photo credit: atennies94

The following article is a reprint of my February 27, 2008 RealMoney column.

A long UPS/short FDX paired trade could work, but I’d wait for a pullback to $65 before UPS would tempt me as a long-only play.

My bullish November 2007 Landstar (LSTR - Annual Report) column represents my most successful pick for RealMoney to date. The stock is up 20%, compared to a 6% decline in the S&P 500. Landstar has also outperformed CH Robinson (CHRW - Annual Report) by 9% since I predicted as much in December, and YRC Worldwide (YRCW) has underperformed the S&P by 10% since I advised looking elsewhere.

Given that my transportation picks seem to be working out better than my others, I decided to push my luck with another long-short idea. This time, I think United Parcel Service (UPS) can continue its recent outperformance relative to FedEx (FDX - Annual Report).

Two years ago, I wrote briefly about the relationship on my blog, saying:

FDX has greater operating leverage and will continue to outperform as long as the economy continues to expand and trucking capacity remains tight…. Timing this switch is the difficult part.

Over those two years, the timing has clearly happened. UPS has outperformed FedEx by about 10% since then, and by 25% in the last 12 months.

Other than the operating leverage, I think the stocks are similar enough that a long-short trade would truly offset much of the risks. Clearly the macroeconomic and industry exposures are similar.

FedEx is expected to grow slightly faster (15% compared to 13% for UPS) over the next five years and has a lower P/E multiple. But UPS generates far more free cash flow. The free cash flow yield at UPS is 5.3%, compared to just 2% at FedEx. The cash flows can be used to buy back shares, pay dividends, or make acquisitions. All of these could boost the EPS growth rate for UPS. Because of the higher yield, I think there is much less downside for UPS.

UPS also tends to have slightly higher earnings quality, on average, than FedEx. I use the accrual ratio, which measures the difference between cash earnings and accounting earnings, as a proxy for earnings quality. This ratio is less volatile for UPS and tends to be closer to zero in most periods, both of which give me more confidence in the earnings reported by UPS (though earnings quality at FedEx is by no means poor.)

Source: Zacks Research Wizard, compiled by William Trent

The differences in performance, however, are only relative. Long-only investors have been disappointed by UPS over time, with the shares trading within 10% of the current price for the last two years, and within 20% for the last five. In fact, UPS is almost exactly in the middle of its long-term trading range.

I think the future performance will remain uninspiring. The 5.3% free cash flow yield is reasonable and offers some downside protection, but is not enough to juice returns. At roughly five times book value and 16 times earnings, I don’t see a huge opportunity for expanding valuation. The tight trading range has also means there is little advantage to a put-write strategy. Low stock volatility means the March $70 puts offer just over a 1% premium. That isn’t enough for taking the risk that the stock falls to the low end of its trading range – though I’d be much more favorably disposed toward UPS if the stock pulled back to $65 or so.

For the reasons outlined above, I think a paired trade going long UPS and short FedEx could continue to work over the next few months.

Disclosures: William Trent is long Landstar (LSTR - Annual Report)

Zacks Investment Research has provided Stock Market Beat with a complimentary trial subscription to Research Wizard.

The following is my RealMoney column from December 6, 2006.

YRCW shares are pricing in a much lower EPS outlook than the consensus. Does that signal a buying opportunity?

Nobody believes trucking company YRC Worldwide (YRCW) will earn the consensus estimate of $2.52 per share in 2008. If they did, the stock would be trading significantly higher than $17.50 per share.

After all, the company earned $5.00 per share in 2006 and is expected to pull in $2.40 this year. If this year is really “the bottom” for earnings investors should be willing to pay at least $30, which equates to the company’s 5-year average P/E of 12x.

So investors clearly think YRC will earn less – probably much less – than $2.52. The questions then become:

1. How much less will they earn?
2. Does the current price reflect the worst case scenario?
3. If nobody believes YRC will earn $2.52 how did it become the consensus estimate?

I’ll leave the last question to philosophers, but I think I can take a stab at the first two.

How Low Can They Go?

To get a feel for the potential earnings bottom, I looked at the history available from Zacks Research Wizard.

