XPO Logistics: Value Play or Value Trap?

XPO Logistics (XPO 1.41%) is one of the world's biggest freight brokerage providers, and it's down about 50% from its highs in October. In this week's episode of Industry Focus: Energy, host Nick Sciple talks with Motley Fool contributor Bill Barker of MFAM Funds about this company's impressive past and uncertain future. Find out the biggest reasons the company's sold off so sharply since October, how XPO is pivoting to reposition themselves in the logistics market, what this all means for current and prospective shareholders, what risks investors definitely need to keep an eye on, and, of course, whether the company could be a value play at these depressed levels. Tune in to hear more.

A full transcript follows the video.

This video was recorded on Feb. 28, 2019.

Nick Sciple: Welcome Industry Focus, the podcast that dives into a different sector of the stock market every day. Today's Thursday, Feb. 28, and we're talking XPO Logistics. I'm your host, Nick Sciple, and today I'm joined in studio by MFAM Funds' Bill Barker. How's it going, Bill?

Bill Barker: It's going well. Thanks for having me!

Sciple: I'm glad to have you as well! This week we're answering a listener question from Peter F. Smith. He says he listens to way too many Motley Fool podcasts, has been investing since he was a teenager. He wants us to talk about XPO Logistics. He says it's a pick in one or more of The Motley Fool funds and ETFs. He just read their transcript from the last conference call and couldn't square what was said by management with the recent movement in the stock.

Well, Bill Barker is from MFAM Funds and has been falling XPO Logistics for a little while. Bill, before we dive into this company, when I was talking to you last week as we were getting ready to record this episode, you had a very interesting story about how you came across this company. It's indicative of how you always have to have your nose out for opportunity. Can you talk to us a little bit about how you first encountered XPO Logistics? 

Barker: Sure. I spend most my time on the funds that we have, MFAM Funds. Back in 2012, I went to a conference in New York hosted by Credit Suisse, I believe. Their normal conference mechanics are, there are a bunch of tracks where you go into one room or another to listen to management presentation. I had a certain presentation that I wanted to hear in one of the four rooms during the, let's call it the 2:30-to-3:00 block. Then, the 3:00 block, I didn't have anything that I was particularly interested in seeing, so I just stayed in my seat for the next presentation, which was XPO Logistics. And it was just a series of letters and the word "logistics." I thought it couldn't possibly be interesting, but easier to just stay in my seat than go walk into a different room.

It turned out that they were giving a presentation -- this was in 2012 -- on their plans for growth, and Bradley Jacobs' history in executing roll-ups in other industries, and the attractiveness of doing it at the time, strictly in truck brokerage. And the growth numbers through a roll-up strategy that they were projecting seemed hard to believe. I'll just say that what they've done since then is far bigger a growth roll-up strategy than they were presenting even back then. 

Sciple: For our listeners who may not be familiar with what a roll-up strategy is and what it entails, can you explain that in general terms, for someone who's new to that term? 

Barker: Sure. It's the acquisition of other businesses, either what you might call a tuck-in business, which is a small piece, to add to a large piece of what you've already got, or a major acquisition, which is transformative to the business. At the time, just to put some numbers around that, the company was doing, let's call it, $150 million a year in revenue. The plan was to grow to something billion over a period of time. Of course, they're a $17 billion revenue company today. That's roughly 100X growth. That's only achievable, in most businesses, through acquiring other businesses, rather than through purely organic growth. For the most part, organic growth is more attractive, growing your own business rather than paying up to acquire other businesses. I'll just say that for the most part, I wouldn't recommend pursuing companies that have a roll-up strategy. It tends to lead to empire-building. While it can be rewarding to shareholders, more often it is not.

Sciple: XPO Logistics, as you mentioned, has been very aggressive with that strategy. The number I saw is that between 2012, when you first discovered the business, and 2015, they acquired 17 U.S. and European businesses over that time. Can you talk about the industry in which they operate? XPO Logistics is a trucking and logistics company. You mentioned the logistics brokerage services. Can you talk about the kind of businesses that XPO has been acquiring and their strategy in doing so over time?

