Description

“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is usually the reputation of the business that remains intact.”

                                                                                                            -(You Know Who)

XPO Logistics (XPO) checks both boxes:  a business that features good economics and management with a terrific track record. 

First, a brief overview of the business.   XPO is a non-asset based third party logistics provider (a “3PL”)--- essentially a transportation broker that connects a shipper with a carrier that can deliver the goods.  The company has 3 divisions:  truck brokerage (25% of sales, but clearly the focus of XPO’s growth going forward); freight forwarding (29% of sales); and expedited shipping (46% of sales, but not the focus of future growth).  On a TTM basis, the company logged $190 million of sales, but as I detail below, the company is at a current run rate of $325 million as of September, 2012, and importantly, expects to be at a run rate of $500 million by 12/31/12.  As the company invests in its infrastructure and acquisitions, the company showed a GAAP loss of $5.9 million (net) in the quarter ending 6/30/12, with OCF of -$10 million.

XPO’s Market

3PLs exist in different flavors—some, such as Expeditors International (EXPD), focus on shipping by air, arranging shipping with airlines and others who have excess capacity.   Others, such as Swift Transportation or Hunt, offer a 3PL solution alongside a traditional, asset-heavy carrier business:  they actually own and operate the trucks, containers, railcars, etc.. In XPO’s case, while it pays lip service to working with all modes of transportation, the primary emphasis (particularly on a go-forward basis) is on land transportation—truck brokerage.  The company has relationships with some 12,000 carriers, and utilizes its IT system to optimize routes, capacity, and cost for its clients within that network of carrier relationships.  A typical transaction might involve a small manufacturer with a half-truckload of goods; XPO serves as the single point of contact for the customer to get those goods from point A to point B as efficiently as possible.  XPO might combine that half-load with that of another shipper to reduce costs, and leverage its network of carriers to run a quick bidding process and optimize the route and pricing of the load.  While a Fortune 50 company may have some of these capabilities, a small to medium sized business often does not—XPO removes the time sink & hassle of identifying and negotiating with an appropriate carrier.   At the moment, XPO is focused on shipping within the North American market, although they do handle transactions between the US, Mexico, and Canada.

Jacobs & Team

Brad Jacobs, the CEO of XPO, is a serial entrepreneur that has built four businesses from scratch to over $1 billion+ in revenues.  The most recent two were United Waste, a roll-up of rural sanitation service providers, which he took public in 1992 and sold to Waste Management for $2.5 billion in 1997, after compounding earnings at 55% per year.  Over that time period, the stock outperformed the S&P 500 by 5.6X.  

Most recently, Jacobs founded United Rentals, and over a decade at the helm—from a start-up in 1997 to his exit in 2007--  he grew it from scratch to the world’s largest rental equipment company.  Over that 10 year period with Jacobs as CEO, the stock outperformed the S&P 500 by 2.2X.   To round out the resume, earlier in his career he built 2 companies in the oil services & oil trading space:  Amerex, which he grew into one of the largest oil brokers; and Hamilton Resources, a global oil trading company which he grew to c. $1 billion.

It’s worth noting that United Rentals and United Waste were 1) roll-ups in fragmented industries with demonstrated demand (as opposed to a developing market with nascent demand), and in the case of United Waste, populated with large cap industry incumbents;  and 2) logistics-intensive businesses with a transportation element. 

So point #1 in the investment thesis is straightforward:  this is a jockey with a terrific track record, and perhaps most importantly, he’s taking the same approach with XPO that he’s successfully executed upon in the past. 

To say that Jacobs has skin in the game is an understatement; through his investment entity, Jacobs Private Equity, he put $75 million of his personal funds into the company when he came on board in June of 2011, in the form of 75,000 preferred shares that convert into 10.7 million common shares. Additionally, his investment gave him 10.7 million warrants at a strike price of $7 per share.  Therefore he has majority control—more than 50% ownership on a fully diluted basis (and has specific rights to appoint a majority of the BOD while he maintains ownership at or above a certain level), which most of us have learned can be a plus or minus.  Having been involved with similar situations in the past, my view is that it’s a “plus” in this early stage of the company’s growth, given Jacobs’ record—as a check, the company pays executive salaries ranging from $300K to $495K (the latter to Jacobs himself)— at least three or four on the team are accustomed to making much more than that.

