All Star Stifel, Nicolaus & Company Analyst John G. Larkin: Macroeconomic Uncertainty Leads to Tepid Freight Environment

Wall Street Transcript

67 WALL STREET, New York - September 24, 2012 - The Wall Street Transcript has just published its Transportation and Logistics Report offering a timely review of the sector to serious investors and industry executives. This special feature contains expert industry commentary through in-depth interviews with public company CEOs, Equity Analysts and Money Managers. The full issue is available by calling (212) 952-7433 or via The Wall Street Transcript Online.

Topics covered: FMCSA CSA Regulations - Regulatory Issues in the Trucking Industry - Trucking Pricing & Capacity Dynamics - Retail and Industrial Transportation Demand - Truckload, LTL, Parcel, Rail and Intermodal - Capacity Constraints Result in Pricing Power

Companies include: FedEx Corporation (FDX), United Parcel Service, Inc. (UPS), Ryder System, Inc. (R), Penske Automotive Group, Inc. (PAG), Wal-Mart Stores Inc. (WMT), Lowe's Companies Inc. (LOW), Sears Holdings Corporation (SHLD), Norfolk Southern Corp. (NSC), CSX Corp. (CSX), CH Robinson Worldwide Inc. (CHRW), Kansas City Southern (KSU), Canadian National Railway Comp (CNI) and many more.

In the following excerpt from the Transportation and Logistics Report, an all star equity research analyst discusses the outlook for the sector for investors:

TWST: Is there anything else you would point out in terms of highlights, trends or an overall tone from the space?

Mr. Larkin: I think, in general, with 2% GDP growth or greater, the tone for the industry would be pretty positive, because a fair amount of capacity was shed starting in 2006, when the automotive and housing industries slowed down dramatically. That was exaggerated in 2008 and 2009, when we almost went into a depression. As the economy has slowly come back, there has not been a lot of incremental capacity additions, so supply and demand have been roughly in balance the last 18 months or so. That has created a reasonably good environment for most of the transportation carriers out there, who have succeeded in getting some respectable rate increases, which along with a real focus on cost control - almost a necessity to survive the downturn of 2008 and 2009 - has led to some decent margin expansion over the last 18 months, and has probably, more than anything else, been driving earnings growth more or less in line with expectations.

However, the second quarter also had the benefit of declining energy prices, and in transportation, there is always a fairly large benefit, call them tailwinds, when energy prices are declining on account of the way the fuel surcharges work. There is anywhere from a week to two months of lag built in to the fuel-surcharge adjustment. The railroads, UPS (UPS) and FedEx (FDX), in particular, are at the longer end of that surcharge-lag range; as such, they can have hundreds of millions of dollars of swing in terms of the fuel-surcharge benefit. However, what they, in theory, lose when fuel prices are rising, they get back when fuel prices are on their way down. Conversely, the truckers adjust their fuel surcharges every week, so it is not quite as pronounced for them.

But we are in a period where fuel price has been rising, even though the economy has been somewhat soft here over the last couple of months. Some of that may have to do with the potential for armed conflict in the Middle East. Other contributing factors are a recent refinery blowup in Venezuela, which does not help, and the hurricane running through the Gulf, which just adds insult to injury.

The other major factor that I will comment on is the availability of labor, particularly as it pertains to the trucking industry. With unemployment around 8.3% and the fully developed unemployment, or U6, at something closer to 16% - that would include those who have a part-time job but would prefer a full-time job, as well as those that have dropped out of the work force as they have been sufficiently discouraged to no longer look for a job - one would think that finding truck drivers would be easy because it is a relatively high-paying job. There are many trucking companies that will pay drivers in the $45,000, $50,000, $55,000, and even a few in the $60,000, a year range, yet virtually all those companies are struggling to find people who meet the minimum criteria, which would include being drug free/passing a drug test, having no criminal record, having a clean driving record, and having a willingness, perhaps most importantly, to actually be out on the road, sleeping in the sleeper compartment of the truck, eating at the truck stop and showering at a truck stop - not exactly the most glamorous lifestyle.

As a result, driver availability has been a real issue. One wonders what might happen if the economy were to take off and start growing a little bit faster and if we were to start doing a little more construction around the country. Some of the people that are currently driving a truck would probably leave to go back to some of those construction industries, and that would leave us in a much rougher position. The railroads could pick up some of the slack through their intermodal offering, but intermodal only serves the longer-haul, higher-density markets anchored by big cities and automated intermodal ramps, so the trucks still have to do most of the heavy lifting. It is going to be interesting to see what happens if, in fact, the economy does finally gain its legs and starts to grow at a more typical 3% or 4%.

At that point, I think we are going to be facing an equipment shortage, and those without contracted capacity may not have their freight moved. To mitigate this, some shippers have already been exchanging rate increases for capacity commitments, because this is a problem that has been extensively written about and talked about in the trade press as well as in industry association meetings.

Those are the big factors out there. However, one last one to touch on is the rising cost of transportation equipment. A new tractor today might cost $125,000, a new trailer might be $30,000, and you may need to have 2.5 or three trailers for every tractor. As a result, each unit of production is getting to the point where it is close to a couple hundred thousand dollars. When you take a look at the lending policies of some of the banks, some of the finance companies and some of the leasing companies, they are really shying away from lending a lot of capital to the smaller, struggling carriers.

So those are the carriers that are going to drop off the edge of the cliff if we were to go into a double-dip recession, if energy prices were to skyrocket again, or if the driver shortage really does become totally debilitating, which it might, in a faster-growth environment. There is no easy solution to this capacity crisis. What has kept it somewhat out of the headlines has been this continued period of what I would call "subpotential growth" in the overall economy.

TWST: What will you be paying most attention to in the next round or two of earnings?

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