Tuesday, August 14, 2012

XPO Logistics -- Third Party Logistics


XPO Logistics is a third party logistics (“3PL”) firm, mostly focused on truck brokerage in the United States.

An understanding of the 3PL industry is probably a prerequisite for getting the most out of this post, and no introduction is more lucid than this set of posts.

Back to XPO: as it stands today, XPO is a quality business, earning 36% on invested capital and reinvesting some of its profits at 21% incremental returns on investment. In its favor are the economic logic of its value proposition and the benefits of both network and scale economies. In other words, time is on its side, the sort of investment opportunity that I favor.



Growth in line with GDP, and an 8% discount rate, will get us to a value 25% above today's price. 


But the above is not all that interesting and certainly not worth writing about.

What is interesting are the recent developments in XPO's life. A certain Bradley Jacobs acquired a controlling stake in the company in 2011 and laid out his plans in a 14A filing, the extended highlights of which are reproduced below. 
"Once I settled on transportation, I first looked at an asset-heavy trucking company roll-up, but I couldn’t figure out a way to create the kind of shareholder value I was looking for. I wanted a higher return on capital. Then I discovered C.H. Robinson and Expeditors International of Washington. C.H. Robinson is the leader in truck brokerage, and Expeditors is the largest U.S.-based freight forwarder.

I love these two companies. They’re both non-asset based, which is a business model I understand because of my oil brokerage days. They have no debt to speak of. They throw off free cash flow in all parts of the economic cycle. Their returns on capital are 20% to 30%. So I started looking very intently at brokers, and I liked what I saw.

There are four verticals within the brokerage space that, together, represent a very large acquisition universe — about $200 billion in aggregate. All four are non-asset based, meaning the companies don’t own the trucks, ships or planes. They manage the logistics of how freight moves from one point to another by matching shippers with carriers. XPO is already in three of the four verticals.

The first is truck brokerage. It’s a really attractive model, very straightforward — basically, it’s like a trading floor, with a bunch of salespeople talking to shippers and carriers. Our people are matching freight loads to trucking companies and making a spread. We don’t own any of the trucks. We’re brokers; middlemen between the shipper and the carrier.

Domestic truck brokerage is around $50 billion a year. It’s very fragmented — more than 10,000 licensed truck brokers in the U.S., and 99% of them have revenue under $200 million. In other words, only about 25 truck brokers have revenue over $200 million. Lots of opportunities for consolidation.

There should be a big opportunity for penetration as well. Truck brokerage is a classic outsourcing service that delivers value to both shippers and carriers, and yet of the $350 billion of freight that’s moved on the ground in the U.S. each year, only around $50 billion, or about 15%, of that freight currently goes through brokers.

I believe that the 15% penetration number is going to go up. It’s a similar bet to the one I made when I got into construction equipment rental. I thought the trend was for rental penetration to grow because the economics of the customer favored rental, and in fact that happened.

There’s a similar incentive to outsource freight arrangements. Brokers offer a real value proposition by excelling at their core competency, which is to efficiently manage the flow of traffic. So there’s a fundamental economic benefit that should drive penetration. In addition, I think that as we grow XPO, our technology, size and professionalism will help attract business from the 85% who don’t currently use brokers.

If you look around the room, literally every single thing here — including the clothes you’re wearing — was on a truck at some point. It’s an exciting landscape. The trucking industry isn’t going away, and neither is truck brokerage."

Vertical number two, freight forwarding, involves trucks as well because freight needs to travel by ground transportation to get to an airport or seaport or rail yard. If the freight is continuing on overseas, it also requires an ocean carrier or air carrier. Freight forwarding is a global business, so it has the advantage of exposure to the growth rates of other countries, many of which are growing faster than the United States. Freight forwarding is a $150 billion industry worldwide. It’s a big ocean to go fishing in.

So those are two of the four legs I’m planning to grow XPO on: truck brokerage and freight forwarding.

Then there’s an area of the business called expedited services. It’s like truck brokerage, but it’s for freight that needs to be moved very quickly. XPO’s Express-1 unit is already a major player in expedited; it’s ranked as the fifth largest expeditor in the U.S. by the Journal of Commerce . We get paid a premium price because the customer needs something picked up really fast and delivered in a time-sensitive way. There’s room to grow the business through acquisitions, as well as organically by recruiting more owner-operators. Expedited is vertical number three.

