It appears that third quarter 2019 may provide another round of earnings cuts. Equity analysts have been busy in the last few days lowering estimates on many publicly traded transportation companies.
In a few different notes out from analysts, the theme seems common – earnings expectations are moving lower, no one wants to have published estimates higher than consensus and the bottom of the freight recession has likely occurred.
For most truckload (TL) carriers, 2019 started with the coffers refilled coming off of the exceptional strength of a hot freight market in 2018. Most were looking for another decent year, likely not as strong as 2018, but a solid year with many eyeing incremental capital investment in their networks. A lack of volume to start the year was chalked up to harsh winter weather and a tariff-induced freight pull forward that left an overhang of inventory. In the first quarter of 2019, the TL carriers had a bit of an earnings buffer as contractual rates were higher on a year-over-year comparison. Inclement winter weather turned into a late spring with persistent flooding in the Midwest. As April and May passed without a seasonal uptick in demand, many TL companies pointed to June as a make or break month. As June failed to materialize, estimates began to be reeled in significantly for the quarter and the year.
The weeks leading up to second quarter 2019 earnings reports brought several negative earnings pre-announcements from the carriers. Those companies that didn't adjust expectations lower prior to their quarterly reports, lowered their full-year guidance on earnings calls or in their reports. The magnitude of estimate revisions in the second quarter was due in part to some holding on too long to the hope of a meaningful recovery as the year progressed.
While many were hoping that second quarter earnings revisions would be a one-time event, it appears at least a couple of revisions will be required to right-size earnings estimates to market trends.
In a note out to clients lowering earnings estimates, Susquehanna equity analyst Bascome Majors said, "With the truckload market again showing signs of softer demand, increased capacity, and contractual pricing risk (base rates inflected negative in July) into year-end and 2020, we remain cautious on companies' bottom lines and are slightly trimming nearly all of our [third quarter 2019], 2019 and 2020 estimates."
While Majors' estimates were only modestly reduced, all of his earnings per share (EPS) estimates are below consensus forecasts, which have been gravitating lower most of the year.
Contractual Rates Now a Headwind
Majors cited deteriorating contractual truck pricing as a primary reason for lowering estimates. Most public carriers generate the bulk of their trucking revenue from contracts, typically one year in duration, with shippers. It's uncommon to see a large, publicly traded carrier with more than 10% of its total revenue coming from spot market transactions for any sustained period of time. Some of these carriers usually only have 5% spot market exposure.
A prolonged period of weak spot rates, which are usually the basis for contractual rate negotiations, appears to have ensnared contractual rates, which have begun to decline. Majors contends that contractual rates turned negative in July as spot rates have fallen for more than a full year now. While spot rates are still down in the mid-teen percentage range year-over-year, Majors noted that the severity of the declines eased throughout the quarter. Additionally, the normal seasonal sequential changes in spot rates have been a little better than their historical averages according to Majors.
As the two converge and spot rates firm, spot rates will take contractual rates higher. However, the contractual rate comparisons remain tough through 2019 and at least into first quarter 2020. Recall, first quarter 2019 earnings results for the TLs benefitted from favorable pricing comparisons when compared to first quarter 2018. On average, first quarter 2019's contractual rates had been negotiated during the tighter truck capacity backdrop of 2018. This provided the group with a revenue tailwind in what was otherwise a pretty soft quarter.
"Looking forward, with tough [year-over-year] comparisons and continued seasonal underperformance, it looks like contractual truckload rates will remain negative into 2020 spring bid season," said Majors.
Morgan Stanley analyst Ravi Shanker said, "we expect another tough quarter for the group, as demand trends meaningfully decelerated in [third quarter] and most macro data points are indicating that we are near the bottom of a freight recession."
He lowered forecasts and highlighted that his estimates sit in-line to well below the already diminished consensus estimates for the TLs. He said that he expects no company in his coverage universe to beat estimates, prognosticating 16 of the transportation companies he follows will miss consensus estimates with the other five reporting in-line results.
