Keep an Eye on First-Rate Freight Broker Landstar

Wide-moat Landstar (LSTR) is well positioned as a key player in the asset-light highway brokerage market. Its unique business model--namely the use of captive owner-operators, its independent agent network, and focus on specialized flatbed shipments--sets the firm apart from the pack. Moreover, we estimate the company boasts the second-largest network of shippers and carriers (following C.H. Robinson (CHRW)) in a highly fragmented industry. We expect Landstar to benefit from market share gains and rising demand for top-tier providers typified by efficient access to trucking capacity, market know-how, and sophisticated IT infrastructure. We would prefer a larger margin of safety to our fair value estimate before recommending the shares, however.

Use of Owner-Operators Keeps Gross Margins on a Smooth Road
Gross profit margin compression on truckload freight has been a headwind for the truck brokerage industry over the past year, weighing on the net revenue trends of many providers, particularly industry behemoth C.H. Robinson. Tightening truckload capacity has enabled carriers to raise rates, which inflates cost of hire, while unfavorable brokerage market conditions (balanced supply and demand and low levels of unplanned or surge freight) have tempered pricing to customers. There is also a time lag for most brokers in terms of passing along rising carrier rates to contractual shippers. (To clarify, gross profit--net revenue--refers to gross revenue less purchased transportation, while gross margins are net revenue over gross revenue.) Gross margin pressure for Landstar has been much more subdued, thanks to its unique operating model.

A key difference between Landstar and a conventional broker like C.H Robinson is the firm's capacity network. Most providers source capacity in the spot market with unaffiliated third-party carriers (broker carriers). Landstar, on the other hand, also uses owner-operators, which it refers to as business capacity owners, for more than half of its trucking business. In 2012, BCOs hauled 50% of total revenue (54% of trucking revenue), while broker carriers made up 43% (46%). BCOs are independent contractors, but haul freight exclusively for Landstar (under its USDOT-issued operating authority) in accordance with a cancelable lease agreement. They provide their own trucks and pay their own expenses (driver wages, fuel, and so on), though many make use of Landstar's specialized trailing fleet. Importantly, Landstar's BCO freight enjoys steady gross margins because these drivers are paid a fixed percentage of the revenue generated from a load--generally around 75%, though that can be lower if the BCO provides only a truck and no trailing equipment. Thus, gross margin on BCO-hauled loads hovers around 25% on average. When using the firm's definition of net revenue (gross revenue less purchased transportation and agent commissions), BCO gross margins approximate 17%, since Landstar's sales agents generally receive 8% of revenue. Landstar's gross margins on freight hauled by broker carriers do fluctuate throughout the business cycle because these carriers earn a negotiated rate in the spot market--this is the typical brokerage model. That said, even a portion of this business is fixed margin because certain agent contracts allow the firm to apply a retention rate. In these transactions, Landstar retains a portion (10% on average) off the top of the line-haul invoice, pays the carrier, then pays the remainder to the sales agent.

Landstar's Capacity Network (% of Transactional Freight Revenue)

Altogether, when including BCO business and the retention rate on some broker carrier loads, 60% of the firm's business carries fixed gross margins. As a result, Landstar is less exposed to shifting supply and demand dynamics. Further, because Landstar specializes in nonroutine, irregular route business, it rarely guarantees a price to shippers. Thus, unlike brokerage industry leader C.H. Robinson, which been increasing the mix of defined-lane, price-committed business among large accounts (some of this is for good reason), Landstar sees less of a time lag when passing along higher carrier rates to customers.

While freight hauled by broker carriers will probably increase at a faster pace than owner-operator loads in the years ahead, Landstar is still intently focused on BCO recruiting, and owner-operator interest appears to be sound based on activity among recruiting personnel. Because of the power of the network effect, Landstar remains a highly attractive destination for an owner-operator. Its immense customer base and breadth of loading opportunities rank among the largest in the industry, a factor not likely overlooked by drivers in a sluggish, competitive freight environment. Further, Landstar operates a highly entrepreneurial model, in which BCOs receive a cut of revenue from a given load rather than the more customary rate-per-mile payment. This motivates drivers to be as efficient and productive as possible to maximize their income. Additionally, BCOs are able to cherry-pick loads (rate, size, origin, and destination) that meet their specific requirements because the firm does not force dispatch. Other benefits include faster payment and discounts for key cost items like tires and fuel. We note the vast majority of BCOs operate only one truck. Overall, BCO turnover is relatively low at about 30% this year (well below the truckload industry average of more than 95% among large asset-based carriers), and much of that occurs in the first year when some drivers figure out they aren't suited to run their own operation.

Independent Sales Agents and Flatbed Cargo Further Differentiate Landstar
In addition to its owner-operator capacity, a few other factors differentiate Landstar from its peers, including its network of independent agents. In fact, the firm has built the largest network of independent sales agents in the domestic brokerage industry. Landstar's agent locations are essentially small freight brokerage businesses run by entrepreneurs who are paid a percentage of revenue for BCO-hauled freight, or a margin split on most broker-carrier loads. In general, agents are responsible for finding freight, matching it with capacity providers, and coordinating the entire move. In contrast, C.H. Robinson (like most brokers) employs a captive salesforce throughout its branch network, paying fixed salaries, commissions, and bonuses. Although Robinson can terminate employees at the branch level to flex head count further, Landstar's salesforce compensation is 100% variable--without the burden of layoffs--since agents are only paid when loads are hauled. Also, relative to traditional brokers, we think the firm's highly entrepreneurial operating model creates a heightened focus on productivity and top-shelf service.

