WERN - Heartland Express: The Worst Is In Sight And M&A Provides Opportunities

Summary

• Heartland saw weaker operating earnings in the fourth quarter, with the business pressured by weaker freight demand, a weaker market for used equipment, and the inclusion of less-efficient acquired businesses.
• Trucking continues to correct, with spot rates down over 20% on weak freight demand and still-abundant capacity.
• Trucking demand should recover in the second half of 2023, but it may be too bullish to expect a big inventory-driven freight cycle.
• Heartland benefits from long-lasting relationships with large customers, but upside in 2023 will likely come more from cost synergies tied to the Smith and CFI deals.
• Heartland shares still look attractive below $18 as an early play on a trucking cycle recovery.

The trucking market has certainly turned, but just as the good times never last, neither do the tough times. I'm a little concerned that high inventories will temper the traffic recovery that the market wants to believe in for the second half of 2023, but I do think the cycle will go through its bottom in the coming months.

I liked Heartland Express ( HTLD ) back in November as an early play on that eventual turn, and the shares are up about 14% since then - outperforming the larger transportation group and keeping pace with Knight-Swift ( KNX ) and Werner ( WERN ), while underperforming Schneider ( SNDR ). At this point, my concerns about the broader truckload market are offset at Heartland by opportunities to drive synergies from recently-completed M&A transactions, and I still see a worthwhile upside in the shares from here.

Tougher Conditions And Inefficiencies Take Their Toll

Regrettably, Heartland offers far less information and detail to its shareholders (the co-owners of the company) than other trucking companies, so it's hard to speak to specific drivers. Making matters worse, the inclusion of significant M&A further obscures the numbers - reported revenue growth of 140% year over year and almost 30% quarter over quarter is clearly not reflective of what's going on in the broader trucking industry. Still, a beat is a beat, and Heartland beat revenue expectations by about 5%.

Extrapolating from other carriers, it's highly likely that Heartland saw weaker volumes in the quarter, and indeed management did note "much lower levels of freight demand", as well as challenging pricing. My understanding is that Heartland doesn't do a lot of business at spot rates, so plunging spot rates weren't as much of a driver, but with retail making up a larger-than-average part of the mix, there had to have been volume shortfalls as retailers tried to manage excess inventories throughout the holiday season.

Operating income declined 1% in the quarter, with the operating ratio deteriorating from 82.1% last year to 92.6% this year. If you go along with excluding intangibles amortization from results, operating income rose 4%, with the operating ratio falling from 78.8% to 90.6% (I say "falling", as lower is better with operating ratios). Heartland stock saw a greater hit from the relative inefficiencies of acquired businesses (Smith had a 93.5% operating ratio, while CFI was 98.1%), as well as reduced gains on equipment sales, driving an $0.08/share miss ($0.21 versus $0.29).

The Market Is Still Sorting Itself Out

For all intents and purposes, there was no "peak season" this year in the fourth quarter, as retailers (clothing retailers in particular) found themselves with excessive inventory going into the holiday season. Making matters worse, many manufacturing companies have likewise built inventories to robust levels, though this is a relatively small part of Heartland's customer base.

The holiday sell-through wasn't particularly strong, and that has continued to weigh on freight demand. Trucking companies scrambled to add capacity during 2021 and 2022, and now find themselves with far more capacity than freight to fill it - while the Transportation Capacity Index has come off a bit from its record high of 73.1 in October, but at 70.2 in January, it really hasn't come off that much.

A lot of capacity chasing less freight is having a predictable impact on rates - spot dry van rates continue to fall, with January rates down 23% year over year and down about 1% from the prior month.

Looking at various surveys and indices, it does look like there may be some signs of stabilization coming into the market. Capacity does seem to slowly be leaving the market, as current rates aren't sufficient to fund operating costs for smaller, less efficient operators. This is about the time of year when contracts are repriced, so we'll see what happens with these negotiations, but I think Heartland would do very well to achieve simply flat rates, and they may have to accept some modest rate decreases on some contracts.

Having seen this cycle play out before, there's nothing too special about this cycle beyond a couple of points. First, the downturn started from a much higher level than prior downturns, but with rising operating costs a lot of major operators have said there's a definite limit as to how far they will give on pricing before it makes more sense to just turn down the business.

The second point is the more uncertain state of the economy. While most forecasters seem to be expecting a relatively mild downturn in 2023, high inflation and high inventories going into a downturn have been a dangerous combination in the past. If spending continues to fade, those inventories are going to remain high, and it may well lengthen out the bottom of the trucking cycle.

The Outlook

The cycle will do what it will do, and there's not a lot that Heartland can do about it. The company has been an efficient operator in the past, which gives it some leeway on pricing, but they've also been disciplined, so there will be a delicate balance to be struck between pricing, volumes, and capacity utilization.

One potential positive specific to Heartland is the post-deal integration work for Smith and CFI. Heartland has been an active acquirer over the years, and while the company's deal history is mixed, I do think the company will be able to integrate Smith and CFI and drive costs out of those businesses in 2023 and likely into 2024.

Between discounted cash flow, assuming long-term core revenue growth in the low-single-digit and low-to-mid-teens FCF margins, forward EV/revenue, and forward P/E, I believe Heartland is still undervalued. Discounted cash flow suggests a double-digit annualized return opportunity, while a 7x forward EBITDA multiple (in line with the cycle average) and 18.5x P/E multiple (about halfway between trough and normal) get me a fair value in the $18.25 to $18.50 range.

The Bottom Line

Operationally, I still prefer Knight-Swift (among other options in the transportation space), but I don't think Heartland is played out as an early trucking cycle recovery play. I do still see risks for the cycle, but they seem priced into the shares, and I think this is a name to consider for investors who want some recovery exposure and have the patience to wait for the cycle to play out over the next six to nine months.

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