For the second time this year, a truckload-centric transportation company has acquired a less-than-truckload carrier.
Canadian TL and logistics outfit TFI International (NYSE: TFII) announced the $800 million acquisition of UPS Freight (NYSE: UPS) in January. Last week, the biggest TL carrier in the nation, Knight-Swift Transportation, inked a $1.35 billion deal for regional LTL carrier AAA Cooper Transportation.
What’s so intriguing about the LTL space that warrants the significant investment dollars currently rolling in, and what, if any, synergies can Knight-Swift (NYSE: KNX) really extract out of its latest acquisition?
Will there be a lift in equity valuation?
From a financial perspective, the deal isn’t materially accretive to Knight-Swift’s annual earnings: 30 cents per share, less than 10%. Repurchasing shares would have been more accretive or Knight-Swift could have increased its dividend as a means of returning cash to shareholders. Since 2018, Knight-Swift has generated $3 billion in cash flow from operations; $1.4 billion in free cash flow.
However, the deal likely changes the narrative around its equity valuation on two fronts.
The size of the transaction reasserts Knight-Swift as a top-tier acquisition-oriented growth company. (This was the sixth acquisition it has made since the merger with Swift Transportation in 2017.) The deal also provides it with a new growth platform (beyond TL, brokerage and intermodal) to allow it to attempt to tap into the premium valuation multiples placed on the shares of LTL carriers.
Pre-deal, shares of KNX were valued at a 13x price-to-earnings multiple of 2022 earnings estimates. Most other TLs have been trading in the same low-teens multiple band recently compared to the LTLs, where the better operating carriers are trading at mid- to high-20s multiples, and at even higher levels earlier in the year.
Many investors view the highly fragmented TL industry as more transactional and dependent on spot market trends like changes in capacity and rates, which can whipsaw more frequently than in the less fragmented LTL industry.
By comparison, the LTL market is traditionally more rate-disciplined, which provides steadier revenue per shipment. And, while the group spends nearly the same amount on total capital expenditures as a percentage of revenue, the LTLs spend less on maintenance capex, which is often tied to depreciating assets.
Some LTLs allocate half of their capex budgets to real estate (acquisition, construction and expansion), which has asset values that increase over time, thus the lofty multiples. Also, LTL equipment is in service longer than in over-the-road TL operations where some fleets burn through tractors every two years.
The thinking of Knight-Swift’s management team is that the perceived value to shareholders steps higher as some of the high cyclicality associated within the TL industry is lessened.
“We’re here to create shareholder value and part of the way we do that is being a growth company,” Dave Jackson, Knight-Swift CEO, told analysts on a call following the deal announcement. “Part of the way we do that is generating returns that exceed our weighted average cost of capital, and what LTL uniquely offers us is a lower beta, less volatile, more consistent earnings stream.”
If the carrier can successfully grow the new LTL platform to a level materially more impactful to its revenue and earnings over time, it should see its valuation multiples expand in lockstep.
Investor reaction to the deal was favorable. The stock is up 10% since the announcement compared to a 2% decline in the Dow Jones Transportation Average and virtually no change in the S&P 500.
A deep moat keeps most from entering
The top 10 LTL carriers account for 75% of the more than $40 billion industry. In comparison, the TL industry has roughly 50,000 fleets, 90% of which have five or fewer trucks.
LTL requires expansive infrastructure and technology as carriers aggregate numerous smaller shipments on the same trailer. The life of an LTL shipment includes multiple stops, riding on different trucks (local pickup and delivery and linehaul) and different terminals (origination, intermediate and destination). All along the freight is being scanned and handled at facility docks, which requires labor and technology.
The combination of the inputs makes the capital hurdle high for new entrants.
“LTL carriers are deep, valuable entities. They are tech companies, real estate companies, operational powerhouses,” Curtis Garrett, VP of pricing and carrier relations at Recon Logistics, told FreightWaves. “The core businesses here are not very complementary to each other. However there is a lot of harmony on the periphery.”
Advantages and risks for both
Knight-Swift bought itself a regional LTL network and a dedicated contract carriage business by adding AAA Cooper. The carrier has coverage of every ZIP code in the southern U.S. from El Paso, Texas, to the East Coast of North Carolina, down to Key West, Florida. Its terminal map also includes multiple locations in the Midwest (Chicago, Indianapolis and Cincinnati) as well as Lexington and Louisville, Kentucky.
It’s important to note, Knight-Swift will run AAA Cooper as a separate unit with current leadership remaining in place. There isn’t an immediate plan to leverage the terminal footprint, but if they make that move, there are some advantages.
Garrett said the addition of 70 terminals gives Knight-Swift access to more cross docks (3,400 doors), which will allow it to play more in the pool and multistop TL arena. The additional facilities could also provide shorter distances between terminals, which is good for e-commerce and final-mile fulfillment as well as on-time delivery and increasing driver home time.
The regional infrastructure also provides more maintenance shops and fueling stations as well as access to backup drivers. The transaction provides Knight-Swift with a much larger customer base as LTL carriers depend on a large number of shippers to fill their network’s capacity. This should present incremental bid opportunities moving forward.
AAA Cooper will see benefits too.
It may be able to offload the heavier, TL freight that spills into the LTL market when capacity is tight as it now has an internal outlet for the oversized shipments. Removing heavy shipments keeps LTL networks more efficient and increases throughput as heavier loads often means tying up trailers and drivers. It also allows them to focus service on their better-margined LTL accounts.
A notable advantage will be on the linehaul side.
Most LTL carriers have seen significant increases in purchased transportation expense, both rail and truck, as capacity has been tight for roughly a year now. The linehaul move — typically a full truckload from point A to B over longer distances — is an area of expertise for Knight-Swift, which may also be able to provide incremental capacity during tight markets.
Garrett cautions that “forcing too much of an integration or rolling AAA Cooper up into the parent company” would present significant risks.
This isn’t really a synergistic deal, at least not initially. There also doesn’t appear to be a large IT systems conversion or any material upfront integration initiatives.
The plan is to achieve some cost benefits early on in purchasing (fuel, truck buying/replacement, liability insurance, etc.) and risk management through Knight-Swift’s captive insurance companies. The two companies will also benefit from best practices, business intelligence tools and shared technologies.
The deal is not meant to take AAA Cooper from a regional to a national carrier. Knight-Swift management said that could come from acquisitions over time.
In the interim, the deal presents a high-single-digit growth opportunity with incremental terminal additions that are in line with AAA Cooper’s historical growth rates. The combination of revenue growth and cost improvements is expected to take the carrier from operating at a roughly 90% operating ratio to the mid-80% range within three years.
“We’re going to be very careful to allow the existing truckload and then now this LTL business to operate independently,” Jackson said. “As we find the ways to take advantage of efficiencies you know we’ll be very careful and deliberate on that, but there is no immediate, there are no plans to try and merge operationally these types of businesses in a way that can disturb what are already two very, very successful businesses.”
Jackson did say the goal is to take its new LTL platform from a top-15 carrier to a top-10 carrier over time, which likely represents a 50% increase in revenue from its current position.
Garrett believes that as long as each unit “keeps growing as a stand-alone business and playing together around the edges,” the deal is promising.
Asked who the clear winner was, Garrett said, “Both benefit from this, however Knight-Swift has acquired a higher-valued, fast-growing company that will grow as the LTL industry grows with e-commerce and micro supply chain.” He referred to LTL carriers as “the prize.”
He also sees AAA Cooper benefiting from increased availability to capital through Knight-Swift’s balance sheet and lender group.
“Both benefit from flexibility and increased options as well as redundancy that this provides,” Garrett added. “Both will play off each other.”