Barker: Back then, 2012, truck brokerage. What is that? That's basically being a middleman between the trucker and the company that needs goods moved. If they don't have their own fleet, and most companies do not have their own fleet -- of course, if you're driving around, you'll see a Pepsi sign, PepsiCo, on a truck, or any number of other major names, which have the capacity to move their own goods. But most companies are using somebody else to move their goods. Trucking companies, there are several large players, but more often it's a mom-and-pop operation. You've got, literally, the pop is usually the truck driver, and the mom is handling that side of the business on arranging some of the work. You've got to keep your trucks full. You've got to be out on the road. You build up a little fleet, maybe five or 10 trucks, something like that. That can be a good business. But you still have to have customers. XPO, on the truck brokerage side, is putting truckers together with merchants.

Sciple: Right. They mentioned in their filings they're the second largest freight brokerage provider worldwide, based on the value of freight under management. They've really grown significantly over time with these acquisitions. 

One of the areas in which XPO specializes, and I wanted to call out, is this idea of less than truckload transportation. Can you discus for our listeners what the significance is of less than truckload transportation, how XPO is positioning themselves and offering those services, and what potential that has for some growth for the business over time?

Barker: Let's use some round numbers. There's, call it $1 trillion of transport going on in the U.S. annually. About $700 billion of that is trucking. You've also got air cargo, shipping, rail, and a few other ways to move things. Trucking is about $700 billion. Of that $700 billion, about $600 billion is going to be full truckload. About $40 billion annually is going to be less than truckload. Less than truckload is just, it's a truck that's picking up a bunch of different cargoes along the way, and then bringing them to a distribution center, and maybe that cargo gets put on another truck. It's a logistics-intensive industry unlike truckload, which for the most part is, the truckload is a full truckload of one thing that's going in one place. That's the larger part of how things are moved. 

But still, $40 billion annually is a good business to be in. And it's a little bit more insulated from protection, in terms of, the logistics are just more complicated in moving something with a number of different customers to a number of different places. 

A couple of years ago, XPO did something that it had said it wasn't going to do, which was to get into this asset-intensive trucking business. It bought Con-way. This was an operation which had substantial revenues and substantial EBITDA, but was not an especially well run operation. Then they acquired an European operation called Norbert Dentressangle. Between those, they wound up with a lot of both less than trucking and trucking. What they did is they sold off the trucking, held on the less than truckload of Con-way. That offers them the opportunity to serve their customers with a lot of different operations. 

The other things they do, intermodal is when a ship comes in and then you put it on rail. Drayage is just moving things around within a ship, off the shipping. They've got the less than truckload operation, and truck brokerage. They've got a lot of different ways that they can serve their customers. 

Sciple: Right. What's particularly interesting to me and attractive to look at this space right now is, as e-commerce has emerged over time, the complexity of logistics and moving things around has only increased as we move small numbers of packages to individual homes vs. large numbers of what might be full truckload shipments to stores or things like that. As the role of e-commerce grows in the economy, what opportunities does that provide for XPO Logistics? Is that the main driver for their business over time? How should we think about the shifting demand for logistics and what role that might play in XPO's business moving forward? 

Barker: It's still rapidly growing. The last-mile challenge, they're the leader in last-mile deliveries. That's getting... it's not really packages, they're moving heavy goods on last-mile. If you order a washer, dryer, it needs to be installed in your house, there's a very good chance that XPO is going to be the one doing that. That's high-touch. You've got skilled labor that's involved. It's very consequential to the purchaser whether it's done right and whether the right window is met, and all that. There are better profits to be gained by doing that right than by just moving parcels around. As good as the parcel business is for UPS and FedEx and the U.S. Postal Service, that's a business that XPO is not going to get into. But the last-mile heavy goods stuff is growing because of the growing use of e-commerce. It has been growing very nicely for XPO, although, as we'll get to, there's been a little hiccup in that.

Sciple: Let's talk about that hiccup. A little bit of XPO's recent performance has disappointed investors. If you look at the share price, it's down over 50% since its highs back in October. In the most recent earnings call, CEO Bradley Jacobs right off the top of the call said, "There's no other way to say it, we just missed the quarter." What happened in XPO's recent results that generated this sharp decline in share price? How should investors think about that? 