And the fourth leg, which is the only one XPO is not in yet — but we intend to be — is intermodal, or rail. I’m looking for a good intermodal broker to buy for a platform.

So the company is already established in three of the four legs, which gives us momentum going into this next phase. That’s a big plus. And there’s something else I like about XPO. I like the people. They have a good reputation in the business, and they’ve built a strong company culture. They just haven’t had access to enough capital to grow the company on the scale I am contemplating.

They weren’t alone in that. I’ve met with a lot of brokerage companies, and almost every one of them told me they’d be several times the size they are if they had had access to capital. One big issue is the time lag between accounts receivable and accounts payable. A trucker needs to get paid quickly. They’d like to get their money in a week, which is faster than the shipper will pay. The shipper might pay six to eight weeks down the road. That’s not good enough for the trucker.

The key is to fund that gap. A lot of brokers hit a ceiling where they can’t finance growth. There used to be hundreds of banks lending to these small companies, but that kind of lending decreased dramatically starting in 2008. It can be a home run for a capital-constrained company like that to sell to XPO, because we can provide both working capital and growth capital.

We believe that we can create shareholder value by acquiring companies on accretive terms, and then enhancing returns by growing these operations organically through the addition of more salespeople. The salespeople, in turn, should be able to outperform because they have access to the resources of a larger organization with an expanding network of relationships. It’s a win-win.

We are very excited to embark on our efforts to build a much larger and even more profitable business through the opportunities available to the new XPO.


Potential Questions and Answers

Can you walk us through how you envision your capital structure?

We’ll have over $70 million of cash on the balance sheet at closing. We should be able to spend that on sensible acquisitions within a reasonable period of time. Depending on whether we buy smaller companies or larger ones, and how we structure the purchase prices, we expect to get an additional $8 million to $14 million of EBITDA from that spend. There’s not a lot of debt right now; about $3 million. There’s some goodwill on there. The biggest asset is receivables.

What is your line of credit?

XPO presently has a $10 million line of credit. That could be increased, though.

What about leverage?

We were highly leveraged in the last two companies I ran. This time it’s a non-asset business, so I don’t see the justification for the same level of leverage right now. I’m happy to borrow against the receivables, though, because the write-offs in this industry are typically less than 1%. In addition, I’ve had banks propose lines of credit of up to three times EBITDA, but I haven’t made a final decision about what the total leverage should be.

What’s your timeframe for spending the $70 million?

I’ll probably want to do one or two acquisitions later this year. That would double the size of the company. Then I might stop a bit, integrate, transfer best practices, optimize IT, arrange financings. It’s a very disciplined process. Bite, digest, reassess.

What kind of multiples are these companies going for?

It’s a bell curve. The bulk fall into a band of six to eight times EBITDA, which is where I have the most interest. Smaller companies go for about four or five times EBITDA. And there are a few gorillas I could buy at multiples of eight to 10 times EBITDA. These are higher EBITDA multiples than I’m used to, but because of the minimal capex requirements, they’re actually lower multiples of free cash flow.
 
What sort of multiples were they getting a few years ago?

The multiples have been pretty stable. You see a fairly delineated band of acquisitions based on revenue size.

What do you look for in a target acquisition?

I want to buy companies with good growth trajectories. The targets don’t have to be huge. In fact, in truck brokerage, there are only about 25 companies in North America with revenues of over $200 million. I’m mainly interested in smaller companies between $25 million and $200 million gross revenue, that’s my sweet spot. I want to take those companies and grow them. It’s usually easier to grow a $50 million company five-fold to $250 million, than to take a company doing $500 million and get it up to $2.5 billion. But there will be exceptions to the rule, and every deal is unique. Acquisitions aren’t cookie cutter. The common denominator is that I want to buy from people I like, and who have integrity. I want to take care of the people whose businesses I’m inheriting. Many of the key risks of a business plan like this come down to people.

Where are your acquisition targets located?

The 10,000-plus brokers I talked about are everywhere. Metro areas, small towns. A lot of them work out of inexpensive office space around transportation hubs: Atlanta, Chicago, Dallas, Jacksonville, Charlotte, Memphis — but they’re literally all over the country. Remember, the majority of this business is done over the phone or electronically, not in person, so you don’t necessarily have to be based near the customers.

How do you choose target acquisitions?

Due diligence. I’ve talked with about 120 companies. I have a pretty good nose for this. I also have industry experts working with me, together with boutique M&A firms.

