Due primarily to the severe housing recession, the freight transport industry has been under severe pressure. Truck and intermodal volumes have been depressed which has pressured pricing.  At the same time, railroad rates, fuel and other costs have relentlessly moved higher.  HUBG appears to be the odd man out in the industry.  In an industry slowdown, they should lose, which appears to be beginning to happen.  JBHT and PACR have favorable railroad contracts which should enable them to take volume from HUBG and pressure pricing.  In addition, since Schneider is asset intensive, and a private company, it will be more aggressive in pricing to keep its asset utilization higher.  Some of this thesis began to play out in the recent quarter that HUBG missed, but several items enabled them to mask their vulnerability.  Over the next few quarters, their eps misses should be more substantial and the stock will be pressured accordingly.  HUBG has done an heroic job of pushing up margins, but it appears that they have maxed out and that trend should reverse.  HUBG is a very low operating margin business; a 3% increase in transportation costs is equal to $.70 in eps.  They simply cannot continue to a to avoid the twin pressures of rising costs and slowing volumes.

INTERMODAL INDUSTRY OVERVIEW

Intermodal service is the movement of non-bulk commodity freight by rail.  A full intermodal offering includes pickup of a container by truck (known as drayage), placement of the container on a flatbed railcar, removal of the container from the railcar and delivery of the container to its destination by truck (drayage).  The railroads outsource this function to intermodal carriers (IMCs) because they are not well equipped to sell their intermodal service to small shippers and to arrange for drayage.  In addition, recently, in an effort to to manage their asset intensity, railroads have been diminishing their container fleets and letting IMCs take over that function.  However, railroads are the providers of intermodal service, albeit on a wholesale level.  They, generally, provide the loading of the containers on the railcar, which they own and remove the container when it reaches its destination. 

The railroads sell wholesale carriage on their sytems to international freight companies and IMC’s at wholesale prices.  The IMCs generally resell that carriage to retail shippers and earn a return from pricing above wholesale and from drayage.  The IMCs can sell wholesale but generally do not, except in PACR’s case, because contracts with railroads make it uneconomic to do so.

Intermodal carriage from the west coast eastward is the most important part of the market.  This is because (1) today most freight that is shipped are goods coming to the west coast from Asia and then moving to the eastern population centers and (2) intermodal carriage is presumably more economic over long hauls. 

Most IMC contracts with railroads are of short duration, usually one or two years.  They are price contracts with no volume requirements.  The two intermodal contracts that stand out and are material to an understanding of the business are PACR’s deal with the UNP and JHBT’s contract with BNI.    PACR’s predecessor company negotiated a 15 year contract with the UNP that began in 1996 (they did a similar longer contract with CSX also).  The contract enables PACR to pay below market wholesale rates to UNP.  PACR, unlike the other IMCs, also controls railcars and, with the UNP contract, is in the business of reselling wholesale rail service.  They call this service Pacer Stacktrain.  They can do this because their rates with the UNP are lower than prevailing wholesale rates.  Thus HUBG, Schneider and many other IMC’s use Pacer Stacktrain.  JBHT negotiated a revenue sharing arrangement with BNI that makes JBHT the preferred retail IMC for BNI.  Other IMC’s purchase wholesale space on BNI, but JBHT appears to get better pricing due to its relationship with BNI.  JBHT generally does not sell wholesale because its deal with BNI does not provide it with an economic incentive to do so. 

The other IMC’s, as mentioned, have shorter contracts with the railroads (or Stacktrain) and provide retail service to their customers.  All the IMC’s control their own containers (either through ownership or long term lease) but the railroads continue to control some containers and such containers are available for short term lease by the IMC’s.  In all there are about 230,000 domestic containers in the market today (domestic containers are 58’ long as opposed to international containers that fit on cargo ships which are only 40’ long).    

There are four major IMC’s who control the following number of containers:

PACR                          29,000

JBHT                           26,250

HUBG                         25,000

SCHNEIDER               25,000

Also the following are important players since they are important truckload carriers:

SWFT                                     7,000

WERN                                    3,000

CURRENT CONDITIONS IN THE INTERMODAL AND BROADER FREIGHT MARKET

Intermodal loadings have been lower year over year for most of the year.  This slowdown has been seen in most freight markets, with the exception of bulk commodities.  For example, truck tonnage shipped has been worse than intermodal for longer.

The slowdown in retail sales explains some of the decrease in truck tonnage, but retail sales are still positive, even when adjusted for inflation and truck tonnage is negative.

It is our contention that the freight slowdown is a function of the housing slowdown.  Items that are sold into the housing market tend to be larger volume items and thus the loss of these items has a disproportionate impact on freight demand. 

SECULAR INTERMODAL TRENDS

There are several often talked about secular trends in intermodal.  The most important is the shift away from trucking to intermodal.  This has occurred because of the price differential coupled with better intermodal service and more congested highways.  Even with recent increases in rail rates and decreases in truck, the cost differential still favors rail.  Since rail uses less fuel than truck, higher fuel costs also favor rail.  The market share shift has been material although it appears to have stalled out lately, perhaps due to the above-mentioned higher rail rates and lower truck rates. 

However, when truck rates stabilize and move back up and assuming continued pressure from fuel surcharges, we expect the shift to resume.  This should be a positive longer term underpinning to Intermodal.

