Summary
While I believe CVTI is an attractive long idea, those with a bearish view of the industry and/or the economy can probably realize attractive returns by pairing CVTI with a short in one of the other truckload (TL) names.

Thesis

• Regulatory change has structurally increased pricing in the TL industry.

• The impact of the unprecedented price increases is not being captured adequately in earnings estimates for virtually all TL companies.

• CVTI’s historical earnings are significantly understated due to a fuel hedging program that has since been discontinued.

• Operating margin assumptions implied by earnings estimates for CVTI are unrealistically low compared with the rest of the industry.

• Most TL companies are already trading near trough P/E multiples.
  
  

Industry Overview
The TL industry provides the service of picking up and delivering a full trailer of goods from one location to another. The length of the haul can vary considerably, but typically averages 450-550 miles for the public TL companies.

There are three main types of trailers used in the industry. The standard dry van is the largest segment and the goods being shipped are primarily retail products. Refrigerated vans mainly transport food and beverage, while flatbeds move construction and industrial goods.

Services are also provided via three different models. If a shipper has an immediate, short term or irregular need, services are provided on a spot market basis where rates fluctuate daily. Most services provided by the public TL companies are provided on a contract basis whereby the trucking company agrees to provide the customer service on specific routes at the contracted rates. These contracts are typically 12 months in duration. Finally, some customers want a dedicated fleet of trucks to serve them. Contracts of this nature are normally 2-3 years in length.

Unlike the shipping, air transport, railroad and LTL (less-than-truckload) industries, the TL market is very fragmented because there are not significant infrastructure investments required. There are a few hundred thousand small companies each operating 1-5 tractors.  

Regulatory Change
Among the numerous regulations governing the industry, the Hours of Service (HOS), enacted by the Federal Motor Carrier Safety Administration (FMCSA), are among the most important. These regulations establish limits for the number of hours that may be driven and the amount of rest that is required for all drivers in the TL industry. Historically, drivers would maintain the records of their activities in a paper logbook. Not surprisingly, given that drivers are paid based on the number of miles driven, these logs would frequently be filled out at the end of the day and the driver’s actual activities would be retrospectively adjusted in order to keep the reported hours driven within the legal parameters.

Beginning in December 2017, the FMCSA began requiring all trucks to have an Electronic Logging Device (ELD) installed. This device records the driver’s activities in real time. It is connected to the truck’s engine and automatically reports time spent as driving whenever the truck is in motion. There is now virtually no way to drive more hours than the regulations specify.

Eliminating the ability of drivers to exceed the legal number of hours has reduced industry capacity.  Before the ELD mandate, typically only the largest fleets, including all the public TL companies, had these devices installed.  Most industry estimates were that about 70-80% of trucks needed to have ELDs installed and productivity for these vehicles would decline by 3-10%.  This implies aggregate industry capacity has been reduced by 2-8%.

Driven mainly by the need to offset lower productivity per truck, but also aided by a strengthening economy, the industry has realized unprecedented price increases in 2018. Spot market rates have been up 30% for most of the year and are still running 10% above levels from last year in September. Contract rate increases have continued to accelerate throughout the year, with data from August showing 11% gains. To put this in perspective, contract rate gains peaked around 7% coming out of the financial crisis and 8% in the strong freight market of 2014.

Because the public TL companies have been using ELDs for years, they have been huge winners from this regulatory change, reaping the benefits of the price increases while suffering none of the offsets from lower productivity.

Street Estimates For TL Companies Are Too Low
Street consensus estimates for virtually all TL companies are too low. This is because the estimates are generally assuming incremental operating margins of roughly 20%.  The following tables show implied incremental operating margins for 2018 and 2019 based on Street consensus estimates.

With the exception of USAK, profits for these companies are dominated by their truckload segment.  For CVTI, KNX, HTLD and WERN it is over 90% of operating income, while it is 80% at MRTN and 70% at SNDR.  Consequently, the economics of this business needs to be the focus of any analysis.

