We spent last week meeting with some of the largest investors in the transportation industry, and had a few key messages that we wanted to deliver. As is often the process, we ended up learning as much or more than we taught, and after listening to their educated dissections of outlook, we came away with a distilled version of our outlook and a clear understanding of investors current concerns. Since they are approaching the industry from a pure financial investment perspective and don’t have a single ‘ongoing operational challenge’ thought in their heads, we thought Freightwaves readers might appreciate the chance to look at the industry from a different vantage point.
What is our distilled message? The 2009 through 2014 timeframe was the first industrial led recovery in the U.S. since 1961. This industrial activity was driven by fracking and the success of that industry resulted in the dramatic expansion in the infrastructure and earnings of railroads, the chemical industry, the plastic industry, pumps and cranes, domestic machine tool and die companies, to name a few. This activity came to a screeching halt in the fall of 2014 as oil fell dramatically in price below the marginal cost of its production via fracking. As oil climbed back above $45 a barrel in the fall of 2016, fracking activity resumed and the industrial ‘mini-recession’ ended. Coincidentally, equity markets began to reflate and millennials finally began to form households in meaningful volumes. As a result, we are currently in an environment in which both the industrial and consumer economies are not only growing but accelerating in their rate of growth.
Where are we in the cycle? Obviously, this isn’t the beginning of the recovery with the economy just starting to climb out of the recession as it was in 2010 and 2011, but with the ‘mini-recession’ of the industrial economy just ending in the fall of 2016, we aren’t into the mature years of the industrial cycle. Since the consumer really didn’t recover from the 2009 recession and spent almost 6 years in a slow growth, no growth mode, we certainly aren’t in mature years of the consumer cycle either. To use a baseball analogy, we aren’t in the first three innings of the game, but we aren’t in the last couple of innings either.
Why does it matter? When investing in cyclical companies, such a transports, it is important to first understand what part of the economic cycle we are in. At the beginning of the cycle, they almost all go up, to varying degrees, but the asset based cyclicals tend to be one of the best performing investments as they emerge from a recession. Conversely, investments in asset based cyclicals at the end of an economic cycle tend to be one of the worst performing. As a result, investors want to own asset based cyclicals at the beginning of the cycle, but not at the end.
Are there cyclicals that can be owned now? If we are right about where we are in the cycle, which the freight flows confirm we are (e.g., almost all modes and segments or not only growing but accelerating in their rate of growth), then the requirements for successful investing in asset based cyclicals requires a positive answer to two questions:
1. Can this company continue to generate revenue growth? Through volume or yield, preferably a combination of both, can the company in question continue to generate revenue growth that is preferably at least in the low double digits (>10%)?
2. Is the incremental margin on this revenue growth higher than the current margin? This is actually more important that the first question, but only if the answer to the first question is yes. If the company, in which you are potentially investing in, is generating 20% revenue growth but no incremental margin (the total operating margin is going to stay the same or get worse), it is far less attractive an investment than a 10% revenue growth company whose overall operating margin will go from 5% to 10% to 15% (e.g., high incremental margin). This is of such paramount importance, because if there isn’t positive incremental margin in the top line growth, then there tends to be large decremental margin when the cycle does come to an end and revenue starts to decrease. Every investor who has lived through an economic downcycle knows how painful it can be to watch top line contract and operating margin collapse.
This is how Wall Street thinks about investing in asset based cyclical companies. It is a pure financial perspective with some applicable wisdom for those whose daily thoughts are dominated by ongoing operational challenges. I challenge you to stop and think like a Wall Street investment fund for a few minutes every day. That additional truck or trailer or routing software may make it easier to execute your daily operational challenges, but will it create revenue growth? If so, how much additional revenue and will that additional revenue produce a margin that is greater than the current overall margin? If not, serious consideration should be given toward delaying that capital investment until it does, or redirecting that capital toward something else in the business that does create a higher margin.
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