Forward Air fwrd
September 01, 2016 - 7:06pm EST by
madler934
2016 2017
Price: 46.54 EPS 0 0
Shares Out. (in M): 31 P/E 0 0
Market Cap (in $M): 1,418 P/FCF 14 0
Net Debt (in $M): 33 EBIT 0 0
TEV ($): 1,450 TEV/EBIT 10 0

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Description

On the surface, Forward Air (“FWRD” or the “Company”) is just another “trucking company”, operating in a difficult industry notorious for cyclical swings, capital intensity, cutthroat competition and poor investment returns.  Beneath the surface we have developed a much different perspective; we see the following favorable attributes to an investment in Forward Air:

·         They are a dominant player in a narrow niche within the trucking industry

·         They have achieved pricing power due to their dominant position and have recently flexed their muscle in this regard through a “dimensional pricing” initiative (more on this later)

·         They maintain significant competitive advantages over their competitors due to their scale and long term investments made in support of their business strategy

·         They are a very well managed business that is highly respected by their customers, competitors and employees

·         All of these positive characteristics results in a business with high margins, strong cash flow, and a long history of producing attractive shareholder returns

Of course it is never enough to simply invest in an attractive business, one must buy it at the right price. In 2015 the Company acquired its most significant competitor, Towne Air.  It was the most significant acquisition in the Company’s history and in the 6 months after closing the deal, the Company experienced challenges integrating the two companies.  FWRD’s financial performance struggled as a result of these challenges creating what we believe is an excellent entry point to invest in a very attractive business.  We believe the challenges related to the Towne integration are behind the Company, and the benefits of the acquisition are taking hold in the form of greater efficiencies, dominant market share, and pricing power.  Importantly, we are able to participate at a great price because investors are still focused on the recent struggles as opposed to the favorable current and future trajectory.

Defining the Niche

It is worthwhile to spend a moment discussing the Company’s niche, because it is a subtle one with no specific definition and from a big picture most would simply view FWRD as an “LTL carrier”.  For purposes of this writeup, I will refer to the Company’s niche as “linehaul airport to airport trucking” or “linehaul trucking”.  One could view this as a different way of going to market as compared to a traditional LTL (less than truckload) trucker, and I think the distinctions are most easily identified in terms of comparisons to a traditional LTL trucker:

·         Whereas LTL truckers serve shippers as their customers (e.g. a consumer products manufacturer, industrial products manufacturer or a furniture company etc.), FWRD exclusively servers freight forwarders (non-asset based logistics companies who arrange transportation/logistics on behalf of shippers).  This is important because freight forwarders might use traditional LTL truckers instead of FWRD, but they are wary of doing business with firms who might eventually try to steal their business (an LTL carrier might try to cut out the middle man over time in order to work directly with the shipper). Examples of a few significant freight forwarder customers for Forward Air include Expeditors International, Pilot Air Freight, FedEx, UPS Supply Chain and SEKO Worldwide.

·         FWRD goes to market with a schedule that mimics that of an airline – they run direct routes between cities with very specific departure and arrival times, providing for consistency and reliability to their freight forwarder customer base.  This is distinct from how an LTL goes to market - with an estimated range of freight departure and arrival times, without any planned schedule.  This is why the Company is called Forward “Air” – they were created to mimic the speed, consistency and scheduling of air freight as opposed to that of the LTL carriers.  Furthermore, because the Company runs direct routes they are able to move freight across the country in about half the time (2-3 days, utilizing 1-2 trucks) vs. LTL carriers (who might take 5-6 days and have to move the freight among 4 or more trucks over that period of time).  Hence, FWRD maintains an advantage vs. an LTL carrier in moving high value freight where speed of delivery and less handling is valuable. 

·         FWRD has built their trucking network specifically to serve their distinct customer base, the freight forwarder.  Specifically, they have focused over the years on locating their truck terminals in close proximity to their customers in order to form a close bond.  This has frequently meant locating the truck terminals on or close to airports – significant customers are frequently located at the airports and a meaningful portion of FWRD’s freight is being transloaded from air to truck.  This is why the Company refers to its core business as its “Airport to Airport” network. 

·         FWRD has made significant investments in technology over the years in order to further strengthen their close relationship with their customers.  Notably the Company has meticulously outfitted its 91 terminals with a network of video cameras that allow the Company to locate any piece of freight at any given time (we have heard that some terminals have over 100 cameras throughout the facility).  In the event of damage to an item of freight, the Company has the ability to identify exactly where and how that freight was damaged to determine accountability.  Further, the Company has invested in data interchange and labelling technology in order make interactions and tracking as easy/transparent as possible for the customer.  Notably, the Company has worked for years on a labelling system with customer Pilot Air and Amazon (who is a customer of Pilot Air) which has resulted in a close relationship between FWRD, Pilot and Amazon from a logistics perspective.

