In September 2013, we outlined our favorable view of the domestic intermodal transportation industry driven by cost advantages, continued market share growth opportunities, and improving pricing power. At that time, we viewed Hub Group, Inc. (HUB) and Pacer International, Inc. as the most attractive investment opportunities within the industry. During the last seventeen months there have been material developments in each of these areas, some positive and some negative. As analysts, our job is to evaluate incremental news and assess its impact on the long-term value of our investments. We no longer own Pacer International, which was acquired by XPO Logistics in early 2014, but we have increased our investment in Hub Group despite fundamental results that fell below our expectations in 2014. The following provides an update on recent developments and how they have impacted our view of the long-term opportunities and risks for Hub Group.
Lower fuel prices reduced an important component of the cost advantage of intermodal shipments, but this has been partially offset by rising truck driver wages. As a reminder, fuel and labor efficiencies create a cost advantage for intermodal relative to truckload-only deliveries on long-distance shipments. Diesel fuel has declined significantly since September 2013, reducing the importance of fuel efficiencies. However, labor efficiencies are increasing in importance as trucking companies are finding it difficult to locate and retain drivers at current wage rates. Meaningful wage increases were instituted by many trucking companies during 2014, and recent commentary by trucking company management teams indicates further wage increases are likely in 2015.Intermodal transportation remains a lower-cost option for long-haul deliveries, but the cost advantage has narrowed.
Market Share Opportunities
Poor rail service limited market share growth during 2014. Domestic intermodal transportation continued to gain market share, but at a slower pace. Domestic intermodal shipments increased about 5.1% during 2014 compared to a 3.5% increase in truck tonnage.1, 2 In our prior piece written in September 2013, we stated that improved rail service over the last decade had removed the largest barrier preventing shippers from converting to intermodal from truck-only. Our view was that maintaining this improved level of service was important to achieving further share gains. Unfortunately, rail service took a major step backward during 2014. Higher than expected overall volumes, harsh winter weather early in the year, and increased volumes of slow-moving crude-by-rail shipments contributed to rail congestion, slower train speeds, and less predictable service.
In response, railroads are adding locomotives and hiring additional employees to increase capacity and improve service levels, but it takes time to add capacity and these issues will likely linger throughout 2015. Given recent investments by the rails, we expect to see slowly improving service levels throughout the year. At the present time, it does not appear current service levels have impacted shipper attitudes toward the longer-term conversion opportunities in intermodal transportation. Various shipper surveys and management commentary indicate little change in long-term conversion expectations. While poor service levels in 2014 do not appear to have long-term ramifications, we continue to monitor this situation closely. If service issues persist beyond 2015, it would impact our long-term outlook for market share gains.
In September 2013, we anticipated an improving pricing environment. Our thesis was that improving demand combined with truckload supply constraints would allow trucking companies to increase pricing to offset rising costs. As a result, intermodal providers could increase pricing while maintaining their relative cost advantage. The truckload portion of this thesis began to play out in 2014 as pricing increased dramatically in the spot (non-contractual) market, and this pricing momentum is leading to better contractual truckload rates as we head into 2015. Management comments and shipper surveys indicate contractual price increases in the range of +5% are likely for truckload carriers during 2015. As a result, pricing expectations are increasing for intermodal pricing as we head into the time of year when contractual prices are negotiated.
We believe that a reasonably favorable supply backdrop from truckload competition should persist for several years. By the 2017-2018 timeframe, it is likely that all trucks will be required to have an electronic device monitoring the hours a driver is on the road. This will aid enforcement of current regulations and should further reduce available truckload capacity.
Operating margin expansion from an improving pricing environment is a key component of our thesis on Hub Group. Recent pricing data points provide increased conviction on this element of the thesis.
Hub Group’s fundamental results were below our expectations during 2014. Poor rail service increased expenses and negatively impacted volumes. Also, company-specific issues, particularly relating to the company’s driver model in California, contributed to the disappointing performance. We believe that these cost pressures should begin to abate during 2015 as rail service levels improve and management addresses company-specific cost issues. Recent developments give us more confidence in management’s ability to raise prices to improve operating profitability. Management has been outspoken regarding their plan to improve pricing, and they have structured the sales force incentives accordingly. We view this as the appropriate course of action and one which should lead to better margins and returns on capital over time. Importantly, the current industry pricing backdrop should be conducive to this effort.
Hub Group remains well-capitalized, and we believe free cash flow generation should accelerate over the next few years. The board approved a $75 million share repurchase authorization last October, and in our view, repurchasing shares at current prices is a very attractive use of capital. Hub Group’s stock price declined materially after announcing poor results and guidance in October 2014 due to the short-term issues we have discussed. At that time, we added to our position accordingly, and Hub Group became a large position in many of our strategies.
The last seventeen months have brought both positive and negative developments. In our view, many of the negative developments are transitory, though we continue to closely monitor rail service levels. Pricing is accelerating, with incremental data points supporting a key component of our long-term thesis. We believe that industry dynamics remain favorable and that Hub Group is well positioned to take advantage of these dynamics and grow its intrinsic value over time. We took advantage of price declines in response to near-term earnings disappointments to add to our position. In our view, Hub Group remains a compelling investment opportunity.
1 Clevenger, Seth “Rail, Intermodal Providers Aim for Shorter Length of Haul” Transport Topics January 26 2015: 16, 24.
2 American Trucking Association
Originally published on February 18, 2015
The views expressed are those of the research analyst as of February 2015, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.