Description

Azalea wrote up GXO Logistics (“GXO”) in June of 2023 with a very comprehensive and well written overview of the business model and industry.  Please see that report for such additional information.

Similar to Azalea, we seek to invest in businesses run by owner-operators with substantial ownership interests who prosper by creating long-term business value.  Investors generally view Brad Jacobs as such a person, including us.  Those familiar with Mr. Jacobs understand he founded and built several businesses, creating substantial wealth for himself and his investors in the process.

His most recent business venture, XPO Inc (“XPO”), is an amalgamated end-to-end, full-service shipping and logistics company built through a series of acquisitions designed to provide a one-stop shop for all customer needs.  After approximately two decades of evangelizing this strategy, Mr. Jacobs suddenly changed course, deciding these various businesses should no longer be combined.

XPO began the business dismantling by spinning off GXO Logistics Inc (“GXO”), XPO’s contract logistics business, in August 2021 (followed by the spinoff of RXO Inc, XPO’s freight forwarding business, in November 2022).  This sudden strategy reversal struck us as odd given Mr. Jacobs’ ardent support for the merits of combining these various businesses for decades.  We viewed this as signal number one.

We viewed the second signal as Mr. Jacobs’ subsequent reduction of his GXO equity stake to approximately 1%, making it relatively insignificant to his net worth.  Signal number three was Director Gena Ashe selling almost 60% of her stock in March – after it dropped to $50 per share from her first ever sale at $80 per share just two years prior. 

Ms. Ashe joined XPO’s board in 2016, transferring to GXO’s board following the spin; she has been part of the greater XPO/GXO ecosystem for eight years and seems a bright lawyer by trade.  We therefore asked ourselves, “Why would such an insightful person start selling the majority of her stock during a time of substantial pessimism and underperformance?” 

Our fieldwork seemingly provides the answer to that question, along with why Mr. Jacobs spun GXO off from XPO in the first place and thereafter reduced his equity position (while retaining a significantly larger stake in XPO).

Our field contacts told us GXO’s recently departed President of the Americas, Eduardo Pelleissone, reorganized GXO’s customer service teams by eliminating the lead relationship managers (SVPs organized by industry verticals) and their teams, replacing them with fewer and less experienced people. 

We believe this has manifest into poor customer service and delivery performance which is leading to increased levels of customer churn as evidenced by GXO’s fourth quarter 2023 organic growth of -2%, below the organic growth rates of its publicly traded contract logistics peers.  GXO appears to be losing market share.

Management claims the growth decline stems from an uncertain macroeconomic environment, which we believe is insincere based on this feedback from our industry contacts. Management also claims to have a 30%+ “operating” return on capital, but the financial statements show a business generating 2%-3% returns on invested capital as management’s calculations exclude significant portions of the invested capital denominator.

Of further note, our field contacts stated that Mr. Pelleissone created a negative culture of high attrition, pointing out that he was personally and publicly fined by the SEC for accounting misconduct in 2021 while working at Kraft Heinz, not long before joining GXO. 

These matters present a fact pattern of underperformance combined with insincerity and questionable behavior on the part of management.  We therefore question management’s claims that GXO’s recent underperformance stems from macroeconomic uncertainty.  We believe customer service and delivery degradation are leading to elevated customer churn rates.

As this trend continues, we project GXO’s organic growth to turn negative to -1% over the next two years with annual margin degradation of 25 bps, which could be greater should our thesis prove accurate given the high fixed cost nature of the business.  This translates to our projected 2025 EBITDA of $688 million compared to consensus expectations of $861 million, which assume 5%-7% organic growth the next two years along with modest margin expansion. 

As this thesis unfolds, we expect GXO’s stock to trade near its historical low valuation range of approximately 9x EBITDA for a price target of $21/share, almost 60% downside from the current price of $53/share.

We believe this valuation is further supported by the publicly traded contract logistics peer group valuations.  Some may question a relative valuation analysis with public peers having diversified business models with additional business lines outside of contract logistics, but the financial profiles warrant comparison nonetheless.

The peers have LSD-MSD expected growth rates with EBITDA margins ranging from ~11% to 22%, meaningfully above GXO’s 7% EBITDA margins and what we believe will be sustained negative organic growth.  The contract logistics business is highly commoditized, particularly in GXO’s largest market, the UK, which is largely why the company has structurally lower margins than its peers. 

We would expect GXO to trade at a discounted valuation to the peer group, which trade in the approximate range of 5x-12x EBITDA, should our thesis prove accurate given its inferior relative margins, growth prospects, and returns on capital.  9x EBITDA therefore seems appropriate from both historical and relative valuation perspectives.  Please see the peer forward financial profiles and valuations below.

Catalyst

Earnings / missed expectations