Intermodal transportation is the use of multiple forms of transportation (i.e., combining trucking and rail) to move the same container of freight. Intermodal is a better alternative in many cases to pure trucking because it includes rail, which is cheaper than pure trucking, while also retaining the local trucking necessary to get the cargo from the shipper to the train terminal and from the terminal to the final destination. The local trucking, also called “drayage”, is necessary because railroads do not usually go directly to the backdoor of the business it is being shipped from or to.
Intermodal is superior to pure trucking for a few reasons. First, a train can go about four times the distance on a single gallon of diesel fuel than a truck can, making it cheaper as gas prices climb. Second, trucking has experienced a shortage of drivers and continues to do so. In some cases, trucker turnover is 100%. To reduce turnover, trucking companies will likely need to raise prices, further making trucking the less desirable option. The downsides to rail are that it can take a day or two longer than trucking and some areas of the country are not yet fully accessible by double-stacked trains. Further, service in the past was unreliable, though that has greatly improved. Overall, rail costs 10-30% cheaper than pure trucking over long enough distances, which overcomes the downsides in the eyes of most shippers.
At the end of 2006, intermodal’s share of long haul (550 or more miles) dry van freight in the U.S. was under 5.5%. By the end of 2010, that market share was over 7.5%, according to Hub Group, a major participant in the industry. The only reason the market share was not higher was capacity constraints. The intermodal market was basically at 100% capacity last year. The companies that participate in that market continue to make the investment necessary to expand capacity and accessibility, most of the cost being shouldered by the railroads. In 2011, capacity is expected to increase 15% or more. As capacity grows, so too shall overall volume.
Intermodal Marketing Companies
The participants in the intermodal market that I like the most are the asset-light, intermodal marketing companies (IMC’s), namely Pacer International (PACR) and Hub Group (HUBG). IMC’s are middle men that organize the shipping of cargo from the door of the shipper to the door of the final destination. They are called “asset-light” because they own very little assets. They do not own any railroad companies or trucking companies but instead contract with them for their services. The equipment they are in charge of, which are containers to carry the cargo and chassis and trailers to carry the containers, are mostly leased instead of purchased or rented from the railroad companies on a per use basis. I prefer IMC’s to railroads because of the significantly lower capital expenditure requirements.
While it stands to reason that railroads could simply contract with local trucking companies and work directly with the shipper instead of going through IMC’s, they have chosen not to pursue that route. IMC’s have the expertise and infrastructure in place to provide this valuable service efficiently and railroads have proven all too happy to concede that function to the IMC’s.
The key to success for IMC’s is capacity and efficiency. To get the shipping business, you have to have the capacity to handle it. To justify the expense for maintaining the capacity, you have to have sufficient customers. This scale effect creates a barrier to competing with the four largest IMC’s in the industry, J.B. Hunt, Hub Group, Pacer International, and Schneider. Further, IMC’s most important metric relates to efficiency. Pacer calls the metric “equipment turn” while Hub Group calls it “utilization.” It is essentially a measure of how efficiently each IMC is using its fleet of containers that it owns or leases. Using the equipment turn calculation, the key is to maximize the number of times that each container carries revenue-generating cargo per month. An efficient IMC’s containers should bear revenue-generating cargo at least two times each month.
The great thing about the four largest IMC’s just mentioned is that they do not really need to compete against each other for the near future. First, they will continue to steal market share from trucking as a group. Second, the competitive landscape has become very challenging for their smaller competitors because some recent industry changes have made their higher-cost structure (due to lack of scale) untenable. Third, big shippers prefer to spread their activity over multiple railroad companies to reduce risk, and different IMC’s use different railroad companies. For instance, J.B. Hunt uses Burlington Northern while Hub and Pacer use Union Pacific.
Specific Companies to Consider
Hub Group is a very well-run company with an equipment turn of about 2.4. The company even admits that there is not much room to improve that number. It is as efficient and profitable (margin-wise) as it is likely to get. The problem is that the market knows it also. I think Hub is fairly to slightly over-valued right now by the market.
The real opportunity from an investment perspective lies in Pacer. Pacer has had some difficulties in recent years due primarily to a favorable contract that allowed it to grow complacent. The company lost that favorable contract starting in 2008 so had to adjust its thinking. The company got rid of their old management, brought in all new management with excellent experience in the industry, and implemented a new IT system (10 years after Hub did) to improve efficiency and reduce costs. Since they are in a transition period, Wall Street has been hesitant to invest in the company. Removing capital expenditure decisions for 2010 and looking only at cash flow from operations, Hub only had 2.4 times the operating cash flow compared to Pacer but, prior to Q1 2011 earnings releases, approximately 8 times the market capitalization.
Pacer has increased its equipment turn from 1.5 in 2009 to 1.65 in 2010, proving it is going in the right direction. We purchased a partial position in Pacer prior to the Q1 2011 earnings release because we think the company can execute on its plans but needed further proof. Pacer released Q1 earnings last Thursday, April 28th, and demonstrated that it is continuing to improve efficiency as equipment turn increased to 1.7. As a result, the stock increased approximately 18% in one day. We think there is still plenty of room for growth in Pacer, however, and will continue to move into it as the company successfully executes on its plan.
Jonathan Booth, CEO
Disclosure: Long PACR