What were the best and worst acquisitions of your career?

The worst strategic one was a whole series of acquisitions where we got off the path of equipment rental and bought into highway technology, which is roadwork signs, barriers and highway striping. We bought all these highway companies on the expectation that infrastructure spending would significantly increase when the government implemented the TEA-21 bill. But many of the projects stalled when the states couldn’t come up with their share of the funds, and the revenue growth just wasn’t there. Also, the IT system that we were using to run the rest of the company didn’t fit the highway tech operations. We ended up selling that business at a loss of a few hundred million, so it definitely wins the booby prize.

The best acquisition may have been a Michigan landfill we bought at United Waste for about $4 million. The EPA awarded us a major expansion, and a year and a half later it was worth $40 million. Another home run was a software company called Wynne Systems that we bought early on at United Rentals. They made powerful software with the politically incorrect name of RentalMan that we used to integrate all the rental businesses we rolled up into the company. We couldn’t have done the hundreds of acquisitions we did without RentalMan.

How will you grow a company once you acquire it?

I think we can create substantial value by financing the growth of these businesses after we buy them. Working capital and growth capital are pretty close to a magic bullet. There’s not much capex, but you have to finance the receivables and you have to bankroll the new hires. Hire hungry, talented salespeople at a low base and a big upside incentive, fund their training for a few months, and it’s not that hard for the winners to build a million dollar book after a year or so.

In a nutshell that’s how you ramp up in this business. If you buy a brokerage with $30 million of revenue and you add 30 to 40 bodies, you can double the revenue in time. I’ve looked at many companies that have executed this business plan, but most of them don’t have the capital to sustain it.

Do you plan on keeping the Express-1 brands?

One of the items that will be in the proxy for shareholder vote is a proposal to rebrand the parent company from Express-1 Expedited Solutions, Inc. to XPO Logistics, Inc. The expedited unit, which is headquartered in Buchanan, Michigan, will still be called Express-1, Inc. Our freight forwarding operations, based in Downers Grove, Illinois, will remain Concert Group Logistics, Inc. And the truck brokerage unit, which is based in South Bend, Indiana, will keep the name Bounce Logistics, Inc. Only the parent will change to XPO Logistics.

Where do you expect XPO to be in the future in terms of revenue and EBITDA?

I’d like to be at $4 billion to $5 billion in revenue and hundreds of millions in EBITDA. There are a lot of acquisition opportunities out there. If I had a billion in cash, I could spend it on good acquisitions within a few months. However, I expect our pace will be more measured than that.

Do you view your plan as easy to accomplish?

No, it’s not an easy plan to execute; it’s not for the fainthearted. There’s a lot you can mess up with acquisitions and integration. Acquisitions come with headaches. But the biggest challenge can be managing the human aspect — it’s important to watch out for the well-being of the people who work for the companies you’re buying. It’s a change for them, and it has to be a change for the better. One big thing I’ve learned from the hundreds of acquisitions I’ve been involved in is to sincerely respect the employees, be visible, do town hall-type meetings. Solicit their advice; employees have a lot of great ideas. And don’t just go through the motions — think seriously about the feedback you get. I have a lot of experience in creating this kind of healthy, inclusive company culture.

Can you walk through why bigger is better for a 3PL?

The bigger you are, the less business you have to turn down because you can’t find the capacity — and when you do get business, you should be able to find less expensive solutions because you have a larger universe of carriers to choose from. There are margins to harvest if you are a bigger player. Suppose I’m a broker and I have a shipper who pays me a thousand bucks to place a truckload. I book the load for $850 and make a $150 spread. But if I become part of a bigger organization, I can tap into everyone else’s carrier base as well. Maybe that lets me locate a carrier who is happy to take the load at, say, $800. Now I have a 20% spread instead of a 15% spread.

There are other benefits to size — for example, you turn down less business. It was kind of shocking to me, when I started studying the industry, to see some companies turn down as many as one out of five customer calls. If you can’t fill a load you lose the sale, and you’re not at the top of the customer’s call list anymore. The turn-down rate should decrease as the universe of accessible carriers increases.

With more volume, we should also be able to negotiate better discounts with the carriers, which should improve margin from another direction. And that’s in addition to leveraging scale in areas like SG&A.

Do you think more private equity groups will follow you into the industry?

