I’ve been getting more and more interested in transportation lately, including full truckload carriers like heartland (HTLD), Swift-Knight (KNX), and Werner Enterprises, Inc. (NASDAQ:WERN), as the market seems to be pricing in a fairly steep decline from an approaching rate peak (likely late Q1/early Q2) despite plenty of evidence that the market will experience a less pronounced correction. While it is always risky to buy into cyclical declines, the prospect of attractive long-term values ​​makes the sector worth revisiting.

As for Werner, I have some concerns about the cost of the company’s growth plans (i.e. capital expenditures weighing on the DCF-based valuation) and whether the company can achieve targets bold growth plan, but I like the more defensive trucking mix here and the opportunity to develop value-added businesses like last-mile service. With an apparent fair value of over $50, it’s another name in this industry to consider.

Switch to a higher growth model?

Werner hasn’t exactly been a stellar producer over the years, with an average 10-year revenue growth rate of around 3%. The company has benefited from a long-term shift to dedicated (rather than one-way) trucking services, which has allowed it to grow the trucking business at a long-term rate of approximately 2% over 1.5% growth in tractors.

Today, management is talking about a 10% annualized growth rate over the next five years, at least half of which comes from trucking and most of it comes from organic growth efforts. Management steadily increased its in-house training capabilities, ending the year with 19 driving schools, but generating that kind of growth will likely require increased fleet capital spending.

The growth opportunities are definitely there. The truckload market remains highly fragmented and there are opportunities for scaling, not to mention the overall growth in shipping driven by factors such as the continued growth of e-commerce. Although rail is still an ongoing threat to long-haul trucking, little of Werner’s business falls into this category.

I also see continued growth opportunities in the dedicated business. As the name suggests, dedicated service involves multi-year contracts with customers where those customers are assigned dedicated shipping capacity. These are generally shorter routes (which drivers generally enjoy) and although the business is not as lucrative as spot trucking can be during peaks, it is a stable and profitable business, and Werner has developed this activity over time (from around 50% to over 63% now).

Logistics still offers growth opportunities

Compared to Knight-Swift (or XPO logistics (XPO) which competes in trucking and LTL logistics), Werner’s logistics operations are still quite small, but they are quite significant to Werner, accounting for nearly a quarter of reported revenue.

Truck brokerage is the biggest part of this, and like Knight-Swift, Werner offers a power-only service where contracted carriers show up with a tractor to pick up a pre-loaded Werner trailer from a customer site with an agreed price. This essentially allows smaller carriers to choose the type of business that is right for them while allowing customers to meet their shipping needs profitably.

Beyond brokerage, Werner has a small intermodal operation and a growing last mile business. Werner acquired NEHDS for $64 million in the fall of 2021 to further develop its last-mile capabilities, including augmenting what was until now a single-driver operating structure with a two-person option so that services such as furniture/appliance installation can now be offered.

I see growth opportunities in Werner’s logistics offerings, but more mergers and acquisitions will likely be needed if the company is serious about achieving critical mass in markets such as brokerage and intermodal, although the option of power alone in brokerage creates significant investment growth opportunities.

Defensive versus short-term challenges

Trucking remains hot now, as operators simply don’t have the drivers available to meet the demand that exists. Trucking companies saw spot rates increase by around 20% in the fourth quarter and it looks like the double-digit rate growth will continue into the first half of 2022. After that, however, I expect a price correction based on driver availability and overall capacity. begin to improve and as the urgency of maritime demand diminishes (especially in the face of rising fuel costs).

While I’m expecting a 25-30% correction in spot rates, the market seems to be expecting a lot worse – maybe 50% or more. Given the continued limitations in driver availability and higher shipping demand, I believe the bearish scenario is unlikely unless the US economy tips into recession. Beyond that, Werner’s dedicated activity offsets a significant portion of this risk. Although there are adjustment mechanisms in his contracts, Werner essentially trades off the rise in peak shipping rates to protect himself from the lowest rates.

A not-so-defensive piece of the story to watch is the high probability of significantly lower earnings on equipment sales. Like most major carriers, it is strategically advantageous for Werner to maintain a young equipment fleet, and so the company frequently sells used equipment to smaller carriers.

With truck OEMs unable to fill their order books due to labor issues and component shortages, used truck prices soared and Werner saw sales gains rise by nearly 5.5 times over 2020, with those gains contributing $61.5 million to operating profit, or nearly 20% of reported operating profit versus around 5% in FY’20. With these gains likely to decline significantly, margins are expected to shrink in 22 and it will likely take a few years to see substantial margin leverage again.

Perspectives

I’m looking for roughly 6% annualized revenue growth over the next five years (and just over 5% over the next 10 years), so I don’t entirely agree with the company’s growth targets. direction. I think they are workable, but I’m not ready to make them my base case just yet, especially since I think it might take a bit longer to resolve the bottlenecks in the production of OEM trucks. I think M&A is still a growth option, although I expect relatively modest deal sizes.

Over time, I believe FCF margins can grow into the high end of mid-single digits, helping to drive mid- to high-single digit FCF growth.

The essential

Between discounted cash flow and EV/EBITDA, I think Werner’s stock looks undervalued. The former gives me long-term annualized potential total return in the high numbers, while a 6.5x multiple on my EBITDA of 23 gives me a fair value in the mid-$50s, with a 6.5x multiple in below the long-average over a full term cycle to account for peak earnings risk. I use the EBITDA estimate of 23 as I expect a year-over-year decline and believe this is the most conservative approach.

I still favor Knight-Swift based on total opportunity, risk and quality, but I think Werner’s more defensive dedicated business will be an asset to the business, and I like the growth targets more aggressive. If management can execute, there is more to this story than short-term market mispricing based on a shallower cyclical bottom for the next phase of the rate cycle.