Description

XPO Logistics – Don't hate the player, hate the game

XPO is the third-largest non-unionized LTL (Less than Truckload) player operating in a high entry barrier industry with excellent oligopolistic economics. Less than a handful of players enjoy returns above the cost of capital. Unionized players plagued by pension costs continue to cede market share. No new asset-based LTL player has been able to enter in the last decade. This is despite the industry growing at 1.5x GDP buoyed by the e-commerce boom. Even players like UPS and FedEx, known for operational geniuses, haven't been able to get their LTL strategies correct. Therefore, the sector is akin to Marathon AM's "capital cycle approach," where entry barriers and capital starvation has created superior returns for a few. 

What caught my attention was the sheer undervaluation of XPO (post spinoff) – trading at less than a half of ODFL's EV ($13 bn vs. $31 bn) despite having an almost similar EBITDA! While this looked too appealing, a deep dive into the company changed my opinion to the contrary. With the help of spin-off, Brad Jacobs want to showcase XPO as a benchmark to ODFL, the gold standard in LTL. But I believe that the investors will realize that XPO’s LTL business is not equivalent to ODFL and it does not deserve this valuation. The upside risk, is of course, that XPO is sold-off similar to Brad’s earlier playbook at United Rentals and Waste Management.  

XPO has been very well covered here before by Pluto (Buy) Oldyeller (Short) and Salvo (Buy; contest winner). 

Allow me to present below both bull/bear points. 

Bear points - reasons to short

• Poor earning quality is masking the true economics  

• To boost LTL profitability in the short run, XPO is eroding long-term competitive advantages

• Home run enjoyed in brokerage to come under severe pressure from tech-based competitors

• Value unlocking is dependant on the sale of non-LTL businesses 

• High insider selling before the Spin

Bull case - upside risk to short:

• LTL presents a multi-decadal profitable growth and reinvestment opportunity 

• Run by an owner-operator (13% stake) with an excellent track record!

• XPO becomes a likely acquisition target (that's how the Spin has been structured) 

Table of Contents

1. How does the new XPO stack up? 

2. LTL 101

3. What makes XPO's LTL strategy unique 

4. Why ODFL's strategy is superior to XPO

5. Quality of earnings

6. Last Mile Industry – First-mover advantage in a high-growth fragmented industry

7. Brokerage – Digital advantage in no entry barrier business?

8. Valuations –Brad Jacobs premium

1. How does the new XPO stack up? 

Roll-ups have a terrible reputation of blowing up either from overpaying or cooking of books. But Brad has proved everyone wrong. He started XPO with an investment of $70 m ten years back to dominate the asset-light freight brokerage industry. Later he realized that his aspirations were too modest. So he went on acquiring 17 companies between 2011-2016. However, this made XPO a conglomerate comprising contract logistics (GXO) and transport (XPO). 

I'm sure most of you might not have missed the GXO spin promotions on CNBC. GXO (38% of FY 20 sales) was separated into a new entity this month. GXO is one of the largest pure-play contract logistics providers with marquee clients like Apple, Disney, L'Oréal etc. GXO was mainly built up through three big acquisitions of France-based family-controlled company Norbert Dentrassangle, New Breed and Menlo. 

Source: XPO Presentation

The existing XPO is still not a pure-play LTL. It also houses freight brokerage, last mile and European businesses. Brad's original plan was to sell the entire non-LTL business before the pandemic spoiled the plan. The non-LTL portion has a substantial brokerage commission business, which skews the contribution of operating profit. 

Let us delve into these three most important segments.     

2. LTL 101

LTL is a fascinating industry that has created a niche for itself for freight that is larger than a Parcel (catered by FDX, UPS and AMZN) but too small to require an entire truckload. An ideal weight to qualify for LTL is between 150 to 15,000 lbs. An LTL operator collects freight from different shippers and then combines them into a full trailer load. Customers include a whole range of omnichannel retailers (Home Depot, Lowe's), e-commerce (Amazon), Industrials (chemicals, grains) and grocers.  The routes are pre-defined as it depends upon the network of the LTL operator. Unlike in Truckload, the freight in LTL is handled multiple times while loading and unloading. As a result, operators with better service levels (lower claim damages) command better pricing. In addition, driver turnover is very low because the driver can get home every night, unlike in Truckload, where they are on the road for weeks.