Taking this all together the key ways that we define FWRD’s niche within trucking are i) that they work exclusively with freight forwarders as their customers and have developed and extremely close bond with this customer set and ii) they run a linehaul trucking network that focuses on speed, certainty and a consistent schedule.

As one of the Company’s customers we spoke to put it,

“FWRD provides a scheduled linehaul service - they beat the transit times of the LTLs…. nobody else you can go to that has the scheduled departures and arrivals like FWRD”

We think that expedited linehaul freight is positioned well long term.  Consumer preferences are increasingly demanding immediate gratification and there is value placed on being able to deliver quickly.  At a recent conference management mentioned that sometimes they feel like they are owned by Amazon given the amount of Amazon content going through their networks (through FWRD’s customer Pilot Air) – I doubt Amazon’s volume declines or they decide they have a preference for slower service.  At the same time, all retailers and e-commerce players are being forced to provide the same speed or risk becoming irrelevant.  As an example, Wal-mart recently announced their answer to Amazon Prime (which they are calling ShippingPass), a service that offers free two day shipping for $49.95.  WMT will reportedly be using more third party logistics providers in order to make this happen – these 3PLs are the key customers for Forward Air.  We see these trends being highly beneficial to FWRD over time. 

 

Acquisition of Towne and Competitive Landscape

FWRD completed its acquisition of Towne in May 2015 – we think this marked a significant change in the competitive landscape as the removal of Towne Air from the market will allow FWRD to raise its pricing materially over time.  We also think the management underplayed the competitive impact of the acquisition so as to not stir any scrutiny of the deal amongst customers or regulators.  If you listen to the Company’s earnings calls over the past year management has consistently downplayed the impact of the acquisition in terms of removing competition.  We were surprised in our discussions with industry participants to hear a much different perspective than that provided by management, commentary such as:

“Towne was the major competitor… they [FWRD] now have as close to a monopoly on linehaul as one can get” (customer)

“they do not have one big competitor out there…..they have locked up the market” (competitor)

“FWRD had a big advantage over us - some significant big accounts - made it difficult for us to compete… we would go in to forwarders and get a few lanes here and there but FWRD was able to get the lion’s share of the business… FWRD had done a better job in sales and marketing to gain the business - took very good care of their good customers… we did compete a lot on price and over the past few years the carriers have gotten better at pricing their freight out… we would fight pretty aggressively for lanes” (former employee of Towne Air)

“they are the gorilla….everyone else is a fraction of the size” (competitor)

“FWRD/Towne changed the market dynamics significantly….Towne had been keeping the prices low” (competitor)

“they have a pretty good market cornered with the carriers” (customer)

“not much competition - they have it down, have a good consolidation service… pretty large, sophisticated terminals.  Great company culture” (customer)

“competitors can’t cover the same scope…leverage is that FWRD does all of this for us, and so they get the lion’s share of the business”  (customer)

“by far the market leader…. they were easy to use because they went everywhere….. that became their clear advantage in the market” (customer, discussing the scale advantage that FWRD has)

The relevant linehaul trucking industry players are as follows – note these are rough estimates because all of these companies are private with the exception of Forward Air.

·         Forward Air (excl. Towne Air) $600mm in linehaul revenues

·         Towne Air $230mm in revenues, acquired by FWRD on 3/19/2015

·         American Linehaul: $60mm in revenues, regional player based in New Jersey, www.americanlc.com/

·         Land Air, regional player based in Bowling Green, <$50mm revenues, www.landairexpress.com/

·         Mobile Air, regional player in NY, <$50mm in revenues, http://mobileairtrans.com/

·         BX Solutions, regional player in Toledo, <$25mm in revenues, filed for bankruptcy in Nov 2015 and is no longer in business

·         Sterling Transport, <$25mm in revenues, focuses on a single lane (Los Angeles to Miami), www.sterlingtransportation.com/home

·         Accelerated Freight, <$25mm in revenues, regional player in the East, www.acceleratedusa.net/

As you can see from the list above, FWRD was fairly dominant in the linehaul space even prior to the acquisition of Towne; on a pro forma basis it is no wonder that customer and competitors made the statements referred to above.

