2019: The Year That Wasn't But Was

While management teams from most transportation companies may be eager to turn the page on 2019, investors are likely hoping for more.

The publicly traded shares of the truckload (TL) carriers, as well as other modes of transportation, performed ahead of the broader markets and major indexes and averages in what was a poor year for TL fundamentals. On a market cap weighted basis, which diminishes the negative impact seen by a couple of carriers that experienced one-off events like shuttering business units or outsized expenses, the TLs outperformed.

Sources: SONAR, Seeking Alpha & Yahoo Finance

2019 In Review

Most carriers entered 2019 will their coffers replenished after a historically strong 2018 freight market looking to reinvest fresh capital back into their networks and pursue new offerings and technologies. While most management teams weren't expecting a reprise of 2018 as demand had begun to wane in the fall of 2018 with spot rates in full retreat, what they received was shocking even when taking diminished expectations into account.

DAT Longhaul Van Freight Rate – SONAR: DATVF.VNU

The seasonally weak first quarter of 2019 was expected to be lackluster as many shippers pulled forward goods ahead of the new year's tariffs creating an inventory overhang. While most first quarters are soft coming off of peak shipping season and holiday purchasing, the 2019 version had an extra obstacle in already packed warehouses.

As the quarter progressed, freight shipments did not. Harsh winter weather, dubbed a polar vortex, became the new explanation for sluggish demand. The group did have a bit of an ace in the hole to buffer earnings degradation in the form of higher contractual rates when compared to the period prior. Negotiated during the 2018 boom, contractual rates for most carriers ranged from increases of mid-single to low double digits on a year-over-year comparison basis.

Even with the notable step down in TL fundamentals, the TL stocks and the broader markets continued to accelerate through the first quarter, following a precipitous sell-off at the end of 2018. That sell-off was attributed to several factors, including 2019 tariff uncertainty, the expectation that interest rate hikes would not cease, cash outflows from retail investor accounts and a growing expectation that a recession was probable in 2019. 

Earnings estimates were adjusted lower, but no one was overly alarmed.

Cold weather persisted into the spring and the retail sector, especially the do-it-yourself sector, noted that demand was sluggish. The "late-spring" theory continued, the industrial sector stumbled lower and some started to question the lack of a normal seasonal uptick in demand. However, most management teams kept kicking the can down the road, assuming that a late spring would relent and pent-up demand would create a surge in retail activity, burning off those excess inventories. Poor weather continued, highlighted by heavy flooding in the Midwest. Most management teams began to publicly acknowledge their concerns around the lack of seasonal demand and too much truck capacity. However, they held out hope for a strong June, typically the best month of the year.

All the while truck capacity continued to move higher on a year-over-year comparison due to new truck orders placed during the peak of the 2018 market when spot rates surged.

Class 8 Truck Orders – SONAR: ORDERS.CL8

While TL management teams weren't ready to cut numbers heading into June, equity analysts had seen and heard enough. Considerable data points and discussion about sluggish demand, increased capacity and the expectation for declining contract rates were enough for analysts to begin ratcheting forecasts lower.

As earnings estimates were being reeled in, tariff threats escalated, this time aimed at Mexico. The increased fees, which threatened to slow down freight traffic on the north-south cross-border trucking lanes, representing more than $1 billion of cargo per day, provided another hurdle for the stocks.

The combination of these events led the TL group to its lowest level of the year, excluding the lower levels seen at the beginning of the year when the market was recovering from the Dec. 2018 selloff.

Stock Prices (S&P 500 and Truckload Carriers) – SONAR: STOCK.SPX

With analysts no longer on board with their prior forecasts, management teams made official what the market seemed to know all along — June was a bust. A few TL carriers preannounced lower-than-expected financial results in July before the second-quarter earnings season commenced citing operating ratio (OR) headwinds like soft demand, excess capacity and declining utilization. Those that didn't officially provide an earnings warning noted the weakness in the TL markets when they released results.

• U.S. Xpress lowers outlook for second quarter and full-year
• Knight-Swift cuts its outlook a day after the truckload carriers rally
• Another truckload carrier announces earnings warning
• Landstar sees truckload fundamentals remaining under pressure in third quarter of 2019
• Werner reports slight miss, lowers truckload pricing forecast
• Schneider reports a miss, lowers guidance and shutters a division

While many had hoped that second-quarter earnings revisions would be a one-time event, it has taken at least a couple of adjustments so far to rightsize earnings estimates to reflect current market trends.

Following the second quarter and through the third quarter, a race to the bottom ensued with no analyst wanting their earnings estimates to be above consensus estimates. Third-quarter 2019 earnings reports from the TL carriers provided more of the same. Several carriers were unable to meet consensus estimates and analysts were forced to move numbers lower again.

There appeared to be an inflection point at the end of the summer as many carriers began reporting modest improvement in demand with the hopes of a decent peak shipping season. Those expectations appear to have not fully materialized or to be somewhat muted, with a couple of companies concluding there would be no peak in 2019. There has been a notable improvement in volumes and tender rejections to close the fourth quarter, but likely not enough to salvage the period.

Tender rejection rates measure the amount of contracted freight that carriers reject. As the rate at which carriers reject loads increases, truck capacity tightens.

Outbound Tender Volume Index and Outbound Tender Reject Index – SONAR: OTVI.USA – OTRI.USA

Further, the near six-week UAW strike at General Motors GM was a real earnings hit for some carriers in the third quarter and likely a bigger headwind in the fourth quarter as it dragged on for the bulk of October.