As Jacobs tells it, he was looking for a large, fragmented market as he launched his next company, and truck brokerage fit the bill.  The U.S. logistics market overall is about $1 trillion a year, and U.S. trucking represents about $350 billion per year.  However, “only” about $50 billion of that is currently routed through brokers.  So from a global perspective, the growth story in truck brokerage rests on their ability to sell shippers on the efficiencies that they bring to the table, thereby moving their share north of 15% of the overall trucking market.  Note that ECHO claims that truck brokerage is growing at 3X the pace of domestic trucking overall; separately, XPO says that truck brokerage is growing at 2 – 3X GDP.  On a micro level, the story is about XPO’s ability to capture brokerage market share via organic “cold starts” (new brokerage offices) and via acquisition.

One of the attractive aspects of the truck brokerage business is its performance in less-than-desirable economic times.   This is a very asset-light business, with low maintenance capex & low capex requirements for organic growth; XPO does not carry the burden of maintaining or expanding fleets of tractor trailers, containers, railcars, etc. (although a number of their competitors do).   The company can add or subtract salespeople in fairly rapid fashion, as warranted by the business environment.  The truck brokerage value proposition rests upon improving efficiency, which tends to resonate in down markets—it’s a service that trims costs in a $350 billion expenditure that customers already incur.  It’s also worthy of note that the largest player in the brokerage space, CH Robinson (CHRW), did not miss a beat in 2008 – 2009, growing EPS continuously.  ECHO, one of the other direct comps, also grew at a rapid rate during this difficult period; the company grew via 13 acquisitions from c. $200MM in sales in 2008 to c. $600 million in 2011, and was one of the few firms to go public in 2009.  XPO, albeit under, shall we say, less visionary previous management, saw a 9% decrease in sales in 2009 (not a disaster by any means in that year), but maintained profitability, though income from continuing ops fell from $2.8 million to $1.7 million. 

The truck brokerage market is extremely fragmented:   XPO says that while there are 10,000 licensed truck brokers in the U.S., there are only about 25 with revenue in excess of $200 million;  99% of truck brokers have EBITDA of less than $10 million.  Traditionally a large chunk of the market has been driven by local and regional relationships.  The most significant incumbent in the truck brokerage space—and one of the best direct comps for XPO--  is CH Robinson (CHRW), which did about $10.3 billion in sales in 2011 (note that by its own reckoning, CHRW has less than a 3% share of the $350B U.S. trucking market).  If you’re not familiar with the company, a quick look at CHRW’s numbers should convince you that this is an attractive business.   CHRW has generated ROE of 30%+ (with zero debt…) every year since 2007.  EPS has increased every year, without exception, since 1997.   Operating margins (and EPS) went UP in the Great Recession.  Brad Jacobs has been pretty forthright in stating that CHRW was the inspiration for his entry into the business; he’s also been forthright in stating that he intends to build a multi-billion dollar competitor to CHRW.  Usually I’d take this for what it’s worth (talk is cheap…), but when the speaker has previously built multi-billion dollar businesses using the same game plan, he has a bit more credibility.

XPO’s Strategy

While building his team over the past year, Jacobs’ strategy has been A) to raise some cash to supplement his own $75M investment;  and B) to rely on a combination of acquisitions and “cold starts” to rapidly grab market share.  On the fundraising side, he’s been busy in 2012; the company raised $137 million of equity (net of fees & costs) in March at $15.75 (vs. $11.60 share price as I write this), and just recently raised $125 million through a convertible debt issue.  At June 30, the company had $190 million of cash (and no debt, although that’s obviously not the case following the issue of the convert in September of 2012).

So with his senior team in place and +/- $300 million of change in his pocket, Jacobs moves to step two, a combination of cold-starts and acquisitions to build scale.   A “cold start” is basically what it sounds like;  XPO hires someone with 20+ years of experience in brokerage to launch a new regional office, leveraging his/her rolodex of carrier and customer contacts.  One of the attractive features of the business is that XPO requires very little capital to expand in this way.  The “cold start” cost is essentially the short term salary cost and (minimal) office infrastructure to get things rolling (pun intended).  Earlier in the year, the company stated that it would do about 5 truck brokerage cold starts in 2012, and with 7 now in the works by December 31 (Phoenix, Ann Arbor, Dallas, Chicago, Jacksonville, Morris Cty (New Jersey), and Montgomery AL),  they will exceed that goal.  Here’s what Jacobs said in September:  “We said we were going to do about five truck brokerage cold starts this year. We’ve already done seven here in September and they’ve succeeded very well. The three that we started between January and May now are on a run rate just shy of $20 million of revenue. so we hope by the end of the year that the seven truck brokers that we bought throughout the year will be on a $40 million revenue run rate and when you think about our total invested capital will be low single digits millions of dollars and already without even a full year of each of all those operations will be on a $40 million revenue run rate hopefully… We’re targeting to open about a couple dozen cold starts over the next several years. We think this can be a big, big driver of the company.”  Scott Malat adds that “… when we took over XPO last September, it had one brokerage office in South bend. It’s a great example of a cold start because it grew from zero to $30 million run rate over three years and it was really only backed up by a few hundred thousand dollars worth of invested capital…”

