|Shares Out. (in M):||84||P/E||26||18.6|
|Market Cap (in $M):||3,390||P/FCF||7.79||7|
|Net Debt (in $M):||647||EBIT||217||285|
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NewCo will growing margins after a massive reverse-merger in an improving environment. Swift Transportation (SWFT) is merging with Knight Transportation and has pulled back -5% and after reporting lower sales and resetting estimates. However, SWFT’s risk/reward is attractive at current levels. The shares will trade to over $33; downside $22 after lowering the bar. This upside/downside ratio of 2.3 is driven by the cyclical trough in truckload industry pricing growth during 2017 along with synergy from the merger supports accelerating EPS growth in 2018, presenting a fundamental catalyst to KNX-SWFT.
This past April, Swift Transportation (SWFT) and Knight Transportation (KNX) announced a merger of equals, which will have a pro forma mkt cap of $6.3bn (54% owned by legacy SWFT shareholders and 46% owned by KNX shareholders) and be called Knight-Swift. This will create the leading truckload carrier in North America. Knight's leadership will manage the new company and impose discipline on the much larger business of Swift. After two consecutive down years in pricing, the trucking industry reached an inflection point in Q2 2017 with positive growth and is positioned for an extended pricing cycle through 2018. Merger expected to close in Q3 2017 with straight forward approval process, company has identified $150mm in synergies, boosting pro forma EBITDA from $800mm to $950mm (+18%).
Swift Transportation (the bigger company) operates one of the largest fleets of truckload equipment in North America from over 40 terminals near key freight centers and traffic lanes. They principally operate in short- to medium-haul traffic lanes around its terminals and dedicated customer locations. SWFT concentrates on this length of haul because the majority of domestic truckload freight (as measured by revenue) moves in these lanes and our extensive terminal network affords us marketing, equipment control, supply chain, customer service, and driver retention advantages in local markets. Since SWFT’s average length of haul is relatively short, it helps reduce competition from railroads and trucking companies that lack a regional presence. SWFT four reportable segments are Truckload, Dedicated, Swift Refrigerated, and Intermodal. Their extensive suite of service offerings (which includes line-haul services, dedicated customer contracts, temperature-controlled units, intermodal freight solutions, cross-border United States/Mexico and United States/Canada freight, flatbed hauling, freight brokerage and logistics, and others) provides customers with the opportunity to "one-stop-shop" for their truckload transportation needs.
Knight Transportation’s objective is to operate our Trucking and Logistics businesses with industry leading margins and growth. The company offers a broad range of full truckload transportation and logistics services with one of North America's largest tractor fleets, operated through a nationwide network of service centers, and contractual access to thousands of third-party capacity providers. KNX has grown substantially by increasing the geographic reach of its service center network and by expanding the breadth of its services for customers. KNX’s Trucking segment provides truckload transportation, including dedicated services, of various products, goods, and materials for our diverse customer base through our Dry Van, Refrigerated, and Drayage operating units. The Brokerage and Intermodal operating units of the Logistics segment provide a multitude of shipment solutions, including additional sources of truckload capacity and alternative transportation modes, by utilizing KNX’s vast network of third-party capacity providers and rail providers, as well as certain logistics, freight management, and other non-Trucking services.
Knight and Swift have an all-stock reverse merger in which Knight will become the surviving entity. Swift will undergo a 0.72 for 1 reverse merger, while investors in Knight will obtain 1 share in the new combination. As Swift has 134 million shares outstanding, its shareholders will own 96 million shares in the new combination, equivalent to 54% of the shares. Knight's investors will combined continue to hold 81 million shares in the business, equivalent to 46% of the 177 million shares outstanding. KNX management who are better operators will become management of the pro forma entity and will not close any terminals to keep centers close to their customers and operations of the two brands will remain separate (synergies are from overhead and improved operating metrics at SWFT).
Swift has grown to become a much larger business as it posted sales of $4.03 billion in 2016, accompanied by an operating ratio of 92.9%. This margin works the same as in the railroad industry which means that the lower this number is, the higher operating margins are. Knight posted sales of merely $1.12 billion last year, yet it was vastly more profitable in terms of margins, with operating ratios coming in as low as 85.3%. This corresponds to operating margins of 14.7%. It is comforting to see that the key roles of the new leadership team are being handed to current executives of Knight, as they have done the best job in terms of margins. The family ties between Knight (Knight) and the Moyes family (Swift) appear good, as both families have been in favor of the deal.
Consensus thinks it is odd that Knight will obtain nearly half the shares, as their business is nearly 4 times as small in terms of sales as the business with whom it is merging. This observation is flawed for two reasons: being the higher margin profile of Knight and the fact that it operates without debt, unlike Swift.