Another trend is the expected increase in transloading.  Transloading is when an overseas shipment is unloaded at the port (usually a West Coast port) and reloaded into a domestic container and sent via domestic intermodal.  The percentage of overseas shipments that were transloaded was steady at around 27% for many years.  However, when rail rates began to rise and legacy shipping contracts for international intermodal remained low, freight moved away from transloading.­­

Recently, these legacy contracts have repriced and it is now highly cost saving to transload three 40’ foot international containers into two 58’ domestic containers. Eaerlier this year, A.P. Moller-Maersk, one of the large international shipping companies, announced that due to higher rail rates, they would no longer be shipping goods inland and that they would be transloading all their shipments.  This got the domestic industry (and wall street) very excited  about this potential area of growth.  However there is not substantial evidence yet of an uptick in transloading.  However, we think it may occur and should be monitored in relation to a short position on HUBG.

A third potential secular driver is expected to work against intermodal and thus help our short position.  Intermodal’s most profitable business is moving Asian inbound freight to the eastern population centers.  The West Coast ports have become very congested and expensive and intermodal rates have risen.  Thus some industry analysts claim more freight is moving through the Panama Canal or the Suez Canal directly to the east or gulf coast.  Similarly, there are two new ports opening, one in Canada and one in Mexico.  It is expected that these ports may take market share from the U.S. ports and thus decrease the demand for intermodal eastward (the major IMC’s do not operate in those countries).  However, there is little evidence of a change away from the West Coast yet.

The Canada and Mexico threats are tangible but it is very difficult to tell the extent at this time.  Presumably freight brought into Prince Rupert, British Columbia will be able to make it to Chicago two days faster than freight from California.  However, there is no local market for goods in that area (which is a hefty distance from Vancouver) so the logistics of bringing large numbers of cargo ships to that port just to service Chicago is daunting.  We do not think either of these ports will have an immediate impact on the IMC’s but could materially mitigate any longer term positive industry outlook.

On balance, we are not necessarily bearish on intermodal longer term, however clearly, the slowdown in housing and how long it lasts will impact near term results and HUBG’s estimates are not expecting that.

HUBGROUP BACKGROUND

HUBG is a family run company that entered the intermodal business in  1971.  The company was taken public in 1997 but the Yeager family retains control through 100% ownership interest interest of the supermajority voting B shares.  HUBG did not grow eps between 1996 and 2003 with the same management team that runs the company now (the Yeager family).

However, eps growth did pick up after the 2001-2002 recession and has been substantial since then, materially outpacing the company’s nearest comp, Pacer International and the rest of the intermodal market.  However, the over the past few quarters, HUBG’s sales growth has fallen to “in-line” with the market.  It appears the consensus expectations are for a substantial rebound in sales growth despite the industry slowdown.  These expectations appear to be unrealistic. 

COST PRESSURES

However more important, costs are going up.  Rail rates, fuel surcharges, labor (Schneider recently raised its rates across all its businesses) and outsourced drayage are all rising.

Recently HUBG’s margin improvements have come exclusively from transportation costs, which would be impacted by all the above and depreciation.  Depreciation declined as a software system purchased in 2002-2003 became fully depreciated.  This should be a double whammy because no longer will depreciation benefit numbers, but also the cost improvement from the low hanging fruit from an SAP system implementation has been taken out already.

HIGH OPERATING LEVERAGE MODEL

As noted above, HUBG’s earnings are vulnerable to a very small change in margins.  In the example below, 2008 eps would go from an expectation of $1.58 to losing money if only two things change: (1) a recessionary situation causes revenues to be flat yoy (not unrealistic given the negative revenue in 3q 07) and total cost increase of 1.5% (below what cost increases should be running, despite the recessionary situation).

OPERATING LEVERAGE EXAMPLE:

Another important point in our assessment of the high potential for HUBG’s margins to come under pressure is its situation vis a vis the railroads and JBHT and PACR.  HUBG is essentially at the mercy of railroad intermodal pricing.  Both JBHT and PACR have advantaged contracts with the Class 1 carriers.  HUBG does not.  Thus, despite recent good performance relative to PACR (but not JBHT), HUBG should be “higher cost” than those two competitors and thus suffer accordingly.

It should also be noted that HUBG’s revenue growth has slowed because they admittedly high graded customers to improve margins.  This may work well in a robust demand environment.  However, in a weak freight situation, the company will struggle to keep revenue’s flat and margins have to weaken.

VALUATION

HUBG is trading at 19x eps due to the streets view that the recent margin improvement and thus eps growth will continue.  This appears to be very unrealistic.  We engaged several valuation methodologies.  Using a realistic long term ROE of 15% (10% historic vs. 20% in 2006), the stock appears to be worth ~ $18 per share.  This implies an $1.20 normalized eps number at its current asset level (23x) and 15x normal. 

RISKS

• Operating leverage works both ways.  Just as it does not take much below consensus to tank eps, it would not take much better news for eps to beat numbers.  We suspect if that happens it would be temporary, but the stock would likely react against us.
• The secular transport story is compelling, so the transport group will likely move quickly once a bottom in the economy is sensed by wall street.  As noted, a good transport long with decent upside operating leverage should be paired with this idea if possible.