Description

Canadian investors don’t seem to realize what U.S. investors in the transportation space already know – that freight rates in the U.S. are inflecting very favourably and truckload contract rates in particular are set to rebound dramatically in 2018. While shares of its U.S. freight peers have performed extremely well over the past few months, shares of TFI International (“TFI” or the “Company”), a Canadian-listed transportation and logistics company with significant U.S. operations, have been flat on account of a sleepy Canadian investor base that doesn’t see the writing on the wall. Once it becomes apparent to TFI’s investor base that improving market dynamics will drive contract rates for the Company’s U.S. truckload business meaningfully higher, the current weak sentiment will reverse and consensus estimates will move up significantly. We see TFI’s shares at between $38 and $42 within the next six months, implying 15% to 30% upside.

[Note: all amounts in CAD]

Background

TFI is a Canadian-listed transportation and logistics company, with its sales split roughly equally between Canada and the United States.  Approximately half of its revenue is derived from truckload (“TL”) operations, with the remaining half derived from less-than-truckload (“LTL”), package and courier (“P&C”), and logistics businesses. In a transformative deal, in October 2016, TFI scaled up its U.S. TL operations by acquiring the North American TL operations of XPO Logistics (“XPO”). The TL business acquired from XPO was renamed CFI and took TFI’s total U.S. TL revenue to ~$1.1 billion, which equates to about 25% of consolidated TFI revenue.

Post-acquisition, CFI’s performance was weaker than expected. When the deal was struck in October 2016, TFI management believed it was acquiring CFI at market bottom; however throughout Q4 2016 and most of H1 2017, the U.S. TL market continued to weaken. Additionally, TFI has had to dedicate more time and financial resources than initially anticipated upgrading CFI’s fleet and improving driver retention. Weak market conditions and the underperformance of TFI’s U.S. TL operations in the first three quarters of 2017 resulted in a $130mm goodwill write-down and two downward guidance revisions. Sentiment among Canadian investors and analysts weakened considerably throughout 2017, and management credibility is currently very low.

Investment Rationale

By our estimate, shares of TFI’s closest U.S. peers in the TL, LTL, P&C and logistics segments are up ~15% on average over the past three months. However, TFI’s stock is flat over the same period on account of what we believe to be a temporary overhang. We believe sentiment will improve once the Canadian market clues in to the significant recovery already underway in U.S. TL freight rates.

This investment opportunity exists because market dynamics of TFI’s U.S. TL operations are not well understood by TFI’s investor base. TFI is one of only two publicly-listed trucking companies in Canada. Its investor base is primarily comprised of large Canadian investment funds that lack investment teams focused on U.S. transportation and freight. Although 13 sell-side analysts cover TFI, by our count, only one also covers TFI’s U.S. freight peer group. In our view, the above facts are significant because only those specialized in the space are likely to fully appreciate the major inflection in pricing that 25% of TFI’s business will see in 2018.

TFI’s U.S. TL operations are almost entirely contracted, which means the significant improvements in spot rates that began in late Q2 2017 have not had any positive impact on TFI’s results. However, as any well-informed analyst covering the space should know, the customers of Knight-Swift, Werner, Heartland and the like are now bracing themselves for significant increases in contract rates. Demand is strong and capacity has tightened, and the spot rate increases we’ve seen since late Q2 are beginning to flow through into higher contract rates for 2018. Not only are contract rates set to rise based on the current supply/demand environment, but the pending April 2018 enforcement of new rules on the use of electronic logging devices (“ELDs”) will also restrict freight supply, driving rates even higher.

The following are quotes from TFI’s U.S. peers regarding the state and trajectory of contract rates heading into 2018: [emphasis added]

Heartland – Nov 7/17:

Q: So when you put it all together, the firming of the market in the third quarter pre-hurricanes, ELDs next year, in your mind, what's a reasonable rate growth estimate as we go through the bid season in 2018…?

A: For Heartland, I've been saying it's 4% or 5%. I am confident with that. For the industry, it depends on how much some of these carriers have brought their rates down over the last two or three years, which many have cut their rates drastically. So 10 plus on some carriers. Industrywide I would say 7 to 8.

Knight-Swift – Nov 6/17:

And so as we've looked at the 2018 bid season and I think everybody's talked about it for the last 2 years because of ELDs, all of these conclusions really are independent of any impact from ELDs. And so I think as we started the year, we would've probably anticipated, maybe even have been happy with the 2% type of environment to maybe a 2% plus bid season in 2018. And as the year seemed to progress, second quarter, that number was probably 3% to 4%. And as I said now, we probably look at that as 5% plus and we may view that differently as we get closer to it.

