Beyond the recession
Reduced U.S. consumer spending could uncover weaknesses in many non-asset-based transportation and logistics companies ' while creating opportunities for others.
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For the past several years, investors and executives have been enamored with, and sometimes confused by, the so-called 'non-asset-based' business models of freight forwarders and other transportation intermediaries.
The attractions to this sector have historically included exposure to high-growth markets (typically linked to international trade) and the ability to substitute human capital (information technology, operational expertise, customer relationships) for financial capital.
Besides growth and capital efficiency, margin expansion was a critical value driver for non-asset-based businesses. A multi-factorial metric, margin expansion was partially a result of sizable capacity additions on the part of asset owners that took place during 2000-2007 in almost every transportation sector. Encouraged by strong, consumption-driven demand and aided by easy credit, container shipping companies, truckload and air freight carriers saw in capacity additions a critical means to achieve economies of scale in their relatively high fixed cost businesses. Multi-prong capacity expansion over the economic cycle paved the way for a 'buyer's market' that non-asset-based transportation companies adroitly exploited.
As 2008 brought with it GDP contractions in the U.S. and major consumption markets around the world, transportation capacity in many sectors increasingly outstripped demand ' so far to the benefit of non-asset-based transportation competitors. However, whether an impressive track record is an accurate indicator of future performance by non-asset-based businesses remains an open question, particularly relative to that of asset-based competitors.
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U.S. economic outlook
We identify the following as the four most plausible scenarios for the U.S. economy going forward (Figure 1):
' An 'Upside Surprise' (15 percent probability), often called a V-shaped recession, where the bottom of the cycle is clearly defined and immediately followed by a brisk and sustained recovery, probably by the third quarter of 2009, headed back towards the U.S. economy's historical long-term growth of roughly 2.9 percent to 3.1 percent per year.
' A 'False Start' (20 percent probability), or W-shaped recession, where first signs of recovery (say in the third quarter of 2009) are only temporary, perhaps driven by the short-term effect of a cash-based fiscal stimulus; the economy does eventually recover (say by the first quarter of 2010) at the same rate as that implied by an Upside Surprise scenario.
' A 'Slow Recovery' (40 percent probability), or U-shaped recession, where GDP contraction (on a seasonally adjusted at annual rates basis) takes longer than the widely expected three to four quarters (implying a clear recovery by the second quarter of 2010 or later), but it is eventually followed by an output path that takes the economy roughly, but not quite, back to its historical long-term growth.
' A 'New Normal' (25 percent probability), or L-shaped recession, where GDP contraction is at least as protracted as that under the Slow Recovery scenario, but the ensuing recovery path takes the economy to a new long-term (i.e., sustainable) GDP growth rate that is materially lower than the one observed during the previous 20-year period (2.9 percent).
Our outlook implies that this time around economic recovery (as measured by year-over-year GDP growth) will take longer than in any other recession since 1947 under any scenario. The market will thus test the resiliency of transportation businesses (of any kind) to lower-than-historical volumes one way or another.
Life under a New Normal
But depth and duration aren't the only factors at play in the current recession. A third factor is the post-recessionary outlook for demand.
Last year saw by far the largest reduction in net housing wealth since the Federal Reserve began tracking it in the 1950s (close to 19 percent). While economists generally agree that a change in housing wealth translates into a permanent change (in the same direction) in consumer spending ' a phenomenon known as the wealth effect ' there is wide disagreement as to the size of the change, with most estimates falling between 2 cents and 7 cents per marginal dollar (up or down) of housing wealth.
Assuming a 5 percent wealth effect under our New Normal scenario, we would expect American consumers to permanently reduce their annual spending by about $110 billion (or 1.1 percent of 2007 spending) for the 'foreseeable' future (say, the next 10 years). Such a spending realignment would shift the U.S. GDP growth rate during 2010-2020 to 2.3 percent, assuming a no-realignment base rate of 3.1 percent. Our New Normal scenario thus assumes a loss of 80 basis points in the long-term growth of the U.S. economy, which would negatively impact all sectors of the North American transportation industry, with varying degrees of intensity (Figure 2, right-hand panel).
The implication of segment-specific New Normal volume growth rates is that a significant portion of the capacity additions witnessed over the past few years, partly built on the assumption of permanently higher consumption rates in America, will be made redundant over the next two to three years. This would be particularly true in container shipping, less-than-truckload and, to a lesser extent, truckload. In other words, a New Normal for demand would be the driver of a New Normal for supply in transportation and logistics, which would trigger a generalized unwinding of the massive capacity additions of the recent past.
Assets for solutions
We consider the asset/non-asset distinction between, say, truckload carriers and truckload brokers to be misleading. It is based on the notion that the former operate under a highly fixed cost structure because the assets they own (e.g., trucks) both: a) incur costs (e.g., depreciation) that are insensitive to volumes in the short run; and b) are rigid and lumpy in nature and thus difficult to reduce in response to falling demand.
Non-asset-based businesses, which generally do not own transportation equipment, are on the other hand considered to operate under a highly variable cost structure where lower volumes are almost automatically accompanied by lower costs. In our view, reality is much more nuanced than that.
Freight forwarders, intermodal marketing companies and truck brokerage firms all manage assets and, more broadly, resources, that are essential to their value proposition, whether they show up on the balance sheet or not. For example, while IT systems (hardware and software) do appear on the balance sheet, the costly and critical resources of in-house software development and database integration projects do not ' and the latter costs are incurred without much regard to volumes. In fact, below the net revenue line (i.e., after purchased transportation is subtracted from total revenue), the costs incurred by non-asset-based companies can be set as high as 50 percent fixed within a 12-month period.