Barker: XPO, going into October, was trading over $100 a share. One of the reasons for that is that the company had not only put forward aggressive guidance over the past five or six years on its growth, and it hitting certain metrics -- the company-adjusted EBITDA numbers and things like that; I won't get too much into the accounting details. But, they'd hit them consistently for five or six years. Then, the third quarter earnings came out, and they missed their numbers because of a bankruptcy in Europe. And not only missed the number for the quarter -- it was really one customer prevented them from hitting the previous guidance -- but they lowered their guidance for the fourth quarter. 

That was a new part of the story, which hit the stock fairly hard back then. And then, there was a short-seller report that came out in December. Still, mostly, the stock had delivered on the guidance that it provided. Then, the fourth quarter numbers came in, and a couple of things happened. One, there was weakness in England, the U.K., and France as Europe has slowed down and as Brexit worries have impacted there. That was part of it. A bigger part was that XPO's largest customer in the fourth quarter pulled their postal injection business, and then, a couple of weeks later, pulled another big chunk of their business, so XPO had to radically reduce their guidance for 2019. 

Sciple: Right. Following up on that largest customer, you mentioned it was the postal injection business. For our listeners, postal injection is when a large shipper will have a large number of packages that they have a distribution center. Postal injection is taking those unsorted packages from the distribution center, then taking them to the USPS and then injecting those into the USPS' logistics system. USPS recently increased its postal rates, which may have played a role in this. 

There's some speculation about the identity of this customer. Management said on the call this had been a $900 million customer, but has now reduced its spending to become around a $300 million customer. When you talk about losing $600 million in revenue going forward, you think it's probably a very, very large business that XPO is doing business with. There's been some rumors that this company is Amazon. What thoughts do you have on this rumor on who the identity of this customer might be? If it is Amazon, what are your thoughts on the idea of XPO losing this business moving forward? 

Barker: I think the speculation that this is Amazon is pretty much on par with the speculation that, in previous filings, Individual 1 might be Donald Trump, for instance. It's not stated, but really, there is no other possibility that can be. [laughs] Amazon has pulled approximately $600 million of their $900 million of annual business. Presumably, the reason they have not pulled the other $300 million is -- well, not presumably. They have long-term contracts. So, where they didn't have long-term contracts, they're out. 

Assuming, given the 99% probability that this is Amazon, why'd they do that? Well, they have been staffing up for bringing logistics business in-house. It wasn't a shock that this was going to happen, or would very likely happen someday. The timing was a shock to the company. The postal injection business was pulled right before Christmas. And then, this other deduction in business was done right before the company announced its earnings. Why might Amazon have done this? Speculation includes -- and let's underline that this is speculation -- a fairly high profile hire for XPO, their new COO, had been at Amazon and was a pretty useful guy at Amazon. Maybe this is retribution for that. I can't say anything other than, that's speculation. If that's the case, then you don't look at this as having failed to serve a big and important customer in the right way as much as having put the business at some risk that Amazon might do this by hiring away somebody, and having now seen that risk come up into reality. I don't know that I would excuse XPO for the consequences of the action if it was predictable.

Sciple: Right. It's worth saying, this is concerning news. Amazon was a large customer for XPO. But XPO does have a large, large number of other customers. This individual customer, whoever it was, I believe management said was around 5% of total revenue. A large chunk, but now a double-digit amount of revenue that would be impacted over time. Management still remains bullish on the business' prospects moving forward. They just completed a $1 billion share repurchase that they put forward following the short-seller report you mentioned a couple of months ago. At the beginning of February, they just approved another $1.5 billion in repurchases. So, as you see, Bill, management continuing to double down on repurchases of the business in the face of what appears to be some troubles, how do you think about that as an investor, as someone watching the company?

Barker: Two thoughts. One, a lot of the optimism in the company was, when it was going for over $100 a share back in October, not only were there good current numbers that the company had delivered on, but, looking in the rearview mirror, this was a company that had grown at the pace that it had grown and was talking about making additional major acquisitions. In fact, they had conducted a secondary within the last 12, 18 months, I can't remember when it was, to have some money available for an additional acquisition. They were talking about making an acquisition up into the $6 billion mark. 

