HTLD - Heartland Express Looks Undervalued But The Trucking Cycle Has Struggled To Find A Bottom In 2023

2023-10-11 12:28:45 ET

Summary

• Truckload carriers have had to deal with a protracted downturn throughout 2023, with stubborn excess capacity leading to mid-teens declines in spot rates and inflation chewing into profits.
• Heartland Express has seen its operating ratios return back to the 90%'s as demand has been soft, leading to more deadhead miles, and higher expenses that can't be offset with pricing.
• There's evidence that capacity is finally leaving the market and that the significant 2023 inventory correction cycle may be over, but a recovery in 2024 could be capped by pricing.
• Heartland shares look undervalued on the eventual recovery in the truckload cycle but "eventual" can take longer than investors expect and another round of estimate cuts is possible.

One of the challenges of investing in cyclical companies is that no two cycles are ever the same and that creates a lot of modeling challenges. In the truckload (or TL) part of the trucking industry, for instance, capacity has been slower to leave relative to spot prices and cash operating costs, and there has been a larger than normal inventory correction among customers.

This makes sense - smaller carriers went into this downturn with more cash in the bank after the boom, so could withstand lower rates for longer, and inventories were inflated by companies needing to keep higher inventories on hand to offset supply chain risk – but it has nevertheless complicated modeling and led to a lot of disappointment this year. In particular, both shipping volumes and pricing have been weaker than I expected and what looked like a 2H’23 recovery is now looking like a lost year with a recovery in 2024 that is still looking pretty soft.

Since my last update , Heartland Express ( HTLD ) shares have lost a little less than 10% of their value. That’s not too bad relative to other TL carriers ( Knight-Swift (KNX) is down 13%, Marten (MRTN) is down over 10%, and Werner (WERN) is down 15%, while Schneider (SNDR) is down about 2%), but I wasn’t recommending Heartland as an early-stage trucking recovery play on the basis of smaller losses (though the stock did work modestly for about four months). At this point I do think Heartland remains undervalued and I think the trucking cycle is bottoming out, but thus far lights at the end of the tunnel have been additional oncoming trains, so I understand investors wanting to stay away until there’s real evidence of an upturn.

It’s Different This Time … But Not Really

Every trucking cycle is different and every trucking cycle is the same.

What I mean by that is that boom times drive strong increases in rates and small capacity providers push into the market to get their piece of the pie. Eventually the economy/freight demand cools, that balance of capacity supply and demand shifts to excess and prices start falling. Those falling prices pinch established carriers like Heartland and Knight-Swift, but they’re even more damaging to small carriers and eventually that capacity is forced out of the market. Then the economy/freight demand recovers, there’s insufficient capacity to meet that new demand and we do it all over again.

This cycle has followed that basic pattern, but with some important twists. The pandemic hammered capacity, with reduced demand idling drivers and many older owner/operators deciding to leave the business. At the same time, the post-pandemic period saw a surge in business activity and shipping demand, leading to a big swing in rates and demand for capacity (which, in turn, drove demand for truck brokerage services from companies like Hub Group (HUBG), Knight-Swift, XPO (XPO), et al).

The net effect of all of this is that shipping demand was far higher than normal, capacity came in to meet it, and rates were quite healthy. That generated substantial cash for smaller operators, and that cash is part of the reason why this downturn has been stretched out. Dry van spot rates are down about 16% year-over-year as of early October, and while the rate declines seen in 2023 would normally be enough to push a lot of capacity out of the market (rates have been below cash operating costs for small operators for some time), those operators have been able to rely upon and draw down that cash built up during the boom.

The bottom line for Heartland is pretty simple. Freight demand has fallen off considerably in 2023, due in part to a significant inventory destocking cycle, and with too much capacity in the market (and larger carriers reluctant to let go of drivers), prices and profitability have crumbled.

There have been some signs of a bottom here of late. The big inventory correction cycle seems to be petering out, and there is some evidence that this year’s peak season may be stronger as demand still hasn’t fallen off too bad. Capacity has started to leave the market (but is still too high) and prices seem to be bumping along at low levels.