Source: Zacks Research Wizard

Clearly the earnings per share can be much lower than $2.52. In fact, the last economic slowdown included one year that wiped out the peak year, the subsequent down year and a good part of the next year’s recovery. Furthermore, the late 1990’s also indicate that several down years can wipe out a good deal of the positive earnings in up years. All of which goes to show why I prefer the non-asset based transportation companies like Landstar (LSTR - Annual Report) and CH Robinson (CHRW - Annual Report).

So one approach to valuation would be to take a page from Ben Graham’s Intelligent Investor (page 313 in my edition) and use a longer-term average of earnings per share. I chose five years, giving me the following chart.

Sources: Zacks Research Wizard, William A. Trent

Right away, I see two useful take-aways from this chart. One is that the trough-peak pattern from 1999-2001 looks very similar to the one in 2004-2005. This gives me some confidence that this cyclical relationship may represent the next cycle as well. The other is that the cumulative peak-peak growth rate from 2001-2006 is about 25%.

Applying 25% growth from the 2004 trough gives me a target for the average EPS in the next trough – about $0.44. This helps me answer the first question (as well as some indication of how severe the negative earnings year(s) will have to be in order to push the 5-year average that low.)

Is the worst case priced in?

An old rule of thumb is to buy cyclical stocks when the P/E is high and sell when it is low. This is because the P/E is high when earnings are at their lowest and about to recover. Just looking at the estimates, though, the current P/E is low.

But we already established that the estimates aren’t believed. If the five-year average earnings per share is about to drop to $0.44, the stock is currently trading at about 40x trough earnings. That is starting to sound like the “high P/E” that would signal a buy.

And whaddya know? It looks from this chart that as YRC started to pull out of the last earnings trough it was getting a multiple of about 40x earnings. Furthermore, the stock is now trading below its levels five years ago even though the general EPS trend has been up.

This doesn’t, of course, imply that the worst is priced in. Nobody can really know that for sure. But it sure looks like we’re getting close.

Cash Flow Talks

Of course, I always prefer to look at companies on a cash flow basis rather than an earnings basis. Free cash flow (cash from operations less capital expenditures) has been negative for the last three quarters. Over the trailing 12 months it comes to $68 million – a 3% yield on the $2.3 billion enterprise value.

Ideally, in exchange for accepting the risk related to a stock like YRCW I would to get a higher return than I would from other investments like a 3.3% 5-year Treasury bond. Although the current free cash flow yield for YRC is less than the Treasury yield, if the risk is mostly reflected then proximity to the risk-free rate isn’t necessarily bad.

Once again turning to a full-cycle perspective, the five-year average free cash flow for YRC is $152 million, and the current yield based on that figure is 6.6% – twice the Treasury yield.

Twice the Treasury yield would normally justify the investment, particularly for investors who are either more optimistic or more risk-tolerant than I am. But given that Landstar is yielding even more and has less risk (in my opinion) over the full cycle it isn’t enough to make me switch.

Disclosure: William Trent is long Landstar (LSTR - Annual Report)

Zacks Investment Research has provided Stock Market Beat with a complimentary trial subscription to Research Wizard.

The following is my RealMoney article from December 4, 2007.

A Tale of Two Truckers

The valuation discrepancy between Landstar (LSTR - Annual Report) and CH Robinson (CHRW - Annual Report) may present a paired-trade opportunity to be long Landstar and short CH Robinson.

A couple of weeks ago I predicted Landstar’s stock would shine again, and the first evidence of that was provided with the company’s positive mid-quarter update.

The shares were up more than 5% after the call, but it will be a while before I am ready to sell. Even after yesterday’s rally, the shares are yielding 7.1% free cash flow to enterprise value. With the five-year Treasury at 3.4%, that still amounts to more than a 100% premium, and Landstar should still provide growth.

In fact, I would be willing to own Landstar up to a parity yield with Treasuries, because I believe the growth alone is sufficient premium for the risk. On that basis, and with today’s Treasury yield and trailing Landstar FCF, I get an implied value of nearly $90 per share.

Am I Being Overly Optimistic?

That may at first blush sound like an overly optimistic forecast for a stock trading at $42. But a glance at the company’s most similar peer, C.H. Robinson, suggests it may be warranted. CHRW is trading at a free cash flow yield of just 3.1%, which would allow for even more upside than my own prognostication.