Well, that was a story that had attracted Wall Street analysts and investors consistently over the last seven years. And now, the company has really reeled that back in and said, "We're not going to be making any major acquisition." They had taken a pause on acquisitions as they looked for the right thing at the right price. And now, they're just buying back their shares with as much money as they can get their hands on, and they're taking out some debt to do that. They already had debt. They've been paying debt off in the last two years. You don't grow 100X without issuing shares or taking on debt, and they've done both. They've had a bunch of secondaries. They've taken on a lot of debt. Now, they're buying back shares. There's financial engineering. If that sounds negative, I don't mean it to sound negative. They have taken advantage of a high stock price in the past by having secondaries. They've taken advantage of cheap debt by issuing a lot of debt. Now they're, under their declaration, taking advantage of a low stock price. They have a pretty good track record for doing the right thing with shareholder capital, but this is not a strategy that does not come with some risk.

Sciple: Yeah. Definitely encouraging that management is still seeing value in their shares after the steep decline. However, this shift in strategy for what the business has been for the past five or so years is something that we'll have to see how things develop. 

Barker: Yeah. We've owned this company in a couple of our funds for seven years. We were getting it back around $16 a share back when we were buying it in 2012. We've seen it be cut in half once before. That was in reaction to the acquisitions of Con-way and Norbert Dentressangle, which made the company -- previously, it was a very, very asset-light company, and that's very attractive because they can take advantage of a good economy, hire more people, get on the phones, use technology to put the shippers and the truckers together. But taking on the trucks, which they've done with these two major acquisitions, made them an asset-mixed business, but far more asset-heavy and far more cyclically exposed. So, the change in strategy led to the stock being cut in half. It rebounded from that. Tripled again, back to where it was in October. 

Now, it's been cut in half again because in part, one, they failed to deliver on guidance; two, they've lost this major customer; three, they've changed strategy from "we're going to be an M&A king" to "we're going to buy back our own shares." And you've had a lot of, I would say, Wall Street enthusiasm around the story and the execution of the stock in part, one cynically could say, because they're a very good customer of Wall Street. They've had all these secondaries, they've had all these debt issuances, getting involved in M&A deals is good business for Wall Street and they've been a good customer. Part of the short-seller report that we talked about accused Wall Street of being in the bag for XPO and pumping up the stock price. Well, I think that XPO has delivered a pretty impressive story. But, it's also true that there are plenty of Wall Street firms that want to do business with XPO.

Sciple: Right. Definitely going to be an interesting story to see as the strategy develops over time. Given that they have navigated through such a strategy shift in the past and been able to maintain momentum, definitely encouraging for a shareholder. 

Obviously, these things can create some volatility in the near term. But as we look out as true long-term shareholders at the trajectory of XPO moving forward, is the thesis still intact on the value proposition that XPO brings to an investor? Are you concerned about this short-term volatility? 

Barker: It depends on what your thesis is. If your thesis is, "I believe that management," in this case, Bradley Jacobs, the CEO, "is a good allocator of capital and can see opportunities in terms of acquisitions, and then actually do the hard work of integrating these acquisitions in a way that most cannot," I think that's intact because he's still there. 

Some of the other management have left in the last 18 months. So, if your thesis went beyond Bradley Jacobs, then you've got to identify whether the CFO, they're looking for a new CFO, they've brought in a new COO, the chief strategy officer has also changed in the last nine months. You have to determine what your thesis is. If your thesis is, "This is going to be a rapidly growing company," the thesis has changed. Right now, it is still growing, but it's not growing at anywhere near the pace that it was. So, you've got, probably, in the market, a bunch of growth investors getting out of the story and value investors looking at it right now. It's certainly not deep value, but it's trading at multiples below the comp group. 

I think you have to compare it both against trucking companies and against truck brokerage companies. You have to do the work there. But I think at today's prices, it's going to find some value investors. 

Sciple: Definitely will be an interesting story to follow as the narratives around the company change and, as you mentioned, the shareholder base of the company changes. Operating in this logistics industry, which as we mentioned earlier, with the emergence of e-commerce, is going to be a key cog in that trend going forward. Definitely an interesting company to watch in that space.

Bill, thanks so much for coming on the show to talk about XPO a little bit. I hope to have you on again soon!

Barker: Thanks for having me!

Sciple: Awesome! As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass. For Bill Barker, I'm Nick Sciple. Thanks for listening and Fool on!

Check out the latest earnings call transcript for XPO Logistics.