Investors Should Hit the Brakes on Truckload Stocks

The electronic logging device mandate for U.S. truckers is looming, and somewhere around 65% of small fleets, which constitute most of the truckload carrier base, are waiting until the last minute to install the devices. They will have to install them eventually, however, or risk being taken off the road.

Because ELDs are far more exacting than paper logs, they force drivers to adhere more closely to hours-of-service rules, tempering the distance a truck can legally run. As a result, we expect widespread ELD adoption to reduce or potentially eliminate excess truckload capacity and revive pricing, which has been mostly sluggish since late 2015.

This is good news for the large sophisticated truckload carriers, most of which have already installed ELDs, as well as for moatworthy truck brokers that benefit from supply disruption.

But despite the prospect of a pricing rebound, we think investors should hit the brakes on asset-based truckload stocks. Several carriers, including

Installation Mandate Just Around the Corner In December 2015, the Federal Motor Carrier Safety Administration ruled that interstate truckers must install compliant electronic logging devices by Dec. 18, 2017. The FMCSA provides a registry of self-certified vendors. ELDs automatically record duty status and driving time, which is regulated by hours-of-service rules. A last-ditch effort by the Owner-Operator Independent Drivers Association to convince the Supreme Court to overturn the rule failed in June, as the high court refused to hear the case. Only an act of Congress can reverse the rule at this point, and that seems unlikely, given that the deadline is looming and a proposed amendment to a funding bill looking to block funds for the ELD mandate was voted down by the House on Sept. 6. With that in mind, and considering there is general acceptance of the rule among large carriers and the American Trucking Associations, we think it will more likely than not be implemented in December. Truckers that have already installed previously approved and grandfathered devices that don't meet the most recent federal technical specifications for the upcoming mandate have until December 2019 to become ELD-compliant, but we don't foresee any material industry disruption on that front, as those truckers are likely to have already experienced a productivity hit.

In late August, the Commercial Vehicle Safety Alliance, which is composed of local and regional enforcement officials across the United States, announced its members will begin issuing citations for ELD noncompliance on Dec. 18, but “out-of-service” enforcement won’t begin until April 1. This implies that drivers will be fined for noncompliance starting with the December deadline, and those violations will hit the driver/carriers’ safety rating. The more severe penalty--being placed out of service for 10 hours--has been pushed back slightly, probably to minimize disruption. State departments of transportation, along with state police, are the most common enforcement officials in terms of commercial vehicle inspections.

ELDs make it tough to cheat because they automatically record driving time. Thus, owner-operators and fleets that are egregiously distorting their paper logs to gain an edge by running more miles than hours-of-service rules allow (truckers are paid by the mile) are certain to see a material reduction in utilization. We understand that even the drivers with the best intentions periodically fudge their logbooks in a pinch. As a crude illustration, let’s say it’s 4 p.m., a driver has 30 minutes remaining of legal driving time (on the 14-hour clock), and it normally takes 15 minutes from that point to reach the customer’s dock. However, because of traffic, it takes 35 minutes and the driver arrives at 4:35 p.m. Because paper logs use 15-minute intervals and the driver only went 5 minutes into the next 15-minute time slot (4:30-4:45), perhaps he rounds down and logs the 4:30-4:45 slot as on-duty/not driving to avoid a violation. An ELD would automatically record the incremental 5 minutes of driving. Thus, with an ELD on board, the driver would probably have rescheduled the load and started looking for parking at 4 p.m. (or earlier) to avoid the risk of a violation, effectively reducing the number of miles he or she can drive that day.

Changes in routines like this are among the chief factors behind carriers’ productivity losses under the watch of an ELD. For example, drivers will cut a trip short to locate parking (which can be hard to find) before running out of legal driving hours. Simply put, drivers can no longer round to the more favorable 15-minute increment, periodically shave driving time, or retrofit logs to avoid violations or accommodate delivery schedules. Even the most vigilant hours-of-service-compliant cultures like that of

Most of the Carrier Base Has Yet to Install ELDs Most (if not all) large truckload fleets like Knight-Swift, Schneider National, and Werner Enterprises have already phased in some type of electronic tracking device over the past six or seven years. A survey conducted by logistics firm Transplace suggests that more than 80% of carriers with more than 250 trucks had installed the devices by mid-2016, and we suspect much of that gap has since closed. On the other hand, a very large proportion of small carriers (those with fewer than 250 trucks) have yet to install ELDs, but they will in the coming quarters or risk being taken off the highway. Small, independent operators have objected the most to federal mandates over the years because they usually have the most to lose. This is no small niche--91% of carriers run fewer than six trucks, and those with fewer than 250 trucks constitute nearly 99% of the carrier base. Estimates vary, but it appears that slightly more than one third of small carriers are currently compliant. Transplace's survey suggested 33% were compliant in mid-2016, while more recent studies from Fleet Owner magazine and consultancy FTR point to about 34% and 38%, respectively, in the first half of 2017.

