Freight markets have entered the second year of peaklike conditions, and there aren’t many signs on the horizon of a material letup in the current dynamics: supply chain dislocation, equipment shortages, labor challenges, astronomical freight rates and an ongoing need for materials and inventory replenishment.
The year-over-year comparisons become more formidable in the back half of 2021 and the first half of 2022 as many carriers have posted record operating and financial results the past couple of quarters.
With second-quarter earnings season in the rearview, FreightWaves caught up with Amit Mehrotra, Deutsche Bank’s (NYSE: DB) managing director and head of transportation and shipping research, to get his take on the back half of 2021 and beyond.
Trucking to see ‘higher highs and higher lows’
FREIGHTWAVES: You’ve been very bullish on this trucking cycle. What’s different about this cycle, and have industry dynamics really structurally changed?
MEHROTRA: “Our positive stance on the truckload cycle incorporates both demand and supply considerations, and both remain firmly in positive territory with no meaningful change in sight.
“On the demand side, it’s hard to underestimate the strength of the consumer — U.S. household net worth is at an all-time high today at $136 trillion, and household nonmortgage debt as a percentage of that net worth is 4.7% … the lowest it’s been since the mid-1960s. And the industrial economy continues to reawaken from an 18-month hibernation.
“All the while, drivers are being sidelined due to Drug & Alcohol Clearinghouse dynamics, fiscal stimulus, and the potential 800-pound gorilla in the room: infrastructure. If we get an actual bill passed — which may or may not happen — drivers will move from the cab to the construction site, which will keep drivers away for years.
“Now with all this being said, it’s never ‘different this time’ when it comes to a fragmented market like truckload. But the case we’ve been making is for higher highs and higher lows, and that’s certainly playing out when we look at the earnings power of truckload companies.”
FREIGHTWAVES: How long do you expect driver hiring headwinds to persist? Once consumer demand normalizes, what will recruitment and retention look like?
MEHROTRA: “This is more the new normal than the exception. What’s amazing — if you take Knight-Swift’s unseated truckload count today, that number would amount to one of the largest fleets in the country. That hasn’t happened before.
“Some of it is transitory — some drivers will come back when extended unemployment benefits end, but time doesn’t stop for anyone. The average age of drivers was over 50 many years ago, and that continues to increase with each passing year. Interestingly, we think large fleets are realizing this new reality, and investing in autonomous technologies; i.e., Werner’s recent equity stake in TuSimple and Knight-Swift’s investment in Embark.”
Carriers have rejected at least one of every five loads tendered under contract for more than a year now. Difficulty finding drivers to seat trucks has been the main culprit. Chart: (SONAR: OTRI.USA)
Rail, port congestion blow out candles on intermodal’s cake
FREIGHTWAVES: In a market where we would traditionally see freight shipments convert from truck to rail (high fuel prices, extremely tight truck capacity and nosebleed rates), we have actually seen the opposite as shippers struggle to keep pace with demand. Does rail service get noticeably better in the back half of the year?
MEHROTRA: “It’s difficult to see how that occurs as demand reaccelerates due to back to school and peak season. Congestion is likely to only increase, and new equipment is not coming online fast enough to clear backlogs.
“But things should get better over time. As an example, investment in new containers was relatively low in the first half of 2020 with only 1.1 million TEUs [twenty-foot equivalent units] delivered. That increased to 2 million TEUs in the second half of 2020 and 1.35 million in just the first quarter of 2021 alone. The world container fleet is expected to increase from just over 44 million TEUs in 2020 to over 53 million in 2025. And ports are investing to increase their throughput at a faster rate than TEU growth.
“There is also the question of how PSR [precision scheduled railroading] has impacted rail companies. Have they cut too much? And do they need to add resources? Our sense is it’s more about equipment shortages and supply chains at the moment, and so we’re hopeful that it is transitory, but it may take some more time given demand is likely to remain robust.”
FREIGHTWAVES: What’s your call for when port congestion eases? Will it be the end of the demand cycle/inventory rebuild before it happens?
MEHROTRA: “Not anytime soon! Demand remains robust for the reasons we mentioned previously. We don’t expect any letup here for the foreseeable future.”
Intermodal rail service off the West Coast remains strained. Chart: (SONAR: RAILSPEEDINT.UNP)
TL rates and carrier margins to remain firm
FREIGHTWAVES: If TL contract rates shake out up midteen percentages this year, how much can carriers practically capture in rate next year assuming the current demand-supply dynamic spills into at least early bid season in 2022?
MEHROTRA: “It’s a fluid situation, but what we are convinced on is that pricing will be positive in 2022, which is an impressive feat given midteens-plus pricing in 2021. Our best guess is 3% to 5% yield improvement next year for the TL industry. We think this is the most reasonable assumption from where we stand today, with possibly some upside if the industrial economy really starts to get going.”
FREIGHTWAVES: At what point does cost inflation (driver pay/labor expense, insurance, fuel, etc.) limit margin upside?
MEHROTRA: “It’s important to note that one point of pricing does not equal one point of driver pay. Because pricing is applied to the entire revenue base, whereas driver pay is applied to only about 30% of the cost structure. In this sense, one point of pricing is worth three points of driver pay. This is why we are not concerned about margin squeeze related to driver pay hikes.
