C.H. Robinson Can Still Deliver the Goods

 C.H. Robinson Worldwide (CHRW) has seen persistent gross margin compression for more than a year, weighing on its net revenue growth. However, we expect margins to stabilize in the years ahead, and we think this wide-moat truck brokerage specialist remains well positioned for gradual third-party logistics industry consolidation. We expect the firm to benefit from market share gains and rising demand for top-tier providers with access to flexible capacity and sophisticated IT infrastructure. Overall, the stock still trades at a discount to our fair value estimate, in part because of the near-term gross margin headwinds.

Net revenue (gross profit) margin pressure as well as soft employee productivity trends (due in part to new hires and the Phoenix acquisition) have weighed on C.H. Robinson's results, but our fair value estimate of $69 per share reflects the likelihood that sluggish freight demand, including soft transactional activity, tempers volume and pricing growth in the year ahead. We note that net revenue reflects gross revenue less purchased transportation, while gross margins are net revenue over gross revenue. We model average annual net revenue growth in the high single digits through 2017, reflecting a combination of low-single-digit underlying domestic freight demand, incremental third-party logistics outsourcing, and solid market share gains from both asset-based trucking companies and small freight brokers. We project consolidated operating margin off net revenue to approach 41% over our forecast period. This compares with our adjusted 39.5% forecast for 2013 and an adjusted 41.9% in 2012 when excluding nonrecurring items associated with the T-Chek divestiture and Phoenix acquisition. Our long-run operating margin forecast is below the firm's five-year historical run rate of 42%, primarily reflecting Phoenix's lower-margin global forwarding operations, but also the likelihood that Robinson increases salesforce investment as it targets market share.

Gross Profit Margin Compression Has Been a Headwind
Robinson's core transportation gross margins are historically countercyclical because of the natural time lag in passing along higher capacity rates to customers. Contraction usually occurs when industry freight demand expands, truckload capacity tightens quickly, and carriers are able to boost spot rates. This dynamic was evident in 2010 as macroeconomic conditions began to recover. The opposite happens when demand falls off, as seen in 2009 when Robinson's transportation segment gross margins increased 320 basis points despite lower freight volume.

This time, however, gross margin weakness has been a persistent theme; margins have fallen on a year-over-year basis since the middle of 2011. Yields fell in 2010 as well, but this was driven by normalization from record highs in 2009 when declining freight demand drove down the firm's cost of hire. In sum, carrier rates have been rising faster than Robinson's pricing to customers, with the transportation segment gross margin hitting a record low of 14.9% in the second quarter of 2012 (versus a previous low of 15.4% in the second quarter of 2008 and a 10-year average of 17%). As a result of the recent weakness, net revenue increased only 5% in 2012, below the 10% rise in gross revenue. While there have been recent hints of stabilization, this dynamic continued into the first quarter of 2013--on a pro forma combined basis with Phoenix and excluding the recently divested T-Chek division, gross revenue was up 10%, but net revenue increased a less inspiring 4%.

Much speculation surrounds the source of Robinson's gross margin woes, and there is concern that intensifying competition from aggressive new entrants is the main offender. While it is difficult to isolate the magnitude of any one factor, our take is that margin compression is more the product of rising carrier rates (supported by limited industry capacity) coupled with the firm's mix shift in recent years to larger price-committed accounts, which offer more volume opportunities in a lethargic market, but carry higher margin risk. Moreover, given sluggish macroeconomic conditions, many shippers are seeing less unplanned freight, which carries higher pricing. We do think competition is a factor, though to a lesser degree given the highly fragmented nature of the freight brokerage market--there is a long runway of opportunity for the top-tier 3PLs to take share thanks in part to benefits from the network effect.

In terms of Robinson's cost of hire, carrier rates are on the rise, thanks to limited capacity and truckers' aggressive yield initiatives. Relatively balanced supply and demand over the past few years, including tight conditions on some freight lanes, has provided asset-based truckers with decent pricing power. Thus, Robinson's cost of hire has been rising since the firm procures most capacity on a local basis in the spot market. Interestingly, capacity has been gradually tightening not so much because of robust freight demand, but in part because of the shrinking driver pool.

