In a couple of different notes out to clients on October 11, UBS equity analyst Thomas Wadewitz upgraded his rating to “buy” on truckload (TL) carriers Knight-Swift Transportation Holdings Inc. (NYSE: KNX) and Schneider National, Inc. (NYSE: SNDR). Additionally, Wadewitz raised his price target on “neutral” rated Werner Enterprises, Inc. (NASDAQ: WERN).
The theme is fairly common from most equity analysts heading into the third quarter 2019 earnings season – earnings expectations are moving lower, no one wants to have published estimates higher than consensus and the bottom of the freight recession has likely occurred, prompting some analysts to advise their investor clients to become more constructive on the sector.
As earnings forecasts for the TLs move lower, valuation multiples are rebounding from recent lows and stock prices are moving higher. While this seems counterintuitive, it’s often been said that the best time to own the TLs is when their outlook is the darkest. While we aren’t likely in the “darkest” of times for the TLs, that was likely in the spring of this year for the current TL cycle as demand was thin and the stock prices bottomed at the end of May/beginning of June, fundamentals appear to have only improved to the “not as bad” phase.
Typically, stock prices are driven by a multiple of future earnings. Stock price-to-earnings (P/E) multiples are most commonly used and a key valuation metric for TL stocks.
In his reasoning for the upgrades to the TL stocks, Wadewitz cited the expectation for continued improvement in “market metrics” like a tightening truck market as Class 8 demand declines. He noted the recent rebound in Truckstop.com’s Market Demand Index (MDI), which values truck supply versus demand in the spot TL market, as a catalyst to make the change. The MDI has bounced from -50% year-over-year in May to +22% in October and Wadewitz expects this trend to continue given easy year-over-year comparisons for the index moving forward. Also, capacity is expected to come out of the market in a meaningful way as Class 8 truck orders sputter.
As excess truck capacity came on to the market and volumes slowed, spot rates declined materially, requiring most TL fleets to reassess their truck needs. This resulted in a significant drop in new truck orders. As the industry works through the overbought position, new Class 8 truck orders are running well below standard replacement levels. FreightWaves estimates replacement demand to be 250,000 to 300,000 units on an annual basis. Currently, the industry is only placing new orders at a seasonally adjusted annual rate (SAAR) of 150,000 units.
Additionally, TL capacity is expected to decline further as fleets fail, capacity is cut at small and mid-sized carriers, the electronic logging device (ELD) mandate (December 16) and drug and alcohol clearinghouse reporting begin (January 6).
In his report, he highlighted that TL stocks performed poorly in 2018 even with a hot freight market as the backdrop. The underperformance was due to declines in future earnings estimates in late-2018 when the TL market cooled.
He lowered his 2019 earnings per share (EPS) estimate for Knight-Swift by 4% to $2.33 and took 7% out of his 2020 number, down to $2.00 per share (well below the consensus estimate of $2.38). He said the estimate reductions were across all of the companies segments, including lower pricing assumptions in TL, lower revenue and margin expectations in Knight-Swift’s logistics segment and a headwind to its intermodal results due to the loss of a contract.
While he sees estimates moving lower, he believes that the earnings estimate reductions will help the stock.
“For KNX we believe a reduction in EPS expectations could actually provide a favorable backdrop for the stock,” said Wadewitz. The thought is that with earnings expectations washed out and capacity being purged from the market, investors are likely to become more constructive on the group.
“We view 2020 [estimates] as trough EPS for KNX and we believe it is reasonable to apply a peak P/E of 20x (previously 18x) to derive our price target of $40 (previously $39). We expect improvement in forward-looking TL market metrics (MDI, etc.) to support valuation expansion,” said Wadewitz.
While he still sees macro risk and softer demand in the market, he said that TL stocks “generally perform well one year after the ISM new orders index falls below 50, as earnings expectations come in and investors look forward to improvement in truckload supply/demand fundamentals.” He went on to illustrate how trucking stocks improved by 12% on average in such scenarios.
The Institute for Supply Management (ISM) compiles data from a survey of manufacturing supply executives. The New Orders Index, a sub-index of the Purchasing Managers Index (PMI), has been sub-50, viewed as contraction territory, for two months now. September’s reading was 47.3. The 47.2 reading in August was the lowest since June 2012.
Wadewitz said that he expects continued softness in the spot market to weigh on contractual pricing in 2020, but he believes that the expectations for negative earnings revisions are already priced into the stock. His contention is that future supply/demand dynamics for the TLs are more important to investor sentiment and that the industry appears to be on the path to right-sizing capacity. He is calling for “freight to stabilize and for spot market pricing to inflect positively by mid-2020.” He believes that these factors support the peak valuation multiple and his $40 12-month price target. He views Knight-Swift as having the most leverage to the TL cycle of all the names in his coverage universe.
Schneider National upgraded
Schneider was upgraded to buy for many of the same reasons as Knight-Swift – improving truck supply/demand dynamic, future earnings estimates potentially reaching trough levels and the expectation that freight will stabilize with spot rates inflecting positively by mid-2020. Additionally, he believes that Schneider has some of the easiest earnings comps in 2020 given the closure of its First to Final Mile (FTFM) operation and because it has lowered its exposure to the spot market. FTFM was operating at a $35 million loss this year and Wadewitz believes that its closure is likely an 11% tailwind to 2020 earnings. Also, Schneider entered the year overexposed to the spot market, 30% higher on a year-over-year comparison to the first quarter of 2019. Now the carrier is back to a mid-single digit percentage range, which is in-line with historical levels.
Wadewitz lowered his earnings forecasts for Schneider. He took 3% out of his 2019 estimate lowering it to $1.30 and 5% out of his 2020 forecast, which now stands at $1.25 (consensus is $1.37) on weaker pricing and volume performance within the truckload and intermodal segments. Further, he sees lower margins for the intermodal business for the rest of 2019, with both TL and intermodal margins declining modestly in 2020.
He said 2020 is likely a trough year for earnings for Schneider, but believes a 20x P/E multiple is supportive of the positive catalysts in front of the company and industry, thus the 12-month price target of $25.
Lastly, Wadewitz lowered his earnings forecasts for “neutral” rated Werner very modestly in 2019, taking 7% out of his 2020 estimate, which was lowered to $1.92 compared to the consensus estimate of $2.34. The new 12-month price target of $38 (previously $35) also reflects a 20x P/E multiple of 2020 EPS. Soft freight demand and excess capacity, which will weigh on contractual pricing in the first half of 2020, were the reasons listed for the estimate revision lower.