Description
On October 1, 2002, the E.P.A. will begin enforcing strict guidelines for heavy-duty diesel engine emissions. However, with less than three months before the deadline, a potential crisis seems inevitable as the engine manufacturers have yet to build an acceptable engine (only Cummins has an E.P.A. approved engine, yet trucking firms testing the engines have reported poor performance and mechanical problems). Industry sources suggest that the new engines might add $15,000 of costs over the life of the truck due to the higher engine purchase price, increased fuel consumption, and higher maintenance requirements. Ryder should be a major short-term and long-term beneficiary of the new E.P.A. guidelines (as discussed later) and earnings should increase sharply in 2003. Even without the potential benefits stemming from the new E.P.A. guidelines, Ryder is attractively valued and well positioned for eps growth as its new management team corrects problems caused by prior management. We expect Ryder to earn a 20%+ ROE in a few years and thus earn more than $5.00 per share; at a 13x to 15x p/e multiple, the shares would trade at $65 to $75.
Truck Leasing & Rental and Programmed Maintenance
Ryder's core business is full service truck leasing. The full service truck leasing business is essentially an oligopoly with Ryder and Penske (GE) each having roughly 35% market share. Penske has grown substantially over the past two years by adding the Rollins, UPS, and Rentway leasing businesses. Ruan (private) is the next largest lessor with 4% market share; additionally, there are thousands of small local and regional competitors. While the full service truck leasing industry generates roughly $6 billion in revenue per year, the U.S. private truck fleet is estimated to be the size equivalent to another $60 billion in annual lease revenue; thus, the big opportunity for Ryder is in converting private fleets into lease customers (and the new EPA regulations, which are discussed later, may be a stimulus for leasing).
Full service leasing is essentially outsourcing the financing and servicing of vehicles. A customer (such as a food distributor, retailer, etc. - Ryder's customers serve many diverse industries) would typically sign a six-year lease agreement with Ryder. Ryder would then purchase the vehicles, prepare the truck to the required specifications (adding lifts, painting the truck with the customer's logo, etc.), provide all preventive maintenance and repairs, offer roadside assistance, provide temporary replacement of vehicles, and sell the units at the end of the lease (Ryder assumes the residual value risk). Contracts require fixed monthly payments and a smaller variable payment based on mileage.
A related business is Ryder's Commercial Rental unit. These are the white trucks with the red/black swoosh-like Ryder logo that you might see on the highway (the yellow Ryder trucks are not affiliated with Ryder Systems and are being phased-out over the next year) and are used by both Ryder's lease customers and non-lease customers for peak cyclical and seasonal needs or for temporary replacement of a truck undergoing maintenance. As one might suspect, this is a cyclical business that has been suffering from weak utilization and pricing. Ryder also has a programmed maintenance business that provides maintenance for private fleets; it should be noted that Ryder has an excellent reputation for its maintenance capabilities and Ryder-maintained trucks generally are worth more than comparable trucks in the used truck market.
Ryder has significant competitive advantages versus its smaller competitors (and also non-outsourced private fleets) for the following reasons:
Financing: While Ryder recently began accessing capital at attractive rates through securitizations, smaller competitors (as well as private fleet owners) are having difficulty accessing funds as banks reduce lending. We do not believe that Ryder is at a competitive disadvantage to Penske with respect to financing as GE charges an arms-length cost of capital.
Purchasing: Ryder - which might purchase 30,000 vehicles in a typical year - has significant buying power with OEMs due to its size.
Maintenance/Repairs: Unlike regional competitors, Ryder (along with Penske) has hundreds of maintenance facilities nationwide and can offer national roadside assistance. Ryder also has significant buying power for tires, replacement parts, and supplies. Ryder has what is considered the best-trained mechanics in the industry, and as mentioned previously, Ryder trucks get premium pricing in the used truck market.
Truck divestment: Ryder has used truck retail outlets across the country and often moves trucks from region to region based on local demand.
