KNX - Knight-Swift Transportation's Self-Help Offsetting Disappointing Market Developments

2023-10-20 12:15:00 ET

Summary

• Knight-Swift Transportation beat expectations in the third quarter, helped by good LTL performance and faster integration-driven improvements from U.S. Xpress.
• Excess capacity is starting to leave the truckload market at an accelerating rate, but a weaker peak season is limiting the benefit and demand weakness could spill over into '24.
• Excess capacity in brokerage and intermodal markets remains problematic, but the market is starting to squeeze out weaker players.
• Knight-Swift offers leverage to a growing LTL business, a recovering truckload market, and meaningful self-help from the USX integration.

It’s fairly early in the reporting cycle, but it seems pretty clear so far that the trucking, brokerage, logistics, and intermodal markets are still under a lot of pressure and not improving as quickly as some industry participants had hoped. More specific to Knight-Swift Transportation ( KNX ), spot rates remain quite weak in the dry van market, as the flight of excess capacity is being mitigated by weaker overall demand, and while power-only logistics opportunities remain attractive, brokerage and intermodal is facing a lot of pressure.

I’ve liked Knight-Swift for a little while now (my most recent prior article can be found here ), but noted the ongoing risk of a “lower for longer” bottoming out for the company’s operations. Offsetting that has been self-help, and management is executing well here, with the U.S. Xpress integration already ahead of plan. I do still see risks to the freight cycle (and the risk of a weaker U.S. economy in 2024), but I also think the valuation more than reflects that and patient investors may end up happy buying shares as the business comes up off the bottom.

Better Than Expected Results As Self-Help Delivers

Knight-Swift didn’t get any favors or tailwinds from its served markets in the third quarter, but self-help (particularly the integration of U.S. Xpress) did a lot to offset that pressure. With earnings beating expectations, I think management is handling this downturn well, though external pressures will still very much be an issue over at least the next 2-3 quarters.

Results Review

Revenue rose almost 7% as reported and closer to 8% on an ex-fuel surcharge basis, beating expectations by more than 6%. The outperformance was broad-based excluding Intermodal, though Truckload was boosted by USX to a greater than expected extent. Operating income fell 61%, with operating ratio worsening by more than 10 points (93.8% vs. 83.1%).

Truckload saw 19% revenue growth, or 22% ex-fuel, though the base business was down almost 16% on a 12% decline in revenue per mile; reported revenue per tractor was down 8%. Spot rates remain quite soft (down mid-teens), but Knight-Swift generally avoids spot business where it can. Operating earnings declined 66%, with the operating ratio worsening to 94.9% (from 81.8% a year ago).

Rival Marten ( MRTN ) reported a 12% revenue decline on a 13% decline in rev/tractor, with operating ratio of 97.2% (versus 86.5% a year ago), though dedicated performed better (revenue down 8%, OR of 86.4% vs. 84.9%), and about a third of Knight-Swift’s truckload business is dedicated. J.B. Hunt ( JBHT ) did even better, with dedicated truckload revenue per truck down 2% and operating ratio stable at 88.5%.

With far better market fundamentals (including more concentrated competition and the disruptions caused by the Yellow bankruptcy), Less-Than-Truckload delivered better results. Revenue rose 7% ex-fuel, with pricing (revenue per cwt) up about 11%. Operating profits rose 4%, with the operating ratio worsening modestly (84.9% v. 84.5%).

Logistics revenue declined 25%, with rev/load down almost 16% and volumes down about 10%. Gross margin declined 290bp to 18% on excess capacity across the industry, while operating earnings declined almost 62% (OR of 93.3% vs. 86.8%), though the USX brokerage business did generate positive returns. Looking at rivals Marten and J.B. Hunt, the former saw revenue down 22% on a 3% decline in volume (with operating ratio of 89.7% vs. 89.3%), while the latter saw volume down 38% yoy and 16% qoq, with gross margin down 140bp.

Intermodal revenue fell 23% yoy, as over 5% growth in volume was offset by a nearly 27% decline in yield per load. Operating earnings fell into the red, with an operating ratio of 104.5% vs. 90.2%. Marten reported a 17% decline in volume (with OR of 105.9% vs. 96.9%), while J.B. Hunt’s volumes rose 1% on a 16% decline in yield.