That being said, the early days of integrating Towne were without a doubt a little bit rocky.  During the course of the integration, Forward shut nearly every single one of Towne’s 61 terminals in order to gain the efficiency of running all of that volume through FWRD’s network.  They moved perhaps a little too quickly, and the result was a material amount of missed shipments, delays, damaged freight, lost freight and cancellations.  Through our channel checks in the industry, we believe that management has been pretty straightforward in their description of the timeframe of this turbulent period, which started shortly after closing and lasted about 6 months through the end of September.  We also have gotten consistent feedback that operations have since reverted to historical levels of reliability.  Ultimately we believe that FWRD’s customers experienced modest dissatisfaction during the integration of Towne but were largely satisfied with the Company’s response to the problems – we are not aware of any significant loss of business that occurred as a result of the challenges experienced with the Towne integration.

Forward Air’s Recent Move to Dimensional Pricing

In early January 2016, just months after shutting down Towne’s redundant terminals and completing the integration, the Company began to notify its customer that they would be moving to “dimensional pricing” on February 1st.  This is a fancy term that is a simple intuitive concept – pricing freight based on volume of the freight as opposed to the weight of the freight.  Traditionally, freight in the trucking industry has been priced based on its weight.  The problem with this in recent years is the “Amazon effect” – people are shipping rolls of paper towels, blankets and pillows.  Many categories of freight have simply become lighter even though they remain the same size (think about what a flat screen TV weighs today vs. 10 years ago).  Trucks have thus been “cubing out” – filling up in terms of volume but not generating as much revenue $$ because the average weight of the freight is lower. 

The Company implemented a “dim factor” of 200 (down from a traditional level of 250), on February 1st.  Effectively this means that light weight, bulky freight will be priced 25% higher, as if that freight weighed 25% more.  Of course, only a portion of the freight passing through the network (the light, bulky stuff) would “dim out” (be subject to that 25% dim factor change).  Thus, understanding the ultimate impact on pricing from the change in dim factor requires an understanding of the percentage of freight that will “dim out”.  We have talked to customers who have told us 15% will dim out and others who have said 50% will dim out – the answer is going to vary widely by customer.   

We think management has once again sandbagged with respect to the significance of the dim factor change, playing down its relevance in communication with the Street.  They have talked about the dim factor change as “being designed to replace a normal general rate increase” that would have come through in any normal year.  Our discussions with industry participants has suggested something radically different – here are a few things that we heard in our discussions:

“It felt to me like they are taking advantage of us….. they took the fedex/ups playbook on this…. they did not announce this on wall street because they wanted to keep it low key…. this is definitely not the same as a general rate increase, this is much much bigger” (customer)

“in the last month they introduced a substantial rate increase - this is massive - a big change” (customer, referring to the DIM pricing change)

“the systemwide increase was a result of them feeling their strong position in the market” (customer, referring to recent price increases from FWRD)

“this is a game changing volume factor” (customer)

We cannot define the exact impact of the change in dim factor, but it is fairly clear to us that management has been downplaying the impact of the change.  We could see it working out as a mid to high single digits impact on pricing (implying that 20-30% of volume is “dimming out” and subject to a 25% price increase).  But the bigger picture here is the event path and what it means with respect to the quality of the business and long term profit/margin potential.  The story basically goes like this – FWRD buys their biggest competitor, downplays the impact it will have on their competitive position, completes the integration, shuts down all of Towne’s terminals, and then starts to raise prices significantly, all the while downplaying the significance of those price increases.  It’s a recipe for long term success we think, because this first move on pricing is just a signal of things to come in the future.  When companies gain pricing power, I rarely see them raise prices just once, they frequently push that pricing power over time in modest increments.  We think there are more price increases coming – in fact management has already alluded to potentially going further with the dim factor to ultimately match the airline industry at 166.   

An Extremely Well Run Company

During the course of our research on Forward Air, it has become clear to us that this is a very well-run Company with a solid culture, strategy, management team and values.  Businesses with these characteristics tend to compound value over time, and Forward Air has done just that (FWRD has been over a 10 bagger over the past 15 years under the current CEO’s leadership).  Here are some of the comments made about the Company by its peers:

“Incredibly well run, very strong operating platform, very hard to compete with - engine is oiled, lots of very good people” (competitor)

“they have a very well defined view of what they do, turning away business if they can’t do it well - very smart, disciplined, methodical” (competitor)

“strategically they are very strong - for an OR they are off the charts” (competitor, referring to the Company’s Operating Ratio which is superior to anyone in the LTL space)

 “they definitely have an advantage from a scale/technology perspective” (customer)

“it has been a solid partnership with them….. it took a lot of time, trial/error to get here - it would be a lot harder for us to separate from them” (customer, talking about their technology integration with FWRD)

“there are no peers in industry with that technology” (customer)

“FWRD runs a good system / has their act together - they are very honest about what is right and wrong and that went through their whole organization)” (former employee of Towne Air)

High Barriers to Entry

Importantly, we think that this niche business is very well protected from potential competitors who might try to undercut FWRD’s pricing.  We think the primary barriers are:

·         Scale.  FWRD’s customers want to do business with a logistics provider who can provide comprehensive nationwide service (someone who is able to run all of the required routes around the country).  There are no competitors of scale who can be cobbled together, nor is it possible to build this business from scratch – it would take years of work and operating losses to put together a viable competitor to FWRD.  While the small regional players can compete on pricing on a few routes here and there, FWRD is the only player who can provide a comprehensive offering and thus they will continue to win the lion’s share of the business.