To be sure, CH Robinson is a great company, and in 2007 is showing much higher growth – an estimated 20% compared to a flat year for Landstar. But as I mentioned in my original piece, Landstar provides disaster-relief services for FEMA, and the milder hurricane season in 2006 led to lower revenue in early 2007 than was experienced after Katrina and Rita for 2005/2006.

According to Landstar’s latest 10Q, revenue would have been up 5% excluding FEMA business in both years. And for next year, analysts are predicting 15% growth at CHRW and 13.3% at LSTR – pretty close to parity if you ask me.

Are the Companies Really Peers?

The next fair question to ask is whether the companies are truly peers, or if the valuation discrepancy is otherwise justified. CH Robinson is much larger, with $7 billion in trailing-year revenues compared to $2.5 billion for Landstar. Landstar’s $185 million in operating income is also a fraction of the $497 million CH Robinson earned.

But size alone does not justify a huge valuation premium. And judging from the way the companies describe themselves, they sure do seem like peers.

In its 10Q, CH Robinson says “we are a non-asset based transportation provider, meaning we do not own the transportation equipment that is used to transport our customer’s freight.”

By comparison, “Landstar’s business strategy is to be a non-asset based provider of transportation capacity and logistics services delivering safe, specialized transportation services globally, utilizing a network of independent commission sales agents, third party capacity providers and employees,” according to it’s 10Q.

Looking at the ratios, the companies still seem like peers and if anything Landstar might deserve the higher multiples:

Even the stock chart suggests the companies are peers, as they have tracked each other fairly closely for the last five years.

Am I Using the Right Valuation Measure?

The only remaining concern is whether my choice of free cash flow yield is picking and choosing a valuation method that fits my thesis. So, I look at several other possible valuations.

Based solely on sales or operating margins, Landstar is about 35% the size of CH Robinson. If it had the same relative valuation it would trade at $52 per share.

CH Robinson’s forward P/E multiple is 24.6, compared to 19.3 for Landstar. At 24.6x estimated 2008 earnings, Landstar would be trading north of $54. Assigning CHRW’s 1.67 PEG ratio to Landstar would give it a $49 value.

CH Robinson has a lofty 16.1x EV/EBITDA ratio. If Landstar got that multiple its stock would be $60.

In fact, the only comparison by which Landstar looks more highly valued is price/book – and Landstar’s higher return on equity indicates that that multiple may also be the least valid comparison.

The more I look at it, the more I think Landstar and CH Robinson would make for a great paired trade. Both are great companies, but Landstar clearly seems like the better stock right now.

Disclosure: William Trent is long Landstar.

Last October I said “I would not own Green Eggs or Yellow Trucks.”

As the economy slows, those companies like CH Robinson (CHRW – Annual Report) and Landstar (LSTR – Annual Report) that get their capacity from independent contractors on an as-needed basis have lower overhead expenses and remain profitable. If the economy slows much further, Yellow’s guidance reductions will be even larger.

My lack of appetite was well founded, as trucker YRC Worldwide (YRCW) – the trucker formerly known as Yellow – is down 22% since then while CH Robinson and Landstar are flat or up. As to the economy, the ATA trucking index says it all:

The American Trucking Associations’ advanced seasonally adjusted For-Hire Truck Tonnage Index decreased 0.1 percent in June, marking the third consecutive month-to-month drop. Tonnage fell 1.3 percent in May and has dropped 3.5 percent since March. The not seasonally adjusted index dropped 3.3 percent from May to 114.1.

On a seasonally adjusted basis, the tonnage index declined to a seven-month low of 110.5 (2000 = 100) in June from 110.6 the previous month. Compared with a year earlier, tonnage was down 3.4 percent in June, which is just a slight improvement from the 3.6 percent year-over-year decrease in May.

Meanwhile, Yellow’s guidance reductions have indeed been large. From initial expectations of $5.65-$5.85 for 2006 the company ended up earning just $5.00. What had once been expected to be an up year in 2007 is now forecast at just $3.17 and estimates have been steadily dropping for the last 90 days. It is probably safe to say that few investors believe the $3.81 forecast for 2008.

But still, even with the current depressed earnings there are earnings. Further, it looks like it would take a significant further decline for the company to end up with a loss. The trailing twelve month EV/EBITDA is a mere 4.35x. Given that the cycle peak earnings should still someday be in the $6.00 range the stock is starting to look like a bargain.

