A couple of bullish reports this week highlight reasons to favor transportation stocks moving forward. The outlooks call for favorable freight fundamentals around demand, utilization and pricing to remain in place for the foreseeable future.
Consumer demand not likely to wane anytime soon
UBS (NYSE: UBS) transportation analyst Tom Wadewitz said he sees a “perfect storm” for freight demand, pointing to tight capacity, inventory rebuilding and a steady stream of stimulus money. “The combination of strong goods spending and low retail inventory levels should support freight demand in 2021,” the report read.
His firm’s economics team views goods spending as “well supported” through the second quarter of 2022, even as consumer spending on services starts to grow. Many transportation experts have speculated that as the economy reopens more broadly, spending will transition from hard goods that require freight transportation to services that do not.
The firm’s forecast for spending on real goods calls for a 9% year-over-year increase in the first quarter, 13% in the second quarter and a mid-single-digit percentage increase in the second half of 2021 and the first half of 2022.
Morgan Stanley’s (NYSE: MS) Ravi Shanker said in a report to clients that a return to spending on services “is not likely to hold the cycle back.” He believes a reopened economy can support consumer spending on both services and goods.
“We believe this concern is vastly overblown. While services spending clearly has more room to grow to catch up (given the pull back in 2020), a robust consumer balance sheet means that this is not a zero sum game — spending on goods does not need to decline for services spending to increase given the ~$2.3 trillion excess savings on the consumer’s balance sheet,” Shanker said,
Morgan Stanley’s economics team is forecasting a 9% year-over-year increase in services spending in 2021 alongside a 6% rise in goods spending. The outyear forecast is promising even as the comps become more difficult. The firm expects spending on services to climb 8% in 2022 with goods spending increasing 3%.
Shanker pointed out that many of the “services that will see higher spending also need goods to perform/support them.”
Further, if mass inoculations don’t occur until the end of summer, spending on events and experiences may not materially disrupt freight demand in 2021. Late summer through early fall is traditionally the time when consumers transition back to buying goods.
Inventory restocking keeping freight volumes elevated
Outbound tender volumes fell in February as severe winter storms drastically impacted service at most transportation providers. By the end of the month, shipments had recovered. Volumes are now ahead of levels seen prior to the network outages.
While retailer inventories improved during the fiscal fourth quarter ended January, many major chains are still in supply restocking mode as sales growth continues to outpace inventory additions.
Morgan Stanley’s January shipper survey showed net inventories were at the lowest level while the need to restock was at the highest level in the survey’s 15-year history. While February results aren’t in yet, Shanker said that due to the weather, he was doubtful there was any improvement in February.
The restocking need is high but likely to step higher as supply chains take on more merchandise than in prior cycles to avoid future supply shocks like those experienced last year. The change in inventory strategy is expected to add as much as 10% of additional supply for many shippers.
Even with poor weather during February, which kept consumers at home and backed up e-commerce fulfillment channels, retail sales were off only 3% sequentially in the month. Compared to 2020, sales were up 6.3%, with the three-month period ended February 6% higher year-over-year. In fact, retail sales have increased year-over-year in every month since June.
The National Retail Federation’s calculation of core retail sales, which excludes auto dealers, gas stations and restaurants, was up 8.9% year-over-year on average for the December-to-February period on an unadjusted basis. The group is calling for retail sales to rise 6.5% to 8.2% this year, with inbound container imports at major ports climbing 23.3% year-over-year in the first half of 2021.
Rates move higher but TL investors are spooked
With a lack of truck capacity (tender rejections from carriers remain elevated) and sky-high demand, spot rates have continued to step higher. The year-over-year gap in spot rates has widened of late as contractual bid season progresses. Recent indications from TL carriers suggest contractual rates are resetting higher than the high-single- to low-double-digit forecasts previously issued.
Shanker said that has actually scared off some investors. “While investors in most other sectors would cheer new record-high rates, trucking investors/analysts instead kicked off another round of worry over whether the cycle has peaked.”
He said many investors throw in the towel on the TL trade once spot rates reach new highs or truck orders surge. Both have already happened. Rates crossed the 2018 record eight months ago and are sitting at a new high currently. Truck orders spiked at the end of last year but have stepped lower since.
Shanker said the recent weather disruption, which coincided with a seasonal freight uptick, likely means “the spot rate remains elevated from here for a while.” He likened the event to hurricanes around peak season in 2017, which had the added noise of an electronic logging device mandate later that year.
Also, while the addition of new capacity was expected to threaten the fundamentals of a tight TL market, original equipment manufacturers will likely struggle with production delays again in 2021, given raw material and semiconductor shortages.
Current freight cycle has moved normalized EPS higher for TLs?
Shanker believes that normalized earnings per share have reset higher for the TLs, which isn’t reflected in current share prices. “TLs are trading at the largest discount to the S&P 500 despite typically trading at the largest premium,” he added. The current cycle has resulted in a “structural supply tightening,” meaning earnings should be higher throughout the freight cycle than in the past moving forward.
He specifically called attention to Knight-Swift Transportation (NYSE: KNX), which he believes has normalized midcycle EPS of $3 per share now versus the roughly $2 per share that is currently priced into the stock.
Shanker has an “overweight” rating on all of the TL companies that he covers as it is the only group out of the transports trading at a discount to historical valuation multiples.
Driver headwinds a barrier to TL volume growth
Wadewitz believes TL carriers will have the toughest time growing volumes.
The driver pool shrank by 200,000 last year as drivers fearful of contracting COVID sat out, driver schools operated at half capacity and the Drug & Alcohol Clearinghouse sidelined operators. Wadewitz said carriers with more exposure to irregular routes — Heartland Express (NASDAQ: HTLD) and Knight-Swift — will struggle more than carriers that have greater dedicated exposure or the less-than-truckload carriers.
He believes a tight driver market and rising fuel costs favor modes like rail, LTL and intermodal.
The cost-savings spread between intermodal and truck appears to be leveling after falling from year-end highs. Elevated TL rates, driver cost inflation and diesel prices, which have increased sequentially in each week of the first quarter, are supportive of a widening gap between intermodal and truck costs.
“In a tight driver market, we are most optimistic about volume growth for LTL, intermodal and railroads while truck brokers should also realize strong volume & revenue. Driver constraints likely make it more difficult for the truckload focused names to grow volumes,” Wadewitz said.
He is calling for rail intermodal volumes to increase in the double-digit percentage range in the first half of this year, easing to the mid-single-digit range in the second half as the comparisons become more formidable. The second-half volumes forecast could come in better than expected if the inventory replenishment cycle is extended, he added.
Wadewitz said “the freight and pricing backdrops are favorable for most transports” but called special attention to a couple of names. He likes the “clear visibility to strong volume growth” for Canadian Pacific (NYSE: CP) and Old Dominion Freight Line (NASDAQ: ODFL) and the “leverage to strong conditions in both LTL and brokerage” at XPO Logistics (NYSE: XPO), even though the rails and LTLs are trading 20% to 30% above five-year historical price-to-earnings multiples.