Source: Logistics Plus

The top 5 players control 56% of the market. This has given them rock-solid pricing power, especially over the last decade, just like the Rails. Moreover, LTL players are classified as union and non-union. The non-unionized players have steadily increased their market share from 52% to 75% in the last two decades. To give you an idea, ODFL has outpaced the industry by growing at a CAGR of ~12%. On the contrary, the second-largest player, YRC, unionized, was twice on the brink of bankruptcy wherein it got saved by the union in 2009 and an equity injection by the Federal Government in 2020.

3. What makes XPO's LTL strategy unique 

XPO's entry into LTL was led by the acquisition of Con-way in 2015. The purchase came in as a surprise because it changed XPO's strategy from an asset-light freight broker business into an asset-based player. Consequently, the stock was severely punished, and questions were raised on the success of this strategy. On the contrary, XPO proved everyone wrong by doubling the EBITDA within four years of acquisition. This was done by bringing in an owner-operator "Tony Brooks" to manage LTL. Tony had experience running the business's shipping side with large companies (like Sears, Sysco, & Pepsi) and the LTL business at Roadway. Both Brad and Tony changed the culture at Con-way by decentralizing and assigning P&L for each service centre. This meant that every service centre operator was paid depending upon the profitability at their hubs rather than an earlier system of organization-wide profitability. Second, XPO massively overhauled its service centres by closing down unprofitable ones. Third, it put an impressive investment into technology that ensured better pricing algorithm and route optimization. 

…in an industry where players hardly make money

Despite a favourable industry dynamic, only two players make a double-digit operating profit margin. XPO's operating ratio (a measure of revenues compared with expenses) is second only to ODFL but much better than other players, including FDX. Except for the top 3-4 players, none make reasonable returns above their cost of capital. This provides a vicious cycle for these top players to redeploy profits back into the business and create a formidable moat. UPS is a prime example, which exited LTL by selling to Montreal-based TFI (TSX: TFII). Based on a rough projection, UPS's operating profit margin was a mere 3-4%. The problem with UPS was that managers tried to treat LTL similar to parcel and its union workforce. Consequently, LTL was axed after Carol Tome joined as CEO in 2020. 

Source: Company filings and estimates. XPO, FedEx & ArcBest margin excludes corporate overheads, XPO's RoIC is depressed due to acquisition of assets at fair value

4. Why ODFL's strategy is superior to XPO

No doubt XPO has made great progress in LTL. But I believe that ODFL's superiority will continue to persist. ODFL's secret sauce lies in – 1) Investing in strategic real estate and 2) Getting the network density better than anyone else.

ODFL's Secret Sauce #1 – Investing in Real Estate

Going against the industry odds, ODFL has consistently expanded service centres over the last 10 years. For example, against XPO's flattish growth of 1%, ODFL has grown by 13%. In addition, XPO's underinvestment was due to the realignment of unprofitable centers. In this regard, ODFL's real estate team has perfected the art better than anyone else. As a result, ODFL has created a significant competitive advantage, especially in urban areas. First, everyone wants same-day delivery, but no one wants a warehouse in their neighbourhood. Second, XPO has started the sale and leaseback of its properties recently. I believe it's a trade-off between boosting your short-term profitability vs. control of your most strategic assets. Third, XPO has focussed on deploying pricing algorithms to improve profitability. On the other hand, ODFL simply gets a premium pricing from having the best network density from these real estate investments.   

ODFL's Secret Sauce #2 - Getting the correct Network Density

"We were somewhat like some of our competitors back in the day. We used a lot of purchase transportations. We were dependent upon those for our linehaul moves and what not. We eliminated that over the years. And I think, by and large, we've just gotten better. I don't want to say that we did stupid things. Maybe that's not exactly the right terminology, but I think we've just gotten smarter, and we've gotten better over the years."

• ODFL Management

An LTL carrier often purchases transportation from a competitor when a pickup/delivery destination is outside their network. Many times LTL still prefers purchasing over their own network if a competitor has a better density. Hence, you'll see that purchase transportation is the second-highest cost after labor. The importance of perfecting the art of a profitable network density can be underpinned by FedEx's recent decision to embargo freight not fitting its requirements due to capacity constraints. Hundreds of shippers, including big-box retailers like Home Depot and Lowe's, were left scrambling for carriers. Not even premium pricing could help because FedEx didn't have the network density. 