Landstar also operates in a different freight niche, specializing in odd-size freight and irregular routes. Approximately 37% of truck-related revenue reflects unsided flatbed business, and within that segment, about one third is specialized heavy-haul freight. In fact, Landstar is by far the largest flatbed and specialized freight hauler in domestic trucking. This is one reason Landstar owns/leases a fleet of approximately 9,000 trailers, many of which are used for unusually heavy, oversize loads. Trailers are also used to supplement capacity for its sizable drop and hook services. Interestingly, the firm has several transportation firms (including third-party logistics providers) among its top 25 customers. This suggests to us that even many of its brokerage peers turn to the firm for help when dealing with specialized freight. Although Landstar is tied to industrial-related end markets, with little retail, it is well diversified in terms of overall industries served.

Landstar's Wide Economic Moat Is Intact
The network effect provides Landstar with a powerful advantage. Its immense network of shippers and carriers generates a robust value proposition for all parties, making duplication a daunting task, particularly for small providers. Importantly, the more parties (suppliers and customers) that use a broker's network, the more powerful it becomes. Even many of the relatively new rapid-growth brokerage startups have discovered the difficulty of driving network scale without pressuring profitability. XPO Logistics, for example, posted an operating loss in 2012, due to its aggressive acquisition strategy and heavy salesforce investment. Echo Global Logistics has also generated notable growth (organic and via acquisition) since its inception in 2005. That said, although we think Echo is well run, the level of salesforce productivity gains and leverage over general and administrative expenses it can ultimately generate remains uncertain.

From the perspective of customers, Landstar's buying scale enables the firm to negotiate more favorable capacity rates than small and midsize shippers can generally secure for themselves, providing material transportation cost savings. The firm's ability to aggregate fragmented demand among a customer base of about 26,000 shippers (while also leveraging its balance sheet to pay carriers quickly) also provides greater buying efficiencies relative to small brokers lacking scale. Moreover, for shippers, the firm's vast network of 8,000-plus captive owner-operators and roughly 32,000 third-party broker carriers (at the end of 2012) acts as a highly attractive source of capacity. We estimate the firm has the second-largest active-capacity network in the industry, following C.H. Robinson, which has more than 50,000 carrier relationships. This is an increasingly important advantage because of tightening truckload industry capacity--the driver pool is shrinking, carriers aren't increasing fleet size, and intensifying government regulation (recent changes to hours-of-service rules, for example) will probably pressure industry productivity. Should domestic freight demand growth accelerate only modestly from current levels, we think shippers would encounter a material capacity crunch, making Landstar's web of carrier relationships even more valuable. While much of the firm's freight opportunities involves irregular route or nonroutine shipments, which tend not to gravitate to intermodal, certain agents specialize in multimodal solutions via Landstar's centralized relationships with rail carriers; intermodal made up 3% of revenue in 2012. In general, demand for multimodal solutions is rising, driven by intermodal service in new geographic corridors, variability in fuel costs, and shippers' focus on driving down supply-chain costs. Landstar's network of capacity is well positioned to capitalize on that trend.

For captive owner-operators and broker carriers, Landstar represents a deep reservoir of cargo given its ability to aggregate demand across an expansive customer base of shippers. Thanks to its scale, the firm probably boasts the second-largest reservoir of freight opportunities in North America, following C.H. Robinson. By joining Landstar's network, broker carriers can minimize unpaid empty miles, supplement their sales efforts, and boost overall asset utilization. While Landstar does source some capacity from large truckers like Swift and J.B. Hunt, it primarily works with qualified, small carriers (those with 10-20 trucks); this is where it can add the most value. Landstar's BCOs profit further from the freedom to select loads as they see fit, since the firm does not force dispatch.

Landstar's historical returns on invested capital have approximated 29% over the past decade. 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 expect returns on capital to approximate 27% over the next five years.

Landstar's ROICs vs. Cost of Capital

We think Landstar's moat is sustainable, particularly against smaller, less capable providers. The firm's network of shippers, carriers, and independent agents is expanding, and the freight brokerage market remains highly fragmented. There are more than 10,000 registered freight brokers in the United States, and while the top 15 comprise slightly more than 40% of industry sales, gross revenue for each of the remaining providers falls off significantly beyond that point. In fact, there are only about 25 brokers posting more than $200 million of gross revenue annually. Overall, industry dynamics point to a long runway of opportunity for top-tier brokers like Landstar to grab market share as smaller, less capable providers find it harder to keep up with rising demand for access to capacity, sophisticated informational know-how, and multimodal expertise. While IT capabilities are not the foundation of our wide economic moat rating for Landstar (technology is replicable over time), they can provide differentiation from providers with limited resources--proprietary software platforms and communications infrastructure necessitate significant up-front and maintenance outlays, placing providers with scale in an advantageous position. Landstar's technology platforms, coupled with its vast reservoir of market data, also enhance pricing decisions and increase the productivity of agents and capacity providers.

Solid Long-Term Growth Prospects, but Fairly Valued
Landstar's unique operating model for a truck broker (it uses owner-operators that are paid a fixed percentage of revenue for more than half of its shipments) has protected the firm from the full brunt of broker carrier rate increases and sluggish customer pricing. These factors would have otherwise weighed more heavily on consolidated gross margins over the past year. Overall, Landstar appears fairly valued, suggesting investors are baking in the firm's decent growth prospects. Landstar is currently trading at $57.50 per share, 8% above our $53 discounted cash flow-derived fair value estimate, 19 times 2014 consensus earnings per share, and 10 times on a forward enterprise value/EBITDA basis (off 2014).