Limited Driver Availability Prevents Quick Fix As widespread ELD adoption firms up truckload capacity in the year ahead, we think driver recruiting challenges will restrain most carriers' attempts to quickly offset lost miles via fleet growth. This should keep supply tight for a longer time frame, which bodes well for an industry pricing rebound. Although not related to ELDs, a similar trend occurred in 2014 into early 2015 as the market tightened materially.

Carrier complaints about the limited driver pool aren’t as ubiquitous as they were a few years ago because freight volume growth, although slightly better in recent quarters, has been mostly sluggish since late 2015; thus, carriers have had little incentive to add trucks. Nonetheless, the driver pool is by no means flush with qualified talent, for a host of reasons: A large number left the industry during the previous downturn, new entrants have long been inadequate (it’s not a glamorous lifestyle and attracting young prospects is a challenge), and it’s a rapidly aging group (the average age of an owner-operator is 55, with many retiring). Some new drivers entered the trucking market in 2014 and 2015 as wages increased, with help from a talent influx from beleaguered energy end markets. Thus, many of the large carriers managed to post fleet growth for a season, but it was usually not to the degree desired, and drivers were commonly secured via acquisitions or poaching from competitors.

Driver availability has long been a concern, especially for large fleets, even before the 2009 freight recession, which masked the issue. But it came to the forefront in 2014 through early 2015 as market conditions strengthened and carriers expanded their fleets for the first time in many years to capitalize on favorable pricing. Truckers ran into abundant challenges, especially high turnover and increasing driver-related costs linked to aggressive recruiting initiatives and the need to boost wages to more competitive levels. The National Transportation Institute estimates average driver pay rose 14% between the middle of 2014 and the end of 2015. According to the ATA, driver turnover among large truckload fleets exceeded 95% on average (an unusually high level) between 2012 and 2015. In 2014 and 2015, carriers able to find drivers would often expand their tractor fleet at the cost of lower utilization (miles per tractor) as high turnover resulted in unseated tractors. Others simply didn’t add trucks and forfeited freight. Driver turnover dropped into the low 70s in late 2016 on loose capacity, but the decline was short-lived, with turnover spiking back up to about 90% in the second quarter of this year--further evidence that truckload market supply is firming, even without a major impact from ELDs. We expect driver-related pressures to once again rise to the forefront in the year ahead as tighter capacity puts fleet growth back on carriers’ agendas.

While less obvious because of lackluster cargo demand and loose capacity over the past few years, which caused carriers to shrink their fleets, growth in the driver pool remains limited. There were approximately 1.7 million tractor-trailer drivers in 2016, according to the Bureau of Labor Statistics. Despite help from carriers boosting pay in recent years, it took until 2016 for the driver pool to return to levels seen in 2007, its prerecession high. At the same time, industry demand has grown to a greater degree, as reflected in the ATA truck tonnage index, which in 2016 was 18% above its prerecession peak reached in 2005. The ATA estimated the industry needed about 48,000 additional drivers in 2015 (a historical high) to optimally handle shipment levels. While we suspect that number dissipated over the past year and a half on sluggish demand and excess capacity, the shortfall will very likely return. Even without considering the impact of ELDs, a study conducted by the ATA in late 2015 concluded the driver shortage could reach 150,000 by 2020 based on its estimates for driver population growth and industry expansion, with retirements among the largest contributors.

We Expect 2%-3% Hit to Total Truckload Industry Capacity From ELDs What's the potential loss to truckload market capacity from widespread ELD adoption? It's not an exact science, and the net impact on individual carriers partly depends on network density and the strength of customer relationships. Most large truckload fleets, like Werner Enterprises and Schneider National, saw a 4%-5% initial hit to productivity upon installing ELDs. Importantly, that mid-single-digit productivity hit was seen among large sophisticated providers capable of mitigating the impact by adjusting network routines and convincing shippers to tweak their own habits (reducing dwell time at docks, for example). Large carriers also have more options in terms of using team drivers or large trailer pools (drop and hook), and many have invested in advanced telematics systems that provide sophisticated data analytics, such as driver behavior monitoring and engine diagnostics. These resources can help mitigate the impact. But it's not a stretch to conclude that less capable operators--many of which operate on razor-thin margins--will see a much greater hit from ELDs since they usually lack the IT, network density, and know-how that enabled large fleets to offset some of their lost miles. Productivity refers to revenue per tractor, which is a function of revenue per mile (pricing) and miles per tractor (utilization), and our take is that ELDs primarily affect utilization.