The company has also been active on the acquisition front, focusing on targets in the range of $20 - $200 million of sales.   The company bought a Canadian company, Kelron Logistics, in August of 2012.  While perhaps not representative of a typical deal, the terms were instructive:  XPO bought Kelron, a $100 million a year business, for $8 million.  I have not looked closely enough at Kelron to understand the reasons for their struggles (they were basically breaking even), but I do know that XPO is excited about the opportunity to introduce Kelron’s 1,000 customers to XPO’s larger carrier network, to migrate Kelron to XPO’s IT platform, and to add Kelron’s carrier relationships to its existing network.  And I do know that XPO’s multiple on sales (I know, we’re value investors; but even Graham used price/ sales) —whether one uses 2011, TTM, or 2013 numbers-- is considerably higher than the multiple they paid for Kelron (again, acquired for 0.08X sales).   Separately, in May of 2012, XPO bought Continental Freight, a smaller brokerage at $22 million in sales, for total consideration of $3.7 million.  Note that acquisitions in this business add more than just market share; each deal build’s XPO’s network of carriers and customers.   A larger carrier network brings greater pricing leverage to XPO, and greater efficiencies to its customers.

Jacobs’s goal is to roll up the smaller entities and introduce them to efficiencies of scale that XPO will bring to the table:  1) a dedicated operations center in Charlotte that coordinates bidding and carrier relationships, while allowing regional offices to focus on sales;  2) a much larger network of carrier relationships and extended geographic reach, which grows with each acquisition; 3) a level of information technology sophistication (again, this is a logistics business) that smaller businesses do not have;  and 4) working capital that smaller players may not have (many carriers demand immediate payment, while the customer often has 30 days to pay).  Running point for XPO on I/T is David Rowe, who previously built the carrier I/T system of Echo Global Logistics (an XPO competitor with $600 million in sales in 2011). 

Financials

In 2011, the first year of the Jacobs era (he joined mid-year), the company generated $177 million of sales, with an operating margin of less than 1%.  For reference, the company was at c. $48 million in sales in 2007, $109 million in 2008, $100 million in 2009 (note less than 10% drop in an extremely tough environment), and $157 million in 2010.  Operating margins in 2010, to give you an idea of the pre-Jacobs era, were 5.3%, and operating margins were positive in all of the aforementioned years.

Jacobs is recently on the record—in September of 2012—in confirming that XPO was at a then-current annualized run rate of $325 million in sales, and by virtue of acquisitions and cold starts, would be at an annualized run rate of $500 million by 12/31/12.  One would think that he has pretty clear year-end visibility by September, the time of his comment; it seems reasonable to assume that he has a couple of additional small acquisitions that will be announced prior to year end.

Consensus analyst projections are:

2012  $280M Revenue,  -1.21 EPS

2013  $744M  Revenue, -0.35 EPS

Investment Thesis

As a value investor, I’m not particularly excited about negative EPS and cashflow over the next c. 18 months, and I’m certainly not excited about using multiples of sales as a valuation technique (however, I will not complain if XPO hits that top-line target…). 

The crux of the investment thesis is this:  with $300 million in cash on hand and a very specialized in-house M&A team in motion (in a very fragmented space with dozens of size-appropiate targets), I see little risk in XPO eventually achieving a run rate of $500 million in sales.   If the capital markets seize up in 2013, that may even be an advantage for XPO; the cash is already in hand, and with $300 million in cash and no debt maturing until 2017, the risk of financial distress is basically non-existent.   If there’s a hiccup in the M&A process(es) and it winds up taking a while longer, that’s fine, but Jacobs & team have affirmed the goal so many times recently that I believe they’ll be there by 12/31/12  (Jacobs stated on 8/7/12: “We are right exactly where we want to be, because we wanted to buy $250 million [in acquisitions] by the end of the year. Between Continental Freight Services and Kelron, we are at about $122 million and are on track for our goal by the end of the year and are a little bit ahead on the Cold Starts….”)