By the same token, not all asset-based transportation providers are alike in terms of their supposed rigidity to adjust their cost structures to declining volumes. Recently, YRC and other LTL companies have in fact had a difficult time reducing 'capacity' in their LTL networks. But over the last 12 months a number of truckload operators adapted their cost structures to a rapidly deteriorating environment far more effectively than LTL providers by shedding discrete assets. Tractors, in particular, have relatively short lives and truckload fleets can be reduced surprisingly quickly simply by cutting annual replacement purchases.
In our view, the key distinction between asset- and non-asset-based businesses lies in the primary goal behind each business model: Maximization of network utilization for the former, customer interfacing for the latter. We thus refer to network operating truckload, LTL, rail and integrated package carriers as Asset Optimizers; we call non-asset-based businesses Customer Solutions companies.
Over the past nine years, North American Customer Solutions companies have outperformed Asset Optimizers on the basis of profitability ' as measured by return on capital employed, or ROCE (Figure 3, upper panel).
However, ROCE for Customer Solutions companies is no less variable than that of Asset Optimizers (by segment), except for LTL (Figure 3, lower panel). This evidence challenges the common belief that Customer Solutions companies generate stable returns over the economic cycle, predicated upon the idea that these companies benefit from plentiful supply during downturns (thus protecting profitability) but are constrained at the peak by a highly variable cost structure.
Our ROCE variability finding is consistent with our previous point that Customer Solutions companies have much higher operating leverage in their cost structures than it is generally believed. Notably, it is also evidence that some Asset Optimizers have means at their disposal to reduce costs relatively rapidly (and thus partially smooth returns over the cycle). The surprisingly low ROCE volatility for the integrated carriers we believe is a result of:
' Relatively limited sample size.
' The fact they may be cushioned by the relatively concentrated nature of the industry.
New Normal, revisited
A New Normal scenario for demand could have challenging short-term (say, within one to two years) as well as long-term (say, over the next five to 10 years) implications for Customer Solutions companies.
The short-term implications have to do with ongoing demand contraction in America and around the world. While financial capital may be minimal and returns on capital high for Customer Solutions companies who have been very successful over the past few years, many such companies who are incapable of reducing fixed costs and/or expanding market share will face enormous strategic challenges in a weaker freight environment. Simply put, many Customer Solutions companies have yet to test the true operating flexibility of their (supposedly highly variable) cost structures.
'Over the long term (i.e. beyond the next five years), we believe that leaner economic conditions after the current global recession will force asset-intensive, network-based transportation platforms to come to grips
with many of the structural inefficiencies that have been exploited for years by the Customer Solutions companies. As supply eventually realigns with demand and carrier networks are pared down, we expect to see:
' Less overcapacity, whether due to excessive equipment orders (e.g. container shipping lines ordering ever-larger vessels) or reluctance to cut capacity because of damage to network coverage and density (e.g. U.S. domestic LTL carriers).
' More concentration, especially in the highly fragmented truckload industry.
' Less pricing based on 'incremental' costs, whether belly cargo on passenger flights or backhauls on intermodal stack trains.
These changes will be painful, especially for the companies that do not survive the rationalization process, but they will benefit the surviving Asset Optimizers at the expense of Customer Solutions companies.'
Strategic alternatives
Over the past several years, a number of Customer Solutions providers invested heavily and aggressively to expand their service offering and market coverage. Many initiatives were part of an effort to be a 'one-stop shop' or to develop global leadership rather than to focus on specific geographies and sectors. These expansions, though not necessarily always unwise, increased fixed costs. The fixed nature of these costs was often hidden by the ability to 'grow into them.'
Now, facing depressed demand in the short run and a possible realignment of supply in the long run, the Customer Solutions companies' strategic response will be constrained by both their strategic position and the capital they can reasonably find at their disposal (Figure 4).
While the current weak backdrop in financial markets will discourage investment, mergers and acquisitions still provide executives with the most potent and immediate strategic tool to restructure and reposition their companies.
Customer Solutions companies with high fixed cost structures should consider combinations that drive additional volume into the heart of their systems as well as ways to 'variablize' other aspects of their network where they lack scale (e.g., switching from owned offices to agents in marginal locations). Those with financial resources should consider exploiting the relatively narrow options available to capital-constrained competitors by making strategically wise acquisitions. Those with limited financial resources should consider how they can best benefit from consolidation, either as a seller able to articulate the value it brings to a business combination or through joint ventures, stock-for-stock combinations, or other acquisitions driven through third-party financing.
But not all Customer Solutions providers were willing or able to rapidly expand over the past bountiful years. Those who have not expanded or invested as aggressively and have maintained a highly variable cost structure (generally with greater focus) may have temporary advantages in terms of their ability to adapt to lower volumes. Additionally, and contrary to conventional thinking, some Asset Optimizers may actually be better positioned than Customer Solutions providers to reposition themselves as: a) discrete pieces of capacity can be shed relatively easily (e.g., tractors); and b) significant pieces of industry capacity are likely to be eliminated in broad restructuring (both in and out of Chapter 11).
Regardless of their position, however, all Customer Solutions providers should reassess their threats and opportunities in an environment in which old rules no longer apply.