I was concerned about being too bullish on Knight-Swift (NYSE:KNX) in my last article, as the company was heading into what I expected will be a significant correction in the trucking and logistics/shipping sector Those concerns have proved reasonable, as the shares have underperformed since then – losing about 13% of their value and underperforming Heartland (HTLD) and Werner (WERN), while outperforming J.B. Hunt (JBHT), Schneider (SNDR), and U.S. Xpress (USX).
My bullishness was based on the fact that while revenue, EBITDA, and cash flow would decline in FY’23, that decline would be cushioned by the diversification efforts undertaken by management and the overall quality of the business. I still think there’s an argument for owning the shares, but I can’t rule out even worse erosion in rates and sentiment, and there is a risk that buying Knight shares today is essentially reaching to grab a falling knife.
Weaker Than Expected Q3 Results Undermine The “The Bottom Is In” Argument
Expectations had been declining going into the third quarter, but Knight-Swift still missed expectations, as conditions are deteriorating at a rapid rate. Simply put, normalizing business inventories and a slowing macro environment are leading to softer demand for transportation.
Revenue rose more than 15% as reported, just missing expectations, while revenue excluding fuel surcharges rose 9%. Truckload revenue rose 11% as reported and about 4% excluding fuel, with revenue per loaded mile up 8% but offset by weaker volumes and higher deadhead miles (miles where the truck drives empty). Less-than-truckload revenue rose 45% as reported and 34% ex-fuel, with solid mid-teens growth in shipments.
In Logistics, revenue fell 7% as load growth (up 20%) was offset by weaker revenue per load. Intermodal revenue rose 16% on a 9% decline in loads and a 28% increase in revenue per load, as container turns slipped below 1.0x per month per container. “Other revenue”, largely services offered to other carriers, rose 56%.
Operating income fell 1%, with the operating margin falling from 17.2% to 14.7%. Adjusted margins were better (16.9% vs. 15.1%), with an adjusted operating ratio of 83.1% (versus 84.9% last year). Relative to sell-side expectations, Knight-Swift’s operating income missed by about 6%, or $0.04/share.
Truckload profits declined 15%, with operating ratio worsening from 77.3% to 81.8%, and this was the major driver of the miss. Less-than-truckload profits rose 66%, with operating ratio improving to 84.5% (from 87.5%). Logistics profits rose 1%, with operating ratio improving 110bp to 86.8%, and Intermodal profits jumped 34%, with a 130bp improvement in operating ratio to 90.2%
The Fall Has Come In The Fall
I had expected earlier this year to see a significant decline in dry van rates, and that process is playing out now. As of last week, spot dry van rates are down about 21% year-to-date to $2.32 versus my expectation of a bottom around $1.90 to $2.00. At the same time, though, there’s a growing gap between spot and contract prices (recently more than 20%), and operating costs per mile are up about 14% (to $2.01, as per DAT Analytics).
So, we have costs at around $2.00 per mile, and I expect spot prices to head below that. That means that small and/or inefficient carriers are in for some real pain, and this is a normal part of the cycle – the bottoms of the pricing cycle often see less efficient operators squeezed out as prices fall below costs.
Costs have been heading higher due to driver pay and benefits, maintenance, and insurance, and I don’t see any of these letting up soon. On the demand side, normalizing inventory levels and slowing demand are leading to less urgency on the part of customers; to that end, both Knight-Swift and J.B. Hunt management have said they’re not seeing the typical seasonal peak in the final months of 2022, and Old Dominion (ODFL) (a leading less-than-truckload carrier) has just reported a 2.6% decline in third quarter tons.
This isn’t just a trucking phenomenon. Knight-Swift and other capacity providers have also noted softening trends in volumes in intermodal and logistics, with “less urgency” among customers, though Knight-Swift is seeing strong demand for its power-only services (up 33% yoy).
My earlier bullishness on Knight-Swift was based at least in part on what I saw (and still see) as opportunities to use diversification to offset core pressures in the truckload market. That aforementioned power-only service in logistics is one such example, with that service allowing Knight-Swift to utilize its large tractor fleet when truckload demand is softer.
As a more concentrated market, less-than-truckload should hold up better where rates are concerned, and this remains a growth opportunity for Knight-Swift, with the company exploring both organic and M&A options to add terminal capacity. Management is also looking to add trailers that it can cross-sell into markets like less-than-truckload and logistics. Last and not least is a growing third-party service business focusing on providing maintenance and other functions to smaller carriers.
While the correction in the shipping cycle has definitely started, not much has changed yet with my expectations. My revenue outlook for FY’22 is actually a little higher now given stronger performance before the decline began, and my outlook for FY’23 and FY’24 has changed by less than 1% (slightly better in FY’23, slightly worse in FY’24). I have decided, though, to take a more conservative approach to margins and free cash flow, as I see more cost pressure, more pressure from interest rates (Knight-Swift has significant floating-rate debt that took about $0.03 out of earnings this quarter), and more pressure on asset sales.
I’m still looking for long-term revenue growth in the neighborhood of 5% to 6%, and I expect the company to continue to invest in its less-than-truckload, logistics, and intermodal growth opportunities, as well as making selective transactions in truckload if market conditions push some otherwise attractive carriers to look to sell out. Relative to a normalized starting point, I expect Knight-Swift to generate 10% long-term FCF growth, with FCF margins heading into the low double-digits over time.
The Bottom Line
Between discounted cash flow and EV/EBITDA, I believe Knight-Swift is undervalued and priced for a double-digit long-term annualized return. I’m using a 7x forward multiple (a discount to my full-cycle 8x multiple) to account for the elevated risk now, but I’d also note that Knight-Swift management has claimed a worst-case scenario of $4.00/share in earnings. Looking at past cyclical troughs prior to COVID-19 and these current unusual circumstances, the forward P/E has typically troughed at 15x; 15x and $4.00 gets me to $60, which is about where my EBITDA-based approach gets me today.
There’s definitely a risk that conditions get even worse from here and fall below my already-conservative assumptions, not to mention the assumptions of buy-side and sell-side analysts. Likewise, there is still significant sentiment risk here. It may be too early to step up and buy these shares, but I do see a long-term value that’s getting more and more interesting for investors who can take the risk of getting in too early.