2023-10-24 17:13:25 ET
Summary
- XPO has posted a total return of ~117% so far in 2023, significantly outperforming the S&P 500.
- The company's strong performance is driven by a strong economic backdrop and the demise of one of its largest competitors, Yellow Corp.
- XPO competes in a highly competitive business which results in low profit margins.
- XPO's valuations are currently elevated reflecting expectations of rapid earnings growth following the demise of Yellow Corp.
- I am initiating XPO with a hold rating and will consider upgrading my rating once the company grows into its current valuation.
Shares of XPO, Inc. ( XPO ) have proven an excellent investment so far in 2023. They have generated a total return of 117% compared to just an 11% total return delivered thus far by the S&P 500.
XPO has also significantly outperformed its competitors which include Old Dominion Freight Line, Inc. ( ODFL ), J.B. Hunt Transport Services, Inc. ( JBHT ), ArcBest Corporation ( ARCB ), and Knight-Swift Transportation Holdings Inc. ( KNX ).
Strong performance by XPO has been driven by a number of factors including a strong economic backdrop, strong operating performance, and the demise of Yellow Corporation ( OTC:YELLQ ) which was previously one of XPO's largest direct competitors.
The significant rally in XPO shares has pushed valuations to highly elevated levels and thus I am initiating coverage with a hold rating.
Company Overview
XPO is a leading player in the freight industry with a focus on the less-than-truckload ("LTL") segment. XPO commands an 8% market share and has an expansive network covering 99% of U.S. zip codes. XPO has over 27,000 customers including companies such as Ford and GE as well as smaller companies. XPO is focused on providing a best-in-class service experience. This is evident in the long tenure relationship XPO has with its top customers. XPO's average tenure of its top 10 customers is 16 years - a remarkable feat given the competitive nature of the trucking business.
XPO owns its own trailer manufacturing facility in Arkansas which has allowed XPO to become self-sufficient in terms of providing the fleet capacity. Additionally, XPO also has a national footprint of 130 commercial driver training schools. This has provided XPO with a uniquely strong competitive position in regards to combating the industrywide driver shortage.
In addition to its strong position in the U.S. market, XPO also has a strong operation in Europe. In France XPO is the #1 truckload ("FTL") broker and the #1 pallet network provider. In Spain and Portugal XPO is the #1 FTL broker and the #1 LTL provider. XPO generated ~41% of its revenue and ~18% Adj. EBITDA from the European segment. In 2022 XPO said it was planning to divest the European business with the goal of becoming a pure-play North America LTM company. However, those plans are currently on hold.
Highly Competitive Industry with High Barriers To Entry
The trucking industry is highly competitive. In the LTL business, XPO competes with FedEx Corporation ( FDX ), Saia, Inc. ( SAIA ), ODFL, ARCB, Estes Express Lines, TFI International, and many other players. XPO holds a market share of 8% (as of 2022) and the top 10 players hold a combined market share of 77%. XPO estimates the LTL industry is worth $59 billion annually and is growing at a 6% growth rate.
To understand how challenging the LTL industry is we need to look no further than the recent bankruptcy of Yellow Corporation ((YELLQ)). Yellow was the 2nd largest LTL market player prior to its bankruptcy in August 2023.
While the LTL marketplace is highly competitive, it also must be noted that there are significant barriers to entry in terms of becoming a large player. Barriers to entry include the need to have a large geographic footprint, a large network of drivers, and the high asset intensity of the business. As shown by the chart below, 9 of the largest carriers now were also in the top 10 a decade ago. This fact suggests that the LTL market does have significant barriers to entry which is a positive for companies already operating in the LTL market.
As shown by the chart below the industry is characterized by low profit margins, typically in the mid-single digits. ODFL stands out as the most efficient player in the industry and has been able to achieve higher margins.
Historical Performance
As shown below, since coming public XPO has been able to generate returns well above the S&P 500. However, more recent performance has been challenging as XPO has significantly underperformed the S&P 500 over the past 5 years.
Potential Boost From Yellow Corporation Bankruptcy
One of the reasons why XPO shares have rallied sharply of late has been the meltdown of Yellow Corporation, the 2nd largest player in the LTL market. Yellow is in the process of winding down and selling off its assets. Wall Street analysts have been calling for XPO to benefit. XPO already appears to be benefiting to some degree as the company reported that August 2023 LTL tonnage per day increased 3.1% as compared with August 2022.
While I do believe XPO will see some benefit due to Yellow going away, I believe a lot of that benefit is already priced into the stock.
Valuation
XPO currently receives a C- valuation grade from Seeking Alpha quant ratings and I tend to agree. XPO trades at 29x FY 2023 forecast earnings and 21x FY 2024 forecast earnings. This compares to 17.4x 2024 earnings for the S&P 500. Analysts are currently forecasting 41% earnings growth for 2024 followed by 26% earnings growth in 2025. My view is that those growth rates seem high relative to XPO's own forecast of 6% to 8% revenue CAGR through 2027 as well as an 11% to 13% Adj. EBITDA CAGR through 2027.
XPO appears to be trading in the middle of the range relative to peers. I believe XPO should trade at a discount to ODFL given that ODFL is the best-in-class operator in the space. Additionally, XPO is also trading close to its average historical forward PE ratio over the past few years.
Overall, I believe XPO is currently fairly valued and I would feel more comfortable owning the stock in the future at a lower valuation.
Seeking Alpha
Conclusion
XPO has been an excellent investment thus far in 2023. The move up in the stock related to the crumbling of one of its largest competitors, Yellow Corporation, makes sense as XPO appears poised to benefit. However, the sharp rally in XPO's share price has led to relatively high valuations.
XPO operates in a highly competitive business but a business that enjoys relatively high barriers to entry in terms of becoming a large player. In my view, XPO should not trade at a significant premium to the broader market due to the highly competitive nature of the trucking business and the high degree of cyclicality.
I believe that XPO has the ability to grow into the current valuation, as opposed to the market re-rating the valuation, but I will wait to see evidence that is happening before considering a rating upgrade to buy.
For further details see:
XPO: Why I Am Cautious