2023-07-13 08:24:18 ET
Summary
- The slowdown in macro is a difficult force to overcome in the cyclical industry. Freight spot rates have come down from 2021-2022 levels and ARCB monthly metrics are pointing down.
- I have no concerns with ARCB from an operational perspective and have no issues with the way management is running the company. However, current prices levels appear rich.
- The Yellow bankruptcy could be a tailwind for ARCB, but I don't see the justification for re-rating to even higher levels.
Summary
This analysis represents the third company I've decided to conduct a deeper dive on. I believe ArcBest ( ARCB ) is overpriced given a macroeconomic slowdown that is playing out. Initially, I thought there would be an opportunity to own a well run company with a strong history and track record. However, after building my model the numbers are pointing in the other direction - for now. Unfortunately, with where we are in the US economic cycle and at current price levels, I can't justify a long opportunity in ARCB stock here and would recommend sitting on the sidelines if you have an existing position.
Business Overview
ARCB is a multibillion-dollar integrated logistics company that provides innovative logistics solutions across industries and around the globe and offers a wide range of services to transport a variety of goods, including manufactured goods, retail products, and food and beverage.
ARCB has two segments: asset-based and asset-light. The asset-based segment consists of ABF Freight, which provides regional and national transportation services for shipping freight. The asset-light segment includes Panther Premium Logistics, ABF Logistics, and ArcBest Technologies.
FleetNet America provides maintenance and repair services for commercial vehicles. This business was included in a prior acquisition back in the 1990s and was recently sold since this isn't a core ARCB activity. The sale makes sense in my head, but I don't know why it was held on to for so long. The business generated roughly $300 million in annual sales, but only ~$4 million in profits in recent years. There were some material cost structure concerns with this business, it seems.
Relevant Macro Themes
ARCB is part of the broader supply chain/logistics industry. The market size of the third party logistics market was estimated to be ~$247 billion in 2022 with average annual growth of ~4.7% per IBISworld ( IBISworld 3rd Party Logistics) .
The basic supply and demand equation here is broad based both at a consumer as well as a business level. Generally speaking, as consumers acquire goods, retailers need to replenish inventory levels to continue selling. Consumer spending and PMI is where I'd keep my focus on at a macro level with respect to revenue trends.
The post GFC era of spending growth has been strong on the back of low borrowing costs and stimulus (char below). My opinion is that further growth in consumer spending will only be attainable to the extent consumers can still borrow money and not tap themselves out.
Could my thesis be wrong and could consumer spending continue to move up throughout the rest of the year? Absolutely. Consumers aren't in over their heads (chart below) and the labor market is still relatively healthy.
However, I think the growth you're seeing now is being pulled forward and there will be a correction. I just don't see much room for optimism when the 2s/10s is inverted the way that it currently is and with rates such as SOFR as high as they are.
For some companies, this has already been priced in and current trading prices reflect a more dire scenario than something I've already modeled as being pretty bad. See my LZB write up as an example ( link ). However, this doesn't seem to be the case with ARCB.
The impact from COVID led to a dramatic bust then boom then bust within the shipping industry. Activity ground to a halt as a result of COVID closures and stay at home orders in 2Q20, which then translated into a tsunami of unfettered demand for goods and services which was largely brought on by various forms of government stimulus. Times were good. Very good, in fact.
Fast forward to 2023 and some of the signs point to a slowing economy. Freight spot rates are down and things seemed to have normalized back to pre-COVID trend. I follow @FreightWaves on Twitter and one alarming data point was that June, which is normally a busy month in trucking, was trending below 2019 levels.
Another indicator that is pointing towards lower activity in the movement of hard goods is the inventory to sales ratio, which has returned to pre-COVID levels. This is telling me that trucking companies have lost the pricing power they were able to leverage when supply chains were much tighter. The manufacturing PMI isn't really indicating any good news either, with the latest reading at ~46. I don't want to fear monger and allude that we are in a recession, because we aren't. However, there are signs of a slowdown that are occurring.
One of ARCB's main competitors, Yellow Corporation (YELL), has been going through some financial challenges. This boosted truck stock prices recently and I believe this is assuming competitors can grab additional market share if YELL goes bankrupt. YELL does about ~$5b in annual revenues per year, which is roughly the same as ARCB. My opinion is that the theory makes sense, but the market is suffering from amnesia with respect to the challenging macro environment.
