With a $27.66 close (September 23, 2015), XPO’s shares have fallen nearly 50% since reaching a high of nearly $51 in May 2015 and are approaching levels not seen since 2013. Sell side analysts remain extremely optimistic on the stock, with 12 month price targets averaging $56 and as high as $62.  Brad Jacobs is an impressive executive, with an unusual combination of strategic vision and attention to detail.  Moreover, unlike many historic acquirers in the logistics sector, he has remained disciplined in the multiples paid for his numerous acquisitions.  But there is a disconnect between how the equity research community has viewed the company and its fundamental value.

We’ll assume for the moment that XPO can integrate its various acquisitions and identify cost synergy and cross selling opportunities among its various businesses.  And we’ll assume that the balance sheet, with pro forma Debt to EBITDA of 5x is not excessive for a company with considerable cyclical exposure.  In fact, we’ll even assume that Con-way’s LTL business is not overly exposed to the economic cycle and that a company with more than 20,000 tractors and 150 million S.F. of warehouse space (including Con-way) is not asset intensive.  With all of that, let’s just consider the following math:

1. 81% of XPO’s pro forma EBITDA comes from Norbert Dentressangle and Con-way. The LTL and truckload businesses of Con-way are in GDP growth markets.  Norbert Dentressangle’s groupage (LTL) and over the road (truckload) businesses are also all in GDP growth markets (in this case Old Europe GDP growth), as is its European warehousing business.  The two interesting pieces of these companies are Jacobson (the US warehousing business acquired in 2014 by Norbert Dentressangle) and Menlo.   While growth rates are higher in the US third-party warehousing market (and relatively mature in the European market, where more outsourcing has already occurred), neither Jacobson nor Menlo has improved operating profit on a sustained organic basis over the past 8-10 years.  At $27MM in 2014, Menlo’s operating profit is only slightly higher than it was before the Great Recession.
2. On a pro forma basis and using favorable depreciation assumptions, XPO’s pro forma return on capital employed (ROCE, which we define as EBIT divided by Net PP&E and Net Working Capital) is 23%. Leading “asset light” players like Expeditors and CH Robinson are over 80%. Moreover, XPO benefits from having relatively low working capital.  With similar EBITDA levels, XPO has 5x Expeditor’s Net PP&E and 13x CH Robinson’s.  Its ROCE is much closer to that of an asset based truckload carrier like Swift or Werner than it is to asset light comparables.
3. Asset-light competitors typically have capital expenditures to revenue ratios of about 1%. XPO is estimating that its ratio will be 3.3%.  The implication of this is that the “DA” part of “EBITDA” will be higher and that benchmarking XPO vs low capex competitors on an EBIITDA multiple basis is inappropriate because “XPO’s EBITDA isn’t as good as their EBITDA”.

To sum up the bad news, the vast majority of XPO’s EBITDA is from relatively low growth markets and its ROCE is either reflective of an asset based business or of a very unprofitable asset light business.  (We don’t get caught up in this terminology too much, as it is actually not a good reflection of the overall Beta (or economic risk) inherent in a business.   For example, a truckload carrier can actually usually reduce costs more quickly to accommodate volume decreases than an asset light network operator like Forward Air can.)  As such, XPO deserves a lower EBITDA multiple than the sell side community suggests.

But, offsetting at least some of the bad news and contrary to what investors seem to think (based on XPO’s recent share price performance), we believe the Con-way deal will create value.  It was well priced, there are clear synergies, and both Con-way and Menlo have excellent franchises that probably offer upside on the financial side.  While Con-way’s management team built a company with an excellent reputation and loved by its customers, it will benefit from a fresh focus on profitability – which XPO’s team can likely provide.  Finally, we don’t have a big problem with mixing asset and non-asset businesses as long as one understands the core issues of growth, ROCE, and risk.

Despite a strong equity market and some high profile transactions, we thus far see relatively little evidence of a robust M&A market in the logistics sector.  Most acquisitions by large competitors have been of targets with a specific industry expertise (e.g., health care) or geographic market.  The Russian Railways acquisition of GEFCO, Platinum Equity’s buyout of CAT Logistics, and C.H. Robinson’s transaction with Phoenix are the most notable exceptions.  But none of these match the size and complexity of Deutsche Post’s series of acquisitions in the 1990s or even of the last really big deal in the sector when CEVA (then known as TNT Logistics)combined with Eagle for $2 billion in 2007.  Public multiples in the sector are down, reflecting concerns on whether — as a recent Merrill Lynch research report suggested on freight forwarding — the best days of industry growth are in the past.

The last acquisition wave was driven in part by unrealistic extrapolations of the status quo competitive environment and unreasonably low views of the cost of capital cost (used explicitly or implicitly to price acquisitions).  A common characteristic of the most aggressive acquirers was availability of (and desire to redeploy) cash, either from a mature dominant business line in a conglomerate (e.g., Deutsche Post, Toll, UPS) or from aggressive lending to the LBO market.  We now see the inverse of conditions during this period.  Executive and investors are too gloomy, extrapolating the uncertainty of the recent past into perpetuity.  Companies are very reluctant to spend excess cash and the leveraged finance market will not support aggressive capital structures.  As a politician once said after the fall of the Berlin Wall, “The march to freedom in Eastern Europe is irreversible.  But that could change.”

While many of the larger logistics combinations did not work out as easily or as well as investors and executives once hoped, M&A remains a potent tool for growth in the sector.  With low margins and increasingly high fixed infrastructure costs needed to compete broadly, even relatively low cost savings or revenue enhancements can be enormously accretive for acquirers.  Moreover, there remain numerous logistics companies in the hands of private equity holders, which will not remain static.  And there are many quality logistics concerns still owned and run by their founders, who will eventually wish to retire.  So we recommend a more balanced, long term view of the state of logistics M&A.  Broad auctions of the type that attracted dozens of financial buyers might not make sense.  But keeping a steady eye out for potential partners constituting the right strategic and organizational fit and a long term plan emphasizing value creation will pay off in the long term.