Another reason for tightening capacity is carriers' reluctance to increase fleet size. Most are focused on asset returns and merely refreshing their equipment to lower fleet age and maintenance costs.  Most truckers are unlikely to take on additional asset-utilization risk over the next few years, especially given low macroeconomic visibility and the driver shortage. Truckers are also faced with rising equipment costs due to increasingly stringent government emissions standards and complicated new engine technology.

In addition to rising capacity costs, Robinson's pricing to truckload shippers has been sluggish, increasing only 1% on average since the first quarter of 2012, compared with a 2% rise in the cost of hire. We think one of the chief causes is the firm's gradual migration to large, price-committed accounts, for which it essentially acts as a core carrier. These accounts are a double-edge sword in that Robinson is able to leverage its vast network service capabilities to win sticky, scheduled freight in a static demand environment, but these loads tend to be on lanes with rate-per-mile commitments, which boost margin risk.

We think the impact of this mix shift is twofold. First, Robinson now has a greater mix of contractual business subject to a time lag in terms of passing along higher capacity rates. Moreover, contractual shippers have been less interested in renegotiating pricing arrangements over the past year, since truckload supply and demand have been balanced. Capacity is limited, but not enough to cause carrier service failures. The highway brokerage model works best during periods of market dislocation because shippers return to the negotiating table in order to secure capacity.

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Another source of soft customer pricing is modest (and choppy) growth in underlying freight demand and lethargic macroeconomic conditions. Robinson is seeing softer spot market activity and less unplanned freight from existing customers, which tend to carry better pricing dynamics.

We believe the firm's gross profit margin compression will stabilize throughout the next year. Comparisons are easing, but more important, the trucking industry is likely to see capacity shortages in the years ahead, assuming only modest increases in freight demand. Of note, the driver shortage is showing few signs of improvement, and the government's new hours of service rules will weigh further on carriers' productivity. We expect a shift in the market balance favoring tighter supply to improve Robinson's ability to pass along the full brunt of carrier rate increases as shippers look to secure reliable access to capacity.

What About Competition?
The competitive environment is playing a role in Robinson's sluggish yield trends and is one reason our longer-term performance assumptions are below the firm's historical run rate. But we think the aforementioned factors--tightening capacity, a mix shift to lower-margin accounts, and the unfavorable brokerage environment--are the more pressing elements, and conditions will stabilize. Because the domestic freight brokerage market remains highly fragmented and since Robinson benefits from a strong network effect, we think competition is likely to prove a more subtle, gradual impact as the firm continues to take market share from smaller brokers.

The domestic freight brokerage market remains highly fragmented, with myriad less capable providers. More than 10,000 registered freight brokers operate in the United States, and while the top 15 constitute approximately 43% of industry sales, gross revenue for each of the remaining providers falls off significantly beyond that point. Overall, the data seems to bear out our thinking on Robinson's ability to grab share in this environment. We estimate the firm's stake of the industry increased to about 21% in 2012 from 14% in 2004, based on market statistics from Armstrong & Associates. Furthermore, when expanding the market definition to include the other major buckets of the North American 3PL industry, such as international air and ocean forwarding and contract logistics, the firm's share remains relatively small at 3%-5%. We consider the broader 3PL market to be an addressable market for Robinson, given the firm's increasing penetration among large, global shippers and its recent acquisition of Phoenix, which more than doubled its scale in the international forwarding business.

The network effect bestows a powerful advantage. The firm's industry-leading network of shippers and carriers generates a robust value proposition for all parties, making duplication a daunting task, particularly for the small providers that make up most of the marketplace. Most important, the more suppliers and customers that use a 3PL's network, the more powerful it becomes.

Robinson's customer base of 42,000-plus shippers creates massive buying scale. As a result, the company is able to negotiate more favorable capacity rates than small and midsize shippers can generally secure for themselves, providing material cost savings. Robinson's ability to aggregate fragmented demand among thousands of shippers while leveraging its balance sheet to pay carriers quickly provides greater buying efficiencies relative to smaller brokers lacking scale as well; despite recent pressure, the firm maintains best-in-class net revenue margins (15.8% in 2012 versus 14.5% for the industry).