To be fair to consensus estimates, looking back over the past 25 years, incremental margins of truckload segments have been all over the place. 20% is probably not far from the average incremental margin seen when the industry is in an upswing.  However, given price increases are running at levels never seen before, I believe incremental margins will also be far above historical averages. The following model is my attempt to provide some insight into the impact of price increases on the truckload business model. It is intended only to provide a quick and dirty approximation of incremental margins under various price scenarios.

The public TL companies have adjusted operating margins (defined as operating income/revenue before fuel surcharges) ranging from 10-20% for their truckload segments, so I will use 15% as an average. Labor is roughly 50% of the cost structure and the other 50% is comprised (in order of magnitude) of depreciation/rent, maintenance, insurance, fuel, and a few other smaller categories.

Because of the chronic shortage of truck drivers, TL companies have to raise driver pay at rates close to, or even above, the price increases they obtain from their customers. Drivers are about 75% of total employees. For the sake of simplicity and to be conservative, assume all labor costs increase at the same rate as price increases. For the other bucket of costs, assume they increase at the rate of inflation.

In 1H18, TL companies have been realizing price increases of about 10%. Running that through the model would lead one to expect incremental margins near the 50% range. For most companies, this is a close approximation of what they have actually reported.

I think price increases in 2H18 will be in-line or even above levels seen in 1H18.  This is because the substantial majority of truckload revenue comes from contracted business, not the spot market.  While contracts are signed throughout the year, contracting season is heavily weighted to 2Q and 3Q. This means 2Q18 results did not yet have the full benefit of contract repricings.  Additionally, as noted before, contract price increases have accelerated every month in 2Q18 and 3Q18. There will be some offset from the decline in spot rate increases from 30% to 10%, but given that spot is typically not much more than 10% of the business, the net pricing impact should be neutral to slightly positive.  If price increases stay around 10% for 2H18, incremental margins should remain close to 50%.

Given normal contract durations of 12 months, this dynamic will provide a lot of support to realized pricing through 1H19.  The big question is: what happens to pricing during the 2019 contracting season? My base case assumes at least 3% increases driven by my belief that: wage gains continue to support consumer spending; inventory levels for both the industrial and consumer goods are in good shape minimizing the risk of an inventory correction; GDP growth stays above 2% through 1H19.  Combined with the pricing rollover from 2018 contracts, this should put incremental margins at 30% in 2019.

With the exception of KNX and HTLD, where I am close to Street numbers, my assumptions about incremental operating margins for 2018 and 2019 put my EPS estimates 5-7% above the Street for 2018 and 10-15% above in 2019.    

CVTI Historical Earnings Are Understated
CVTI stands out because its historical earnings are understated. Uniquely amongst the TL companies, CVTI employed a fuel hedging program to lock in its costs. Unfortunately, when the oil market started to decline in 2014, CVTI found itself in the position of having locked in fuel costs at levels far above market costs.

This headwind persisted for four years, impacting EPS by $0.12 in 2014, $0.52 in 2015, $0.56 in 2016 and $0.14 in 2017. Looking at the peak EPS year of 2015 demonstrates the magnitude of this impact. GAAP EPS for that year was $2.30, but after backing out the benefit of a tax credit and the commutation of an insurance policy, adjusted EPS was reported as $1.93. Adding back the $0.52 drag from the hedges means EPS, on a basis comparable with the other TL companies, was $2.45 – a change of 27%.

CVTI has not hedged any fuel exposure since 4Q15 and the last of the hedges will roll off in 4Q18. Hedges have been a $0.03 boost to EPS in 1H18 and should add another $0.04 in 2H18.

CVTI Operating Margin Assumptions Are Unrealistically Low
In large part due to the understatement of historical earnings, CVTI operating margin assumptions are unrealistically low when compared with the other TL companies.  The following table shows truckload segment operating margins realized during the past three peak trucking markets and my estimate of the 2019 truckload segment operating margin implied by Street consensus.

