A Smoother Road for Less-Than-Truckload?

The recent freight recession decimated the profitability of most less-than-truckload (LTL) carriers, primarily because the industry is marked by asset intensity and minimal switching costs--factors that drive our no-moat ratings for all pure-play LTL stocks in our coverage universe. Profitability is thus quite cyclical with limited protection from the competitive landscape, particularly during periods of weak freight demand. Consequently, throughout 2009 as freight volume tumbled, numerous struggling carriers on the brink of collapse slashed rates to unsustainable levels in a desperate attempt to grab volume and stay afloat. Nonetheless, industry pricing (yield) reached a key inflection point in the latter half of 2010 as capacity utilization improved. Since then, carriers' yield gains have largely continued. Although year-over-year growth comparisons become a bit more difficult in the second half of 2011, we expect favorable pricing conditions to remain a tailwind. In fact, pricing execution has become the focal point for most LTL carriers as they endeavor to recapture normal operating margins.

The chart below depicts LTL industry yield trends over the past few years. Excluding the recent, rapid rise in fuel surcharges, we estimate base rates increased 3%-4% year over year on average in fourth quarter 2010 and first quarter 2011. In general, recovering freight demand and the return of rational rate setting among the industry leaders have supported the pricing improvement. More specifically, rising volume has consumed excess capacity, enabling carriers to launch aggressive initiatives aimed at shoring up historically low yields. These efforts have been particularly focused on underpriced contractual business, and negotiations have met with success.  Con-way ,  Arkansas Best (ABFS), and  Old Dominion (ODFL), for example, all generated mid-single-digit rate increases on average in first-quarter contract negotiations. Moreover, most of the major LTL carriers implemented two general rate increases (each around 6%) during 2010. Encouragingly, a significant portion of these GRIs appears to be sticking.

Looking forward, we expect core LTL-industry pricing to expand 3%-5% on average in 2011 followed by low-single-digit growth in 2012. Modest volume increases combined with firming industry capacity and rational pricing among the large carriers should support decent pricing power. In terms of capacity, we expect supply and demand to remain roughly balanced in LTL shipping, with a slight tilt in favor of supply as most carriers are electing to maintain the size of their active fleets (equipment replacement is more of a priority following cutbacks in capital expenditures during the downturn). Furthermore, shippers have become much more cognizant of general trucking-industry capacity reductions, as well as the marginal profitability of many carriers. Shippers are thus more amenable to rate increases in the interest of getting freight moved on time. Some carriers, like Con-way and  FedEx Freight (FDX), are also aggressively managing business mix by turning a cold shoulder to freight that does not optimize network density or yield. This implies that shippers seeking premium service are finding fewer options if their freight is not priced to the liking of carriers.

We expect LTL carriers to encounter some pressure on driver recruiting efforts given probable attrition from the Federal Motor Carrier Safety Administration's new safety program (FMCSA), which links driver performance to carrier safety ratings. However, we think this dynamic will have more of an impact on capacity in the full-truckload market as pay and quality of life (runs are scheduled) are materially higher for drivers in LTL shipping, and LTL industry consolidation in recent years has increased the pool of available drivers. On the other hand, should the FMCSA issue more stringent hours-of-service rules later this year, we think there is potential for declines in the efficiency and productivity of capacity across the LTL industry as carriers would probably need to run more trucks to haul the same level of freight volume.

Stock Ideas
All of the LTL carriers we cover stand to benefit from the favorable pricing environment, but some more than others. We think Arkansas Best enjoys solid upside potential to yields as improvement has lagged that of its peers, due in part to substandard fuel surcharge agreements conceded during the downturn and disproportionate growth among less profitable accounts. Since pricing execution has become vital to the company's return to consistent profitability, we expect management to be quite aggressive in addressing poorly priced freight and inadequate fuel surcharges over the next year. Low-hanging fruit and improved pricing power should support its efforts. Overall, the current market price per share of Arkansas Best reflects a reasonable discount to our fair value estimate, though this margin of safety is not without risk. The firm faces persistent wage and benefit inflation as mandated by union contracts. As a result, it needs base rates to rise roughly 10% on a large portion of its business in order to restore more normal profitability levels, and this magnitude of price improvement will take time. A pullback in U.S. economic growth would serve to lengthen the firm's recovery period.

Last year was unusual for Con-way as previous business wins from aggressive pricing discounts and share gains from struggling competitor  YRC Worldwide (YRCW) drove an unplanned spike in tonnage once market fundamentals improved in late 2009 and into 2010. The volume surge drove variable costs up and operating efficiency down as the firm needed to add inexperienced headcount and tap the more costly spot market to supplement capacity. Throughout the second half of 2010, however, Con-way shifted attention to optimizing the mix of freight flowing through its network via disciplined pricing initiatives. Since then the company has reduced volume to manageable levels and secured low- to mid-single-digit rate increases on average. We think there is opportunity for additional yield gains going forward as contracts mature and the company avoids unprofitable relationships. Incremental yield improvement should move the company closer to its short-term operating ratio (expenses divided by revenue) goal of 95% for its LTL operations, which compares to an OR of 99% in 2010. In our view, Con-way's share price is borderline inexpensive, so a pullback in valuation would make us more comfortable recommending the shares.

Unlike many of its peers, Old Dominion maintained pricing discipline throughout the recent freight downturn, contributing to industry-leading operating margins. In general, we expect that dynamic to persist. While incremental margins will probably moderate over the next few years, we think the firm can still post modest operating ratio improvement driven by increased network density and modest yield gains. While we expect yield improvement as contracts come due for renewal, the magnitude will likely be less than that of many competitors owing to the fact Old Dominion managed to keep rates relatively flat throughout the recession. Despite Old Dominion's best-in-class execution, our interest in buying shares is tempered without a larger margin of safety to our fair value estimate.