Even Considering A Downturn, ArcBest Seems Too Cheap (NASDAQ:ARCB)

Given the difficulties of predicting the timing and magnitude of the cycles, trucking stocks can create some attractive trading opportunities, but at the cost of elevated risk. I think that’s a relevant consideration when looking at ArcBest (NASDAQ:ARCB) – the shares do look undervalued now, but trucking stocks (including less-than-truckload carriers like ArcBest) don’t perform well when the PMI heads below 50 and there is growing evidence of a meaningful slowdown in industry drivers.

Since my last update, these shares have risen about 15% overall (and they ran up almost 80% toward the end of 2021), outperforming other LTL carriers like Old Dominion (ODFL), Saia (SAIA), and Yellow (YELL). I am concerned that I’m underestimating the degree to which ArcBest will see volumes and profits contract in the coming downcycle, but the shares look undervalued on what I consider to be reasonable modeling assumptions. While the space is a little crowded with ideas now, I think ArcBest is worth a look.

Strong Growth As The Cycle Winds Down

In absolute reported terms, ArcBest had a strong quarter. In comparison to sell-side estimates, the results were a little more mixed, with a strong top-line result but evidence of cost pressures at the core operating income line. Management also acknowledged building macro pressures – not a surprise, but also not welcome.

Revenue rose 33% as reported, beating the sell-side by about 1%. The Assed-Based business (the LTL trucking operations) reported 16% year-over-year revenue growth on over 4% daily shipment growth and realized unit revenue growth of over 11%. Shipment growth was modestly below tonnage growth (+2.8% vs. +4.4%). The Asset-Light business (logistics operations) posted 63% revenue growth, with ArcBest (brokerage, dedicated trucking, expediting, and DIY moving) growing 69% and FleetNet (repair and maintenance) up 34%.

Operating income rose 32%, while adjusted operating income rose 33% – the biggest difference between the two is technology invested expenses that management excludes from the adjusted number. Operating ratio did improve a bit (+30bp to 90.3%), but core operating profits were modestly weaker than expected on higher costs in the Asset-Based operations. Speaking of which, Asset-Based profits rose 29%, with OR improving by 140bp to 85.3%, while Asset-Light profits rose 60%, with a steady OR of 96.7%.

Freight Conditions Getting Tougher From Here

As I’ve detailed in recent pieces on Knight-Swift (KNX) and Heartland Express (HTLD), conditions in the trucking industry are starting to weaken on flagging demand and increased trucking capacity. There are important differences between truckload and LTL trucking, with the former being more cyclical, but the same basic economic trends are impacting both – supply chains are much better stocked now, with much higher inventory levels, while trucking capacity availability hit a record high recently.

Moving into 2023, I expect ArcBest to see weaker volume and weaker pricing, and management pointed to preliminary October numbers that included a 4% year-over-year decline in tonnage and warned of up to 500bp of sequential operating ratio deterioration on weaker volumes (worse expense leverage). Management also noted that they believed they saw a pulling-forward of orders in the quarter, and many trucking players have commented that there really isn’t/wasn’t a peak season this year like you normally see in the fourth quarter.

I don’t believe ArcBest’s business will fall off a cliff. Renewal pricing was still up 7% in the quarter (versus +8% in Q2’22, +9% in Q1’22, and +10% in Q4’21). More relevant is the fact that LTL trucking is much more concentrated than truckload, with the top 10 players controlling about 80% of the market (while the 15 largest truckload carriers control less than 10% of the market).

That still leaves volume as a risk. Like Old Dominion, manufacturing is a major part of the business, making up around half of the revenue mix. With weakening short-cycle demand and improving inventories, I do expect weaker demand. Here again, though, I don’t see huge downside risk. First, while the exceptional demand of the last year or so won’t be repeatable as inventories don’t need to be rebuilt, there will still be ongoing activity provided we avoid a severe recession. Moreover, Old Dominion is exceptionally strict about pricing discipline (willing to give up volume to maintain pricing), and the worst year-over-year declines I’ve seen there in recent times (the last decade) were in the mid-single digits, excluding the pandemic disruptions in 2020.

I will note, though, that while the LTL business may not be as vulnerable as feared, the asset-light business may not be as invulnerable as some might assume. Truck brokerage thrives in tight trucking markets, and that’s not going to be the market in 2023. Likewise, while I think expediting is an attractive market over the longer term, this market too is vulnerable to short-term declines in demand, particularly if consumer spending slows more significantly.

The Outlook

I have little doubt that ArcBest will continue to invest in growing the business. I don’t expect as much of that investment in the Asset-Based business; ArcBest already has 98% national coverage and I’m not sure there’d be too much to be gained by acquiring other operators. There are a lot of directions that management could go with the Asset-Light business, though. The MoLo deal in 2021 was a significant transaction that basically doubled the truck brokerage business, but there’s room to grow expedited, last-mile, and other premium-type services.

I also see opportunities for a hybrid synergy. I think a little too much is made of “asset-based” and “asset-light” in the logistics market, but I think there are opportunities for ArcBest to take a mode-agnostic approach and blend the capabilities and offerings of its asset-backed and asset-light businesses (like power-only offerings).

Management has talked of doubling the business by 2025 ($7 billion to $8 billion in revenue), but I don’t see that happening unless the company is more aggressive on logistics M&A than I currently expect. On the other hand, a target operating ratio of 85%-90% in Asset-Based may not be ambitious enough, given that Old Dominion has shown that sub-80% ORs are possible.

I’m looking for revenue to fall 6% next year, and that’s about 5% below the sell-side average right now. I expect a recovery in 2024 and 2025, and long-term revenue growth in the 5% to 6% range. I do expect further M&A, but do not have it built into the model. I also believe I’m being conservative on modeling; ArcBest has been over-earning and will need to invest more in capex, but I believe low double-digit EBITDA margins are attainable, with low-to-mid-single-digit FCF margins driving mid-single-digit cash flow growth.

The Bottom Line

I don’t think my modeling assumptions are particularly aggressive, though again, the magnitude of cycles often ends up surprising analysts and investors. I like the moves that ArcBest has been making to improve the business, and I still see this company as a long-term winner in the sector. Discounted free cash suggests a low-teens annualized potential return, and multiples-based approaches likewise suggest undervaluation; a 9.5x trough multiple on 2022 EPS (which should be a peak) gives me a low-$90’s fair value.

Buying at the start of a downturn is risky, particularly when sell-side analysts may not be fully factoring in the coming slowdown. Even if I stress my model further, though, the long-term value still appears to be there. So I’ll call this a riskier-than-average name to favor today given the weakening macro backdrop, but it’s a name for contrarians to consider.