Our WR Transport has badly underperformed since the market highs in late Sept. (-26% vs. the S&P 500 down 16%) as freight volume growth has started to slow and trucking capacity continues to normalize. We expect freight volume comps will be increasingly challenged in 1H:19, which we expect will lead to slower pricing for most transports in 2H:19 and into C20. While the stocks have already underperformed and valuations appear increasingly attractive, downward EPS revisions haven’t even begun yet. So it seems too soon to paint a constructive view on transport stocks for the first half of the year.
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Based on a strong finish to the year, volumes finished above our expectations for most of the rails in 4Q (ex-KSU), although mix headwinds appear worse than expected for some of the rails. As a result, we expect mostly in-line 4Q reports, other than CP where we expect a strong beat, driven by positive mix, strong operating leverage, and higher real estate gains. Among the other rails, we’re slightly below Cons. for CSX and KSU, and more in line for the rest.
Following 2 straight years of material outperformance, our WR Transport index fell 15% in C18 and underperformed the S&P 500 by over 900bp thanks to a terrible December when our group fell 16%. Despite the benefits of tax reform, strong freight volumes for most of the year and record TL pricing gains, our group underperformed badly on “peak cycle” fears as TL spot rates inflected negative and freight volumes started to slow.
From a stock standpoint, 2018 was a year to forget with our WR Transport index falling 15% and underperforming the 6% drop in the S&P 500. The Rails (+0.4%) barely eked out positive returns, but all other transport sub-sectors badly underperformed with the TLs (-35%), Integrators (-30%), Forwarders (-14%) and LTLs (-14%) down the most. Not something we would have guessed at the beginning of last year just following tax reform and amidst an accelerating economy and perhaps the tightest truck market ever. But rather than rehash a tough year for the stocks, let’s look ahead and review the top 10 themes, catalysts and questions on our mind entering 2019.
We spoke with a contact at the West Coast Ports about recent freight trends. Volume growth has been extremely strong the last couple of months as shippers rushed to move cargo into the country ahead of originally planned tariff increases in the beginning of 2019. But the higher than anticipated volumes have led to operational issues at the port. In addition, warehouses are full and it’s very tough to find rail flat cars and crews. So lots of freight remains on dock at the port and hasn’t yet moved inland. Meanwhile, December port volumes have remained strong despite the tariff pause as overseas production that ramped up couldn’t be suddenly halted. But some ships have slowed more recently to avoid docking around the holidays, so some December cargo could trickle into early January. And with the postponed tariff increase, our contact now expects port volumes to remain strong until Chinese New Year and doesn’t expect as much of a lull in January as previously thought.
Last week, the Surface Transportation Board (STB) released its annual review of rail returns on capital. When a rail’s return on capital exceeds the industry’s cost of capital, that rail is deemed “revenue adequate” for the year. While annual revenue adequacy has no near-term regulatory implications, this is an important metric longer term with future implications for potential rail regulatory reform.
We spoke with a large manufacturing shipper about current TL pricing and capacity trends. Our contact’s tender acceptance rates have held steady this peak season around 95%, improved from 90% over the summer. Given looser TL conditions, our contact noted that truck brokers are starting to aggressively go after market share. As a result, spot market premiums have fallen from 50% in July to just 5% on average currently including several lanes where spot rates are now below contractual rates. And looking ahead, this shipper expects spot rates to take a big seasonal step down after Christmas and thus fall below contractual rates on even more lanes. Our contact still expects his TL rates to increase 3% next year, but this is down from his 5%+ expectation two months ago, and he continues to have a downward bias to his expectations. This shipper also now expects just modest intermodal rate increases next year given the looser TL market and continued intermodal service issues. But even with intermodal service issues and lower fuel, our contact has no plans to shift any intermodal business back to trucks next year. Lastly, this shipper is also preparing for an LTL bid and expects rates to increase 4%-6% y/y in C19, decelerated from 7%-9% increases this year.
After the close (12/18/18), FDX reported adjusted F2Q EPS of $4.03, above Cons. of $3.94 and our estimate of $3.78, although most of the upside to our model came from a lower than expected tax rate. Despite the F2Q beat, FDX lowered its full-year EPS guidance by 8% at the midpoint, which implies F2H guidance 13% below prior Cons. While expectations were very low heading into the report, the implied cut to 2H guidance and thus the run-rate entering F20 was worse than we expected.
Last week, we hosted meetings in Washington, DC with key railroad legislators, regulators, and lobbyists. It’s clear from our meetings that regulatory and legislative risks for the rails are currently very low. While regulatory activity at the STB will increase whenever the STB increases from 2 to 5 members, we sense the STB is more focused on rail service than any material regulations that could negatively impact rail pricing power. Thus, we don’t expect any upcoming regulatory risks that would negatively impact sentiment on the rails and weigh on valuations.
. The STB released Nov. headcount data for the U.S. rails over the weekend. Total headcount increased 2.1% y/y, the largest y/y increase in over 3 years. Headcount also ticked up 0.2% sequentially, the 10th straight m/m increase. With rising headcount and slowing volume growth (+2.2% y/y in Nov.), labor productivity has flattened out for the group overall after 34 straight months of positive productivity gains. That said, we’re seeing a clear divergence with headcount for CSX, NSC and UNP down 2% y/y on avg. and headcount for the other rails up 6% y/y on avg.