Even with the fundamental headwinds experienced throughout 2019, the TL group along with the broader market continued to perform. Of course, three rounds of interest rates cuts (the first since the 2008 recession) beginning at the end of July provided a shot in the arm.

Analysts Become More Bullish On The TLs

The thought that a backdrop of manufacturing sector weakness, poor freight fundamentals and declining earnings estimates presented analysts with the opportunity to become more bullish on the group sounds counterintuitive.

However, beginning in the late summer analysts began to look at the TLs more positively under the guise that fundamentals — sluggish demand, excess truck capacity, significantly lower TL spot rates and declines in contractual rates — were pretty well washed out. Many analysts used historically reasonable stock valuation multiples and the rationale that freight recessions only last four to six quarters and the group appears to be at this cycle's midway point as reasons for the upgrades.

The other primary catalyst for the upgrades, and the most fundamentally sound, is the expected capacity shakeout set to occur in 2020.

Capacity The Real Catalyst

Nearly 800 carriers have exited this year, including the largest ever, and many more have downsized and are operating fewer trucks.

There are several catalysts on the horizon that could materially trim truck capacity in 2020 and beyond.

After overbuying equipment during a robust freight market with deliveries continuing well into 2019, a meaningful capacity exodus may be materializing. Current truck orders have declined significantly and are running well below replacement levels, sub-20,000 orders per month.

The date mandating the final conversion to the more restrictive electronic logging devices (ELDs) from automatic on-board recording devices passed in mid-December.

The Drug & Alcohol Clearinghouse, which aims to speed the reporting of drivers' positive drug or alcohol tests, requires reporting of failed tests starting Jan. 6. Further, some have estimated that if hair follicle and saliva testing became the new norm, approximately 10% of the current driver population would be ineligible.

A new wrinkle was added on Dec. 26 when the Federal Motor Carrier Safety Administration (FMCSA) announced that the minimum rate for random drug testing would increase from 25% to 50% for the 2020 calendar year in response to an increase in positive tests.

The industry has seen insurance premiums spike by 50% to more than double in response to "nuclear verdicts" — those jury awards in the tens of millions of dollars. Even the financially strongest carriers have noted the negative earnings impact premium increases have presented.  

The International Maritime Organization (IMO) 2020 regulation, effective Jan.1, seeks to significantly reduce sulfur emissions. As the maritime industry begins to use fuels with lower sulfur content, demand for refined products is expected to increase. Some have estimated that diesel prices could increase by as much as one-third, placing increased financial strain on the smaller carriers, which may have inadequate fuel surcharge programs in place to pass through fuel cost increases to shippers.

California Assembly Bill 5, or the AB 5 rule, is effective Jan. 1 as well. The rule limits the definition of independent contractors, potentially requiring carriers to reclassify independent owner-operators with whom they contract to haul loads as company employees. While the new requirement is being challenged, some carriers already have begun to alter their operations in California. Additionally, many believe that other states will review their own classification standards for independent contractors.

The new regulations along with cost inflation seen on almost every expense line of a carrier's profit-and-loss statement have most analysts and industry forecasters in lockstep belief that more carriers/capacity will be forced to the sidelines.

Bulled Up Heading Into 2020

Equity analysts have become more bullish on the TL space, with some saying that the bottom in the current freight recession likely occurred at the end of the summer. As earnings estimates continued to move lower, many analysts called an inflection point in ownership of the stocks, citing an improving capacity dynamic in 2020 and "reasonable" stock valuations as reasons to become more positive on the stocks.

• Analysts more bullish on TLs, valuation a key reason
• Truckload estimates lower, sentiment higher
• Truckload stocks upgraded as fundamentals ‘bottom'

However, as the year came to a close, earnings estimates may still be too high for the fourth quarter of 2019 and 2020.

Knight-Swift Transportation Holdings Inc. KNX provided an earnings warning on Dec. 19, lowering fourth-quarter expectations again, this time by 20%. The company cited excess capacity, the lack of a peak season and the expectation that future rates will be lower in the near term as reasons for the reduced forecast. Additionally, the carrier "expects to revise" its first-quarter 2020 guidance when it releases fourth-quarter results in January.

But that may not matter.

In the near term, analysts seem convinced that the worst of the degradation to TL fundamentals is in the rearview mirror and that the best time to own the stocks is midway through a freight recession. Further, trade and tariff headwinds have calmed, at least temporarily, and many have forecast a stable interest rate environment in 2020. The consumer continues to be the backbone of the economy, spurred along by 50-year lows in unemployment and modest wage growth. Also, it's worth noting that the transports do well in presidential election years, up in all of them since the '90s, excluding the sell-off in the back half of 2008.

With regard to the TLs, year-over-year comparisons, both volumes and price, will likely inflect positively at some point in 2020 barring a negative catalyst like another step down in the industrial patch, trade, tariffs, etc. For now, it seems like analysts are bracing themselves for a rocky start to 2020 as their forecasts are largely back-half or late-2020 loaded. They appear content with the expectation that truck capacity will be purged meaningfully enough to raise TL rates and earnings at some point in the year. With TL valuation multiples within historical ranges and the stocks continuing to move higher, it's now a race to see if future earnings expectations can catch up with valuation multiples that will become stretched if the rally continues.

For a really bad year for the TLs, TL investors are probably content with a repeat.

Image by analogicus from Pixabay