Is Another Price War Brewing in Trucking?

Pricing wars are never good for any industry. When any company or a group of companies try to gain market share by lowering prices, others often have to follow suit to protect their own market share, and the profitability of the whole industry suffers. The U.S. less-than-truckload, or LTL, industry has endured one such price war during the 2008-09 recession -- and it may now be poised for another.

LTL industry and 2008-09 price war

Before getting into details of what happened, let's first discuss what the LTL industry is.

LTL is a sub-segment of the trucking industry; it deals with freight that requires less than a full truckload capacity. Unlike the full truckload business, which is less capital-intensive and has low entry barriers, LTL companies require heavy investment in their terminals and service centers, where freight can be sorted and reloaded for its respective destinations.

Given the significant fixed costs involved in running these service centers, it is in the best interest of LTL companies to make sure that they are operating near full capacity. This sometimes gives rise to bad behavior among LTL players.

When freight volumes declined during the 2008-09 recession, Fedex Freight and Conway (NYSE: CNW) decided to fill their networks by agressively cutting their prices. They may also have wanted to seize upon the poor financial health of YRC Worldwide (YELL 0.61%), the largest LTL company in the United States. Conway and Fedex apparently thought they could drive YRC Worldwide out of the business with a short-term price war, which would reduce U.S. LTL capacity and let them raise prices again.

If that was their strategy, it didn't work. YRC Worldwide remained in business, and the industry was left with low-priced tonnage.

Another price war in offing 

Old Dominion Freight Lines (ODFL -11.04%) was the only LTL company that maintained pricing discipline during those times. But as a result, it attracted fewer customers, leaving its network with significant excess capacity. The company is now taking steps to fill its networks, even if it means being a bit flexible on pricing.

On Monday, the company updated its third-quarter guidance, raising its tonnage growth outlook but lowering pricing expectations (which it measures in revenue per hundredweight).

This isn't good news for the LTL industry, which is still emerging from its 2008-09 pricing war. These companies are still trying to renegotiate rates with their customers, and so far all the LTL players have remained disciplined on pricing.  Old Dominion's recent update has ignited concerns that it'll plunge the industry into another pricing war.

Why this move makes sense for Old Dominion

Old Dominion is in the best financial shape among all LTL companies. The company has a roughly 15% operating margin, which is almost double that of the next best LTL peer, Saia (SAIA -3.38%). Old Dominion  already enjoys the best pricing in the industry, and it makes little sense for it to increase prices further. On the other hand, the company's service centers have between 20% and 25% excess capacity, and the company can benefit from increased utilization by gaining more tonnage.  

To see how well Old Dominion's doing in this cycle and the last, let's look at its incremental margins. Regular margins measure how much of each dollar of revenue a company gets to keep in its gross, operating, or net profits. But incremental margins measure that percentage based not on a company's total revenue and profits for a given period, but on the amount by which those figures grew year over year. So if a company booked $100 million more in revenue year over year in its first quarter, and $10 million more in operating profit in the same period, it'd have an incremental operating margin of 10%

Old Dominion's current incremental operating margins are much higher than it's ever recorded -- currently exceeding 30% year to date, and well above 20% in each of the last three full fiscal years -- which gives it a little more room to cut its prices without losing too much profit. With a long-term target range of 15%-20%  for this figure, it makes sense for Old Dominion to add as much additional tonnage as possible in the current environment, even if that forces the company to get a little more flexible on its pricing. 

Current cycle incremental operating margins

Source: Company data

Previous cycle incremental/contribution margins

Source: Company data

What it means for others

Currently, many investors are very bullish on the ability of LTL companies to increase prices and grow their EPS. But by giving away some of its price increases to gain market share, Old Dominion may force other players to slow down their planned price increases, or risk losing market share. 

For Conway, analysts expect EPS to grow from $1.99 in the current year to $2.81 next year, a 41% year-over-year increase primarily on pricing. Given the emerging signs of increasing price competitiveness in the industry, this estimate may prove far too optimistic.

Conway and Saia are the principal peers of Old Dominion in regional markets, which include shipments of less than 1,000 miles. They will be affected directly, and they must become more cautious to ensure they don't lose their customers while raising their prices.

Conway in particular is in a tough spot. For the first half of this year, the company reported a 4.11% operating margin in its LTL operations, compared to 6.67% at Saia and 14.5% at Old Dominion. Conway was counting on improving pricing dynamics to get back to the 10% LTL operating margins that it enjoyed during the previous cycle. Now, the chances of that happening seem slimmer.

Conway's currently trading at 21 times its FY 2013 consensus EPS, which is higher than both Saia and Old Dominion. The stock is likely to see downward revision in its earnings estimates and P/E multiple compression going forward.

Arkansas Best (ARCB -6.13%) and YRC Worldwide are primarily into national markets -- routes greater than 1,000 miles -- and have limited direct competition from Old Dominion, which only gets 14% of its tonnage from national routes. However, if Conway responds to losing regional tonnage by trying to add more national cargo, Arkansas Best and YRC may find themselves with increased competition.

Also, YRC Worldwide is highly leveraged with more than $2 billion of long term debt, pension liabilities, and other claims  on its balance sheet. Even a slight deterioration in the LTL pricing environment might push it again toward fiscal trouble.

In conclusion...

While it is still too early to calculate the exact impact of Old Dominion's recent announcement on the LTL industry, it definitely is a negative development. The high expectations of potential improvement in industry pricing among investors increases the likelihood of a disappointment. The commentary on the latest pricing environment during the next earnings call will help investors gain a better understanding of what going on in the industry. Until then, it is best to avoid these stocks.