Times are starting to get tough in the trucking industry. High channel inventories and weakening end-user demand are undermining the demand side of the equation and there is now a lot more capacity in the market. With that, spot rates fall and are likely to collide with (and then briefly dip below) spot rates in 2023, or possibly sooner.
This is not a good setup for a trucking company, but Heartland Express (NASDAQ:HTLD) is more than just a trucking company. Heartland has a solid operating history and a solid core of drivers and equipment that stand out in the industry, not to mention a longstanding customer relationship. The company also has M&A synergy levers to pull in 2023 which I think can help offset some of the industry pressures coming in 2023.
Heartland shares have slipped around 4% since my last update, outperforming Swift-Knight (KNX) and Werner (WERN) by around 5%, while outperforming the broader transportation sector (the DJT was down around 16% during this period). I don’t favor Heartland over Knight-Swift, which I recently discussed here, but I see Heartland as undervalued and possessing countercyclical attributes that could help over the next six to 12 months.
Mixed results in the third quarter, new acquisitions weigh on the results
Heartland reported 80% revenue growth, or approximately 70% growth excluding fuel surcharges, and total revenue exceeded expectations by 11%. Given the lack of information provided by management, it is difficult to determine the source of the rhythm; it’s plausible that Heartland’s volumes and prices have held up better than expected, but it’s also plausible that the sell side mismodeled M&A contributions (Smith Transport & CFI).
Operating income increased by 4%, or 9% on an adjusted basis, with a published cost/income ratio deteriorating by 910 bps to 87.3% and an adjusted cost/income ratio deteriorating by 920 bp at 83.7%. Heartland missed OR expectations by about 100 basis points, but operating profit would have exceeded expectations by 9% without M&A transaction costs. Heartland still managed to meet EPS expectations, even with a larger than expected 20% sequential decline in used truck sales gains (an ongoing item/activity for Heartland).
Management said it still expects demand to exceed capacity and expects single-digit contract rate increases in 2023, but demand is weakening and this year’s peak season is muted at best (both Knight and J.B. Hunt (JBHT) basically said “what peak?” in reference to the typical seasonal peak of the fourth quarter).
The sector is rolling
Truck tonnage remained solid, up 9% in August and 5% in September (unadjusted data), but cracks are appearing. Spot rates are now down nearly 30% year-to-date and are less than 10% above operating costs per mile. In fact, the most recent spot quote I saw was a bit below 2019 levels and a few percentage points below the seven-year average.
There are other signs of impending trouble. The logistics manager’s index was 61.4 in September and 57.5 in October, while the transport capacity measure came in at 73.1, the highest reading on record. Basically, inventory levels are very high right now, especially downstream from warehouses, freight demand is down, and there’s still plenty of trucking capacity. With that, tender rejections are now at a four-year, single-digit low (meaning truckers are no longer refusing freight like they were a year ago).
Given all of this, I think Heartland’s projection of single-digit contract rate increases might be optimistic. Heartland management knows the business well, but given the weakness in the spot market, it’s hard for me to see how this doesn’t translate/transfer to contract rates in 2023.
Opportunities related to mergers and acquisitions
Heartland has long been an acquisition business, but the recent track record of integrating deals has been mixed. The basic logic is sound – acquiring companies to build a nationwide network of terminals and diversify the customer base, while taking advantage of opportunities for cost synergy (since Heartland is one of the cheapest carriers) – but achieving the synergy in some of the newer transactions have taken longer than originally anticipated.
Heartland acquired Smith Transport earlier this year for $170 million, adding 850 tractors, then announced the $525 million acquisition of TFI International‘s (TFII) Contract Freighters Inc. (or CFI) non-dedicated US climate-controlled dry van assets and CFI Logistica’s Mexican operations.
The CFI deal places Heartland in the top 10 truckload carriers (#8) and increases the number of tractors to 5,550, while adding greater exposure to the Midwest (particularly the North-South Corridor), a temperature-controlled exhibition and Mexican logistics capabilities that include truckload, less than truckload, brokerage and freight consolidation services. I’d also note that this wasn’t the first time Heartland had attempted to acquire CFI, so it’s a company Heartland has known and wanted for some time.
At the simplest level, acquiring two businesses with operating ratios below 90% provides Heartland with familiar leverage/expenditure synergy opportunities as they will strive to push ORs into the mid 80% to low over the next three years. years. Beyond that, I like the continued diversification and expansion of truckload operations, as well as the expansion into Mexican logistics. It’s more of a step into the unknown for the company, but it should be a significant growth opportunity given the continued growth in cross-border traffic.
With additional revenue from mergers and acquisitions, Heartland is expected to experience significant reported revenue growth next year, although I do see risks to the core business (RPMs and loaded miles) given the aforementioned pressures on full load operators. Longer term, I expect low single-digit base revenue growth, but there could be an upside here if Heartland decides to expand further into logistics (which many other truck carriers have done these last years).
I expect Heartland to generate spend synergies from its acquisitions over time, and I expect FCF margins to move into the mid-teens over time, resulting in a mid-single-digit FCF growth.
Between discounted cash flow and a multiple-based valuation approach, Heartland shares look undervalued. Discounted cash flow suggests a double-digit long-term total annualized return, while a multiple of 7x (in line with industry standards) on my EBITDA estimate of 23 and a bottom multiple of 15x on my estimate of EPS 2022 (peak) both give me fair value estimates around $16.
I like Knight-Swift better, but I see legitimate countercyclical advantages for Heartland, and the valuation doesn’t seem demanding. I’m concerned that business and seller expectations for 2023 are still too high, and buying at the start of a cyclical downturn carries above-average risk, but it’s a name that strikes me as more appealing as a what a game against the tide. .