the third-highest monthly order intake in history. What’s interesting is it’s taken longer this cycle for orders to tick up, which supports our view that spot rates need to be higher to justify higher carrier carrying costs like driver pay and insurance premiums. This is very positive for the industry, albeit does not mute peak-to-trough earnings declines (i.e., earnings volatility will remain, but we project higher earnings cycle-over-cycle).”
Contract rates moving higher, drivers remain a concern
FreightWaves: Expectations for contractual truckload pricing in 2021 range from mid- to high-single-digit increases year-over-year. What’s your expectation and why? What would have to happen for rates to move even higher than currently forecast?
Mehrotra: “We are more focused on overall yields — i.e., revenue per mile. Pricing is, obviously, a big component for this, but so is asset utilization and freight selection. We see high-single-digit contract rate renewals this year, but as important, we see very positive freight selection and project opportunities based on our [previously mentioned] macro view. This could allow yields to increase by low double digits, which would be well ahead of expectations. (We believe most earnings expectations are assuming mid/high-single-digit yield improvement in 2021.)”
FreightWaves: Given the headwinds finding drivers, do you think any fleet will meaningfully grow this year? How much top-line improvement can the group see on rates and improved utilization alone?
“Utilization for big truckload fleets will be limited due to driver shortages. It’s possible to see low-single-digit percentage improvement, but anything beyond that will be difficult. That would imply total top-line growth in the high-single-digit/low-double-digit range. But importantly, we think this should translate to very strong margin performance, as pricing disproportionately drops to the bottom line and freight selection allows for very accretive growth.”
Industrial recovery favors LTLs and rails
FreightWaves: What happens if the industrial economy snaps back more meaningfully this year? Which modes will see the biggest impact and how much upside do you see to earnings estimates if this were to occur?
Mehrotra: “This is exactly our call, as laid out in Deutsche Bank’s 2021 Transportation Outlook, published on Nov. 29. We are most optimistic on the outlook for the U.S. industrial economy this year. We see good potential for a sharp, positive inflection in the U.S. industrial economy as early as the first quarter, with Deutsche Bank’s Economics Team forecasting +7.8% average year-over-year growth in U.S. industrial production in the second to fourth quarters of this year and +4.5% in 2022.
“And we see upside to these forecasts as critical elements of the industrial economy recover faster than overall GDP (energy, auto and aero, as we said before). Rails and LTL companies have the most exposure to rising industrial activity and not coincidentally where we are most positive this year.”
LTLs moving in the right direction
FreightWaves: Can the less-than-truckload carriers see meaningful operating ratio improvement without a more robust contribution from the industrial markets?
Mehrotra: “It will be tough. In any fixed-cost business, volumes are incredibly helpful in driving high profitability. But companies like Saia (NASDAQ: SAIA) and XPO (NYSE: XPO) have significant non-volume cost opportunities related to linehaul and pickup-and-delivery optimization.
“Saia’s new Memphis terminal that opened in October, for example, could be a significant driver of density and better profitability for the company, as it allows for the closure of mini break operations that are now unnecessary. And XPO has said every 100 bps of improvement in its load factor is about $10 million to the bottom line.
“The good news is it’s a moot point because we believe the industrial economy will inflect strongly this year, which will be helpful in driving further improvements in ORs across the board for LTL carriers.”
FreightWaves: How much latent capacity do you think the LTL carriers have in their networks and how much volume growth can they take on before adding resources?
Mehrotra: “We don’t believe there is much spare LTL capacity from a real estate/footprint standpoint. We do think Old Dominion (NASDAQ: ODFL) is in a unique position vis-à-vis its own linehaul network, which should allow for continued density build as volumes grow. We estimate, for example, that Old Dominion can absorb at least 20% more volume before having to add structural costs to its linehaul network. This is a huge advantage for Old Dominion.
“But beyond just more capacity, companies like Saia and XPO are being much smarter about how they manage the resources they have, using technology and scale to optimize the current network and drive more productivity. This effectively creates capacity by increasing utilization and operating efficiency.”
FreightWaves: Assuming the LTL industry remains disciplined on price, how much year-over-year yield improvement could be seen this year?
Mehrotra: “Yield in the LTL industry is not just a function of price, but also a function of length of haul and weight per shipment, among other things. For example, higher weight per shipment translates to lower revenue per hundredweight, but it is positive for margins. So it’s important to think about yields holistically and not just a proxy for price.
“But generally, we think the major drivers of LTL margins this year will be positive — that is price and weight per shipment. It’ll be important to deconstruct tonnage between shipments and weight so as to get a perspective on how costs are coming back to the network relative to overall tonnage growth.”
Valuation a concern but fundamentals are strong
FreightWaves: What most concerns you about your bullish calls on the transportation space in 2021?
Mehrotra: “Equity valuations have expanded as we predicted prior to 2020, and now we’re optimistic that earnings power can be well ahead of expectations — reflecting positive inflection in the U.S. industrial economy, housing demand, inventory restocking and release of pent-up consumer demand.
“The risk is as earnings power moves higher, valuations de-rate, translating to neutral-to-negative shift in total equity value. We think the risk of this is low, as we still see solid double-digit earnings growth in 2022, and macroeconomic conditions are likely to remain very accommodative for equity valuations.”