I’m not the only one who thinks so, either. According to StockPickr, the January 35 calls have seen unusually high trading volume lately. I’m thinking those traders may be on to something.

Large Cap Watch List (Track at Marketocracy) member YRC Worldwide Inc. (YRCW) today announced reported diluted earnings per share (”EPS”) for the second quarter 2007 of $0.95 compared to $1.58 in the second quarter last year. Adjusted diluted EPS was $0.91, compared to $1.62 for the second quarter 2006.

Although the results looked awful, the signs of a poor environment for transportation had been building. The shares actually rallied in after-hours trading, suggesting that investors may have feared worse or even think that the bottom has been reached. I doubt that latter point, but of course I’ve been wrong before.

YRC management, however seems to agree with me on this one. They offered guidance for a litany of line items  ranging from interest expense to tax rate to shares outstanding. As far as revenue and earnings, however, your guess is apparently as good as theirs. At least whatever number you come up with, you’ll have a decent idea how much interest to expense, how much tax to reduce it by and how many shares to divide it by to arrive at EPS.

The company managed to increase its cash flow from operating activities slightly, but also managed to spend more than it generated buying new trucks.  Which is one more reason to prefer Landstar (LSTR - Annual Report) and CH Robinson (CHRW - Annual Report).

C.H. Robinson Worldwide, Inc. (CHRW - Annual Report), reported financial results for the quarter ended June 30, 2007. Revenues of 1.88 billion were slightly ahead of the $1.86 billion consensus, and earnings per share of $0.47 were exactly in line with estimates.

In my earnings preview I expressed some concern given Landstar’s (LSTR - Annual Report) recent disappointment. The company was able to grow 15% and expand margins, which ironically was due in part to their slower growth:

As a percentage of gross profits, operating expenses decreased to 58.3 percent in the second quarter of 2007 from 61.6 percent in the second quarter of 2006. This decrease was due to a decline in personnel expenses as a percentage of gross profits from 47.9 percent to 45.4 percent. Expenses related to our restricted stock program and various other incentive plans are based on growth in our earnings. Our slower earnings growth in the second quarter of 2007 compared to the second quarter of 2006 resulted in a decrease in expense related to some of these incentives plans. This contributed to our personnel expenses growing slower than our gross profits.

So by earnings growing slower, they paid out lower bonuses, which in turn helped earnings to grow faster.  My head is spinning a bit, likely alongside the heads of those whose bonuses were reduced.

The Economic Calendar is quiet in the early part of this week but there are important reports at the end of the week. On Thursday is the Durable Goods report, for which the consensus estimates a 2.0% increase. On Friday is the Preliminary Estimate of 2Q GDP, which the consensus has pegged at 3.2%. That sounds a little high to me based on the economic data table I’ve been compiling.

EconomicData

The Earnings Calendar is as busy as it can get. Some of the names I’ll be watching:

Monday

• Altera (ALTR) – Xilinx (XLNX)  filed an awful report. Can Altera do any better? Consensus is $0.19 EPS on sales of $314 million.
• Hexcel (HXL) – This Small Cap Watch List (Track at Marketocracy) member was seeing rising estimates until last month, when they were cut from $0.20 to the current $0.17.
• Steel Dynamics (STLD - Annual Report) – The Mid Cap Watch List (Track at Marketocracy) member is expected to earn $1.04 on sales of $948 million.
• Texas Instruments (TXN - Annual Report) – expected to earn $0.42 on $3.45 billion in sales.

Tuesday

• CH Robinson (CHRW - Annual Report) – estimates have been rising and now stand at $0.47, but Landstar (LSTR - Annual Report) disappointed.
• CDW Corporation (CDWC) – stellar monthly sales reports have kept estimates rising. They now stand at $0.97.
• EMC Corporation (EMC - Annual Report) – The big news is still the VMWare IPO, but it is also a decent look at enterprise tech spend.
• Laboratory Corporation of America (LH) – The Mid Cap and Large Cap Watch List (Track at Marketocracy) member has been seeing positive earnings revisions and is now expected to earn $1.09 on $1.03 billion in revenue.
• Lexmark (LXK) preannounced and will probably offer poor guidance.
• Linear Technology (LLTC) – expected to earn $0.35 on $267 million in sales.
• Norsk Hydro (NHY) – The Large Cap Watch List (Track at Marketocracy) member has no analyst coverage right now.
• Plantronics (PLT) – my covered call position is now being cashed out so I’ve no skin in this one. But it is often volatile.
• United Parcel Services (UPS) is a great read on the health of the economy. Expectations are $1.03 on $12.23 billion in revenue.