A major stimulus for Ryder's earnings over the next few years is the October 1, 2002 introduction of stringent E.P.A. requirements for diesel engines for heavy-duty (class-8) trucks. The new engines will add several thousand dollars to the purchase price of the truck, reduce fuel efficiency, and require more maintenance. Even though we are less than three month away from the October 1 deadline, the engine OEMs have yet to produce a satisfactory engine (Ryder has tested two engines: the first performed poorly and had frequent mechanical failures, and the second engine did not function at all). Given the higher costs to purchase and operate the new engines and the uncertainintly regarding their performance, there is likely to be a significant fall-off in deliveries of Class-8 trucks after October 1st. Ryder should benefit for the following reasons: (A) Demand for used class-8 trucks will increase significantly as buyers avoid new trucks. Due to weak used truck prices over the past two years, Ryder has accelerated its depreciation of trucks, reported smaller residual gains on sale of used trucks, and has been absorbing interest and depreciation expense on more than 5,000 vehicles that the company has had difficulty selling. Prices of used class-8 trucks have already started to rise and Ryder should benefit from further price gains and a reduction of their used truck inventory. (B) Uncertainty about the reliability of the new engines should lead to increased demand for commercial rental trucks as a temporary solution; because Ryder's rental utilization is currently at very low levels, an incremental $1.00 of rental revenue should translate into about $0.95 to $1.00 of pre-tax income. Ryder should also benefit from improved pricing on the entire rental fleet. Additionally, the uncertainly about reliability, operating costs, and residual values may lead to increased leasing by private fleet owners that had not previously outsourced. (C) The programmed maintenance business should benefit as deferred new truck purchasing leads to aging fleets. Additionally, the new diesel engines will require significantly more maintenance (especially if problems continue to arise and trucks are breaking down frequently). Ryder has significant excess shop space and only has to hire more mechanics to service increased maintenance demand.
Ryder will also benefit in the next few years as the new management team implements cost reduction initiatives and stresses an EVA focus. The prior CEO, who recently retired from the Board of Directors and is no longer affiliated with the company, did not run an operationally lean company (as an example, Ryder was considered the "deep pockets" of Miami, where the company is based, and sponsored an annual PGA golf tournament, donated a basketball arena to the Univ. of Miami, and so forth). Many of the initiatives, thus far, appear to be successful. In addition, Ryder is implementing pricing disciple (as an example, new management discovered that even though a CPI inflator was built into contracts, many local managers were ignoring this clause and undercharging customers); fortunately, Penske is also becoming more discriminating on price. Since contracts generally last for six years, lease revenue growth from improved pricing should occur gradually as contracts rollover.
Dedicated contract carriage and Supply Chain Solutions
Ryder also has two non-asset intensive businesses: dedicated contract carriage (DCC) and supply chain solutions (SCS). Ryder's dedicated contract carriage business provides a full turnkey transportation solution of vehicle, driver, dispatch, and dedicated customer service for shipments on a typical closed-loop basis; typical customers are newspaper publishers, pharmacies, auto parts distributors, and so forth. Competitors include Penske, J.B. Hunt, and Schneider. Management estimates that this market is growing 5% to 10% annually.
Supply chain solutions is a money-losing unit that provides many logistics services: consulting, management of transportation systems, distribution, light assembly and kitting, warehousing, etc. Logistics has been a higher growth area due to the trends of "just-in-time" delivery, globalization, and outsourcing. Competitors include UPS, Exel, Menlo Logistics, Deutsche Post, and TNT-Post. Under the old management team, Ryder pursued growth without much attention to profitability (actually - as ridiculous as it might seem for a member of the S&P 500 - Ryder's old management did not use any form of ABC accounting and assumed they were making good returns in the business). We estimate that logistics reduced Ryder's eps by $0.50 last year (on a fully allocated basis), but should be breakeven next year as the new management team continues to cut costs and exit unprofitable contracts.
By yearend, Ryder's total debt-to-equity leverage -- including all off-balance sheet obligations (securitizations, etc.) should be less than 2:1. We believe that the company is significantly under leveraged (6:1 might be considered a more optimal capital structure). While the company should earn approximately $1.75 per share this year, Ryder could potentially earn $3.00 p/s (about a 15% ROE) next year depending on the timing of an economic rebound and an easing in the weakness of used truck pricing. Ryder expects to earn above a 20% ROE in a few years.
In conclusion, we believe that Ryder's past problems were due to poor management and that the new management team will uncover the true strength of the truck leasing franchise. Ryder offers tremendous value to its customers and has significant competitive advantages over smaller competitors. If XTRA, a lessor of truck trailers (more of a commodity than Ryder's business) that was recently acquired by Berkshire Hathaway (Buffett hinted in this year's BRK annual report, page 5, that he hoped to expand in leasing) operated with a mid-teens ROE, Ryder should be able to reach a 20% ROE as it continues to reduce costs and exits unprofitable business.
[note: while we originally submitted a recommendation of Ryder shares last year and the shares have performed well, we have resubmitting the idea to VIC because the shares still are significantly undervalued and because the upcoming E.P.A. deadline should be a major near-term stimulus for Ryder shares]
Catalyst
New E.P.A. emissions standards, effective October 1, 2002, for diesel engines should lead to higher used truck prices, sharply higher earnings from commercial rental, customers switching to outsourcing, and growth in Ryder's programmed maintenance business.
New management continues to solve problems (especially in the logistics unit) caused by the previous management.
An economic recovery