In a note out to clients updating TL trends and lowering estimates on some TL carriers, Seaport Global Securities' Kevin Sterling said, "We think freight bottomed in [the third quarter of 2019] and the truckload industry is beginning to right-size itself on the supply side after about a year of excess capacity where supply exceeded demand by our estimates as much as 5%-7%."
Sterling's referring to Class 8 truck deliveries in 2018. Net Class 8 truck orders topped 490,000 units in 2018, smashing the previous record by 100,000 units.
Class 8 Truck Orders (SONAR: ORDERS.CL8)
Truck Capacity to Bleed Off
As excess truck capacity flooded the market and demand cooled, spot rates declined materially, requiring most TL fleets to reassess their truck needs. The result has been a precipitous decline in new truck orders. As the industry continues to work through the current overbought position, new Class 8 truck orders are running well below standard replacement levels. FreightWaves estimates replacement demand to be 250,000 to 300,000 units on an annual basis. Currently, the industry is only placing new orders at a seasonally adjusted annual rate (SAAR) of 150,000 units.
Other Capacity Limiting Events
In addition to below replacement level truck buying and recent declines in used tractor prices, most TL management teams will talk about other capacity-limiting events likely to trim industry truck counts and drive rates higher. Expect management teams to call out fleet failures, reorganizations and bankruptcies as a primary driver of capacity reduction throughout the industry. In addition to carriers exiting, capacity cuts have also come in the form of small and mid-sized carrier operating fewer trucks. Compliance with the electronic logging device (ELD) mandate which starts December 16 and the Federal Motor Carrier Safety Administration (FMCSA) drug and alcohol clearinghouse requiring drug and alcohol testing program violations to begin being reported January 6 could be focal points in the capacity discussion as well.
Lastly, carriers will likely call out the potential for hair follicle testing, if the U.S. Department of Health and Human Services mandates it, which could produce a 10% reduction in the available driver pool according to carriers that are already using this form of testing.
OTVI.USA, an index based on the volume of accepted tender volumes on a given day, turned positive on a year-over-year basis in July. The mid-single digit increases may be benefitting from easier comparisons as volumes began to really fall off in October 2018. At the minimum, this should perpetuate the "not as bad" drumbeat from most management teams.
Outbound Tender Volume Index – USA (SONAR: OTVI.USA)
Income Statements Seeing Cost Inflation
Most cost buckets on carrier income statements are seeing cost inflation. Insurance renewals are up 70% to more than double on a year-over-year basis. IMO 2020 (regulating sulfur content in marine fuels likely increasing demand for distillate fuel and raising the price of diesel) will likely squeeze the carriers that don't have solidly enforced fuel surcharge programs. The cost offsets are lower incentive compensation and driver hiring/retention costs. Everyone will be talking about company-specific efficiency/cost initiatives.
Don't expect one. Most companies are still trying to get their arms around expectations for this year's peak season. While the public carriers are likely seeing volumes/demand improving and may provide some constructive commentary around peak season, uncertainty around future trade policy and the speed at which capacity reductions take place will likely keep forward looking expectations near-sighted and muted. Further, some companies may not provide a 2020 outlook during fourth quarter earnings season in January and February without more visibility into trade.
Estimate cuts may not be as dramatic as they were last quarter, but the trend for expectations is still moving lower for now.
Landstar System the Only Negative Pre-Announcement So Far
Excluding the railroads, which have largely walked backed revenue expectations in the second half of 2019 as carloads remain under pressure, only Landstar System, Inc. (NASDAQ: LSTR) has pre-announced negative earnings expectations. The company said that earnings expectations will fall short of prior guidance due to a "tragic vehicular accident" and weaker than anticipated market conditions. The company reported that loads were 3.5% lower year-over-year in the first two months of the third quarter and that revenue per load was down 13.5% over the same period. Both of these metrics "are at or slightly below the low end" of the company's prior guidance range.
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