CONTRIBUTORS
Stephen Rigo, CFA
Portfolio Manager
ClearBridge Investments
Hannah Whang
Senior Research Analyst for Industrials
ClearBridge Investments
Key takeaways
- An extended contraction in US manufacturing activity has left the transports industry mired in a freight recession, yet the emergence of reshoring and improving operating efficiencies leaves high-quality operators attractively positioned for an economic recovery.
- Less-than-truckload (LTL) companies benefit from higher barriers to entry and pricing discipline that should allow them to expand margins as volumes pick up.
- Commercial rail operators feature even stronger moats with opportunities to improve efficiency, service quality and pricing power.
Manufacturing recovery would reinvigorate trucking and rails
The last two years have seen a prolonged contraction in manufacturing activity, resulting in weaker volumes for companies that transport industrial goods on trucks and trains. The ISM Purchasing Managers Index, a measure of US manufacturing activity, has a notable correlation with transport volumes, as it reflects the demand for raw materials, intermediate goods and finished products. A PMI reading above 50 in March, a level indicating expansion in industrial activity, was a rare bright spot that drove optimism about a potential freight recovery in 2024. However, the PMI retreated below 50 in April and May and the New Orders Index has also been weak, with a May reading of 45. As a result, we believe a freight recovery has been pushed out but see the pullback in these stocks as a good opportunity to prepare for an eventual pickup in activity and freight volumes.
The macro outlook for the industry remains mixed. On the positive side, a good portion of industrial inventories have normalized, removing the headwinds caused by destocking. Additionally, while the replenishment of inventories or a pickup in end markets has yet to materialize, financial conditions for customers are expected to remain stable or improve as we head into the second half of 2024 and into 2025 (Exhibit 1).
Trucking and rails stocks have retraced directionally in line with the PMI pulling back below 50, but they appear well-positioned for earnings growth when volumes improve. Despite near-term headwinds of overcapacity and cyclically weak demand, we believe the economy is due for a recovery and that secular growth drivers for transports, such as industrial nearshoring and reshoring, are still intact.
Exhibit 1: Transports Stocks Correlated with PMI
Source: Bloomberg, ClearBridge Investments. As of May 31, 2024. Transportation Indexed Returns represent the aggregate performance of 12 stocks in the Air Freight & Logistics, Cargo Ground Transportation, Highways & Rail Tracks sub-industries of the S&P Total Market Index. PMI is the Institute for Supply Management Manufacturing PMI. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
Competitive dynamics separate LTL operators
The trucking industry has been in a freight recession for over 20 months, and a recovery has been delayed. However, we believe there are some attractive segments within trucking, such as less than LTL, which have higher barriers to entry and more margin expansion potential than the more fragmented truckload segment.
LTL companies operate in a more niche market, where they consolidate smaller shipments from multiple customers and deliver them to different destinations. This requires more network density and terminal infrastructure—the larger carriers have roughly 250 to 300 terminals nationally. This real estate component serves as a moat and has led to a consolidated industry with 80% of market share among the top 10 operators. Such concentration also contributes to greater price discipline: in down markets, LTL prices tend to flatten rather than decline, while in up markets pricing steps up and contributes to operating margin expansion. This is unlike the highly fragmented truckload industry where there are no real estate requirements and pricing trends negatively in down markets, compressing margins. The broader LTL industry should also benefit from the 2023 bankruptcy of a leading LTL provider as it eliminated the lowest cost and least disciplined carrier in the industry and should enable stronger pricing for everyone else through the cycle.
Freight rail offers cost advantages
Commercial rail is another highly consolidated industry with high barriers to entry. These companies are effectively duopolies in each region with tremendous pricing power. While rail volumes are highly correlated with the macro environment, rail operators have opportunities to improve efficiency, service quality and pricing power through their continued expansion of precision scheduled railroading (PSR) to reduce costs, improve asset utilization and increase network velocity. As rail companies become more reliable and consistent with delivery times, they also become more competitive with trucking, representing a share gain opportunity. Rails also offer 4x more fuel-efficient transportation than trucking, which helps customers make progress on their emissions targets.
Rail is well positioned to benefit from reshoring trends that have increased the profile of Mexico and Canada as US trading partners. Several commercial rail operators operate networks that offer contiguous coverage from Canada through the United States into Mexico.
With a sluggish economy and expectations being so low, we believe transport stocks with the most attractive competitive dynamics are set up very well for a cyclical recovery. Starting from significantly below normalized volume growth, and with capex being spent on reshoring projects, a rebound in economic activity plus secular tailwinds provide bullish conditions for higher-quality LTL and rail companies.
Definitions
The S&P Total Market Index is designed to track the broad equity market, including large-, mid-, small-, and micro-cap stocks.
The Institute for Supply Management’s (ISM) Purchasing Managers Index (PMI) for the US manufacturing sector measures sentiment based on survey data collected from a representative panel of manufacturing and services firms. PMI levels greater than 50 indicate expansion; below 50, contraction.
Less than truckload (LTL) freight refers to the transportation of products or goods that do not require a full truckload. These smaller freight loads typically result in many separate shipments being transported on one truck.
Precision scheduled railroading (PSR) was pioneered by E. Hunter Harrison in 1993 and is a strategy used by railroads to accomplish low operating ratios by consolidating their networks through the utilization of new point-to-point delivery tactics and consistent departure schedules.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is no guarantee of future results.
Equity securities are subject to price fluctuation and possible loss of principal.
Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
Diversification does not guarantee a profit or protect against a loss.
Companies in the infrastructure industry may be subject to a variety of factors, including high interest costs, high degrees of leverage, effects of economic slowdowns, increased competition, and impact resulting from government and regulatory policies and practices.
US Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the US government. The US government guarantees the principal and interest payments on US Treasuries when the securities are held to maturity. Unlike US Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the US government. Even when the US government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.