ARCB management has mentioned multiple times on its most recent earnings call how challenging the environment is. This is also reflected in ARCB's recent monthly operating metrics disclosure , which shows how dire May was in both the Asset Based and Asset Light segments.
What Separates ARCB From The Rest?
The use of technology has become a major focus for ARCB and the company has invested in platforms which have resulted in the development of systems that are designed to streamline operations and enhance overall performance. One such example is ABF Freight, a proprietary transportation management system that has been developed by ARCB to optimize freight movement and improve overall logistics.
Another differentiator is cross selling. In a 2019 earnings call the CEO did note that a very large majority (~80%) of customers utilized at least two of ARCB's service offerings.
Finally, the last point I want to make is that ARCB has been in the transportation industry for over 100 years and has developed a deep understanding of the industry and its customers' needs. Since my approach tilts towards a value style, you'll rarely find me writing about new companies and industries. I like to see long, demonstrated track records.
Wait a minute - you're recommending to a sell on this company yet this section just summed up how great this company is? I have no issues with how this company is run and think it competes well against others in this space. However, the key point to my thesis is the inertia of a weak macro backdrop that will be hard to overcome. I'd love to buy shares eventually, just not at current price levels.
Revenue and Earnings Profile
ARCB's revenues have been growing steadily over the past decade. The company's revenue growth has been driven by a number of factors, including increased demand for transportation and logistics services, the company's focus on innovation and efficiency, and the company's expansion into new markets. Not all of it is organic growth though, as ARCB has engaged in a handful of acquisitions in recent years. However, I do not see this as a huge concern. One of the things I learned in business school was that a company can choose from the following paths when trying to expand: build in-house, partner or acquire. There are pros and cons with each, and a long position requires a leap of faith that these acquisitions will be accretive within the following dimensions - revenue growth, EPS growth and FCF growth.
ARCB seems to have faced some profitability challenges a decade ago that have improved over time. Margins have expanded from low single digits to high single digits, which gives me some comfort that management is executing well on their strategic plans and diligently running the company from an operational perspective. The other thing that caught my eye was a slide from a 2022 investor presentation detailing margin targets.
Longer term, management is targeting operating margins in the low double digits. They were able to get there in 2021 and 2022 on the back of the supply and macro tailwinds I've cited earlier. However, when you look at the Asset Based segment, salary & benefit expenses are slated to rise.
Management could potentially trim headcount via attrition and the way I've modeled this is by keeping salary expenses at 48% for the next quarter and then tapering down to 47%. In reality, anything can happen but the combination of revenues declining and your largest expense line going up is a red flag. The macro headwinds are a larger force to reckon with, in my opinion. Management can pull some levers here to try and contain expenses, but I believe margins will be constrained to lower single digits in the near term due to a challenging macro environment. In fact, management has already undertaken some planned expense saves of ~$2 to $3 million for 2Q'23 ( ArcBest Announces First Quarter 2023 Results ).
1Q23 Earnings Call Highlights ( transcript link )
ARCB reported some top line growth for the quarter, with revenue up year over year (adjusted for day count). However, the lower spot rates and general economic slowdown are starting to reveal themselves. Operating income has decreased which is consistent with the broader industry wide trends seen across the industry that were covered in the macro section.
So first quarter 2023, consolidated revenue from continuing operations was $1.1 billion, a 13% per day decrease compared to last year. - David Cobb - Chief Financial Officer
Asset-Based revenue was below last year due to reduced customer demand in our core business related to a soft economy which impacted customer order quantities and resulting shipment sizes with customer retention solid, as Judy mentioned. - David Cobb - Chief Financial Officer
The sale of the FleetNet business paves the way for additional capital return to equity investors, but I'm hesitant to model a prolonged trend and rather keep to my conservative modeling style. If this pans out in future periods, it will be a positive surprise.
Following the sale of FleetNet and the corresponding increase in our share repurchase program, we remain in a great position to return capital to shareholders...And based on those share repurchases, $96 million remains available under the current repurchase authorization for future common stock purchases. - David Cobb - Chief Financial Officer
Financial Statements - Notable Items
Declining free cash flow: ARCB's free cash flow has been declining in recent years. In the most recent quarter, the company's free cash flow was a negative $18 million. This decline in free cash flow is due to a number of factors, including increased debt payments and investments in new technologies.
Weakening margins: ARCB's margins have been weakening in recent years. In the most recent quarter, the company's operating margin was ~1.9%, down year over year. This decline in margins is due to a number of factors, with ARCB citing market softness in their earnings release. If we go to the actual footnote table we can see a jump in salary expense in the Asset Based segment and a sizeable reduction in purchased transportation in the Asset Light segment.