I believe that Jacobs, who has built comparable businesses in the past, is fully capable of achieving at least an industry-standard operating margin if conditions compel him to batten down the hatches.  XPO is in full expansion mode at the moment, which is reflected in the income statement and cash flow.  It requires the aforementioned investments in 7 “cold starts” (expansion capex is light, but not non-existent), the newly re-vamped IT system, and the new centralized operations center in Charlotte.  All of this requires up-front investment, and we see it in XPO’s earnings outlook for 2012 and 2013. XPO says that c. $10 million of the cash will be used for cold starts and IT build; $10 million as a cushion; and c. $280 million for acquisitions. But if conditions warrant a slowed pace—for whatever reason— the primary thesis here is that Jacobs could stabilize the business and run it at LEAST at an industry standard margin. 

Comparables and Valuation

So what’s an “industry standard margin?”  Public comparables include CH Robinson (CHRW), Landstar (LSTR), Hub Group (HUBG), Pacer (PACR), Expeditor’s International (EXPD), Echo Logistics (ECHO), JB Hunt (JBHT), Werner (WERN), and Swift (SWFT).  Incidentally, two private companies, TQL and Schneider, are also in the mix.    The most direct public comps are CHRW, LSTR, and ECHO;  each derives more than 76% of its revenues from truck brokerage (76%, 92%, and 90%, respectively).  The other names listed above are 3PLs, but are poorer comps for various reasons—either they own tractors and containers themselves, operating the division alongside a 3PL business (HUBG, JBHT, SWFT, PACR, WERN); or they deal primarily in other transportation modes (EXPD).  From an ROI standpoint, CHRW, LSTR and ECHO have the right model, and Jacobs is clearly following the trail that they’ve blazed.

CHRW and LSTR have 2011 operating margins of 6.7% and 8.0%, respectively (note:  ECHO has lower margins, but is a rapid growth story (reflected in expenses) like XPO--- ECHO has a trailing P/E of 29X with a 5 year revenue CAGR of 78%).   If XPO resorts to “plan B” and puts the expansion plan on hold due to industry or macro headwinds, assuming a 7% operating margin, Jacobs could stabilize the business at $500 million of sales in 2013, with a run rate of $35 million of operating income.  CHRW trades at 13.3X  EV / TTM Operating Income;  LSTR trades at 11.3X EV/ TTM Operating Income.  Applying an 11X multiple to XPO yields an enterprise value of $385 million in this “Plan B” scenario (78% upside from the current EV, as shown below).  There is very little doubt in my mind that a private equity firm would step up and buy this at that level, given the characteristics of the business and the track record of management.  If the company hits consensus revenue targets in FY2013 ($744 million), the company should be worth considerably more—not to mention the potential if Jacobs achieves his full aspirations over the next few years.

Here’s how I look at XPO’s current enterprise value on a fully diluted basis (note: you will not be surprised to hear that typical finance websites are useless, due to the warrants, preferred, and recent convertible): 

Common                                        17.7

Preferred (Jacobs)                         10.7

Jacobs Warrants, net $7 strike       4.3    (assumes $11.6 stock price)

Options & RSUs                             1.0     (as of 8/31/12)    

Total                                               33.7 million shares

Fully Diluted Market Cap:  (33.7 X $11.60) = $391 million

Debt:  $125 million convertible

EV :  (33.7M X $11.60) + ($125M convert) – $300M cash (estimated) = $216 million

I refer you to the public documents (9/24/12) for a full discussion of the convertible debt issued in September of this year, but to summarize, it’s $125 million (underwriters were granted 30 days to place another $18.75 million); pays 4.5%; and matures in October 2017 unless converted or redeemed earlier.  The debt is convertible in four different scenarios;  e.g., it’s convertible after 12/31/12 if the stock trades above 130% of the conversion price (conversion price is initially $16.43, but subject to adjustments) for 20 trading days out of the previous 30.  Again, there are four scenarios and a lot of detail here, so I’d refer you to the 9/24 prospectus.   The debt is redeemable for cash (principal + make-whole premium) by XPO at the conversion price after 9/30/15 if, once again, the stock trades above 130% of the conversion price (initially $16.43, subject to adjustments) for 20 trading days out of the previous 30.  There is no sinking fund, it is unsecured debt, and there are no restrictive covenants.  Note that the market was not excited about the convertible issue:  the stock dropped from c. $15.50 to $12.25 over a few trading days.  The timing of the debt announcement was coincident with a 9/19/12 company revision of revenue expectations for 3Q12, to $68 - $72 million.   In my view, after digging into the details of the debt, it’s an over-reaction-- a buying opportunity ($15.50 to $11.60, as I write this, represents a 25% drop).   Moreover, I’m comfortable with a proven capital allocator (with $75 million of his personal funds at stake, sitting on the equity side of the table with a 50%+ share) making the conversion decisions…

