Echo Global Logistics Makes Inroads Into Highway Brokerage

 Echo Global Logistics is relatively new to third-party logistics, but it has successfully worked its way into the ranks of key players in the highway brokerage niche. We expect Echo to benefit from ongoing market share gains from asset-based truckers and less sophisticated domestic 3PLs thanks to rising demand for top-tier providers typified by broad access to trucking capacity, market know-how, and sophisticated IT infrastructure. In terms of valuation, however, we think the market is currently accounting for the firm's decent growth prospects; the shares are trading more than 20% above our $18 fair value estimate.

By gross revenue, the $150 billion U.S. 3PL market (including domestic freight brokerage, global air and ocean forwarding, and contract logistics) expanded impressively during the past few decades; average annual growth approximated 10% between 1996 and 2013 (including a 16% decline in 2009), according to Armstrong & Associates. This is well ahead of the 3% growth posted in the broader for-hire trucking and rail intermodal markets over that time frame. Coming out of the economic downturn, industry revenue rebounded (up 16% in 2010), but growth over the past three years has been more modest, rising 5%-6% on average. Much of the slowdown derives from anemic airfreight demand since mid-2011, although airfreight conditions had stabilized by the second half of 2013 and have shown modest improvement thus far in 2014.

Gross revenue trends in the $50 billion domestic freight brokerage segment of the 3PL market--where Echo primarily operates--have held up better than those of the global forwarding sector, in part reflecting market share gains from asset-based truckload carriers and an increasing mix of brokered less-than-truckload freight. Nonetheless, gross margin compression has been a headwind for Echo and its peers over the past few years, tempering net revenue gains. Gross margins are historically countercyclical because of the natural time lag in passing along changing carrier rates to shippers--compression normally occurs during periods of strengthening demand when capacity firms and carrier rates increase (and vice versa). This time around, however, tightening capacity and rising carrier rates have resulted from the driver shortage and sweeping regulatory changes, rather than from robust freight demand. Additionally, pricing conditions for truck brokers have been soft because of low levels of unplanned freight and relatively balanced supply and demand. Echo's mix shift to truckload brokerage (driven by acquisitions) has also played a role in its own yield compression--TL transactions carry lower gross-margins than LTL.

Substantial weather-related capacity constraints during the first quarter of 2014 provided the first hint of supply disruption in quite a while, which bodes well for the pricing power of large capable brokers in the year ahead and could prove to be a turning point for industry yields. 3PLs like Echo perform much better during periods of supply disruption when they can step in and secure trucks among their large networks of small carriers, which constitute most of the truckload capacity base. When that happens, spot business recovers and pricing tends to accelerate as shippers scramble to get freight moved. Overall, we expect the domestic freight brokerage industry to expand at a faster clip than the combined for-hire trucking and intermodal markets (which are slated to rise 3%-4% on average over the next five years), as the large 3PLs continue to process more for-hire TL and LTL freight.

Challenges Remain, but Echo's Growth Prospects Are Bright
Formed in 2005, Echo is a relatively new entrant into highway brokerage. It operates in a vastly fragmented and competitive marketplace, and despite progress, there is still some uncertainty surrounding the magnitude of profitability improvement the company will post as it continues to build scale. This factor keeps our long-term margin assumptions below management's stated targets and drives our high fair value uncertainty rating. Nonetheless, we expect several favorable themes to keep the firm on a healthy growth trajectory in the years ahead, particularly its narrow moat positioning, which should support market share gains from less sophisticated 3PLs and asset-based truckers. We also think Echo is positioned to capitalize on incremental transportation management outsourcing among small and midsize shippers. Tuck-in acquisitions remain on the firm's radar screen as well and will probably target full-truckload (versus LTL) brokers.

Echo's Narrow Moat Supports 3PL Market Share Gains
Echo has a narrow Morningstar Economic Moat Rating thanks to the network effect. Its substantial network of shippers and carriers generates a strong value proposition for all involved, making duplication a difficult task, particularly for less sophisticated providers. The more parties (shippers and carriers) that use a 3PL's network, the more powerful it becomes. Of course, building a network is not impossible--barriers to entry in brokerage are relatively low, and Echo itself has morphed into a formidable competitor over the past eight-plus years. However, the vast majority of small domestic 3PLs lack access to the scale of existing industry relationships and financial backing of fortunate startups like Echo. We think the industry has relatively high barriers to success.

