Why XPO's Results Could Signal a Split-Up Ahead

Logistics and transport giant XPO Logistics (XPO -0.76%) delivered second-quarter results at the end of July that exceeded expectations, but you would never know it from the stock's reaction.

Shares of XPO fell by more than 10% in the trading session following the earnings release as investors honed in on sluggishness in some key businesses. XPO also disappointed by comparison, with other high-profile transportation stocks delivering blockbuster results for the quarter.

I believe there is a good case to be made that Wall Street overreacted to the downside to XPO's results, but the stock's move if nothing else widens a valuation gap between XPO and other transports that has frustrated management for some time. Management was ready to act to address that gap prior to the COVID-19 pandemic, and as conditions normalize it is becoming more and more likely they will act again in the quarters to come.

Here's a look at XPO's most recent quarter, and what's next for the company.

Earnings were OK. But only OK

On Friday, July 31, XPO reported a second-quarter loss of $0.63 per share on revenue of $3.5 billion, beating analyst expectations for a $0.73-per-share loss on revenue of $3.38 billion. CEO Bradley Jacobs said in a statement, "the ramifications of COVID-19 dominated the second quarter," but XPO painted a relatively optimistic picture for the remainder of 2020.

"We've seen a recovery take hold in Europe and start in North America," Jacobs said. "E-commerce continues to be our strongest tailwind, benefiting contract logistics and last mile. Our last-mile network in North America generated year-over-year revenue growth of 3% in the quarter, with a net revenue margin of 37%."

Image source: XPO Logistics.

Earlier this year, XPO withdrew guidance due to the pandemic, but the company has enough clarity now to say it expects to produce "at least" $350 million in adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) in the third quarter. By comparison, XPO reported adjusted EBITDA of $172 million in the three months that just ended.

XPO's logistics operation performed better than expected in the second quarter, but investors were focused on weak results from its "less-than-truckload" (LTL) business. LTL pounds per day fell 19%, while shipments per day were down 15%, and gross revenue per shipment dropped to $282.61 from $299.84.

The business's operating ratio -- a measure of how efficient it is -- also fell in the quarter even as other trucking companies including Old Dominion Freight Line posted improvements.

On a post-earnings call with investors, Jacobs blamed the increase on tonnage being down and "an intense focus on employee safety," saying he expects operating ratio "to be substantially better" in the third quarter.

Cue the breakup talk?

The stock's post-earnings performance only amplified an issue that has been weighing on XPO shareholders, and management, for years. The company, a combination of many different logistics and transport businesses, continues to trade at a substantial discount to some of its more pure-play peers.

As of Aug. 3, XPO trades at an enterprise value 9.55 times forward EBITDA, a pretty extreme discount to the multiples the market assigns to industry leaders including Old Dominion and logistics pure-play C.H. Robinson Worldwide and below those of second-tier companies including Echo Global Logistics and SAIA.

Data source: YCharts

Prior to the COVID-19 pandemic, XPO announced it was exploring selling one or more of its business units to address the valuation gap. XPO called off that divestiture plan in late March due to market conditions, but following the second-quarter earnings release and the market's reaction it is hard to imagine there aren't serious discussions going on right now at XPO headquarters.

Multiple ways to win

Prior to its recent difficult run, XPO was able to generate a stock gain of more than 3,000% during a 10-year period ending in mid-2018. The company accomplished that growth largely through mergers and acquisitions, but in the last year, management has shown a willingness to be flexible.

I believe that, absent the pandemic, XPO would have sold off multiple large pieces of the business by now. Industry sources in February were telling me XPO was seeing solid interest in the units that were being shopped. The pandemic provided a reset, and another chance for XPO to show the different parts of the business work well together. Instead, the so-called conglomerate discount remains and shows no sign of ebbing.

XPO is a leader in e-commerce fulfillment, has a strong suit of products to help retailers better compete with the scale of Amazon.com and other giants, and a growing contract logistics business that fits well into the trend of large companies outsourcing warehousing functions. The e-commerce business has proven to be resilient in this environment, helping to offset weakness elsewhere, and the long-term growth trends are enticing.

Given enough time, I believe XPO has the assets to compete and win either as a combined company or as a number of stand-alone pure-play businesses. But looking at the stock's performance, and management's commitment to drive valuation higher sooner rather than later, I'd expect a fresh discussion of breakups is just down the road for XPO Logistics.