A Weak Market Has Undermined Leverage Opportunities

A big part of the Heartland story for 2023-2025 was (and still is) the synergy opportunities from integrating the large Smith and CFI acquisitions (both of which closed in 2022). Neither of these carriers operate as efficiently as Heartland, and driving costs out of these businesses and bringing them in line with core Heartland efficiency (management has targeted low-80%’s for operating ratios) was going to be a meaningful earnings driver.

That story can still work, but it’s very much on hold for now. With revenue (excluding fuel) basically flat on an organic basis in the second quarter, there just isn’t enough volume and price leverage to drive those efficiencies. Not only is Heartland not operating its fleet at maximum efficiency (more deadhead miles, fewer overall shipments, et al), operating costs are higher with inflation in wages, parts, and so on. That’s driven the overall operating ratio back into the mid-90%’s (adjusted), with Smith and CFI both in the high-90%’s in the last quarter.

Heartland is also reaping less benefit from gains on sale. Heartland maintains a very modern fleet, typically selling tractors after around two years of use. Keeping the fleet age low reduces operating and maintenance costs and keeps drivers happier, but Heartland generally relies on smaller carriers to buy their used equipment. With capacity exiting the market, though, that demand has dried up and gains on sale have shrunk this year; in response management has also cut back on its net capex, leading to modest creep in average tractor age (2.1 years versus 1.9 in the last quarter).

The Outlook

I don’t see any reason to expect that third quarter earnings will be strong. Around six months ago the Street was expecting $0.25 in EPS for the third quarter, and even 90 days ago the estimate was still $0.19. Now the expectation is $0.08 and I wouldn’t be shocked if the company misses due to a higher operating ratio. Likewise, I think the Street very much wants to hear that not only has the market bottomed, but there are already signs of improving demand, including a stronger peak season. I do think that may be too much to hope for, and I see a risk of a lackluster peak season and an extended “bumping along the bottom”, as I don’t expect a big inventory rebuild cycle, nor a strong retail season.

Heartland really doesn’t do spot-rate business, but spot rates do inform contract rates, and I see a risk that large carriers like Heartland will be in a poor bargaining position for the next round of rate negotiations. There just isn’t a lot of demand now and even though carriers like Heartland will argue that they need rate support to offset operating costs, customers likely won’t see a compelling need to pay up. The risk, then, is that while the market does recover in 2024 from a volume standpoint, price could still be a headwind and that the real recovery gets pushed into 2025.

I’m still looking for long-term revenue growth in the neighborhood of 4% to 5%, but a lot of that comes from the bump this year from the Smith and CFI deals. Long term, I expect core growth to be more on the order of 2%. Further consolidation could offer some upside, but time will tell. On the margin side, I do expect a significant decline in free cash flow margins in FY’23 and FY’24 as the company absorbs higher operating costs and resumes capex in FY’24. Longer term, I still think low-to-mid-teens FCF margins are attainable, driving mid-single-digit normalized FCF growth.

While Heartland does look undervalued on a discounted cash flow approach, the intense cyclicality of the business makes it very difficult to rely on long-term modeling. Turning to multiple-based approaches like EV/EBITDA and P/E is not much easier, given the challenges in selecting the right multiples and earnings numbers – 2022, 2023, and 2024 results aren’t really representative of normal operating conditions.

I can use $1 in EPS for 2025 and a 17x long-term cycle average PE to generate a $17 target, but it’s worth noting that that 2025 number has come down sharply in six months. Likewise, I can argue for a 6.5x multiple on 2023 EBITDA (which gives me an $18 target), but at some point you have to be wary of picking numbers that give you the result you want – to that point, if I look at prior P/Es on trough earnings, it would seem that 30x my 2023 EPS estimate of $0.42 would be appropriate, and that only gets me to $12.60 for a fair value.

The Bottom Line

I do think that Heartland shares are undervalued and that the trucking cycle has bottomed out, but I also thought that six months ago and that was clearly the wrong call. I think investors can do okay from here with these shares, but I can’t guarantee that there won’t be another round of guidance/expectation cuts as this correction drags on into 2024. If you can take the risk of being early, this is a name to consider but it’s definitely not for those investors who struggle to cope with uncertainty.

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