Transports – Travelling Well

gcopley
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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley

203.901.1629

graham@ssrllc.com

June 15, 2012

Transports – Travelling Well

  • We are adding the Transport sector to our valuation framework and find that the sector, like Paper, has a recent pronounced positive Return on Capital trend and valuation that reflects that trend. The external drivers appear to be increasing global trade and the growth of internet shopping. The internal driver has been consolidation in both trucking and rail.
  • The Return on Capital trend is most positive for the Rails from a cyclical declining trend that hit a low in the late 1990s. Like the paper industry, a period of returns on capital below the cost of debt appears to have been a trigger for significant restructuring.
  • Our reversion to mean driven valuation process shows the sector to be expensive, but valued at a level that is fully supported by current Returns on Capital. It is the only sector in our coverage where the Skepticism Index (a measure of return on capital’s alignment with relative value) is below zero, and suggests that the stocks are being given more than the full benefit of the doubt for current returns and the improving trend. Rails valuation under-reflects returns, Mail is the opposite. While this is an expensive sector, we would favor Rails over Mail and we would be indifferent on Trucks.
  • The following companies would fall in our expensive screens – introduced in our monthly last week – NSC, DTG and JBHT in our mid-cycle analysis and GWR and DTG in our Skepticism Analysis. No companies appear attractive in our mid-cycle analysis and only R, CHRW and HTZ look interesting in the Skepticism screen.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

Partly based on feedback from clients and partly for completeness, we are adding the Transport sector to our coverage universe. We are not including airlines at this time, but are adding rails, trucking, logistics, car rental and express mail. Our aggregate analysis is based on the 15 companies listed in Exhibit 2. We include abbreviated names for each group, which we use in sub-sector analysis throughout the report.

Exhibit 2

The industry has an improving return on capital trend since the late 1980s, as summarized in Exhibit 1, and this is driven in part by some good, though short, history from the express mail/parcel companies and by some effective restructuring in the rail industry which has coincided with increased trade and something of a renaissance in the rail freight business. Aggregate returns were low from the early 1980s to the late 1990s, but have improved meaningfully since. In the poor period we saw declining trends in Rail, which bottomed in the late 1990s, and better trends from the other groups. Note that the analysis is market cap weighted and the inclusion of UPS from January 2000 results in a step change in returns partly because of UPS’ better returns on capital and partly because of its market cap.

As discussed in more detail in the sections that follow, the overall sector looks expensive on our mid-cycle framework, but that would be expected from an industry with an improving return on capital trend where investors are comfortable that the trend is sustainable. Our Skepticism Analysis shows that the sector is trading in line with current returns – in that valuation is above mid-cycle but returns on capital are equivalently above normal. There is variation within the group, as returns in Rail would support higher values, while valuation in the Mail space is discounting the expectations that returns will rise.

Using our Skepticism methodology, the Rail sector is currently discounting a Return on Capital of around 7.7%, 200 basis points lower than current industry returns, but 170 basis points above the historic average – which is effectively also the long-term trend.

By contrast, the Mail sector is discounting a Return on Capital of around 19.5%, but the sector is delivering around 18%. Both are above the long term trend – currently suggesting 17%, and the sector has never seen aggregate returns as high as 19.5%.

In the first week of June we published our first Monthly summary and we included the stocks that screened in the upper and lower quintiles of our valuation and Skepticism Analysis, highlighting those names that appeared in both groups. This is simply an output of two screens and does not include enough stock specific analysis to represent any form of recommendation, but we felt that it would be helpful to demonstrate the “bottoms-up” nature of our analysis. Had we included the Transport sector at the end of May, the stocks shown in Exhibit 3 would have appeared in the analysis.

Exhibit 3

Source: SSR Analysis

Return On Capital – Moving In The Right Direction Mostly For The Right Reasons

If we break down the chart in Exhibit 1 we see how the transport space has changed over time. The Rail industry (we clearly have some survivor bias in this analysis), went through the sort of trough that we have only seen elsewhere in the Paper industry – this is summarized in Exhibit 4. The chart would likely look worse if we included those that have since been consolidated as they were in worse shape in the down-cycle. The prolonged period of returns on capital that sat at or below the cost of debt and well below the cost of capital, was likely the trigger point for the industry restructuring that followed.