From the perspective of customers, Echo'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. Its ability to aggregate fragmented demand among a customer base of about 28,000 shippers (while leveraging its balance sheet to pay carriers quickly, which increases truckers' cash flow) also provides superior buying efficiencies (lower cost of hire) relative to small brokers lacking scale. The firm does not disclose gross profit margins on truckload shipments, but we suspect they exceed the industry average of 13.5%-14%. Robust IT capabilities are not the foundation of our narrow moat rating for Echo (technology is replicable over time), but they do provide meaningful differentiation from mom-and-pop providers with limited resources--proprietary software platforms and communications infrastructure necessitate significant up-front and maintenance outlays. We estimate that Echo's capitalized IT-related costs will be about 5% of net revenue (roughly $10 million) this year. The firm's technology platforms, coupled with its vast reservoir of market data, also enhance pricing decisions and increase the productivity of its salesforce and capacity providers.

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Echo's broad network of 32,000 regional and national carriers acts as a highly attractive source of capacity for customers. Out of an immense group of thousands of domestic 3PLs, we estimate the firm has roughly the sixth- or seventh-largest truck capacity network in the industry, following giants like C.H. Robinson (CHRW) and Landstar (LSTR). This is an increasingly important advantage because of the sustained tightening of truckload industry capacity; the intensifying driver shortage and ubiquitous regulation (including the government's Compliance, Safety, Accountability program and changes to hours-of-service rules in mid-2013) are tempering carriers' productivity and limiting industry fleet growth.

Disruption Can Be a Good Thing
Should domestic freight demand growth accelerate only modestly from current levels, shippers would probably encounter frequent capacity shortages, making Echo's web of carrier relationships even more valuable. In fact, with capacity already restricted, unusually harsh winter weather during the first quarter of 2014 caused substantial disruption throughout the trucking industry, and shippers found it a challenge to source trucks. Although the limitations seen in the winter months have eased, commentary from truckers and 3PLs alike suggests that truckload supply remains constrained. In fact, firms have said that supply appears tighter than it was before the winter crunch because of new safety regulations and continued high driver turnover. Additionally, numerous small, struggling carriers were knocked out of the market in recent quarters because of lost business during the winter weather disruption. Overall, this is good news for the highway brokerage industry, which has been plagued by relatively balanced supply and demand over the past few years. Recent capacity issues make it much more likely that shippers will continue to seek out top-shelf 3PLs with extensive capacity networks, thus increasing brokers' spot opportunities and pricing power. Echo was a beneficiary of this dynamic in the first quarter, reporting an acceleration in transactional opportunities and sell rates as customers scrambled to get freight moved. Better pricing to shippers helped reduce year-over-year gross margin compression on truckload business, despite a spike in rates paid to carriers. In the first quarter, truckload gross margins fell roughly 122 basis points (year over year), marking improvement from the 277-basis-point decline posted in the fourth quarter of 2013. The firm does not disclose actual TL gross margin, though we speculate it is above 14%.

Why are asset-based truckers attracted to Echo's network? For carriers, Echo represents a deep reservoir of cargo opportunities thanks to its ability to aggregate demand across an extensive customer base of thousands of freight shippers--Echo ranks among the top 10 domestic truck brokers by gross revenue. By participating in Echo's network, truckers can minimize unpaid empty miles, supplement their sales efforts, and boost overall asset utilization. On truckload business, Echo primarily works with qualified, small carriers. More than 70% of carriers in its network operate fewer than 50 trucks (60% operate fewer than 25); this is where the firm can add the most value.

Fragmented Industry Ripe for the Picking
Putting it all together, Echo's narrow moat and the fragmented nature of the domestic highway brokerage landscape point to a long runway of market share opportunity as small providers find it harder to keep up with rising demand for access to truckload capacity, sophisticated informational know-how, and multimodal expertise (optimizing the use of TL, LTL, and intermodal). There are more than 10,000 registered freight brokers in the United States, and while the top 15 constitute 40%-45% of industry sales, gross revenue for each of the remaining providers falls off significantly beyond that point. Market data is limited for most privately owned 3PLs, but a look at gross revenue trends for seven of the leading providers (including Echo) over the past five years suggests they improved their collective market share to around 38% in 2013 from 33% in 2009. Echo boosted its own share to slightly less than 2% from 0.5% in 2008 via organic efforts and tuck-in acquisitions, though much of its gross revenue gains (65%) have been organic. Telling of the firm's ability to grab share is its approximate 19% average organic growth rate over the past three years, ahead of the 9%-10% rise for the freight brokerage industry. Echo's organic progress stems in part from ongoing investment in sales and carrier sourcing head count, as well as overall salesforce productivity improvement, which drives transactional business. Adding new enterprise accounts has also played a role, as many small and midsize shippers are still looking to outsource noncore transportation management activities.