We estimate the overall truckload market will see a productivity/capacity decline (losing miles is the equivalent of losing trucks) in the ballpark of 2%-3% by the end of 2018, owing to widespread ELD adoption among small carriers. Behind this, we assume small carriers (fewer than 250 trucks) stand to lose around 7% of their productivity on average. This is a few percentage points above the level that many large truckers like Werner and Schneider have reported because small fleets have limited options to mitigate the impact.

To arrive at 2%-3%, we estimate roughly 42% of the truckload industry tractor fleet has yet to become ELD-compliant and will be doing so in the quarters ahead. For simplicity, we assume large carriers are already compliant and won't see an impact. Small truckers constitute almost 99% of the total carriers in the industry, but for greater accuracy, we further adjust for the portion of the total tractor fleet they actually control--that's closer to 65%, based on data from the Commercial Carrier Journal and RigDig Business Intelligence. Assuming roughly 64% of that group has yet to install ELDs yields 42% of the total fleet. We take our analysis a step further and assume 80% of truckers poised to install ELDs will experience a productivity hit. Not all truckload carriers run up against hours-of-service rules to begin with, especially specialized local/regional players. A 2016 survey conducted by Transplace suggests 25% of small fleets don't expect a material utilization impact. We peg that number as slightly lower, at 20%, based on discussions with management teams of the trucking companies we cover.

We can envision a few circumstances in which our 2%-3% estimate could prove conservative--for example, if a significant number of small fleets become unprofitable due to lost miles and exit the industry (most are paid by the mile). Our numbers don’t assume small providers pull trucks off the road beyond the amount implied by lost utilization. On a related front, the magnitude of the capacity impact will partly depend on the frequency of cheating with paper logs among small carriers. Large carriers, which usually have cultures of strong compliance, have seen a 4%-5% hit, and we assume small carriers see a slightly greater impact of 7% on average because it’s harder for them to make up lost miles. But if a vast number of truckers are egregiously falsifying their paper logs, the impact will be much higher than 7%, likely in the double digits. On the other hand, the impact could be more modest if enforcement is weak. We don’t expect that to be the case, considering the significant attention the mandate has received from regulators and the industry. Additionally, we believe shippers and highway brokers will increasingly require carriers to have ELDs installed, given the potential service disruption if a carrier is placed out of service by enforcement officials for noncompliance.

2%-3% May Not Seem Like Much, but It Can Make a Big Difference We believe an ELD-driven 2%-3% reduction in truckload industry capacity (via lost miles) will be sufficient to bring supply and demand into a healthier state of balance than that seen over the past few years. That's roughly the level of excess capacity the marketplace has been dealing with. According to the Council of Supply Chain Management Professionals, the truckload industry faced an approximate 3% surplus of trucks during the first half of 2016. That's a difficult number to pinpoint because the truckload industry is so fragmented, but commentary from FTR and our discussions with industry participants give us confidence that this is a reasonable approximation of excess supply throughout 2016. That said, given large carriers' fleet reductions, modest demand improvement, hints of tighter truck availability during the summer months (including rising spot rates), and disruption from the recent hurricanes, we believe this has decreased.

Recent trends in the marketplace increase our confidence that the truckload supply glut that’s been lingering since late 2015 hasn’t worsened and is probably dissipating even without help from ELDs. We’ve long believed that the supply glut won’t last, and that appears to be proving true. Capacity tightened materially on many lanes during the second quarter, for the first time in more than a year. This was due in part to an above-normal seasonal uptick in demand heading into the summer holiday period, coupled with carriers’ ongoing fleet reductions. For reference, the ATA truckload loads index increased 2% year over year in the second quarter; it was flat last quarter and in 2016. Pointing to the capacity squeeze this summer are dry van spot rates, which have jumped meaningfully. It also shows up in broader truckload industry pricing (excluding fuel), which reflects both spot and contract pricing and a wider array of operations (dry van, refrigerated, flatbed, and so on). Core pricing has been on the mend this year, and in the second quarter, the Cass Truckload Linehaul Index showed the first year-over-year uptick (1.3%) since late 2015.

Overall, second-quarter trends, particularly rising spot rates, reveal a market that isn’t perilously oversupplied and on average probably isn’t as loose as it’s been. It doesn’t take much disruption to firm up capacity and tip the scales back in favor of carriers’ pricing power--in the second quarter, it came from stronger-than-expected season shipment demand. Overall, the stage is set for a sustained pricing recovery over the next year as widespread ELD adoption removes incremental capacity from the marketplace. We expect truckload market rate gains (excluding fuel) in the ballpark of 3% on average for 2018 and 2019. This is a solid showing relative to the past few years and above the historical 10-year average near 1.5%, which captures a full trucking business cycle.

