JBHT - Freight Markets Are Rolling Over But Hub Group Is Well-Positioned Long Term

Summary

• Hub Group's third quarter results beat expectations on better expense management, but volumes in intermodal were weaker than expected even factoring in rail issues.
• Management is prepping for the downturn, looking to add more containers, insource more drayage, and shift more truck brokerage from spot to contract.
• Hub Group is well-prepared for this coming downturn, but cyclical downturns always carry the risk of worse erosion in fundamentals than initially expected.
• Hub Group shares look undervalued on 6% to 7% long-term revenue and FCF growth, but it's a little strange to me that the shares haven't sold off more in anticipation of the cyclical downturn.

It's never easy to buy into a cyclical downturn, as cycles have a way of defying expectations for duration and depth. Moreover, Hub Group ( HUBG ) hasn't really sold off all that much from its peak, despite the likelihood of weaker intermodal and brokerage pricing and some fall off in volumes as economic activity slows. I think there are good reasons Hub Group hasn't sold off much, though, as this is one of the best-run intermodal/logistics companies that I follow.

Hub Group shares are up about 40% since my last update , handily outperforming other stocks that I watch in the space, including C.H. Robinson ( CHRW ), J.B. Hunt ( JBHT ), Schneider ( SNDR ), and XPO ( XPO ). I do see some risk from the spread between longer-term sell-side analyst estimates and management's targets (the sell-side is higher), and likewise, I do see risk that the next 12-24 months could be tougher economically than currently expected, but it's hard not to like the longer-term value proposition here.

The End Of The Big Beat-And-Raise Cycle

Hub's third quarter results weren't bad, but it did constitute a break from the more meaningful beat-and-raise quarters as the freight boom cycle winds down.

Revenue rose 26%, missing by about 6%. Intermodal and transport revenue rose 22%, with intermodal revenue per load up 31% and volume down 6% while truck brokerage revenue rose 63% (boosted by M&A), and logistics revenue rose 12%. Relative to sell-side expectations, brokerage and logistics drove the miss.

Gross margin improved 180 bp yoy but fell 100 bp qoq to 16.5%, but still good for a roughly 20 bp versus the sell-side. Operating income nearly doubled (up 96%), beating by 4%, with operating ratio improving 310 bp to 91.3% (operating ratio is basically the inverse of operating margin, so lower is better). Relative to Street expectations, the beat was driven by operating efficiency.

Guidance was mixed and basically represented a continuation of the trends seen in the third quarter report, with weaker revenue (a roughly 2% guide down) and stronger gross margin (a 16.6% midpoint versus a prior sell-side average estimate of 16%).

Preparing For A Weaker Environment

There's ample evidence around the freight sector that the boom has ended and that the cycle is about to roll over. Volumes are softening, rates are softening, and companies are basically "battening down the hatches" with respect to guidance and setting expectations for 2023. Importantly, many of the better-run companies (I'm including Hub and Knight-Swift ( KNX ) in that group) are pointing to higher trough results through this next phase of the cycle as a byproduct of investments and improvements made in recent years, as well as some structural changes in the market (intermodal, for instance, is a bigger part of the freight market than in prior cycles).

Hub Group saw some modest underperformance in intermodal this quarter - the first time in quite a while that that has been the case. The worries about the rail strike certainly had an impact (a roughly 200 bp headwind to volume), but there still would have been some disappointment either way.

Management continues to invest in the business ahead of this downturn. The company has been expanding its container fleet by about 13% this year, including significant expansion to its refrigerated container fleet. The company has also continued to build out and insource more of its drayage needs. While owning more tractors and trailers does seem to fly in the face of an "asset-light" model, the reality is that insourced drayage lowers costs and improves service quality and should be an offset to other pressures in the business.

Speaking of those pressures, I do expect to see further moderation in volumes as business activity slows. More significant, though, is the fact that over a third of Hub's volumes reprice in the first quarter of 2023, so the pricing tailwind that has been pushing revenue growth is likely to vanish.

Hub Group is also preparing for a weaker truck brokerage market. While there is always a convenience aspect to working through brokers, and brokers like Hub and J.B. Hunt can offer other value-added services, brokerage is most valuable when capacity is tight. That's not going to be an issue in 2023 given what's happening in the market now. In response to weakening conditions, Hub management has said they're going to shift more business to contract, lowering its spot mix from 52% in the last quarter to something more like 45%.

The Outlook

Forecasting the movements in the freight market is difficult enough, but I expect Hub Group to add a few twists of their own with further M&A. Management has long been active in M&A, and I've liked deals like Choptank (refrigerated truck brokerage), Nonstop Delivery (last-mile logistics), and CaseStack (consolidation/warehousing).

Right now, it looks like the market has a pretty typical cyclical decline baked into earnings. In past down-cycles (2017 and 2020), Hub has seen a roughly 30% decline in EPS, and the current sell-side estimates call for a 28% decline between 2022 and 2023 earnings per share. Still, sell-side estimates for margins over the next few years do look a little high relative to management's targets. I think management has taken a prudently conservative approach with guidance, but there could be some further risk to estimates as the cyclical turn starts biting.

I'm looking for a small revenue decline in 2023, but long-term growth in the neighborhood of 6%, as I expect the company to continue gaining share in its core markets and expand into adjacent markets. I expect EBITDA and FCF margins to decline from 2022 levels but still average out higher over the next decade than the past decade - I'm looking for long-term FCF margins to improve from the low-single digits to the mid-single digits, helping drive FCF growth a bit in excess of revenue growth.

The Bottom Line

Between discounted cash flow and margin/return-driven EV/EBITDA, I think Hub Group shares look undervalued here. Discounted cash flow with the above assumptions suggests a double-digit total return from here, while the EV/EBITDA approach (using a 6.75x multiple) leads me to a fair value of over $100 on my current '23 EBITDA estimate.

Frankly, that kind of undervaluation coming off a cyclical peak makes me suspicious, as does the lack of a meaningful move down in Hub Group's share price. I like this business and I think it's entirely reasonable to expect the company to manage this downturn well, but the undervaluation suggested by my model makes me a little concerned that I'm underestimating the downturn/reset that's coming. A pullback below $70 would probably make me feel better, but it's hard not to like these shares today, even with a freight downturn developing.

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