Skip to Content
Stock Strategist Industry Reports

Well-Managed Con-way Is on the Right Road

Rate growth will slow, but should remain a tailwind.

Mentioned:

We expect pricing to be the principal growth driver for freight transportation and logistics firm Con-way (CNW), as moderate U.S. economic growth and limited fleet expansion temper volume over the next year. We think tightening trucking industry capacity will support mid-single-digit rate gains in 2012--more modest than those realized in 2011, but sufficient to offset cost inflation.

The past few years have been interesting for the company's core less-than-truckload business, Con-way Freight, which contributes 60% of total revenue. Despite the macroeconomic recovery in 2010, an unplanned spike in tonnage from aggressive rate reductions and related market share gains drove the firm's variable costs up without the benefit of enhanced density in lanes where it was needed most. Throughout most of last year, however, Con-way benefited from vastly improved industry utilization and gains in pricing power. As a result, the firm was able to garner much-needed yield increases from customers while reducing freight to manageable levels through targeted, lane-specific pricing initiatives. In 2011, LTL base rates, excluding fuel surcharges, increased 6% on average, while the segment's operating ratio improved more than 250 basis points.

We think yield gains remain the key to margin improvement, as volume expansion will be muted. Con-way Freight is more concerned about optimizing the mix of freight flowing through its network than market share gains or fleet growth. Mid-single-digit rate gains in LTL contract negotiations continued into the first quarter as the firm capitalized on favorable trucking industry pricing conditions. Pricing gains of that magnitude also persist in the truckload segment (10% of sales)--an encouraging sign, given that a large chunk of the truckload segment's contractual price increases are secured in the first half of the year. Relatively balanced supply and demand in LTL shipping is providing backbone to Con-way's pricing power, and we expect that to continue, with a bias to excess demand. Well-capitalized carriers are upgrading their equipment to control rising maintenance costs, but are quite reluctant to increase fleet size--margin improvement and asset returns are the priority. Additionally, although more of a factor in truckload shipping, the driver pool is poised to tighten further over the next few years as the Federal Motor Carrier Safety Administration's new compliance, safety, and accountability program forces workers with poor CSA scores to leave the industry. Changes to hours-of-service rules could also effectively shrink available supply. Altogether, even with only modest industry demand growth, we think capacity will remain firm, enabling Con-way to achieve mid-single-digit rate gains on average in 2012.

Network Efficiency Gains Should Also Provide a Boost
Con-way is a well-run trucker with a strong management team, but as with many top carriers, the freight downturn and resulting margin squeeze forced the firm to shift attention and resources to operational optimization. Over the past few years, Con-way Freight has invested in numerous structural and technological improvements, many of which should continue to provide incremental opportunities for greater network efficiency and profitability enhancement. For example, the firm retrofitted its trailer fleet with a new modular trailer-decking system, SafeStack, which replaced more cumbersome, traditional load tables. Based on anecdotal evidence, we estimate SafeStack increased effective trailer capacity by more than 25% as more cubic space can now be utilized. The new system also secures freight better, reducing claims exposure and driver injuries (drivers also function as dock workers in LTL shipping). Cargo damage claims declined 40% in 2011, partly because of SafeStack, and management thinks claims as a percentage of revenue can gradually fall below the firm's historical average of 1%.

The company is engaged in several other multiyear projects focused on safety and the gradual implementation of lean principles across the service center network. Most of these efforts leverage technology to optimize line-haul efficiency, dock productivity, and pricing sophistication. For example, the firm is installing new scanning technology that captures more specific dimension-related data on a larger portion of shipments, thereby increasing pricing precision and cost visibility. Additionally, the firm is refining its use of real-time information--leveraging existing handheld devices used by drivers and service center personnel--to make its load planning more dynamic, which helps reduce the amount of assets needed to haul the same level of freight. While it is difficult to isolate the impact of any specific initiative, the company appears to be making progress. In 2011, the LTL segment improved the productivity of its dock and pickup and delivery operations by 5% and 2%, respectively, and management is seeing similar results thus far in 2012. Management has also been raising the bar on safety. As a result of aggressive efforts over the past year, dock injuries fell 28%, accident frequency improved 14% (to the lowest level in a decade), and workers' compensation costs were down 30%. While we think some of these gains are due to easier year-over-year comparisons (workers' compensation claims spiked in 2010 as the firm was forced to quickly hire inexperienced help to handle an influx of volume), employee awareness appears to be rising and improvement has continued into this year, with accidents and injuries down 20% and 35% year over year in the first quarter.

Con-way faces several cost headwinds, including rising equipment prices, elevated pension expenses, and higher wages (especially for drivers)--a broad wage increase slated for the second quarter will alone add roughly $33 million annually to the expense base. We estimate the company needs at least 3% base rate increases on average to offset cost inflation. The good news is that favorable pricing conditions, namely balanced supply and demand, should support mid-single-digit rate increases on average over the next year. Furthermore, the firm should see some incremental benefits from ongoing internal efficiency efforts aimed at optimizing business mix and minimizing the assets required to haul the same level of freight, though this will take time. Overall, for the LTL segment, we expect mid-single-digit average revenue growth, with about 130 basis points of operating ratio improvement through 2013 (to 95%). On a consolidated basis, we expect gains to be more moderate (100 basis points) as margins in logistics segment Menlo should remain relatively steady.

Con-way Looks Fairly Valued for Now
We think Con-way will continue to benefit from solid pricing and network refinements, but the shares appear fairly valued, trading near our $35 fair value estimate. We would prefer to see a larger margin of safety before recommending the shares, especially given the competitive nature of LTL shipping. As with many of the trucking stocks we cover, we believe Con-way's valuation currently reflects investors' grasp of the cyclical upswing in pricing power for well-managed carriers with reliable access to capacity, as well as expectations for modest but stable freight demand growth over the next year. For the longer term, we think Con-way can generate mid-single-digit annual revenue growth on average over the next five years, supported by modest freight volume gains and mid-single-digit yield expansion, as well as growth in third-party logistics services. We anticipate gradual improvement in Con-way's consolidated operating ratio to about 94.5% by 2016 (94% in the LTL segment).

Establishing an Economic Moat in Trucking Remains Difficult
While we expect Con-way to post margin improvement over the next few years, with no small thanks to a favorable pricing environment, asset-based trucking is still a highly cyclical, no-moat business. The LTL operating environment is asset-intensive (carriers need to maintain a hub-and-spoke network of cross-docking terminals) and provides few opportunities for differentiation because shipping services are generally commodified and switching costs are low. This dynamic drives significant price competition and profitability erosion during periods of weak freight demand, as evidenced during the recent downturn, when carriers slashed prices to unsustainable levels in a desperate attempt to grab volume and survive. Overall, we think these factors add a significant element of variability to LTL carrier profitability over time, and they are key reasons we consider Con-way and most of its peers to be high-uncertainty stocks.

What About YRC Worldwide?
While not imminent, the exit of struggling rival YRC Worldwide from the marketplace would have a meaningful impact on the LTL industry--the firm represents about 10% of industry revenue. Should YRC ultimately fail, we think the remaining carriers would generally absorb its business about in line with their respective market shares. At first glance, one might conclude that well-run carriers like Con-way would eschew much of YRC's low-margin, long-haul business, especially given efforts over the past year to refine business mix. However, based on current market conditions and our discussions with Con-way's management, we believe industry capacity would tighten sharply--enough to support robust pricing power and the ability to raise rates (on mispriced accounts) to acceptable levels. We still think Con-way and its peers would remain selective, but the top carriers would probably be well positioned to cherry-pick freight that maximizes lane density.

Matthew Young does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.