Wednesday

• Arkansas Best (ABFS) – after Landstar’s (LSTR - Annual Report) weak quarter I’m expecting a poor showing. Estimates have come down to $0.67, but may not have come down enough.
• Colgate Palmolive (CL) – Large Cap Watch List (Track at Marketocracy) member unlikely to surprise much. Consensus is $0.83 on $3.31 billion.
• Corning (GLW - Annual Report) – is LCD supply/demand back in balance?
• Freeport McMoRan Copper & Gold (FCX - Annual Report) -Another Large Cap Watch List (Track at Marketocracy) member with dramatic positive earnings revisions, now standing at $2.71.
• Graco (GGG) is another Large Cap Watch List (Track at Marketocracy) member. Estimates have been coming down and are now at $0.61.
• MEMC Electronic Materials (WFR) – Is polysilicon supply catching up to demand for this Large Cap Watch List (Track at Marketocracy) member?
• Xerox (XRX) – can they make the numbers without asking investors to ignore a bunch of stuff? I don’t doubt they will earn $0.27 as expected but wonder how they’ll get there.

Thursday

• Federated Investors (FII) is on the Large Cap Watch List (Track at Marketocracy) and expected to earn $0.54.
• Ingram Micro (IM) is on the Small Cap Watch List (Track at Marketocracy) and expected to earn $0.36.
• KLA-Tencor (KLAC) – I know the semiconductor equipment fundamentals stink. I want to know how much and whether it is priced in.
• NII Holdings (NIHD) is on the Large Cap Watch List (Track at Marketocracy) and expected to earn $0.49.
• Western Digital (WDC) is on the Large Cap Watch List (Track at Marketocracy) and expected to earn $0.36.

Disclosure: William Trent has a long position in SMH.

In our weekly earnings preview, we said “We’re staying away from truckers who own trucks.” Let’s see how that strategy is working out now that Arkansas Best Corporation (ABFS) Announces 1st Quarter 2007 Results:

Arkansas Best Corporation (Nasdaq: ABFS – News) today announced first quarter 2007 revenue of $422.6 million compared to $425.0 million in the first quarter of 2006. Arkansas Best’s first quarter 2007 income from continuing operations was $4.8 million, or $0.19 a share, compared to $5.8 million, or $0.23 a share, in the first quarter of 2006.

Consensus estimates called for the company to earn $0.15 per share on $415 million in sales. The results included $0.03 per share of “supplemental pension benefits” that it looks like the company wants investors to pull out of the earnings, though we can’t for the life of us imagine why investors would. Sure, the amount is volatile – but so are other Arkansas Best operating costs such as fuel.

“In October of 2006, ABF’s tonnage declined significantly compared to the previous year. In November, when it became apparent that fourth quarter tonnage would be below expectations, ABF began reducing costs to better match available business levels. Those tonnage declines have continued into 2007. However, the expense reduction steps first initiated last November helped better align ABF’s network with existing business. As a result, lower tonnage had less of an impact on ABF’s operating ratio than we’ve seen in previous downturns or in the fourth quarter of 2006,” said Robert A. Davidson, Arkansas Best President and Chief Executive Officer.

Analysts are expecting the company to earn $0.70 on $470 million in sales during the June quarter.

Turning to the financial statements, we are somewhat concerned by reductions in the amounts reserved for bad debt, as a percentage of the amount owed. If the reserves had been kept at the same percentage of receivables as last year earnings would have been $0.17. The fact that they beat estimates regardless of the discretionary accrual rate helps mitigate the concern a bit. However, cash flow from operations declined more than net income for the quarter compared to last year and the operating cash flows for the quarter were below the amount spent buying new equipment. Given quarterly fluctuations in cash flow it is too soon to make much of this concern other than to mention and monitor it.

The company will be holding a conference call at 11:00 a.m. Eastern today to discuss the results.