We consider Echo's economic moat to be narrow rather than wide because although the firm ranks among the top 10 domestic freight brokers, it competes with well-capitalized companies with established brand equity and robust market know-how, such as industry behemoth C.H. Robinson. It also competes with aggressive peers of similar size, such as XPO Logistics (XPO) and Coyote Logistics--firms that are also building network scale (albeit less profitably). For these reasons, we cannot say with near certainty that the firm's excess normalized returns will be positive 10 years from now, which is our wide moat definition. Rather, we think economic profit will more likely than not be positive a decade from now.

Nevertheless, Echo's sizable network of shippers and carriers appears to be expanding. Save for a few speed bumps, the firm has increased its customer base at an impressive clip in recent years, with help from salesforce expansion and tuck-in acquisitions. It has also done a commendable job attracting large, enterprise-level shippers that have not previously outsourced to a third-party transportation manager. Transactional customers served increased an average of 20% annually during the past five years, to roughly 28,000 by the end of 2013. Echo has also expanded its base of contractual enterprise-level customers to 229 from about 95 at the end of 2008. At the same time, Echo's growing base of shippers and ongoing investment in carrier sourcing capabilities have enabled it to develop a sizable network of 32,000 asset-based truckers (up from about 22,000 in 2008). Altogether, we think its core moat source (the network effect) will strengthen as Echo continues to gain share and mature.

Capable Domestic Freight Brokers Taking Share From Asset-Based Truckers
We estimate that only about 14% of the $350 billion-plus spent on for-hire trucking and rail intermodal shipments flowed through asset-light freight brokers in 2013, up from 7%-8% a decade ago. A compelling value proposition should enable brokers to continue processing a larger proportion of for-hire truck freight. 3PL share gains from asset-based carriers can take several forms, including handling more spot transactions and a greater presence in request-for-proposal business among very large shippers--a segment of the market in which Echo intends to boost its presence. These dynamics have been a key component of the approximate 8% freight brokerage industry growth over the past decade, and we think that will continue, albeit to a lesser degree as more truckers are now dabbling in asset-light transportation operations.

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Many large truckload carriers have launched their own asset-light brokerage operations over the past seven or eight years. We think this has tempered some of the opportunity for 3PLs like Echo to take share from big truckers, but not drastically. A few carriers like Knight (KNX) and J.B. Hunt (JBHT) appear to be investing more heavily in brokerage, but based on our conversations with industry participants, we get the sense that most truckers are looking to retain existing accounts by supplementing currently limited capacity conditions (using it as an overflow business), rather than aggressively targeting brokerage market share. We believe some truckers also use brokerage as an alternative means of filling their own backhaul needs. Additionally, most of the industry is composed of small and midsize fleets that lack the resources to launch successful brokerage operations--particularly developing an army of sales and capacity-sourcing personnel.

Small and Midsize Shippers Still Outsourcing Transportation Management
Transportation management solutions usually entail a shipper outsourcing a large portion of its internal freight management activities to a 3PL--from distribution network re-engineering to carrier management and shipment execution. There is normally a high level of automation and integration in these relationships, including dedicated account personnel. We think outsourcing of logistics functions is on its way to maturity among large Fortune 500 shippers; most already outsource to a 3PL. However, we believe there is still a long runway of opportunity among small and midsize shippers (those with $500,000-$10 million in annual transportation spending) that are still looking to redeploy internal resources and optimize supply chain activities in a relatively slow-growth environment.

Echo refers to these customers as enterprise accounts, and it has generated decent expansion in this niche--17% average annual growth rate since 2010. Following the integration process, Echo is commonly able to save enterprise accounts more than 10% in transportation spending by leveraging its buying scale and reorganizing/optimizing clients' transportation routines (particularly mode selection among TL, LTL, and intermodal). Echo's proprietary IT infrastructure is no small part of its value proposition for these functions. In terms of opportunity, the firm has roughly 18,000 small and midsize customers (already using its transactional brokerage services) with which to cross-sell. We forecast 10%-11% organic growth on average over the next five years for enterprise gross revenue, though we think it will hover in the midteens over the next few years as some of the firm's new sales initiatives take hold.