I expect more consolidation, but there aren’t a lot of PE firms with my “serial acquirer” approach. What I’m doing takes a higher tolerance for risk and quite a lot of consolidation expertise. There are a lot of moving parts to this particular business plan. I don’t see droves of people copying me. There have been a few dozen PE investments in this space already, and many have been quite successful. But the typical plan has been to buy a company or two, add financial leverage, strip out the costs, play the cycle and sell it at the right time. I’m trying to do something more transformative.

Why do truckers use brokers?

Look at it this way: 96% of trucking companies in the U.S. have fewer than 20 trucks, according to the American Transportation Association. Only about one out of every 10 trucks on the road is owned by a public company. If you own a couple of trucks, you can’t afford to have people on the phone all day trying to find you freight. It’s also not your core competency. Using a broker is a good value proposition for most carriers — it’s the most cost-effective way to find freight.

Why do shippers use brokers?

Some large shippers manage freight logistics very efficiently themselves, like Walmart. But once you get past the top thousand corporations, it’s often handled willy-nilly. Most shippers don’t have a department of people to check out carrier prices all day long. They may have a handful of trucking companies they use, and when they have product to move they call two or three trucking companies and try to get a good price. That’s not efficient. They should be calling 3PLs like XPO and tapping into a network of tens of thousands of carriers. That’s one of the reasons why I believe that, in the future, brokers will handle much more than 15% of the logistics. There are millions of shippers in North America that need transportation solutions.

Will you target certain types of shipper customers?

We go after all kinds of customers. The three main sectors are retailers, manufacturers, and supply chain logistics management companies.
 
What is your management team going to look like?

I have a team from XPO that I like and respect. A couple of them will be taking on some different responsibilities, more involved with acquisitions. I’ve hired Spencer Stuart and Heidrick & Struggles to find a COO, CFO, chief acquisition officer, chief information officer, controller and vice president of investor relations. I’ve told both search firms to show me only world-class candidates.

What will be your largest operating cost?

When you’re a non-asset-based 3PL, your largest cost is sales compensation. And compensation is mostly variable, because most of it comes in the form of incentive bonuses. If revenue comes down, the house doesn’t get hit as badly as an asset-heavy, fixed-cost business does. On the flip side, though, you don’t get as much operating leverage in the upswings. The profits are less volatile throughout the cycle. Most brokers stay profitable and cash positive even during downturns.

What is the profile of a salesperson you would recruit?

It’s a business where you have to make 99 calls a day to do one or two deals. So you have to hire people who psychometrically test high on “need to win” and low on “need to be liked.” A salesperson will have a base of $25,000 or $35,000, but can make many times that amount on the incentive compensation. Once you get the right people in the system and integrated on the right IT, it can be really powerful.

When we do an acquisition, we’re buying a list of carriers and shippers, but we’re also “acquiring” the people who have those relationships. The risk is if many of the people leave after the acquisition. We’ve got to treat our people right financially, and make the atmosphere one that people gravitate towards. If we have a culture that genuinely respects our employees, and pays them competitively, they’ll want to stay.

You’ve made a point about the importance of IT. Why is that?

It’s the backbone. IT allows people to do their jobs more professionally and use metrics as benchmarks. It gives you an accurate financial grasp of the business. C.H. Robinson and Expeditors have stupendous IT. The best-run companies tend to customize the software for their own businesses. We’ll probably go that route.

I like to zero in on a few key metrics that really matter to the people on the front lines. We’ll have daily metrics for gross profit generated, minutes spent on the phone, turn-down rate, profit per load — about a dozen KPIs. At United Rentals, it was much more complex than anything we’ll be faced with at XPO. We had 750 locations at United Rentals and we had to figure out how to get all of them to talk to each other. I’m used to tackling complex IT challenges.

How do you compare the roll-up opportunity in logistics to other industries?
I would say that at this point in time, from my perspective — and I’ve made a career of studying almost every roll-up opportunity — this is the last large opportunity to be found in an industry that is fragmented and growing, offers a competitive advantage of size, has a large imbalance



All of the above makes perfect sense.

Since this filing, the management team has been hired, equity has been issued (at $15.75 per share), and XPO's listing has moved from the AMEX to the NYSE. The acquisition fund now totals $190 million. Bradley Jacobs’s private equity firm owns 52.6% of the stock, down from 70% from before the recent equity issue, and he is the CEO, essentially an owner-operator.