Dividends & Share Count Considerations
I tend to evaluate dividends and share counts for a few reasons. The first is to evaluate management's allocation of capital. For a mature company such as ARCB, I like to see dividends as opposed to holding onto a pile of cash. The second reason is that a growing top line and operating earnings can be masked by rapid share count increases - in essence, you own less of the company and the returns are going to someone else.
ARCB has paid a dividend every year for at a least a decade, lending credence to consistency. The dividend has remained relatively stable until a recent hike in 2022, pushing annual dividends up to $0.44 per share. The dividend is paid quarterly, with each quarter's dividend being $0.12 per share. We should expect to see ~$0.48 per share in FY23.
The diluted share count for ARCB has remained relatively stable between 26 and 27 million shares in recent years. As of March 31, 2023, the diluted share count was ~25 million shares. With the sale of FleetNet, management has communicated additional capacity to repurchase existing shares of ~$96 million. This could bring share counts down by another ~1 million at current price levels. Tweaking the diluted share counts to 24 million in the back half of 2023 doesn't really move the needle in terms of my price target, so I'll leave share counts flat as is.
Valuation
To value ARCB, I use a blended approach based on NTM earnings and NTM FCF. I typically opt to use a combination of approaches to root out any bias that may have crept up into my financial model. I also believe expectations on operating earnings and cash flow (burn) greatly impact a company's share price.
ARCB is trading slightly under historical averages and I believe multiples will expand to their historical multiples. As shown below, the NTM P/FCF and P/E are averages calculated over the timeframe from 1Q19 through 1Q23. Could multiples remain depressed? Is there a possibility that I may have missed a key factor explaining current multiples? Yes and yes, but my approach hinges on what I expect to be a probable scenario going forward and multiples reverting to their averages. It's not the most exciting approach, and I would never label this approach as a panacea, but this has worked the best for me over the years and suits my personality, mindset and risk tolerance.
Relative to peers, ARCB doesn't necessarily scream crazy value relative to some other peers such as R and ULH. What the table below is indicating at the very least is that I would not be overpaying for earnings, sales or cash flow relative to other trucking names.
Estimates vs. Consensus Ests
vs Street, my revenue estimate for FY23 + FY24 is in line with 23 an my estimate for the outer year is significantly less based on my current view of the economy. This will change over time though, as management will provide guidance in late 2023/early 2024. Below is a comparison comparing my top and bottom line forecast vs. Street as well as some of the baseline assumptions used in my financial model. My EPS estimates are a lot more dire compared to Street. With senior management already commenting on the challenging macro backdrop and facing margin pressures, I see things getting worse before they get better. If I'm missing something, please comment below and I can do a subsequent note with a model refresh. The nice part about ARCB is that management discloses monthly performance metrics that I'd like to link to my modeled revenue and profitability in the near future.
Catalysts / Risks
The inability for retailers and goods manufacturers to move existing inventory will dampen topline revenue growth, in my view. ARCB is a transportation company, and its stock price is sensitive to changes in the transportation industry. Conversely, demand for goods and services could continue to expand if there is enough credit out there to fund it. While a slowdown in the economy may hurt a company like ARCB in the short run, with proper risk management strategies in place and innovative approaches to service offerings, there are opportunities for growth even during challenging times = greater share of a shrinking pie.
Summary
Overall, I believe truck stocks and ARCB specifically have recently re-rated to higher levels based on some misplaced optimism. I say that because when a bank fails, all other banks tank hard. This doesn't seem to be the case here, but if YELL does file for bankruptcy, shouldn't that mean the overall trucking industry is facing challenges? I have no issues with the way the company is run and I think the balance sheet is solid. However, the macro and ARCB performance metrics lead me to believe there is pain to be felt. There may be a bit of seasonal growth with the upcoming holidays in Q4, but I don't think it's enough to reach levels seen in 2021 and 2022 when trucking had enormous pricing power, which is now gone. As I continue to fine tune my model and digest more information about ARCB, maybe my thesis will change but for now I'm fine hanging out at the truck stop. Let me know what you think below, I know most of the recent write ups on ARCB are bullish. The great part about interacting with other value investors is their humbleness and willingness to have an open mind when synthesizing new information.
For further details see:
ArcBest: The 'Best' Thing To Do For Now Is Sell And Wait