ODFL has the lowest purchase transportation cost, which underscores its hugely profitable network density. On the other hand, XPO still has a long runway to improve its network density (despite having higher centers). Similarly, on pricing, weight, and mix, ODFL can be seen to have superior economics compared to XPO. This is despite Con-way starting being more regional before acquisition which ODFL developed later.  

XPO lags significantly behind ODFL in network density	ODFL with superior unit economics

Source: Company filings

5. Quality of earnings

Adjustment to LTL Earnings

XPO makes a host of adjustments to arrive at an adjusted operating ratio for LTL. To give you an idea, the operating profit for LTL jumped from $487 m (GAAP) to $573 m (Non-GAAP; +18%) in 2020. I believe many of these expenses do not make economic sense to be added back. First, XPO adds back other income (read as GAAP pension expense). Since GAAP treats this as an expense, I presume it to be the service cost component of pension expense. Second, transaction and restructuring costs come from the roll-up strategy that should not be treated differently by adding them up. Third, XPO's profit gets a boost from the sale and leaseback (16% of 2020 profit). Fourth, corporate costs are not allocated to segments, thereby increasing the reported profits. After making these adjustments (except amortization of intangibles), the operating profit margin falls from 16% to 10.6%! This makes it worse than SAIA.

Source: 10K

Adjustments to the entire business

Adjustments to the entire business (pre spinoff) are also intriguing. Transaction and restructuring expenses worth $471 m have been added back over the last five years. If we combine sale & leaseback and pension income, a total adjustment of $945 m or ~66% of cumulative net profit has been made. XPO started reporting pension income as "other income" after adopting Accounting Standard Update (ASU) 2017-07 in 2018. Interestingly, XPO's pension managers have made 15-20% actual return on US plan assets primarily consisting of fixed income portfolios over the last five years (quite impressive!). I want to clarify that I'm not doubting any irregularities but only highlighting the accounting quality of earnings. The frequent resignation of CFO's (the latest one just before the Spin) doesn't help instill confidence.   

6. Last Mile Industry – First-mover advantage in a high-growth fragmented industry

The last mile is the easy-to-understand last leg of movement of heavy goods from a transportation hub to your home. Imagine FedEx, UPS and Amazon, which are well-entrenched in the delivery of parcels at doorsteps. But last-mile of heavy goods (usually above 150 pounds) like a washing machine or a Peloton bike is an entirely different business model to crack since it requires a trucker to enter inside someone's house for installation. In LTL, you have a single driver. But in the last mile, you have two people. This makes it a highly service-intensive business because the reputation of a big-box retailer like Home Depot will be at stake. 

Source: XPO

Last-mile is the most significant growth driver for XPO, having grown at a CAGR of 31% (FY 13-20). The industry is so fragmented that despite being the #1 player, XPO's market share is a mere 7% in the US. XPO has the first-mover advantage by buying the biggest last-mile providers like 3PD between 2013 and 2015 to become the largest provider in North America. Companies such as FedEx, JB Hunt and Ryder have entered, sensing the opportunity. The strategic importance of the last mile was felt during the pandemic. But it is too late for someone to scale up quickly because there aren't many assets available to buy. I believe XPO should not have a problem selling this business if it wants to unlock value.

XPO doesn't disclose the profitability of last-mile separately. It should be a high-return business being as XPO uses independent contractors to perform deliveries. The investments are limited to creating 85 hubs that claim to position XPO within 125 miles of approximately 90% of the US population. The scale helps in making more stops per day and hence the flywheel for profitability. The other part that sets XPO apart is the technology piece – from finding the most efficient truck for delivery to providing real-time information to shippers and customers.

7. Brokerage – Digital advantage in no entry barrier business?

Truck brokerage is a straightforward and attractive high return business model which throws off free cash flow during all parts of the economic cycle.  A broker sells the truck capacity to the shipper at a slightly higher price than the broker paid (usually for a 15-20% gross margin), but at a better price than the shipper could otherwise obtain on their own. Thus, the broker simply earns a profit on the spread.  It is a highly fragmented market with millions of shippers and more than 10,000 licensed truck brokers, but only 25 of those have revenue greater than $200 m. Historically, there has been no entry barrier because all one needed was a small office set up anywhere with a set of phone/fax machines to match shippers with carriers. But this has now changed. 

