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Why would you want to invest in a transportation company? And especially one with no assets? Don't you know the economy is stumbling? Won't companies quit shipping stuff?
I have three things to say to these (self-imposed) questions:
- If the economy is stumbling, nobody has told transportation companies. Shipments are the highest they've been in three years.
- Intermodal transportation companies -- which usually don't have any assets -- are the fastest-growing segment of the transportation industry.
- I'm investing in Pacer International (Nasdaq: PACR) because the market hates it right now.
Pacer is an intermodal, asset-light freight transportation company. Let's break that down:
- Intermodal: Pacer transports cargo using multiple modes of transportation, most commonly rail and truck.
- Asset-light: Pacer doesn't own any of the equipment or transportation infrastructure it uses. The company has relationships with major railroads for access to their tracks and with independent truckers to whom they contract out trucking jobs. All of the containers Pacer uses to ship stuff -- which can be moved directly from railcars to trucks -- are leased.
- Freight: Pacer transports big stuff. Think getting 10,000 drivetrains from L.A. to Detroit and stopping in Memphis to pick up 40,000 tires before arriving between 4:00 and 4:30 p.m. on Thursday. This is FedEx for giant industrial companies.
Pacer is an agent, not a broker. Brokers are hired to connect customers who need to ship stuff with the shippers (railroads and truckers). With agents like Pacer, customers hire them to transport stuff. The customers don't know or care which rail system Pacer uses to get their freight to them, just as long as it gets there.
Pacer's story nightmare
Up until a few years ago, Pacer was a small, quiet company will a crown jewel: an exclusive contract to handle all of rail behemoth Union Pacific's (NYSE: UNP) wholesale intermodal business. This business was all Pacer's -- until suddenly it wasn't. Union Pacific cancelled its contract in 2009. The stock cratered, and rightfully so: The loss of that contract blew a huge hole in Pacer's revenue, and as a result the company was in danger of violating debt covenants. Earnings went deeply negative. Management cancelled the dividend. The company was in shambles.
Oh, and by the way, this happened in 2009 -- not exactly the best year to be in the transportation business in the first place.
Righting the ship
In 2009, it looked like the gig was up for Pacer. But then the company hired a new CEO, who quickly started changing pretty much everything about the company. Previously, Pacer had focused on wholesale intermodal transport -- predictable, high-volume, low-margin transportation to and from major rail hubs. With the loss of the Union Pacific contract, that business was dying, and new CEO Dan Avramovich fired the last deadly slug into it and kicked it to the curb. He also scrapped a few other small, unprofitable businesses, including one that did some international military transportation, and cut capacity (and thus costs) dramatically. After all, with that big-box wholesale business gone, there is no need to pay for so much capacity.
Though it doesn't own anything, Pacer has one tremendously valuable asset: relationships. Though a small company, it's previously large-scale business scored it relationships with major railroads CSX (NYSE: CSX), Kansas City Southern (NYSE: KSU), Norfolk Southern (NYSE: NSC), Canadian National Railway (NYSE: CNI), Union Pacific, and others -- all told, more than 60,000 miles of track. And even though big intermodal players J.B. Hunt (Nasdaq: JBHT) and Hub Group dwarf Pacer financially, Pacer has access to more containers than either of them. Its various relationships give it access to 41% of all containers in the country, compared with 25% for industry leader J.B. Hunt.
Armed with this asset, Avramovich focused almost entirely on one division: retail intermodal. This segment had been, in current management's own words, a stepchild. It received little attention, little funding, and little love from previous management. That's because, compared with the wholesale business, retail was a pain. In the wholesale business, customers went to Union Pacific, which handed the work to Pacer. Pacer did nothing to acquire new customers. With retail, Pacer had to find customers itself. But, as Avramovich saw, retail had much bigger potential. Whereas wholesale had been all about high volume and standardized routes, retail was all about customized solutions for individual customers -- and those come with higher margins.
Why intermodal exists
It's worth stepping back for a moment here and asking a good question. Intermodal companies don't bear any of the costs of transportation (ships, rails, trucks, expansion costs, and so on), yet they basically steal money from the companies that do. Why don't the railroads just do this themselves and disintermediate intermodal companies?
Short answer: Like hippos and oxpeckers, intermodal companies and the underlying freight transporters have a symbiotic relationship. Large freight transporters like railroads and steamship companies have massive fixed costs and so are fanatically focused on efficiency and utilization. They have little time for small, unpredictable customers -- but they view intermodal companies, which aggregate many small shippers, as one large customer. Railroads are further bogged down by strong unions, preventing them from competing with nimbler intermodal companies on cost. Also, since they are focused on efficiency, rails and steamship companies are loath to let their containers leave their networks, as they must for intermodal transportation; intermodal companies solve this by providing their own containers, which they'll lease to rail and steamship companies when they are not in use.
Valuation and catalysts
Pacer's stock remains severely depressed. After shrinking 25% in 2009, revenue fell another 5% in 2010. But don't miss the forest for the trees here: Backing out the wholesale business (which is now gone), revenue increased 15.5% last year, and it's on track to growth another 8%-10% this year. Avramovich's plan is working -- but the market isn't yet realizing it.
I think, however, that will change. Earnings and cash flow are both once again positive, and as we pass this fulcrum point in the transformation, the profitability change will be drastic. Pacer is on track to generate more than 100% earnings growth in 2010. On top of that, management finished paying down all existing debt in July, and that will become obvious when the company next reports earnings. And the intermodal industry is growing; if Pacer merely keeps up with industry growth, this is a home run.
All told, I value Pacer at more than $12 a share using conservative assumptions and a 12% discount rate. This is going to be a bumpy road (and shares trade lightly, so be sure to use a limit order), but that would make Pacer's stock -- recently trading around $4.25 -- a buy.
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