XPO is a highly levered logistics company that has been built on an aggressive roll-up strategy. Trying to avoid the fate of similar failed transportation consolidation stories, such as Pacer, UTi Worldwide and DHL Global Forwarding, XPO is already on the third iteration of its strategy just a few years after its 2012 IPO. Bulls believe that the company is led by value-creating management when the past reality is actually very different, though they are extremely promotional. We believe XPO is overvalued and misleads investors. We also believe that the company will miss estimates this year.
Bulls believe that XPO will succeed where others have failed because of XPO’s management, who have started a number of companies and turned them into billion dollar enterprises. While this track record is impressive, today’s investors are buying into XPO when it is already valued at $10 billion. The stock price of United Rentals, which management is most known for, peaked at a high of $43 in 1998, the year it became public. Over the next 10 years United Rentals never reached that peak level again and by the time management left, United Rentals was trading at $33. So unless an investor was there with at the beginning, it was likely that they lost money…and this was over a 10 year period, throughout a housing boom, throughout a time when industrial stocks generally did extremely well, and during a time period when the company completed over 100 acquisitions. In addition, after management left, the stock price tanked (in part due to the recession) and didn’t have a sustained recovery until another 4.5 years later.
As you can read about in savlo’s October 2012 VIC write-up, XPO originally billed itself as an “asset-light” freight broker with high returns on capital and growth from brokerage acquisitions and new office openings called “cold starts.” XPO reported organic revenue growth of above 40% in 2013 and 2014. XPO didn’t report annual organic revenue growth in 2015 though the average of the four quarters was around 5%.
The analysis below shows that if you assume 0% growth on the acquired EBITDA for every acquisition XPO has made since the IPO, put in actuals for Norbert (which has a seasonally stronger 2nd half) and Con-way, then the remaining business including XPO “cold starts” have contributed minimal to negative EBITDA. This is a big disconnect versus the way Management has portrayed company performance each quarter.
Also, XPO claimed organic growth of 33% in 4Q15. Not only is this organic EBITDA claim misleading because it refers to less than 25% of total company 4Q15 EBITDA, but we do not believe that the math adds up. The company said that this was calculated by taking out the four companies XPO bought last year and comparing that to what was owned as of December 31, 2014. Our apples-to-apples comparison suggests that organic EBITDA before corporate overhead declined from $57 million in 4Q14 to around $50 million in 4Q15.
The Crux of Our Theory
It is our theory that the company may be misleading investors to show greater organic growth by shifting responsibility for servicing customer accounts (and the related EBITDA) from acquisitions into the legacy business. We also question what expenses XPO might be shifting to the EBITDA add-backs of transaction, integration and rebranding costs, which totaled $83 million in 4Q15 and $158 million in 2015.
We think “creative” accounting may explain the large discrepancy between our organic growth calculations and what the company has reported. Encountering accounting games such as these is not too surprising when you consider that the United Rentals was investigated by the SEC for improper accounting, settled with a penalty payment to the SEC, and resulted in the termination of the CFO, corporate controller, principal accounting officer and VP of Finance. This article gives a good summary of what went on at United Rentals:http://ww2.cfo.com/accounting-tax/2008/09/united-rentals-settles-sale-leaseback-fraud-charges-with-sec/
Shifts in Strategy
The lack of organic growth helps explain why just two years after its IPO and with the truck brokerage industry still in the early innings of consolidation, XPO deviated from its initial plan and acquired Pacer, a more asset-intensive company in the Intermodal space. Fast forward another 1 - 1.5 years and XPO once again shifted strategy and levered up the balance sheet with debt to buy two more asset-heavy companies, Norbert and Con-way, for $6.5 billion.
The company claims that their special sauce is proprietary IT systems, but our field research leads us to believe that the company’s IT isn’t differentiated and only works in truckload brokerage which was less than 20% of 4Q15 net revenues. All of the other companies that XPO has acquired, which now comprise the majority of the enterprise value, will continue running separate systems.
If XPO cannot execute on the less complicated truck brokerage business, we are skeptical about its ability to integrate these two large asset-intensive companies. With the acquisition of France-based Norbert, XPO must also deal with strong cultural differences overseas, which has historically been a big issue for US transportation companies making European acquisitions. With Con-way, XPO acquired the second largest LTL (“Less Than Truckload”) company. The problem with Con-way is that to provide its top-tier service Con-way had a higher cost structure and earned lower EBIT margins than its non-union peers. XPO has been taking a large axe to Con-way’s costs in order to hit its synergy target. While we believe that Con-way has fat to cut, we are skeptical that this won’t negatively impact customer service levels. In addition, despite Con-way’s strong customer reputation, it is being re-branded to XPO. Our checks reveal that XPO has a weaker brand name and customers are concerned. In the transportation space it is true that some customers prefer to do business with brokers who also own assets. However, many other customers want diversification of suppliers and don’t want to put all eggs in one basket. This helps explain why cross-selling in the transportation space is notoriously difficult.
As an important note, customers we spoke with say that they have multiple XPO salespeople calling on them and competing against each other for the same business from different non-integrated companies acquired by XPO, and that was before adding Con-way. This may also explain the shrinkage of the business versus the “organic” growth they supposedly have been reporting.
Large Customer Loss Not Disclosed
In late December 2015 the former Menlo warehousing segment of Con-way lost the DTCI (U.S. Government Defense Transportation Coordination Initiative) contract to FedEx as noted on the government websitehttps://www.fbo.gov/index?s=opportunity&mode=form&tab=core&id=82c538d61ff3a61f0d529eb596f622ce&_cview=0. While XPO says that its largest customer only represents1.4% of revenues, we believe that this largest customer could be the DTCI contract. While the margin contribution from this contract was likely small by itself, we believe it helped provide scale to support other customers. Before the DTCI contract Menlo margins ran around 2.0% and then jumped up to around 2.7% for the first 3 years after the DTCI contract was up and running in full. We believe the loss of this contract could hamper XPO’s efforts to drive costs out of Con-way. It is also noteworthy that there has been no mention whatsoever by XPO about the lost contract. In fact, just a couple of weeks after this contract loss, XPO told American Shipper at that “XPO hasn’t loss any Con-way business since the deal”. Here is a link to that article --http://www.americanshipper.com/Main/News/Jacobs_No_acquisitions_for_XPO_in_2016_62708.aspx?source=Big6#hide
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.
Since the Norbert and Con-way acquisitions now represent the majority of EBITDA and with a very levered balance sheet constraining them from doing more “deals” for the time being, we expect that it is going to become very difficult for management to hide the actual performance of the business. Given the highly promotional statements the company continues to make, we don’t believe long investors are going to like flat/negative actual organic growth.
While XPO’s guidance is for $1.25 billion of EBITDA in 2016, the company indicated at a recent JPM conference presentation that they internally project $1.5 billion of EBITDA this year. Our 2016 EBITDA estimate is $1,141 million, which is 24% below their “public whisper” number and below the street. Given the stock performance since the JPM conference, we believe their “public whisper” number is relevant.
Looking out, given the fact that base business has had no real organic growth over the last few years (beyond Con-Way cost cutting, which we do believe is real and is embedded in our numbers), we believe they are going to disappoint on an ever larger scale in 2017.
We believe that if XPO starts missing targets, the wheels could fall off rather quickly. Our target is a $17 stock price, which is ~50% below today’s levels and values XPO at 7.0x 2016 EBITDA (using the diluted share count of 135 million shares) – the 7.0x multiple is based on a weighting of where their peers actually trade given a large part of the business is now “asset heavy”.