Since the plan is to grow XPO tenfold within a few years, principally through a rollup strategy, two related question arise: is it feasible?; and can it be done profitably?

In answer to the first question, it is useful to first consider the actual experience of two businesses similar to XPO:  ECHO Global Logistics and Radiant Logistics.





ECHO has grown at a CAGR of 195% since 2005, and Radiant has grown at a more modest 30% CAGR.  Both have grown primarily through acquisitions. ECHO’s acquisitions have yielded 18.5% returns and Radiant’s have yielded 29%.

Second, to the extent that XPO acquires smaller businesses, it can expect to pay between 6x and 8x EBIT, as illustrated by this list of multiples paid for acquisitions in the 3PL space.

I use a 7x acquisitions multiple to model what the next few years will likely look like:




In sum, I think XPO offers an attractive investment opportunity at the current share price. Sell side analysts have characterized it as a four-bagger in waiting, and they almost all have outperform/buy ratings on the stock, and I’m inclined to agree with them:
  • The current price is below the intrinsic value of the equity, even assuming no growth;
  • XPO operates in an industry primed for a rollup acquisitions strategy;
  • XPO is managed by a CEO who has successfully executed rollup strategies in the past, has invested $150 million of his own money in the business, owns 52% of the equity, and has $190 million available to kick start the rollup strategy;
  • The larger XPO becomes, the better it will be able to leverage its fixed assets, the greater its ability to benefit from network economies, and the better its margins will be;
  • A large share of the growth will be financed by secured debt (trade receivables, operating leases) which is the cheapest form of capital available; and
  • There is a defined exit horizon – and therefore payback for current shareholders: Jacobs is a private equity firm, after all, and once XPO has been built up, it will be sold at a higher multiple than it was purchased for and at far higher run-rate EBIT than it started from.

Long post, but simple enough idea. Grahamites will be appalled, I know, but I count very few "ifs" in the rationale for this investment. It just looks like a bleedin' obvious value play with no downside to speak of.

In any case, I expect annual returns of ~25% from this investment and it is my first buy since October of last year.

Disclosure: I am long XPO

2 comments:

  1. I've had some exposure to this business in the past and it's solid, it's amazing how profitable trucking, and truck brokering can be. A lot of players end up in the business by chance and don't have the business experience to grow. In many ways trucking is a very immature industry.

    I'm not sure I'd agree with no downside, trucking is hit hard with high gas prices or an economic downturn. But if neither of those materialize in a large way this will probably be very successful. What I do like is the company is working to get into the intermodal business. This is a way to soften a potential downturn due to high gas prices.

    Not sure why Grahamites would hate this idea, he advocated buying assets at a discount or earning power at a discount. I'd say this surely qualifies as considerable earning power at a discount. I always want a bigger discount when buying earnings, but it seems like that exists here.

    Nate

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  2. Here's why I think there's no downside (other than due to unforeseen acts of god, obviously):

    this is a simple arbitrage play:

    1. when trucking is hard, truck brokerage prospers: the truckers need to use their assets & the shippers (still) need to get their products to market; truck brokers add value to both ends of the equation. (The larger the broker, the more true this is since it will have a bigger database of truckers and shippers and better IT to match the two). And, as you've insightfully pointed out, intermodal will help cushion any blow. Besides, I'm okay with recessions -- I'm holding this for the long haul.

    2. smaller 3PLs have a hard time growing organically because they can't access the necessary credit,

    and

    3. larger 3PLs sell at higher multiples (10x) than smaller 3PLs (7x)

    If these propositions are true, I don't see a meaningful downside risk.

    Grahamites:

    This is what I was thinking when I wrote that, more or less tongue in cheek: "Yes, 72% of XPO's market cap is backed by cash. But that cash is, in the blink of an eye, going to be spent on intangibles. Then we'll be left naked, relying on earnings power, and worse, on profit growth AND on expanding multiples. I don't think Ben Graham would have touched this one!"

    But, I think you're right that even he would think was cheap.

    You and I may be at opposite ends of the value investing spectrum: I always want assets as a huge discount (like 90% off) and I'm okay with sustainable earnings at a modest discount.

    My problem is that I'm often too thick to be able to tell when earnings are sustainable -- "how in the world does this business make a profit and earn its cost of capital?" -- so I spend a lot of time scratching my head and passing on otherwise attractive opportunities.

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