Asset-lite trucking company CH Robinson (CHRW - Annual Report) reported earnings after the close. As we indicated in our earnings preview, they beat expectations of $0.38 in EPS, posting a $0.42 performance. Driving the performance, according to the company:

The increase in our Transportation gross profit margin in the first quarter was due to an increase in our truck transportation gross profit margins, which expanded due to more widely available truck capacity in the marketplace. We also had faster growth in our miscellaneous transportation management services business, which has a higher gross profit margin than our Transportation business overall.

The fact that their gross margin can improve when capacity is more widely available is one of the things we like about the non-asset based truckers such as CH Robinson and Landstar (LSTR - Annual Report). Trucking companies that own their own trucks either lose revenue when capacity is tight or are forced to reduce prices and lose margin when capacity is abundant. Since CH Robinson gets its capacity from independent contractors, abundant capacity makes it cheaper for the company to source capacity and it doesn’t have the fixed depreciation costs to contend with. By contrast, tight capacity still allows the company to raise prices, though they don’t get the margin expansion other truckers enjoy.

In a slowing economy, we think the non-asset based truckers are the way to go. In fact, the only time the asset-based truckers have a real investment edge is typically in the early phases of economic growth, when their margins can go from awful to fantastic over the course of a year or so.

The Economic Calendar is relatively light this week. Potential market movers include:

• Wednesday’s Durable Goods report (consensus 2.2%)
• Friday’s advance report on Q1 GDP (consensus 1.8%)

Earnings are another story. We are in the peak part of earnings season this week. A few of the stocks we follow:

Monday

• Altera (ALTR) – valuation is rich but looks set up to beat on earnings.
• Texas Instruments (TXN - Annual Report) – March and June quarters have both had significant downward revisions. Will day of reckoning be forestalled?

Tuesday

• AU Optronics (AUO) – Forecasting losses, but panel business may have bottomed out.
• CDW Corporation (CDWC) – 14.6% sales growth doable given Berbee acquisition.
• CH Robinson (CHRW - Annual Report) – Could beat.
• CSG Systems (CSGS) – earnings should be a piece of cake. If private equity buyers don’t take them out they’ll do it themselves the slow way.
• Lexmark (LXK) – Estimates are doable but we’re always waiting for this company to trip up.
• ST Microelectronics (STM) – Doing the right thing. Hopefully will pay off.
• AT&T (T - Annual Report) – Estimates and stock both keep rising.

Wednesday

• Apple (AAPL) – Hunch: company will blow away earnings, issue horrible guidance and blame it on iPhone build.
• Arkansas Best (ABFS) – We’re staying away from truckers who own trucks.
• Corning (GLW - Annual Report) – current quarter ok, guidance at risk.
• LSI Logic (LSI) – May blame their poor guidance on Agere.
• Maxim (MXIM) – Company is out of gas but focus will be on whether they might sell out.
• Qualcomm (QCOM) – Nokia Nokia Blah Blah Nokia ad nauseam (excerpt from pending conference call transcript)
• Silicon Laboratories SLAB – Sold wireless just when biggest customer began to recover. What other surprises may be in store?
• UPS (UPS) – They shouldn’t have trouble beating the estimates (but that doesn’t mean they won’t).
• Xilinx (XLNX) – Altera with more risk to the earnings target.

Thursday

• Curtiss Wright (CW - Annual Report) – PPI data suggests they should beat big, but it suggested the same last quarter.
• KLA Tencor (KLAC) – Another place we’d rather not be right now.
• Microsoft (MSFT - Annual Report) – Vista is still not living up to expectations.
• MEMC Electronics (WFR) – Earnings surprises have been getting bigger each quarter. Now that we’ve put a semiconductor name on our Large Cap Watch List (Track at Marketocracy) it will probably stop just to spite us.
• YRC Worldwide (YRCW) – See Arkansas Best.
• Sandisk (SNDK - Annual Report) – Will take more than one quarter to clear the channel inventory.

Friday

• Dassault Systemes (DASTY) – We like Ansys (ANSS) better but don’t see why this name wouldn’t beat.
• Ceradyne (CRDN)  – Earnings could be anywhere and don’t really matter.

Enjoy!

Disclosure: William Trent has a long position in SMH.