Tuck-In Acquisitions Will Continue to Play a Key Role
Tuck-in acquisitions complement Echo's organic growth initiatives; the firm normally targets small, regional freight brokers with solid books of business, capable sales personnel, and operations that can easily leverage its IT infrastructure. Save for the 2012 purchase of Shipper Direct (which involved alleged seller fraud), we believe all acquisitions have been successfully integrated into Echo's IT platforms, supporting material productivity benefits for the newly added operations. Thus far, Echo has organically increased total acquired revenue by 62%, off a base of $300 million, which reflects the cumulative trailing 12-month top line for acquired firms at time of purchase. Deals have also been driving Echo's foray into full-truckload brokerage, which is a much larger opportunity than LTL brokerage--the total TL shipping industry exceeded $305 billion in 2013, with LTL spending near $35 billion; revenue per transaction on TL business is also significantly higher. Recall that Echo started out with a heavy concentration in LTL shipments, which made up 41.5% of gross revenue in 2013, down from 49% in 2008; TL business constituted 45% and 32.5%, respectively. Outside of TL and LTL freight, Echo also handles rail intermodal (7% of gross revenue in 2013) and smaller international forwarding and small parcel (combined 6.5%).

Since early 2007, Echo has closed 18 deals, with an average annual revenue run rate near $20 million at time of purchase. Deal multiples have historically approximated 5-7 times EBITDA. Size has ticked up a bit this year, with Online Freight Services and One Stop Logistics each generating about $50 million in annualized gross revenue. Echo paid 8.6 times EBITDA for One Stop, exceeding previous transactions, but management also said it is one of the most profitable brokerage operations purchased to date, with a long operating history and strong cultural fit. Management has hinted that it would not shun a large transformative purchase at the right price, but we still think Echo is more likely to continue pursuing easily digestible operations to which it can add meaningful value with its proprietary IT systems, buying scale, and multimodal capacity-sourcing capabilities. Acquisitions have made up slightly more than one third of Echo's sales growth in the past, and we expect that mix to remain relatively consistent. Of the $1.1 billion top-line growth the firm intends to generate through 2017, 30% ($340 million) reflects management's projection for new deal flow.

Share Price Reflects Echo's Healthy Growth Prospects
Management is targeting gross revenue of $2 billion by 2017, with adjusted EBITDA reaching $100 million. This implies EBITDA margins near 30% and operating margins of 23%-24% (defined as operating income divided by net revenue). For reference, the firm posted $884 million of gross revenue and a 15% operating margin in 2013. When giving the firm full credit for anticipated acquisitions, we think the 2017 target is achievable. That said, we forecast $1.7 billion by 2017, since we exclude unannounced acquisitions. The firm is baking in an anticipated $340 billion of acquired revenue into its target; of this, $225 billion remains following deals already closed this year.

We model operating margin improvement to 19%-20% by 2017, including 15% in 2014 (it was 15% in 2013), which already assumes healthy execution in an increasingly competitive marketplace. To reach 24% by 2017, however, we estimate Echo would need to post average incremental margins (change in EBIT over change in net revenue) in excess of 30% during 2014-17. Such improvement is not impossible, but we hesitate to extrapolate 30%-plus incremental margins over the long run because this performance is well above the firm's current run rate--incremental margins adjusted for the impact of contingent consideration changes were 17% in 2013 and 18% on average over the past three years. It also depends on several tentative factors, namely the magnitude of increases in salesforce tenure, which boost revenue productivity, and leverage over general and administrative costs.

Management has done an admirable job of constructing a high-quality domestic 3PL, and we think Echo will continue to gain traction in freight brokerage, driven by its strong value proposition and aggressive sales efforts. But we think the market already appreciates this.

Despite Echo's attractive growth prospects and opportunities for productivity gains, we are maintaining a conservative stance with our longer-term model assumptions, particularly in terms of profitability advancement in the years ahead. However, should the firm manage to drive incremental operating margins significantly higher than our currently forecast 24% average over the next four to five years--perhaps through robust market share gains, highly accretive deals, or marked success driving up salesforce tenure--our fair value estimate would probably rise.