This morning (July 8) Morgan Stanley’s transports equities analysts cut their 12-month price targets for most of the companies they cover, but said that following the release of second quarter earnings it may be time to invest in the cyclical stocks again.
The analyst team, led by Ravi Shanker, expects second quarter results for transportation and logistics companies to be poor, and does not expend a meaningful rebound in the second half of the year.
“The first quarter’s weakness was largely driven by weather, destocking and tariff concerns and many of those headwinds continued into the second quarter as well, together with underlying economic/demand weakness robbing momentum from what is a seasonally strong quarter for the group,” Shanker wrote.
The good news is that Shanker thinks that investors have overcorrected and are now too pessimistic on the sector. Morgan Stanley expects earnings misses from the majority of railroad stocks, except for Canadian Pacific, which has some project-related “idiosyncratic” volume growth, mixed calls for truckload stocks, mostly misses for less-than-truckload stocks, mostly misses for third-party logistics companies, and have expectations in-line with guidance from the parcel carriers.
As transportation companies revise downward their guidance for earnings in the second half of 2019, Shanker expects their multiples to rise from current ‘trough’ levels back to ‘midcycle’ levels.
Here’s how it works – equities analysts use a price-to-earnings (P/E) ratio to determine how ‘expensive’ a company’s stock is. The ratio is simple, just the current price of a share divided by the expected earnings per share. The P/E ratio tells an investor how much she has to pay for a company’s earnings, or how many years of expected earnings it takes to buy part of a company. As transportation companies guide downward, their expected earnings, the denominator in the ratio, will drop, bringing the P/E multiple upward.
Shanker thinks that normalizing P/E multiples could be the trigger that will bring investors back into the transport sector.
“Transports are relatively out-of-favor as a group and we believe investors are waiting to appropriately time their entry into the “cyclicals” (particularly TLs/LTLs),” Shanker wrote. “Lowered FY19/20 estimates and continued solidity/improvement in TLFI/pricing data could be that catalyst in the coming weeks.”
If the TLFI – Morgan Stanley’s proprietary Truckload Freight Index – does solidify, then investors may ‘call the bottom’ and start buying again.
That’s what Shanker meant by writing “the second-derivative trade is on” – things are still bad, but the pace of the decline is slowing. The ‘first-derivative’ would simply be a year-over-year comparison, such as the national average spot rate being down 20 percent year-over-year. The ‘second-derivative’ would be the rate of change in that comparison, for example the fact that on June 3, the average spot rate was down 27 percent year-over-year and is thus gradually improving against its year-over-year comparison.
By the time the trucking industry is back to positive year-over-year growth, Morgan Stanley is suggesting, it will be too late to buy the sector because growth will be priced in. But now that the second-derivative is looking better (comparisons are still negative but improving), investors could be willing to re-enter.
“Consequently, a lowered bar with consensus/guidance cuts could see oversold names – particularly TLs [truckload carriers] – rebound on 2Q results, as multiples start to normalize toward mid-cycle from trough levels,” Shanker wrote.
Shanker said his team lowered price targets across the transports sector by anywhere from 1 percent to 14 percent, with an average price target cut of 4 percent. J.B. Hunt (NASDAQ: JBHT) took the biggest hit on a percentage basis, sliding from a $95 price target to $88. Norfolk Southern (NYSE: NSC) dropped from $138 to $130; C.H. Robinson (NASDAQ: CHRW) and Echo Global Logistics (NASDAQ: ECHO) both saw their price targets cut by $2, to $65 and $23, respectively.
On those asset-light freight brokerages, Shanker said that weaker volumes and intensifying competition will offset the favorable spread between contract and spot pricing, which has held brokerages’ costs below their prices.
“We expect misses at all the brokers – spot vs. contract spread remains positive (at similar levels to 1Q) but will be offset by weaker volumes and more competition from new players resulting in negative pricing,” Shanker wrote.