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These are interesting times for the less-than-truckload (or LTL) sector, as company managements have been pretty bullish on the likelihood that the business is bottoming and poised to recover later in 2023 and into 2024, but investors continue to worry about the mixed outlook for the economy in 2024. Looking specifically at ArcBest (NASDAQ:ARCB), shares of this LTL company are up about 35% since my last update, but have lagged others like Old Dominion (ODFL) and Saia (SAIA) – not an altogether unusual situation as ArcBest has long been seen as a riskier operator with higher fixed costs.
It’s true that ArcBest is not a cost leader in the LTL space, and likely won’t be in the foreseeable future. It’s also true, though, that the company has made real progress in improving its cost structure. It’s also true that less efficient operators tend to outperform once the cycle turns and while the margin-dilutive business that ArcBest has been taking on recently has definitely hurt near-term earnings, it could be a “force multiplier” in a recovery if management can hang on to that business and reprice it at attractive margins.
Between discounted cash flow and multiples-based valuation approaches, I think ArcBest is undervalued by at least 10% or so now and possibly more on the order of 20%-25% undervalued if the freight cycle is indeed bottoming.
Choosing Volume Over Price Has Had Some Rough Consequences
The last couple of quarters have not been strong ones for ArcBest, with the company falling well short of sell-side expectations at the operating income line. Given that management has chosen to prioritize capacity utilization and has pursued transactional spot freight in a weak market, pricing and margins have suffered more than expected and more than at (non-union) companies like Old Dominion and Saia where margin preservation has been more of a focus.
Below-par operating ratios are nothing new at ArcBest, and still constitute a big part of the bear case against the stock – ArcBest has long had high structural costs (among the highest in the publicly-traded LTL space) and taking lower-priced incremental freight while maintaining capacity certainly doesn’t help. That said, there has still been a downward trend over the years as management has prioritized structural cost reductions and margin improvement, and unless the next few quarters are meaningfully worse than I expect (certainly possible, I’ll grant), through profitability in the asset-based LTL business will still have improved a couple of points since the worst of the last cycle.
As business improves, particularly with respect to pricing, I expect profitability to improve. It would seem, too, that the union shares this view. The latest five-year contract (finalized in the summer of this year) will see a little over 5% compound annual growth in wages and benefits over the next five years (including a double-digit increase in the first year of the deal), but the union agreed to higher hurdles for profit sharing – workers were entitled to 1% if operating ratios were 96% or better and 3% at ratios below 93%, but now 1% doesn’t kick in until 93% or below, while 3% comes into play at 87%-89% (for investors not familiar with trucking, operating ratios are basically the inverse of operating margins, so lower is better).
Will Business Turn Soon?
Recent reports from the sector show there is still ongoing pressure on the business. While there has been month-to-month improvement in tonnage for ArcBest recently, tonnage was still down 6% in August, where both Saia and XPO (XPO) saw growth (Old Dominion saw a slower decline). Shipment volumes continue to grow, but weights are down. On a more positive note, pricing did improve in August. As you might imagine from its decision to take on more spot transactional business, year-to-date results have generally seen ArcBest outperforming on volumes but underperforming on yields (pricing).
Looking at recent data trends, as well as company management commentaries at a recent sell-side conference, management teams in the LTL remain pretty confident that the worst is over. Peak season demand is expected to be “decent”, and pricing has been fairly disciplined across the sector. Moreover, the collapse of Yellow has helped create some incremental volume opportunities and has helped ease the driver shortage challenges at some of the larger companies.
At the risk of stating the obvious, the key unknown is what happens next with the U.S. economy. Industrial activity has been slowing for some time now, and manufacturing customers are a significant part of ArcBest’s business mix (more than half). Numerous industrial companies reported order declines and evidence of customer destocking with Q2’23 earnings, and it remains to be seen how much further this destocking process has to go. For my part, I’ve been comparatively bearish on the outlook for industrial demand going into 2024, but trends have held up better than I expected so far.
The risk for ArcBest, then, is that industrial activity and consumer demand slow even more (and events like a possible government shutdown won’t help), freight transport demand weakens further, and the margins on those incremental volumes deteriorate even more. Said more directly, the risk is that the light at the end of the tunnel today is an oncoming train and not the end of the downcycle.
Eventually, though, demand and volumes will improve, and pricing will go with it. That, in turn, will drive improvements in operating leverage – I don’t think the mid-80%s operating ratios that ArcBest saw in 2022 are any kind of “new normal” yet, but expectations only call for improvement back to the low-90%s anyway. Moreover, there is a potential bull-case outcome to consider – that these “transactional” volumes that ArcBest is handling today become longer-term customer relationships and that ArcBest picks up market share during the next up-cycle.
The Outlook
ArcBest isn’t out of the woods yet. The asset-light logistics business is still seeing pronounced weakness, with average daily revenues declining at a high-teens to low-20%s rate recently (largely on pricing/yield). Management has already warned that this business is likely to post a loss in the third quarter ($10M to $15M versus a $6M profit in Q2’23), and weak pricing will remain a challenge until the economy improves.
With the trucking business, it’s pretty normal for the Street to look ahead and try to anticipate the turns in the cycle. To that end, ArcBest, Old Dominion, and Saia all saw recent lows in the fall of 2022 (when revenues were still growing double-digits and operating ratios were very good) and have run since then. With these stocks off around 10%-20% from their 52-week highs, I would argue the Street is signally its modelling uncertainty for the sector going into 2024.
I don’t think I’m expecting heroic growth from ArcBest; I’m looking for long-term revenue growth of around 3% (from 2022) with a double-digit decline in 2023 followed by a healthy recovery in 2024/2025 (starting, I think in the second half of 2024). Margins have clearly taken a big step down this year (EBITDA margin will likely finish out in the 7%s versus 11% in FY’22 and 10% the year before), but I think 10%-plus margins in 2025 are definitely possible. While I do think improved margins and asset utilization will support better free cash flow generation, I’m only expecting about a half-point improvement in average long-term FCF margins.
Discounting those future cash flows back, I get a fair value estimate in the low $120’s today. Multiples-based valuation gives me a wider spread of outcomes. Looking at the operating margin I expect in late 2024 (again, the Street tends to look ahead with these stocks), “fair” forward EV/EBITDA would seem to be around 6.25x, giving me a roughly $110 fair value on my ’24 estimate. Using P/Es, though, I get numbers ranging from $110 (using a multiple of 17x on ’23’s trough EPS) to $128.50 using a 13.5x multiple (the long-term average forward P/E) on next year’s EPS.
The Bottom Line
I don’t want to give the impression that $110 is a worst-case “floor value” for the stock – if the economy weakens substantially, estimates for the remainder of 2023 and 2024 will certainly head lower. If you’re bearish on the U.S. economy, this probably isn’t the stock for you in the short term. Looking beyond the near-term weakness and uncertainty, though, I do still see some upside – I think leverage to further cost improvements (and possible sustained volume improvements) is going underappreciated, and I think the shares trade too cheaply relative to upcoming opportunities (whenever the business does turn) to produce better results.
