XPO - XPO: A Good Long Term Bet

Summary

• In the near term, XPO’s revenue and margin growth should be impacted by the weakening demand.
• However, the strategic initiative of investing in capacity and improving service quality should benefit the company to gain market share during this slowdown.
• The company’s cost reduction and operational excellence initiatives should help improve the operating ratio in the long term.

Investment Thesis

XPO ( XPO ) is now a pure-play LTL company following the spinoff of its brokerage service business RXO ( RXO ) in November 2022. Despite tough macros, I believe the company should be able to outperform the industry growth, given its recent business wins and market share gain opportunity from improving service levels. The company should also benefit from operational cost reduction and operational excellence initiatives. I believe the company's strategic initiatives such as investing in capacity and improving service level should allow it to gain market share during this slowdown as well as in the long term. Good long-term growth prospects coupled with reasonable valuations make it a good buy.

Revenue Outlook

The company's shipments per day as well as pounds per day have been declining over the last few quarters due to the challenging demand trends in its end markets, which include agriculture, retail, e-commerce, industrial, and automotive. However, in September and October, the company saw positive Y/Y growth in tonnage due to business wins in the previous quarters as well as market share gains from a higher quality of service and expanding terminals.

XPO is working on its growth strategy, which focuses on investments in capacity and improving service quality in the North America LTL business. The objective of this strategy is to gain market share, optimize pricing, and improve operational efficiency. The company opened a terminal in New Jersey in August last year to manage its volume going through the Northeast Corridor and added 24 new doors to its network. This, along with other terminals opened till the last reported period adds up to 396 doors. The company plans to open 900 net new doors by the year-end of 2023 and has approximately half a dozen projects that are underway in the Dallas market, Houston, Salt Lake, Atlanta, and other markets. XPO is also investing in the trailer side of its business. The company added a second production line at its trailer manufacturing facility in the first quarter of 2022 to increase its output run rate. It will be adding a third production line in the fourth quarter of 2022. The company plans to increase its trailer production by another 50% next year, which would further help expand both its linehaul and pickup and delivery fleets. It is also working with OEMs to bring in more trucks in 2023.

The company is improving its services through its "Gladiators" program at terminals to recognize quality loading. In this program, as the quality target is exceeded, the entire team is rewarded at that terminal. It also launched a new technology in the field that can pinpoint trailers that fall short of XPO's quality loading standards and identify which supervisors and dock workers need more coaching. The company is also investing in its sales force and improving its damage frequency. Damage frequency is the number of skids or pallets that were damaged when delivered to customers. The improvement in service quality should allow the company to charge its customers more.

The company's strong balance sheet should enable it to continue investing in its business during the downturn and gain market share. It had a net leverage of 1.7x adjusted EBITDA on a TTM basis at the end of Q3 FY22, which is significantly lower than its year-end 2021 net leverage of 2.7x. The company should continue to further reduce its net debt from the cash proceeds received in the asset sale transactions.

At the beginning of 2022, the company announced its plans to simplify its business model by separating asset-based and asset-light businesses. On November 2022, the company completed the spin-off of its brokerage business, which now trades as a new company under the name RXO. XPO is now a pure-play LTL company, and RXO is the fourth largest U.S. truckload brokerage service company. In addition, the company also announced the divestiture of European and North American intermodal operations. The company completed the divestiture of North American Intermodal in March. The company was planning to divest its European intermodal business by the fourth quarter of 2022. However, due to weakening macroeconomic conditions in the region, the company has postponed this divestiture for now.

While the macroeconomic environment is certainly tough, I believe the recent project wins and market share gains which helped the company post positive tonnage in September and October should continue to help it offset some of the slowdown in end markets. Additionally, the company plans to increase prices by low-single-digit in 2023. In the long term, XPO's strategic initiatives such as opening new terminals and improving service quality should allow the company to gain market share during the downturn and emerge much stronger on the other side of the macroeconomic cycle.

Margin Outlook

XPO's LTL business' adjusted operating ratio has been on an improving trajectory since FY15 due to the company's cost control measures, exit from low-margin businesses, and technology initiatives. However, the adjusted operating ratio increased in FY20 due to lower volumes. Since then, the company's adjusted operating ratio has improved due to higher volume and company-wide cost improvement and pricing initiatives. Looking forward, I believe the company's adjusted operating ratio should be impacted in the near term due to volume deleverage and inflationary cost pressure. However, these headwinds should be partially offset by the cost reduction benefits and operational excellence initiatives like using technology to refine linehaul pickup and reduce delivery and dock costs. Additionally, the company is investing in trailers and tractors to reduce third-party fleet sourcing, which is expected to save 30% to 40% in terms of costs per mile. The company is also using its digital platform to improve the quality of service and charge higher pricing for this improved quality. Frankly, I believe XPO has a lot of room for Operating Ratio improvement in the long term as the company takes initiatives to catch up with its high-quality LTL peer Old Dominion Freight Line ( ODFL ) which has an operating ratio between the high 60s and low 70s.

Valuation & Conclusion

The stock is currently trading at 11.66x FY23 consensus EPS estimate of $3.24, which is at a discount to its peers.

While the company's revenue should be impacted due to the weakening economy in the near term, its long-term prospects are strong thanks to its strategic initiatives of investing in capacity and improving the service quality. The company's adjusted operating ratio should improve in the long term given its cost reduction initiatives and operational excellence. I believe the current slowdown is a good opportunity to buy this long-term growth story at attractive valuations.

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