Additionally, the firm's vast network of 56,000 asset-based carriers acts as an attractive source of capacity for shippers. Should domestic freight demand growth accelerate only modestly from current levels, we think shippers would run into a material capacity crunch, making Robinson's web of carrier relationships even more valuable and increasing the firm's ability to pass along carrier rate increases.

From the perspective of asset-based truckers, Robinson represents a deep reservoir of cargo, given its ability to aggregate fragmented demand across an expansive customer base of shippers. With its scale, the firm probably boasts the largest reservoir of freight opportunities in North America. More than 80% of Robinson's capacity comes from small and midsize truckload carriers (those running fewer than 100 trucks) with immaterial sales and marketing capabilities. Many of these truckers rely on Robinson to supplement sales efforts, boost asset utilization, and minimize unpaid empty miles.

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Robinson's historical returns on invested capital have approximated 34% over the past decade (including the impact of the 2012 Phoenix acquisition, particularly the addition of goodwill). This ranks among the highest in our transportation coverage universe and well above our 9.5% cost of capital assumption, the hallmark of a moat-worthy operation. We think this record exemplifies the wide-moat characteristics of the firm's customer and carrier network capabilities, as well as the asset-light nature of its business model. We also think its moat is sustainable, particularly against smaller, less capable 3PLs--the freight brokerage market remains highly fragmented, and we expect share gains to continue accruing to the top-tier providers with scale. We expect Robinson's ROICs to hover in the mid-20s on average in the years ahead, below the historical run rate. This does not suggest a lack or degradation of an economic moat. Rather, it primarily reflects the Phoenix deal, which closed in the fourth quarter of 2012. We anticipate ROICs to gradually approach 30% over our five-year forecast horizon.

The Road Ahead
While we don't think the unfavorable brokerage market conditions have improved drastically, the absence of incremental deterioration in Robinson's first quarter is a sign that margins are nearing a trough. Overall, this would be about in line with our expectations for the full year. For 2013, we assume transportation segment net revenue margins decline modestly to about 15.6%, from 15.8% last year.

Looking further out, we anticipate only slight gross margin improvement over our forecast horizon to about 16%, still well below the firm's historical average of more than 17%. We think this is a reasonable assumption when considering the fragmented nature of the marketplace and aforementioned runway of opportunities for the top-tier providers to grab share as the brokerage industry consolidates (effectively mitigating the impact of escalating competition). We also think the likelihood of a truckload capacity crunch in the years ahead--stemming from secular pressures on industry fleet growth--will gradually boost Robinson's ability to pass along higher carrier rates by driving shippers back to the negotiating table and increasing transactional activity, which carries higher pricing.

Although achievable, our assumptions are not without risk, and we envision a few circumstances in which gross margins could shake out below our long-run 16% forecast. First, there are a host of variables behind Robinson's margin compression, and it is difficult to isolate the impact of any one. As such, competition could turn out be stronger than we give it credit for. Additionally, part of our take on the market is that several of the rapidly growing new entrants are rolling up small brokers, aggregating business that has already existed. But it is also possible that large portions of the market that were once limited in scope become more efficient as part of a larger network.

Second, there is the possibility that the currently unfavorable environment for brokers persists in terms of lack of supply disruption and low levels of unplanned freight, encouraging Robinson to continue ramping the mix of lower-margin routing guide business. While this would probably put more volume into the firm's network in a lethargic market for transactional business, it is much harder to push through pricing to these customers, given their pricing power and fixed pricing agreements.

On the flip side, there are cases in which we think gross margins would move materially higher. While not ideal, Robinson's gross profit margins would expand considerably should freight demand deteriorate rapidly. As in the past, capacity would loosen and the firm would be able to pass along lower carrier rates on a lag. A more favorable driver of gross margin expansion over the next few years could be capacity shortages on certain lanes driven by the growing driver shortage and lost industry productivity stemming from new government hours of service rules. Capacity shortages and route service failures would probably drive shippers back to the negotiating table in an effort to secure capacity, providing more opportunities for Robinson to pass along rising carrier rates despite sluggish underlying freight demand.