Swift has 96 million share outstanding which values equity of the business at $1.92 billion ahead of the deal. If the billion-net debt load is taken into account this valuation increases towards $2.9 billion. Knight has 81 million shares outstanding which traded at $31 ahead of the deal, while it operates with a clean balance sheet, for a $2.5 billion valuation. If we take the enterprise valuations into account and the vastly different margin profiles, the premium for Knight is much less extreme. Based on these numbers, Knight is valued at little over 15 times operating earnings, while the valuation for Swift comes in at little over 10 times.
The NewCo opportunity:
In 2016, the trucking industry experienced a confluence of negative events, including: slowing demand from elevated inventories, contracting manufacturing activity and tractor supply overhang from record orders in 2015. In Q2 2017, across the board, management teams at asset-heavy companies have noted improving volumes and rising spot prices with the June freight index increasing +24% overall MoM and +57% YoY, while dry van spot pricing increased +35% vs May and +68% YoY. For example, CH Robinson reported Q2 2017 results on July 19th and noted margins in its truckload brokerage segment declined substantially because of a rapid rise in spot rates that could not be passed on to customers.
Pricing will improve: Upcoming implementation of electronic logging devices by Dec 2017 deadline is expected to remove 3% to 7% of existing capacity, reducing supply and creating an environment for higher pricing. After experiencing a significant increase in class 8 tractor builds above replacement demand in 2014 and 2015 that applied pressure on trucking pricing in 2016, tractor builds in 2016 were below replacement and 2017 is expected to be below replacement again, indicating that the improved pricing cycle is not expected to be dampened in near future. ELD implementation in 2H 2017 will impact smaller truck fleets the most, causing some supply to exit the industry and lowering profitability of some providers that may be forced to exit the industry, thus improving the supply / demand balance for existing larger players
What is remarkable about the deal is the fact that Knight is much smaller than Swift, yet it is a better operator. Given that its management will pretty much lead the new business, there are huge opportunities for synergies if its best practices can be copied. This is further reinforced by network effects and the fact that both companies have operations in similar locations. Management sees synergies reach $100 million in 2018 and even $150 million a year later. Looking at the deal presentation reveals that just half these synergies are costs synergies, with the remainder being revenue synergies. That being said the $75 million in revenue synergy is calculated as the net contribution to operating profits, so these can be one-on-one translated into higher operating earnings.
The costs synergy estimates furthermore look very reasonable as they correspond to a little less than 2% of the sales being reported by Swift. Once achieved, that would close just a relative small portion of the margin gap between both companies.
The company itself claims that the deal will boost 2018s earnings per share by more than 30%, being the first year in which the deal is fully implemented. Using an operating earnings number of $151 million of Knight, and $266 million for Swift, pro-forma operating earnings of $416 million. Applying a 4% cost of debt on a net debt load of $1 billion, interest costs are seen around $40 million.
That yield pre-tax earnings of $376 million, which corresponds to $233 million after applying a 38% tax rate. This in its turn is equivalent to $1.30 per share, based on 177 million shares outstanding. If you factor in $100 million in pre-tax synergies by 2018, earnings per share might improve towards $1.65 per share, which implies 27% accretion. Using the $150 million synergy run rate by 2019, pro-forma earnings might improve towards $1.85 per share.
The NewCo will drive +$150mm in combined synergies. KNX management team will be able to implement many of the operational strategies that has led to KNX achieving better margins than SWFT (KNX = 14.7% operating margin, SWFT = 7.1%) on a larger asset base (SWFT = 14k tractors, KNX = 4.2k). The equity valuation of NewCo is a little over $6 billion, for an 19 times earnings multiple. Synergies are seen at less than 2% of Swift's revenues, as the margin gap between both companies is actually far greater.
Risks: Factors that might affect NewCo is clearly if the deal breaks. The results of operations are industry-wide economic factors, such as freight demand, truckload and rail intermodal capacity, etc. NewCo’s success depends on its ability to efficiently and effectively manage resources in providing transportation and logistics solutions to customers. Key metrics to monitor are: the number of tractors operating, revenue per tractor (which includes primarily revenue per total mile and number of miles per tractor), freight volumes brokered to third-party capacity providers (including rail partners), driver and independent contractor recruitment and retention, and the company’s ability to control costs on a company-wide basis.
1. September 2017: Expected close of KNX-SWFT merger and higher synergies announced.
2. Revaluation potential: will see new Sell-side, re-initiations on NewCo with street synergy assumptions and improved operating ratio assumptions at SWFT.
3. Tailwind: a likely cyclical trough in truckload industry pricing growth during 2017
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