C.H. Robinson (the largest), TQL, Echo etc. were long-established players before XPO made inroads in 2013. More than half of the revenues for C.H. Robinson stems from long-term contracts from its biggest 500 customers (out of a total customer base of >30,000). So XPO focussed on targeting small and medium-size shippers to gain scale. XPO was an early adopter of technology which helped it gain scale quickly to become the fourth-largest player. For example, its freight optimizer tool gave it a significant advantage in using data-driven algorithms for price discovery vs. human judgment based on small brokers. Consequently, XPO grew net revenues at a much faster rate than CHRW.

Competition to dent margins

"Broking is becoming more automated with more digital interactions. I think long-term, margins will come down; as costs come out of the way brokers do business, a good chunk of that cost savings will get passed along to customers, and that's going to degrade margins. Having said that, lower margins on a much larger amount of business with lower SG&A can still be a beautiful thing, and you can still create a lot of value from that. And I think there will be a shrinking of the number of players. There's not going to be 10,000 or 20,000 brokers 5, 10 years from now. I think it will be a smaller number of larger brokers who have very significant investments in technology and are tightly integrated electronically with both customers and carriers."

• Brad Jacobs

Over the last few years, the incumbents have been challenged with an onslaught of tech-based disruptors (Uber Freight, Transfix, Convoy etc.) who have Uberised the industry. XPO was also not far behind in launching XPO Drive but was a little late to the party as it initially focussed on gaining scale with the truckers before approaching the shippers. As of December 2020, it exceeded 100,000 downloads of Drive XPO but is still below competitors. The biggest challenge for brokers will be to keep the trucker engaged, like getting them the backhaul load etc. XPO Connect (cloud-based digital freight marketplace) is a platform developed by XPO that connects freight optimizers with AI.

I believe that the members here will have their opinions on the freight brokerage industry, so I will keep it short. I hope that everyone will agree that the industry is becoming competitive. Here is the most recent statement from the management: 

"The difference between the digital players and the non-digital players has become almost non-existent. We're as digital, more digital than the so-called digital ones. I think over time, with respect to margins, I think margins will come down. Having said that, I think profit will go up because I think volume will go up because I think the amount of transactions and the velocity of transactions will increase. So I think there's -- it's going to evolve very much like you see commodity markets, particularly like the oil market, for example where it morphed from purely physical markets, then derivative markets and Wall Street got involved."

• Brad Jacobs

8. Valuations –Brad Jacobs premium

XPO's management has often laid emphasis on EBITDA as a preferred valuation tool. But having discussed the perceived quality of earnings, cash flow would be a better metric. To show you what I mean, XPO has the lowest conversion rate of 58% from EBITDA to operating cash flow. 

Source: Company filings, XPO (ex-Spinoff) 2021, ODFL & Saia for 2019

While on an EV/EBITDA basis, XPO looks dirt cheap to ODFL and SAIA, the same is not the case with P/FCFE. A 40% discount to ODFL on EV/EBITDA falls to a 27% discount on P/FCFE. Selecting a higher multiple is all about giving Brad Jacobs premium, in my opinion. Imagine if he was not a part of the company. Would you have given it a premium to the current multiple? While I agree that some excellent bull thesis exists and shorts have mainly been proven wrong, a good exercise for me was to check the growth and margins imbibed into the current price. 

Source: Company filings, TIKR, XPO EV is own projection for 2021; ODFL & Saia EV is current

Implied Valuation

The market is factoring in a revenue CAGR of 4.9% over the next 10 years, which I suppose is not cheap. For context, XPO has overall revenue by 1.8% over the last four years. Similarly, the market also gives XPO full credit for margin expansion from 5.4% in 2021 to 8% in 2026. I have assumed that the ROIC will increase from 9.7% in 2019 to 17% in 2030. While the implied assumptions are subject to the perpetual rate and discount factor used, one can form their opinion by tweaking estimates. To illustrate, a 100 bps increase in WACC to 7.9% will reduce the intrinsic value by ~25% (on my assumption), thereby simply making the investment case unviable for me. Finally, against the current P/FCF of 20x, the exit P/FCF (after 10 years) will also be almost at the same level of 20.5x. While I agree upon the potential growth opportunity for LTL to grow in the next 10 years, the growth and reinvestment potential would have certainly moderated by then.  

Catalyst

• XPO will come out with guidance for 2022 later this year
• As a standalone entity, investors focus will go on the corporate cost allocation to LTL
• Non-LTL businesses will undergo investors scrutiny
• More insider selling if Brad Jacobs is unable to find a seller