HUBG - Hub Group Faces Challenges In 2023 Amid Cooling Retail Freight Demand

Summary

• HUBG saw 2% YoY top-line growth and 130bps decline in margins in Q4.
• Potential decline in overall freight volume due to decreased retail freight demand.
• Fair value estimate at $82 per share, potential to increase to $120 per share if US avoids deep recession.
• As the risk of a recession in 2023 is high and the risk-reward profile is unfavorable, I advise avoiding the stock at this time.

HUBG's Q4 Results and Outlook: Top-Line Growth but Operating Margin Decline

Hub Group, Inc. (HUBG) delivered year-over-year top-line growth of 2% in the fourth quarter, though sales came in slightly below expectations due to a greater-than-expected falloff in truck brokerage sell-rates. The results and outlook were consistent with the broader trend of retrenchment in the retail sector, which has been pressuring freight volumes in the trucking and logistics sectors. However, this was partially offset by lingering intermodal contract pricing tailwinds. HUBG's operating margin declined 130 basis points year over year to 8.1%, driven by softer truck brokerage net revenue and a lower intermodal gross margin percentage, including rising rail purchased transportation outlays.

In 2022, the company saw a solid revenue growth of over 26%, led by contract pricing momentum and tuck-in deals such as Choptank and TAGG Logistics. Despite a 3.5% decline in intermodal volumes due to rail service challenges, the company's operating margin improved to an impressive 8.9% thanks to changes in business mix and strong contract pricing.

An Overview of the Second-Largest Intermodal Marketing Company

HUBG is the second-largest intermodal marketing company and one of the 20 largest asset-light truck brokers by gross revenue. It operates the second-largest intermodal fleet in the industry and has an approximate 10% market share. Hub has built intermodal and truck brokerage networks that are attractive to customers and suppliers, due to its sophisticated IT systems, market know-how, and large volume of loads. The company's primary rail carriers are Norfolk Southern (NSC) and Union Pacific (UNP). The truckload capacity shortage in mid-2020 through 2022 led to increased contract pricing and intermodal demand, but the onset of rail service shortfalls in second-half 2021 impacted Hub's container volumes. The service levels are now recovering, but retail end market demand is softening. The outlook for 2023 is a year of normalization, before recovering in 2024. The company expects single digit recovery in the intermodal market volume and core pricing.

The Long-Term Trends and Growth Potential of Intermodal Shipping

Intermodal shipping has positive long-term trends driven by constraints on truckload capacity growth and efforts by shippers to reduce transportation costs. The intermodal market share in the eastern US has potential for expansion, offering growth through share gains from shorter-haul trucking. HUBG has been enhancing its service reach through tuck-in acquisitions in the dedicated trucking and outsourced logistics sectors.

Impact of Cooling Retail Freight Demand on Operations

The retail sector's demand for freight has decreased significantly as the inventory restocking surge ends, leading to a potential decrease in HUBG's overall freight volumes. Contract pricing across the intermodal, truckload, and asset-light brokerage sectors will return to normal in 2023 as capacity limitations have lessened. HUBG's intermodal division, however, faces challenges in transportation costs and customer satisfaction due to the performance of its partner Class I railroads, which are currently facing network difficulties related to labor.

Scale-Based Cost Advantage and Network Effect

HUBG's operations benefit from a combination of scale-based cost advantage and the network effect, making it a major player in both the intermodal and truck brokerage markets.

In its highway brokerage business, HUBG serves as a valuable intermediary, matching capacity from asset-based truckers with shippers. Its network of over-the-road carriers is highly valuable to shippers throughout the cycle, partly due to the small size of most truckload carriers and structural constraints on driver availability.

In its flagship intermodal segment, Hub's vast customer base generates significant buying power and preferred access to rail capacity, making it an attractive source of freight opportunities for the Class I railroads.

While there are opportunities for HUBG to expand its business, its asset-based dedicated truckload operations do not have a competitive advantage due to the lack of differentiation in the asset-intensive trucking industry. Increasing fleet size does not necessarily lead to lower costs, and truckload carriers struggle to establish a competitive edge through cost advantage, intangible assets, efficient scale, switching costs, or network effect.

Valuation

Following the release of the fourth-quarter results, my fair value estimate for HUBG is $82 per share. In 2021, HUBG experienced a significant surge in revenue with a 21% increase, largely due to the high demand for restocking by retailers and the limited availability of intermodal and trucking capacity, leading to exceptional pricing conditions. Despite challenges in intermodal volumes caused by rail network congestion, strong pricing and elevated fees contributed to strong revenue growth. The company's total EBIT margin also improved to 5.6%, driven by yield gains that outweighed rising driver wages and network inefficiencies.

However, for 2023, a decline in demand and pricing is expected in the intermodal and trucking markets, but not a major recession in the freight industry. There may be a slight increase in intermodal volume due to pent-up truck-to-rail conversion demand. I expect an approximate 4% decline in total revenue and a 300 bps compression in margins. However, if the US avoids a deep recession, HUBG has the potential for organic top-line growth of 4% and my fair value estimate would increase to $110 per share.

Note that my revenue and margins assumptions are a bit lower than HUBG's lower-end guidance for 2023 but are more aligned to the long-term guidance.

Below are my main assumptions.

Risk and Uncertainty

HUBG's operations, including intermodal, dedicated trucking, and asset-light freight brokerage, are subject to the economic health of North America, serving clients in both industrial and retail sectors. Additionally, HUBG's intermodal operations are contingent on the service quality provided by its partner Class I rail carriers. Despite railroads making considerable investments in their infrastructure, the level of customer satisfaction is often beyond HUBG's control. Environmental regulations have caused tractor cost inflation in the past, and there is a possibility that future regulations will require the adoption of electric Class 8 truck technology before it is economically viable.

Conclusion

In the fourth quarter of 2022, HUBG reported a 2% year-over-year increase in revenue, but a decline in operating margin to 8.1%. Despite challenges in the retail sector, the company saw strong growth of 26% for the year, driven by contract pricing and tuck-in deals. The operating margin improved to 8.9% due to changes in business mix and strong contract pricing. HUBG has been expanding its service reach through acquisitions and intermodal shipping has positive long-term trends.

However, the retail sector's demand for freight has decreased and the intermodal division is facing challenges with transportation costs and customer satisfaction. Based on my fair value estimate of $82 per share, there is a 16% downside to the current price. If the US avoids a deep recession, the fair price could increase to $110 per share, a 13% upside. As the risk of a recession in 2023 is high and the risk-reward profile is unfavourable, I advise avoiding the stock at this time.

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