Werner – Nov 8/17:

…rates that we see today are generally renewing and going out north of 5%. In some cases, they are closer to 10%, but it really is representation more of the freight characteristics. As we think about next year, we think somewhere in that range of 4% to 8% is probably where the book falls. But that's really without any firm knowledge yet of how big this ELD impact could be. So it could tighten further. It could go up from there.

Although only about 25% of TFI’s revenue relates to U.S. TL, high operating leverage and moderate financial leverage result in meaningful EBITDA improvements from price increases in this segment. Based on our due diligence, we believe a 7% year-over-year increase in TFI’s U.S. TL contract rates is a reasonable expectation. As illustrated above, industry consensus is a rate increase in the mid-single-digit to double-digit range, excluding the upward pressure on prices that will come from ELD introduction. After accounting for ELDs, 7% may even be too low.

If we assume a 7% price increase on $1.1 billion in revenue, and net out a 30% cut to drivers (as per industry standard), we see an easy $55mm EBITDA benefit to TFI from improving contract rates. On the Q3-F17 call, management identified a total of $50mm in non-recurring CFI integration costs and money-losing contracts inherited from XPO management that have been rolled off. With the addition of these non-recurring items, it should be easy for TFI to register a $100mm+ EBITDA improvement in its U.S. TL operations.

TFI’s TTM EBITDA is $520mm. If we assume +$100mm from TFI’s U.S. TL operations and only modest improvements in its other business units, the Company’s run-rate EBITDA should be at least $650mm by mid-2018, once all U.S. TL contracts have been renewed at market rates. Management’s preliminary guidance on F18 EBITDA is “at least” $600mm; however, consensus only reflects EBITDA of $589mm in F18 and $612mm in F19. We understand why the sell-side is so pessimistic given the recent underperformance of CFI, but believe analysts are grossly underestimating the market tailwind that will be propelling this integration story forward. TFI should be able to achieve EBITDA of at least $630mm in F18.

We only assume modest EBITDA growth for TFI’s other business units, which is conservative. TFI’s Canadian TL operation, which is roughly the size of its U.S. TL business, has performed very well. Although independent data points on the Canadian freight market are hard to come by, our due diligence has confirmed management’s view that pricing has inflected favourably during 2017 and is likely to continue moving higher into next year. As the largest TL business in Canada, TFI is well-positioned to take advantage of an improving market.

In addition to improving TL fundamentals in both the U.S. and Canada, TFI’s strong earnings trajectory is buttressed by well-managed, asset-light LTL, P&C and logistics businesses. The Company’s LTL business includes a significant and growing intermodal operation in Canada that is underpinned by strong pricing power and a favourable new partnership with CN Rail, Canada’s largest railway. TFI’s P&C business is well-positioned to grow from its high exposure to U.S. e-commerce volumes.

Based on a conservative $630mm in EBITDA and an 8.0x – 8.5x multiple range, we value TFI at $38 - $42. For context, we estimate a weighted-average EV/F18 EBITDA multiple for U.S. TL, LTL, P&C and logistics companies is 8.7x EBITDA. We apply a lower valuation to TFI on account of the Company’s higher-than-average financial leverage. Note that although U.S. TL comps typically trade at forward EV/EBITDA multiples in the 7.5x range, 50% of TFI’s business is asset-light and, therefore, we apply a blended valuation multiple to TFI that takes into account higher valuations ascribed to LTL, P&C and logistics peers.

Primarily due to the strong performance of its asset-light businesses, TFI generates significant free cash flow (“FCF”). At $630mm in F18 EBITDA, TFI should generate ~$320mm in FCF, which implies an 11% FCF yield at the current share price. Management has been actively deploying FCF to share buybacks, buying 1.8mm shares in the market over the first three quarters of 2017, representing 2% of outstanding shares. The Company’s NCIB was renewed in October 2017, authorizing the purchase of up to 6mm in additional shares, or 6.5% of outstanding.

TFI’s current EV/F18 EBITDA is 7.6x, which we believe will re-rate higher along with an increase to consensus EBITDA. We believe investor sentiment and consensus estimates will improve meaningfully in the first half of 2018, once it becomes clear to the market that TFI is indeed benefitting from significant pricing improvements in its U.S. TL business. 

Catalyst

Once it becomes apparent to the Street and investors that improving market dynamics will drive contract rates for the TFI's U.S. truckload business meaningfully higher, current weak sentiment will reverse and consensus estimates will move up significantly. We see TFI’s shares at between $38 and $42 within the next six months, implying 15% to 30% upside.