Productivity losses from ELDs should be sufficient to extinguish any lingering supply glut, but we don’t anticipate a full-fledged capacity crunch like that seen in 2014 into 2015. It’s true that time frame has a few parallels, particularly changes to hours-of-service rules in 2013 that reduced capacity by about 3%, as well as a lack of fleet growth following the recession. But productivity saw an additional hit from more widespread adverse winter weather across much of the U.S., along with stronger freight demand. That said, the recent hurricanes in the Southwest (Harvey) and Southeast (Irma) are having an impact on capacity (via congestion, delayed restocking, and inbound recovery supplies), providing a boost to spot rates. According to consultancy DAT Solutions, truckload spot activity/rates hit a two-year high in mid-September. Thus, if storm disruption and increasing ELD adoption manage to cause a capacity crunch by the fourth quarter, we would expect a robust contract bidding season in early 2018 as shippers scramble to lock in capacity. In that case, industry rate growth (excluding fuel) next year and into 2019 could look more like it did in 2014-15, reaching 5%-6% on average--well above our 3% forecast.

A key reason the supply/demand balance is showing progress this year is that large carriers have been trimming their tractor fleets. The truckload industry saw a brief period of fleet growth in late 2014 into the first half of 2015, driven by a rapid tightening of capacity and related uptick in carriers’ pricing power. This provided fleets with the stomach to invest in equipment for the first time since before the 2008-09 freight recession. However, carriers didn’t overbuy as much as in past cycles, thanks in large part to improved discipline following the downturn, which decimated most carriers’ profitability. Also tempering fleet growth was limited driver availability and a relatively short time frame. Carriers’ expansion programs reversed sharply as demand weakened in late 2015, and most of the large carrier base has been reducing tractor count since.

According to FTR, active truckload capacity utilization (needed trucks divided by active/in-service trucks) reached a nadir of 94% in early 2016 but improved to the high 90s by the first quarter of 2017. A reading above 95% implies the market is sufficiently tight for carriers to secure rate gains. Interestingly, in 2016 this metric never tripped the 90% mark, below which fleets would be painfully underutilized--it fell into the high 80s during the 2009 freight recession. Overall, these conditions bode well for the large truckload carriers on our coverage list as widespread ELD adoption tightens supply and revives pricing.

Hit the Brakes on Asset-Based Truckload Stocks We believe widespread ELD adoption among small carriers will temper industry productivity. That impact should at minimum be enough to eliminate any lingering excess capacity, which (aside from recent signs of improvement) has plagued the marketplace for almost two years. As a result, assuming no major pullback in freight demand, we expect the truckload carriers we cover to enjoy a solid rebound in pricing power throughout 2018 and into 2019, especially as limited driver availability will temper broader fleet growth.

That said, truckload stocks look ultra-expensive to us, offering little upside. In early 2015, we considered most carriers we cover to be overvalued, likely reflecting overly optimistic assumptions surrounding fleet growth and pricing gains. As operating conditions softened, those valuations came back down to earth by early 2016 as reality set in. Despite sluggish demand and abundant capacity throughout 2016, however, the truckload stocks on our coverage list resumed an upward climb, with a meaningful jump in November, rooted in the prospect of U.S. tax reform and rumors of accelerated infrastructure projects. We also think truckload stocks have enjoyed support from the prospect of tighter capacity by 2018 from ELDs. Valuations saw another drive upward this summer, linked to improving spot rates, which rose even more following the landfall of two hurricanes, Harvey and Irma. Hints of firming capacity in the second quarter suggest the supply/demand balance is improving, and disruption from the storms, although regional, could offer another positive pricing catalyst. These factors have created significant optimism for truckload stocks, but we would caution that several names are once again hovering in overvalued territory.

The full truckload carriers we cover are trading at nearly a 30% premium to our discounted cash flow-derived fair value estimates on average. Additionally, save for Schneider, which has a limited operating history as a public company, three of the leading carriers--Heartland HTLD, Knight-Swift, and Werner--are trading well above their long-term average price/earnings ratios. In our view, these are peaklike multiples implying overly optimistic assumptions regarding long-term revenue and earnings growth, even with the prospect of a favorable pricing environment in the year ahead. This dynamic looks a lot like late 2014 and early 2015 (during the truckload capacity crunch), when we also cautioned that valuations for these same high-quality firms were running ahead of themselves. By early 2016, that had generally proved true.