The rest of the balance sheet is unremarkable.  At 6/30/12, the company had $190 million of cash and no debt; in my EV calculation I assumed $300 million in cash and $125 million of debt as of today, after closing the convertible debt in September.

As far as potential exits are concerned, it’s worthy of note that CHRW, a $10 billion dollar company, has been acquisitive in the past.  CHRW had no debt at 6/30/12.  There would be no shortage of interested PE shops if Jacobs ever chose to go that route; he could recap the company and get liquidity that way.

Risks

To use Daniel Kahneman’s term, what happens if we conduct a “pre-mortem” of XPO?  Two years from now, if the company is a disappointment, why will it have fallen short?

First, the trucking industry obviously suffers as the economy suffers (“let’s not kid ourselves,” Jacobs said in a recent interview); obviously lower freight volume translates into fewer transactions for XPO’s organic business, and pain for the industry as a whole.   But the company is positioned well to grow through acquisition, and has c. $300 million in hand with which to execute; from a pricing standpoint, wouldn’t one prefer to be an acquiror in a sluggish time in the cycle, rather than when the market is flourishing?  If the fundamental play is to buy a dollar of revenue for 8 cents (or twenty or thirty cents, for that matter), and the market assigns a significantly higher multiple for XPO’s revenue (currently the fully diluted market cap is around 0.6X sales), that approach should hold up even if the overall market is struggling.  Additionally, truck brokerage (currently with 15% of the pie) as a percentage of overall shipments can grow even if the overall US trucking market is stagnant.  But this is a competitive business—make no mistake-- and XPO is subject to decreased organic volumes & compressed margins like everyone else.  Moreover, the “spot” priced shipping market (which drives a lot of XPO’s business) tends to be pressured in tough economic times.  It’s never easy, and Jacobs certainly isn’t assuming it will be.

There’s also a key man issue (eat your vegetables, Brad…).  Not sure there’s any way around that one.

Other risks:

-        Risk of acquisition prices increasing as competitive bidding increases

-        Most of management team has not previously worked together

-        As previously mentioned, Jacobs contractually controls the Board as long as his ownership exceeds 33% of fully diluted capitalization

-        Potential execution risk of integrating multiple acquisitions

-        Industry risks:   e.g., possible regulatory risk if DOT shortens maximum shift length for truck drivers, which would drive up costs across the board in trucking;  other forces (regulatory or cost-related; e.g., a prolonged spike in diesel prices) could drive shipping away from trucking in general to rail and alternative modes.

-        Employment-related lawsuit from CHRW recently announced.  Looking at the roster, this would appear to be directed at XPO's SVP of Brokerage Ops, but that's speculation.

Conclusion

At $11.60, XPO is an interesting business, driven by a compulsively successful CEO, that shows asymmetrical upside potential.  Jacobs has the capital in hand, and the team on board, to execute a strategy that he’s pulled off before on two separate occasions;  furthermore, he’s proven in 2012 that there are brokerage owners out there that are willing to sell at attractive multiples.  The capital efficiency of the “cold start” approach is not to be underestimated, not to mention the very low maintenance capex requirements of the business.  If the company performs in line with our 2013 revenue expectations, this should prove to be a very attractive investment.  I can easily see an EV of 2 times the level I’ve calculated above, though I know better than to try and predict a specific timeframe. 

Looking at a downside scenario, even if the acquisition plan completely falls apart, the business is at a run rate of $325 million as of September, 2012 (Jacobs stated this in a published interview).  Stabilized at an operating margin of 6 - 7%, that gives us $19 - $23 million—a number that would be attractive to plenty of buyers, even in a difficult environment.  Over the long term, I think that puts a floor on the value of the company.  If Jacobs were looking for a PE partner/acquiror in today’s market, he would have plenty of takers at a level greater than $216 million, the company’s EV as of this writing. 

Ben Graham might call this “intelligent speculation,” but if you look at the EV vs. the private market value of the company, and consider it vs. the runway of the company, I think it’s an attractive play. 

Catalyst