Two adjustments are required to the reported numbers to calculate the truckload segment OM for CVTI in 2015. First, the $15.3mm drag from hedging losses must be added back. Second, CVTI now includes corporate overhead within the truckload segment, so that cost must be subtracted. This results in the 12.9% OM shown in the table.

CVTI did recently acquire LandAir at the beginning of 3Q18. The company has $120mm revenue of which $80mm is TL. Based on guidance for EPS accretion from the deal and a recent 8K filing, it looks like operating margins are in the 7% range. Given their relative size, this should only dilute CVTIs prior peak TL margins by 100bps.

If I assume CVTI TL margins decline by an additional 100bps, which would be worse than expectations for any of the other TL companies, that would make 11.0% a reasonable estimate of CVTI TL margins in 2019. Relative to the 8.25% implied by Street consensus, this would add about $0.75 to EPS and put 2019 estimates at $3.40.

Most TL Valuations Are Near Trough P/E Multiples Even On Street Consensus EPS
The caveat here is that there are fewer than 10 publicly traded TL companies and most have experienced company specific operating challenges at some point.

With that being said, TL industry operating profits have shown a very consistent pattern of five good years (95-99, 02-06, 10-15) followed by two years of declining profits (00-01, 07-09, 16-17). The stocks have also consistently peaked 9-12 months before earnings have and traded at a P/E of 18-23x those peak earnings.  More importantly, from a risk management perspective, the stocks have generally bottomed at 12x the peak earnings. The only real exception to this has occurred when financial leverage has gotten too high at various companies.

While it is possible to construct a scenario in which the TL companies fall short of 2019 Street consensus, in my opinion this would require a degradation in economic conditions that is not being discounted in the overall stock market, so the indexes would also likely post negative returns. Unless one believes historical valuation levels won’t hold, there should not be much more than 10% downside for CVTI, KNX, SNDR, WERN relative to the indexes.

Addressing The Bear Case
The bear case, which has dominated sentiment on the stocks recently, centers on the strength of class 8 truck orders and decelerating increases in spot rates.

Class 8 truck orders running above 500,000 units on an annualized basis has been a pretty good indicator of a deteriorating operating environment for the TL companies 12 months later.  However, prior to 2018, this has only occurred twice – in 1999 and 2006. In both instances there were significant economic events, the tech crash in 2000 and the unfolding mortgage crisis in 2007, that likely also had a major impact on the profit declines.  I don’t see a similar event occurring in 2019 and, if one did, it would have repercussions far beyond the TL industry.

Spot prices typically lead contract prices by 6-12 months, so a decline in spot rates will usually lead to weak contract pricing.  Spot markets have decelerated markedly. Pricing in June and July was running up 30% on a Y/Y basis and that went down to 20% in August and 10% in September.  While this is a dramatic slowdown, under normal circumstances 10% spot market increases would be viewed as indicative of a very strong market.

Additionally, outside of a spike in June & July, spot rates have stayed in a tight range from $2.12-$2.15 since February, so the deceleration has been coming from tougher comps, not a decline in rates.  Rates in the last week of September stood at $2.15, higher than rates seen in each month of 4Q17. Even if rates continue to stay flat, this means spot prices stay positive until Jan 2019. However, the fourth quarter is peak shipping season and spot rates have a strong tendency to rise during this period.

January 2019 will face a very tough comparison from the prior year, when spot rates spiked in the wake of the ELD mandate becoming effective, and may show a decline. However, it typically takes several months of declines to push contract rates to levels that pressure margins.

Price Target
I think CVTI earns $2.50 in 2018 and $3.40-$3.75 in 2019.  Once contract pricing for 2019 becomes clear, which should occur by the time CVTI reports 1Q19 EPS in late April, I think the stock could start moving back to a 15-16x P/E, implying a target price of $55-$60 by the end of 2019.

Risks
CVTI experiences problems in the integration of their recent acquisition.
The trade war escalates significantly.
The Fed raises rates more than expected, leading to slower economic growth or a recession.