·         Integration with Customers.  As discussed above, FWRD has integrated its business with its customers creating a very sticky relationship.  This integration with customers includes technological integration which makes FWRD a very efficient partner to do business with and also physical integration (locating their terminals close to their customers).  Recreating this level of trust and integration with the freight forwarder customers would be quite difficult to pull off.

·         LTL Networks not set up to compete.  The LTL players can try to compete with Forward Air, but their trucking networks are simply designed to do business in a different way.  In order to truly compete, they would have to start from scratch and build systems and a trucking network that functions in a fundamentally different way than they are used to doing business. 

I think these barriers are best demonstrated by Old Dominion’s attempt to enter this market a number of years ago.  Old Dominion has a great reputation as the best run LTL and they are a much larger company than FWRD (many times the size).  Old Dominion made a concerted effort to enter the expedited LTL space years ago, failed in their effort and scrapped the plan.  We think this data point is further evidence that it would be difficult to re-create FWRD’s business.

 

Valuation, Target Price

Forward Air has generally been viewed as one of the more attractive businesses in the trucking industry and has thus been rewarded with a premium valuation multiple.  That remains the case today; we are investing in FWRD at an EV / 2016 EBITDA multiple of 8.8x at our cost, which is above where other trucking companies trade but below FWRD’s historical valuation multiple.  This probably does not seem like a barn burner of a multiple to you (nor does it to us).  That being said, we think that investors have misinterpreted the events of the past year and have been too myopically focused on the LTM results and challenges experienced with the Towne integration.   We see a business at an inflection point from a pricing perspective and believe that the Company is stronger than it has ever been in the past, with a really dominant position in its niche and clear competitive advantages.  We think that over the coming year investors will begin to appreciate these characteristics and that the earnings trajectory will improve at the same time.  The Company is also extremely well capitalized and highly cash flow generative – one point not discussed in the writeup is that the Company employs an “owner operator” model where the truckers themselves own their capital assets and act almost like a franchisee.  This is not necessarily a unique structure in and of itself in the trucking industry, but we view it positively as it shifts the significant capital burden of owning and maintaining capital assets from FWRD to its owner-operator partners, allowing FWRD to focus on sales/marketing, running their terminals and technology. 

Below we lay out the current enterprise value of the company as well as its 2016 projected financial performance. 

 

($ in millions)

 

 

 

 

Stock Price (as of 9/1/16)

   

$46.54

Fully Diluted Shares Outstanding

 

30.5

Equity Market Cap

   

1,417.5

         

Debt

     

70.6

Cash & Equivalents

 

 

38.0

Enterprise Value

   

$1,450.1

         

Enterprise Value / 2016E EBITDA

 

9.8x

Total Debt / EBITDA

   

0.5x

Levered FCF Yield

   

6.5%

Unlevered FCF Yield

   

6.4%

         

Financial Summary

   

2016E

Net Sales

     

$982.4

EBITDA

     

$147.7

% Margin

     

15.0%

         

Less: Cash Interest Expense

 

1.2

Less: Cash Taxes

   

34.4

Less: CapEx

 

 

 

20.0

Levered Free Cash Flow

   

$92.0

While the current valuation multiple is admittedly not stunningly low, we think the combination of paying a reasonable price, the strong pricing power, cash flow generation and strong competitive position bode well for this business over the coming years.  We can see appreciation of 50% from our cost basis over 2 years based on a combination of earnings growth and very modest multiple expansion (which we expect as sentiment improves as the Company shows more quarters of solid performance combined with Towne and price increases start to flow through into the financials).

Everything Else is Likely Irrelevant

 

For purposes of this writeup, I decided to focus the discussion entirely on FWRD’s core Expedited LTL segment, which represents 75% of the Company’s business.  FWRD is in a few other business, some of them cats (their intermodal business which is actually quite promising) and some of them dogs (their “solutions” business and TQI which never seem to make any money).  I doubt these cats and dogs collectively will have much of an impact on the overall performance of FWRD and for brevity and to keep the discussion on point, I have omitted any discussion of these segments.  I look forward to any thoughts or questions that you might have about our investment in Forward Air.  

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Compounding earnings and value over time.

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