Accepting a cyclical downturn is never easy, as cycles tend to defy expectations in terms of duration and depth. In addition, Hub group (NASDAQ:HUBG) hasn’t really sold much since its peak, despite the likelihood lower intermodal and brokerage rates and some lower volumes as economic activity slows. I think there are good reasons why Hub Group hasn’t sold much, as it is one of the best run intermodal/logistics companies that I am.
Hub Group shares are up around 40% since my last updateeasily outperforming other stocks I monitor in space, including CH Robinson (CHRW), J.B. Hunt (JBHT), Schneider (NRDS), and XPO (XPO). I see some risk in the gap between longer-term analysts’ sell-side estimates and management’s targets (the sell-side is higher), and similarly I see a risk that the next 12 to 24 months will be tougher economically than currently expected, but it’s hard not to like the longer-term value proposition here.
The End of the Big Beat-and-Raise Cycle
Hub’s third-quarter results weren’t bad, but they were a break from the more significant beat-and-recovery quarters as the freight boom cycle comes to an end.
Revenue was up 26%, lacking about 6%. Intermodal and transportation revenue increased 22%, with intermodal revenue per load up 31% and volume down 6%, while truck brokerage revenue increased 63% (boosted by mergers and acquisitions) and logistics revenues increased by 12%. Compared to expectations on the sell side, brokerage and logistics led to failure.
Gross margin improved 180bps YoY but fell 100bps QoQ to 16.5%, but still good about 20bps on the sell side. Operating income almost doubled (+96%), beating 4%, with an operating ratio improving by 310 bps to 91.3% (the operating ratio is essentially the inverse of the operating margin). exploitation, so less is more). Relative to Street’s expectations, the pace was driven by operational efficiency.
The guidance was mixed and essentially represented a continuation of the trends seen in the third quarter report, with lower revenue (down about 2%) and stronger gross margin (a midpoint of 16.6% vs. to a previous average sell-side estimate of 16%).
Prepare for a weaker environment
There is ample evidence in the freight industry that the boom is over and the cycle is about to reverse. Volumes are down, rates are down, and companies are “battling down the hatches” on guidance and setting expectations for 2023. It’s important to note that many of the best-run companies (I’m including Hub and Swift-Knight (KNX) in this group) indicate higher results during this next phase of the cycle as a by-product of the investments and improvements made in recent years, as well as certain structural changes in the market (intermodal, for example , represents a larger share of the freight market than in previous cycles).
Hub Group recorded a slight underperformance in intermodal this quarter – the first time in a long time that this has been the case. Railway strike concerns certainly had an impact (a headwind of about 200 basis points on volume), but there would still have been some disappointment anyway.
Management continues to invest in the business ahead of this downturn. The company has increased its container fleet by approximately 13% this year, including a significant expansion of its reefer container fleet. The company also continued to develop and further internalize its drayage needs. Although owning more tractors and trailers seems to go against an “asset-light” model, the reality is that in-house drayage reduces costs and improves service quality and should offset other pressures from the company.
Speaking of these pressures, I expect to see further moderation in volumes as trading activity slows. More importantly, however, is the fact that more than a third of Hub volumes are being revised in the first quarter of 2023, so the pricing tailwind that has been driving revenue growth is likely to fade.
Hub Group is also preparing for a weaker truck brokerage market. While there is always a convenience to working with brokers, and brokers like Hub and JB Hunt can offer other value-added services, brokerage is more valuable when capacity is limited. This won’t be a problem in 2023 given what’s happening in the market right now. In response to weakening conditions, Hub management said it would shift more business to contracts, bringing its cash mix down from 52% last quarter to something like 45%.
Predicting movements in the freight market is hard enough, but I expect Hub Group to add some twists with new mergers and acquisitions. Management has been active in M&A for a long time, and I like offerings such as Choptank (refrigerated truck brokerage), Nonstop Delivery (last mile logistics), and CaseStack (consolidation/warehousing).
Right now, it looks like the market is going through a fairly typical cyclical downturn priced in to earnings. In past bear cycles (2017 and 2020), Hub has seen around a 30% decline in EPS, and current sell-side estimates call for a 28% decline between 2022 and 2023 in earnings per share. Still, sell-side estimates of margins over the next few years look a little high relative to management’s targets. I think management has taken a cautious and conservative approach with guidance, but there could be additional risk to estimates as the cyclical turn begins to bite.
I’m looking for a slight decline in revenue in 2023, but long-term growth of around 6%, as I expect the company to continue to gain market share in its core markets and expand in the adjacent markets. I expect EBITDA and FCF margins to decline from 2022 levels but remain on average higher over the next decade than the past decade – looking for long-term FCF margins to move from low numbers mid-single digit, helping drive FCF growth a little beyond revenue growth.
Between discounted cash flow and margin/yield driven EV/EBITDA, I think Hub Group shares look undervalued here. Discounted cash flow with the above assumptions suggests a double-digit total return from here, while the EV/EBITDA approach (using a multiple of 6.75x) leads me to a fair value of over $100 on my current EBITDA estimate of 23.
Frankly, this kind of undervaluation after a cyclical high makes me suspicious, as does the lack of a significant decline in Hub Group’s stock price. I like this company and I think it’s entirely reasonable to expect the company to handle this downturn well, but the undervaluation my model suggests makes me a bit worried about underestimating the slowdown/the upcoming reset. A pullback below $70 would probably make me feel better, but it’s hard not to like these stocks today, even with a developing freight slowdown.