Non-reportable business, namely the insurance operations, generated another loss ($5.4M versus an $18.5M profit last year) as the company continues to see negative reserve development (essentially meaning that the business was mispriced and is generating higher than expected claims).

Self-Help

Knight-Swift did see a greater than three-point negative impact to margin from U.S. Xpress, but the company nevertheless is integrating and improving the business more quickly than expected, leading to improved results. Rate per mile improved sequentially at a low single-digit rate, as management reduced USX’s spot exposure from 45% to 15%, and cost per mile improved sequentially at a mid-single-digit rate. I remain of the opinion that Knight-Swift will work the same “magic” at USX that it did with Swift, and that this is an underrated multiyear tailwind for better results.

Not Much Good News In The Market

Conditions really aren’t improving all that quickly in the truckload market. There has been some gradual improvement, or at least stability, in spot rates, and capacity has finally started to leave the market as smaller, less efficient operators no longer have the cash reserves to operate at prices below marginal per-mile costs. At the same time, contract renewal pricing has improved from “down mid-teens” in the summer to “down low single-digits” more recently, as per DAT. I still think operators like Heartland ( HTLD ) are too optimistic in thinking they can get compensated for higher operating costs, but time will tell.

Offsetting better news on pricing, demand is not developing as hoped. I’ve previously expressed my view that optimism over a stronger peak season was likely too bullish, and Knight-Swift’s commentary would seem to back that up, as demand has been muted. Destocking may not be as much of an issue as it has been, but underlying demand just isn’t that strong across retail and industrial markets, and I do remain concerned that demand could weaken further in 1H’24.

Less-than-truckload is healthier, and I expect it will remain so. Yellow’s volumes are being absorbed into the market, and that should still provide a tailwind in the fourth quarter. While Knight-Swift wasn’t involved in the bidding for Yellow’s terminals ( Estes beat Old Dominion ( ODFL )), the company is moving forward with organic expansion plans to add terminals in the Midwest and South.

Intermodal and brokerage basically need freight volumes to improve and for more capacity to leave the market. Convoy , a digital brokerage, closed up shop this week, but there’s still a lot of underutilized capacity, particularly on the brokerage side.

Looking at the insurance business, management says it's evaluating its strategic options, including reinsurance, but it sounds as though an exit from the business could be on the table as well. The trouble with insurance is that it’s a great business until it isn’t – if you get the underwriting wrong, you pay for years (literally), and it would certainly seem that management didn’t fully appreciate what they were getting into when they entered this business.

The Outlook

The biggest risk I see to my outlook/model at this point is that the first half of 2024 is even weaker than I expect (I’m generally bearish versus most analysts). I’m still below the average estimates for EBITDA and EPS in 2024, but again demand could prove even weaker as higher interest rates do their work.

I’m still expecting high-teens revenue growth in 2024, though, and long-term revenue growth of around 5%. Assuming EBITDA margin comes in around 16.4%-16.5% for FY’23, I’m expecting around 30bp-40bp improvement in ’24 and then a multipoint jump in FY’25 into the high-19%’s. On a free cash flow basis, I’m expecting mid-single-digit margin this year and next, improving into the high single-digits over the next five years and the low double-digits beyond that, driving around high single-digit growth on a normalized basis.

Between discounted cash flow, EV/EBITDA, and PE, I think Knight-Swift is undervalued below $55-$63. The upper end of the range comes from discounted cash flow (less reliable with very cyclical businesses like trucking, while 8x my ’24 EBITDA and 18x my ’24 EPS estimates get me to $55.

The Bottom Line

Knight-Swift isn’t can’t-miss cheap, but I think it’s important to remember that just as this down-cycle exceeded expectations, so can the next up-cycle, and I may yet be giving the company too little credit for self-help. In other words, I’m using what I think are conservative near-term estimates that don’t reflect the full longer-term value here, and beat-and-raise quarters are a possibility starting later in 2024. I still think Knight-Swift is worth owning today.

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