Subsequently we have seen an industry that has been able to turn around a negative pricing spiral and restructure contracts to protect against fuel price fluctuations. This has happened as volumes have remained strong, based on increased global trade. However, despite the significant turnaround in pricing and returns on capital, it is only in the last three years that the sector has returned more than a nominal US cost of capital, and this is for the first time in our coverage history.

The cost of capital used is driven by the long term bond rate, an equity premium, a beta and the average industry debt/capital in any year. The cost of debt is based on a simple 2% premium to the long term bond rate.

Exhibit 4

Source: Capital IQ and SSR Analysis

As a reminder we have summarized our methodology for calculation return on capital by company below:

 

Return On Capital = Net Income + Tax Adjusted Interest Charges

Total Assets – Current Liabilities

The Trucks space shows higher aggregate returns than the rails, and has less cyclicality – Exhibit 5.

Exhibit 5

Source: Capital IQ and SSR Analysis

The Mail sector has a much better overall profile and at the same time has seen considerable growth as more traditional mail has moved to express mail and as on-line shopping has grown – Exhibit 6.

Exhibit 6

Source: Capital IQ and SSR Analysis

Valuation – Above the Historical Relative Mean, But Supported By Improved and Sustained

In the discount from normal (mid-cycle) value analysis for the overall sector (Exhibit 7), we have extended the chart back to 1970. We have done this because occasionally we find that a period of peak or trough valuations at the very beginning of our analysis period can be a function of return on capital drivers lacking consistency as the sample set gets smaller in the earlier years. In this case it is not. There was a genuine period of real enthusiasm for the group in the early 1980s, though at this time the constituents were very heavily weighted to rail. The chart has more normal swings before and after that time.

The valuation trough for the group in the late 1990s coincided broadly with the trough in returns on capital in the rail space (it actually lagged the trough by around 18 months), and of course the tech pull on the S&P multiple. For this group, one standard deviation of relative discount is around 30%, so the relative move from 1998 to today has been around 75%.

This metric would suggest that the sector is expensive, and if we compare with other sectors in our group it is one of the most expensive – Exhibit 8.

Breaking the sector down into its subgroups, there is not much deviation in value. Trucks look more expensive than the other two groups, but both Mail and Rail are at greater than one standard deviation above normal (mid-cycle value). In isolation, all three sub-groups have a higher premium to normal value than the overall group in aggregate. This is possible because the volatility tends to get more muted the larger the sample size of companies. As of June 13th, the trucking group was 1.45 standard deviations above normal, which makes it the most significant of the sectors or subsectors we have analyzed.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

Looking at Returns versus Normal – the SSR SI Suggests Fair Value As a Group, but Rails Have Upside and Mail Looks Expensive.

Given the return on capital improvements in the group, and the consistency of the improving slope to return on capital, we may be missing something by looking at a mid-cycle analysis alone. Our Skepticism work shows that current valuation is not materially out of line with current returns and the sector has a negative SSR SI – Exhibit 9. This is the only sector we cover with a negative SSR SI today, where valuations appear to be discounting an improvement on high returns on capital – in other sectors valuation is either anticipating a fall in returns on capital, or is not giving the sectors credit for improved returns – Exhibit 10.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10

Source Capital IQ and SSR Analysis

There is a significant difference by sub-sector, however, as we quantified in the overview, with the higher valuation in Trucks appropriately reflecting better returns on capital, but different and opposing positions in the other two groups. In Rails, while valuation is above normal, returns on capital are much more improved than valuation reflects, suggesting that the stocks could see even more upside on a relative basis. Consequently, the Rail SI suggests a degree of Skepticism around whether returns can be sustained.

While valuation in Rails is discounting Returns on Capital some 200 basis points below current levels, perhaps a more interesting way to look at it is how much upside there is in the group to have valuations reflect current Return on Capital – this is 35-40%.

In the Mail group, things are different. Valuation is high and well ahead of returns on capital; suggesting that there is an expectation that returns on capital will continue to rise. The downside in Mail to reflect current Returns on Capital is around 20%.

Based on these differences, we would be more interested in the Rail group than the Mail group today, with the caveat that all look expensive relative to the broader market. Sub-sector SSR SIs are summarized in Exhibits 11 through 13.

 

Exhibit 11

Source Capital IQ and SSR Analysis

Exhibit 12

Source Capital IQ and SSR Analysis

Exhibit 13

Source Capital IQ and SSR Analysis

©2012, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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