“In fact, it’s actually a positive indicator of operating leverage, as driver pay increases are paid for by the shipper through higher pricing. We also think truckload companies are being very thoughtful about pay … using productivity-based rewards to incentivize the right drivers (team drivers, for example) and right behaviors (i.e., accident-free mile rewards) rather than across-the-board pay increases (although this is also occurring).”
Chart: (SONAR: TSTOPVRPM.USA)
Outlook for fleet growth and M&A
FREIGHTWAVES: Is fleet growth possible in this driver market or is M&A the only way to meaningfully grow?
MEHROTRA: “It’s very difficult given the driver challenges, many of which we view as secular. So M&A is the clear and present option, as we recently saw with Werner’s recent acquisition of ECM Transport, which added 500 highly qualified drivers to Werner’s ranks.”
FREIGHTWAVES: Do you expect to see more large deals like the ones we have already seen this year (TFI/UPS Freight, Werner/ECM Transport and Knight-Swift/AAA Cooper)?
MEHROTRA: “Large deals are few and far between in transports, because integrations are difficult, there is little debt across most capital structures, and there are few willing sellers. But we are most positive on Knight-Swift’s ability to acquire additional LTL companies.
“The Knight-Swift team are prudently aggressive and ambitious, and we think they are being thoughtful in approaching the integration of AAA … in a way, we think, that will attract other family-run LTL companies with an interest in selling but also a focus on preserving the brand and legacy that has been built over generations.
“It’s notable that 17 of the top 25 LTL companies are private, some very large, with all but one being nonunionized. This is fertile ground for additional M&A, and we think Knight-Swift can see more opportunities.”
FREIGHTWAVES: Will more TL carriers with solid cash flow generation continue to gain a footing in the LTL market?
MEHROTRA: “We don’t think so. Based on our work, Knight-Swift has looked at the LTL sector for well over a decade, with a few missed opportunities. So this wasn’t something that came out of left field. We wrote back in January that we thought Knight-Swift would make a transformational acquisition this year, and it could be in the LTL sector. It took a bit longer than we thought, but that’s what happened.
“Separately, in addition to Werner’s management team, we think Knight-Swift management are very good fiduciaries; and now they are taking that skill and applying it to an adjacency that is well regarded in the capital markets. Like we said before, LTL is the ‘Beverly Hills’ of trucking, and Knight-Swift is looking to change neighborhoods.”
How much is left in the tank for LTL carriers?
FREIGHTWAVES: LTL networks have been a freight catchall recently, capturing e-commerce market share, taking on spillover freight from a tight TL market and seeing some uptick in more traditional industrial shipments. What does the demand cycle look like moving forward?
MEHROTRA: “The bread and butter of the LTL industry is, and always has been, the industrial economy. And on that front, we continue to be very positive that we are in the early innings of a multiyear upcycle in U.S. industrial production.
“We do not think e-commerce growth is necessarily a great thing for LTL. E-commerce volumes tend to be lighter versus industrial-rated freight, and lighter packages moving through the same LTL network is less attractive than heavier ones, all else equal. Our view on this is still evolving at this point, but we feel confident that the industrial economy will be what drives overall LTL industry volumes for the foreseeable future.””
FREIGHTWAVES: What’s left in the tank for the LTLs in terms of pricing and margins?
MEHROTRA: “We think the LTL industry can consistently achieve pricing above inflation. If this is the case, then margin expansion can continue on a slow and steady trajectory upward cycle-over-cycle. Some of this has to do with the level of consolidation in the industry; also better actors vis-à-vis FedEx Freight; XPO versus Conway; TFI versus UPS Freight; and the Saia of today versus Saia five years ago.
“We think the industry as a whole is deploying technology and analytics that give it a more accurate estimate of the costs of moving each shipment through its network, which allows pricing and accessorials to move accordingly.
“And lastly, real estate is not getting any cheaper; it’s not easy to grow service centers and doors. This limitation on capacity is a positive thing for pricing over time, as we’ve seen over the last decade vis-à-vis flat to down industrywide service center growth.”
When and how does it all end?
FREIGHTWAVES: When does the current freight cycle end, and how do you think the landing plays out?
MEHROTRA: “We feel comfortable saying that we will be in a healthy freight market through the end of 2022 and even into 2023. Demand drivers are significant; and in fragmented markets, heighted supply growth doesn’t make its presence felt in any meaningful way until there is demand destruction.
“But to be sure, we do expect demand and rates to moderate from white-hot levels today. But fundamentally, even with this moderation, we think returns can be solid for the next 18 months. But equity values are likely to discount this sooner. And some sectors are already exhibiting this — like truckload.
“But we do not believe the ‘peak’ narrative bleeds into LTLs and other, more consolidated sectors with stickier share capital bases. We think second-quarter earnings season proved this point to be true, with very strong LTL results, albeit well anticipated, being met with strong equity price performance and good follow-through. But the key for stocks from here is looking beyond the cyclical, and finding companies where the structural and true earnings power is significantly higher than current levels. We think this can be found in companies like UPS and FedEx, and also Saia, XPO and Knight-Swift.”