Werner Enterprises To Accelerate Growth As Rates Approach Cyclical Peak (NASDAQ:WERN)

I’ve been getting more interested in transports lately, including truckload carriers like Heartland (HTLD), Knight-Swift (KNX), and Werner Enterprises, Inc. (NASDAQ:WERN), as the market seems to be pricing in a fairly steep decline off of an approaching peak in rates (likely late Q1/early Q2) despite a fair bit of evidence that the market will see a shallower correction. While buying into cyclical declines is always risky, the prospect of interesting long-term values makes the sector worth another look.

Specific to Werner, I do have some concerns about the cost of the company’s growth plans (namely, capex spending weighing on DCF-based valuation) and whether the company can hit some bold growth targets, but I like the more defensive trucking mix here and the opportunity to grow value-added businesses like last-mile service. With an apparent fair value above $50, this is another name in this sector to consider.

Shifting To A Higher Growth Model?

Werner hasn’t exactly been a scintillating grower over the years, with a trailing 10-year average revenue growth rate of around 3%. The company has benefitted from a long-term shift to Dedicated trucking services (over One-Way), allowing the company to grow the trucking business at a long-term rate of around 2% on 1.5% growth in tractors.

Now management is talking about an annualized growth rate of 10% over the next five years, with at least half of that coming from trucking and most of that coming from organic growth efforts. Management has been steadily growing its in-house training capabilities, ending the year with 19 driver schools, but generating that sort of growth is likely going to require a step up in fleet capex.

The opportunities to grow are certainly there. The truckload market remains highly fragmented and there are opportunities to leverage scale, not to mention leverage overall shipping growth driven by factors like ongoing e-commerce growth. While rail is still an ongoing threat to long-haul trucking, not much of Werner’s business is done in that category.

I likewise see ongoing growth opportunities in the Dedicated business. As the name suggests, Dedicated service involves multiyear contracts with customers where those customers are allocated dedicated shipping capacity. These are typically shorter routes (which drivers typically like) and while the business isn’t as lucrative as spot trucking can be during peaks, it’s a steady, profitable business, and Werner has been growing this business over time (from around 50% to over 63% now).

Logistics Still Offers Growth Opportunities

Relative to Knight-Swift (or XPO Logistics (XPO) which competes in less-than-truckload trucking and logistics), Werner’s logistics operations are still quite small, but they are quite significant to Werner, making up close to a quarter of reported revenue.

Truck brokerage is the largest part of this, and like Knight-Swift, Werner offers power-only service where contracted carriers show up with a tractor to pick up a preloaded Werner trailer at a customer site with an agreed-upon price. This basically allows small carriers to pick the sort of business that suits them while allowing customers to get their shipping needs met cost-effectively.

Beyond brokerage, Werner has a small intermodal operation and a growing last-mile business. Werner acquired NEHDS for $64M in the fall of 2021 to further build out its last-mile capabilities, including augmenting what until now has been a single-driver operating structure with a two-person option so that services like furniture/appliance installation can now be offered.

I see growth opportunities across Werner’s logistics offerings, but more M&A will likely be necessary if the company really wants to attain critical mass in markets like brokerage and intermodal, though the power-only option in brokerage does create meaningful capex-growth opportunities.

Defensive Relative To Near-Term Challenges

Trucking remains hot now, as operators simply don’t have the drivers available to meet the demand that is out there. Trucking companies saw spot rates rise around 20% in the fourth quarter and it looks like double-digit rate growth will continue into the first half of 2022. After that point, though, I do expect a correction in rates as driver availability and overall capacity start to improve and as some of the urgency of shipping demand declines (particularly in the face of higher fuel costs).

While I’m looking for a 25% to 30% correction in spot rates, the market seems to be expecting quite a bit worse – possibly 50% or more. Given ongoing limitations in driver availability and higher shipping demand, I think the bear-case scenario is unlikely unless the U.S. economy tips over into recession. Beyond that, Werner’s Dedicated business offsets a meaningful portion of that risk. While there are adjustment mechanisms in its contracts, Werner basically trades off the upside to peak shipping rates to shield itself from trough rates.

One not-so-defensive element to the story to watch is the high likelihood of substantially lower gains on equipment sales. Like most of the leading carriers, it’s strategically advantageous for Werner to maintain a young equipment fleet, and so the company frequently sells used equipment to smaller carriers.

With truck OEMs unable to fulfill their order books due to labor issues and component shortages, used truck prices have spiked and Werner saw gains on sale grow almost 5.5x over 2020, with these gains contributing $61.5M to operating income, or almost 20% of reported operating income versus around 5% in FY’20. With those gains likely to shrink substantially, margins are likely to decline in ’22 and it will likely take a couple of years to see substantial margin leverage again.

The Outlook

I’m looking for around 6% annualized revenue growth over the next five years (and a little over 5% over the next 10 years), so I’m not fully onboard with management’s growth targets. I think they’re achievable, but I’m not ready to make them my base case yet, particularly as I think it could take a little while longer to resolve bottlenecks in OEM truck production. I do think M&A remains an option for growth, though I’d expect relatively modest-sized deals.

Over time I think FCF margins can rise to the high end of the mid-single-digits, helping drive mid-to-high single-digit FCF growth.

The Bottom Line

Between discounted cash flow and EV/EBITDA, I think Werner shares look undervalued. The former gives me a long-term annualized potential total return in the high single-digits, while a 6.5x multiple on my ’23 EBITDA gives me a fair value in the mid-$50s, with a 6.5x multiple below the long-term full-cycle average to account for the peak earnings risk. I use the ’23 EBITDA estimate, as I do expect a year-over-year decline and feel it’s the more conservative approach.

I still favor Knight-Swift on the basis of total opportunity, risk, and quality, but I think Werner’s more defensive Dedicated business will be an asset to the company, and I like the more aggressive growth targets. If management can execute, there’s more to this story than a short-term market mispricing based on a shallower cyclical trough for the next phase of the rate cycle.