Wall Street to C.H. Robinson: what happened to flexibility?

Wall Street transportation equities analysts weren’t surprised by narrower margins in C.H. Robinson’s (NASDAQ: CHRW) freight brokerage business when the company reported earnings on April 28 after the market’s close. After a year when revenue growth was hard to come by, Robinson management had made the decision to ‘take market share’ – more on that later – and cut prices to customers. At the same time, an unprecedented truckload volume surge in the month of March raised spot prices.

Net revenue margins in Robinson’s North American Surface Transportation (NAST) division, comprising truckload, less-than-truckload (LTL), and intermodal brokerage, compressed by 420 basis points (bps) year-over-year and about 80 bps quarter-on-quarter. Robinson’s margin across those three lines of business was 13.2% in the first quarter of 2020; margin compression, management said, was driven mostly by truckload pricing dynamics. 

The trouble was what happened to that net revenue once the brokers covered their loads. Robinson’s operating costs failed to adjust to the market. The company’s operating margin, the percentage of net revenue converted to operating income, fell from 33.1% in the first quarter of 2019 to 19.3% in the first quarter of 2020, the lowest since Robinson began publicly reporting its financials in 1995. Then Robinson still had to pay taxes and interest on its debt.

To be fair, C.H. Robinson operated well in a very tough environment. Note that Echo Global Logistics (NASDAQ: ECHO) posted a loss for the quarter, as did J.B. Hunt’s (NASDAQ: JBHT) freight brokerage, Integrated Capacity Solutions.

The gradual and still-in-progress evolution of Robinson’s business model from a decentralized network of sales branches to a technology-first organization built largely inside the company’s headquarters has yielded some fascinating results already. 

For starters, NAST was able to achieve a decisive decoupling of trucking volume growth and headcount in the quarter – truckload and LTL volumes were both up 7.5% compared to the year-ago period, while NAST headcount was down by 5.2%. In effect, each NAST employee generated 6.5% more gross revenue than the year prior, and crucially, this happened as contract and spot prices were negative year-over-year.

As management noted on the call, the year-over-year productivity gains should not be attributed to a high degree of routing guide compliance, which makes it easier for brokers to source capacity, because average routing guide depth has been roughly the same for five quarters.

But when it comes to the flexibility of adjusting operating costs to market conditions, hiring lots of software developers, computer engineers and data scientists comes with a downside.

“The re-centralization of a tech-enabled, non-asset business over the last decade has shifted comp structures to become less variable than they were in the 2000s,” Susquehanna analyst Bascome Majors pointed out in a client note.

On the call, Robinson chief executive officer Bob Biesterfeld explained that the incremental headcount additions made in engineering, data science and shared professional services came with a less variable compensation structure. In other words, computer programmers don’t want their paychecks tied to trucking rates.

Despite the cuts in NAST headcount, the number of employees in “All Other & Corporate” grew by 10.4% year-over-year. When combined with 2.5% headcount growth in Global Forwarding, Robinson’s total number of employees grew by 0.4%. That said, Biesterfeld announced that Robinson had furloughed 7% of its employees temporarily until volumes returned to normal.

Morgan Stanley’s Ravi Shanker was pessimistic about what he perceived as Robinson’s lack of flexibility in operating expenses.

“We believe CHRW’s first quarter clearly disproves the bull case of brokers being ‘defensive’ in a downturn,” Shanker wrote in a client note. “While this was clearly in evidence during the 2016 and 2019 freight recessions as well, the fact that operating income and free cash flow are declining so sharply in a soft volume environment are signs that the cost structure is not as flexible as the market believes.”

Contrary to Shanker, freight brokerages do well in the initial phase of a downturn, when falling spot rates (costs) outrun lagging contract rates. But there’s nothing inherently defensive in the non-asset third-party logistics model that can protect profits after a year-long bear market in freight, a fact noted by Bascome Majors, who wrote that Robinson’s “typical variable compensation cushion was largely exhausted by a challenging 2019.”

But it appears that investors did not fully anticipate Robinson’s growing operating costs (personnel costs now consume 58.1% of net revenue, up from 50.1% a year ago, while depreciation and amortization rose 70 bps to 4.3% and other SG&A ballooned from 13.2% to 18.3%).

Deutsche Bank’s Amit Mehrotra described the results as “incredibly bad,” adding that “we thought we made a mistake in our model when entering the actual results, but unfortunately we didn’t.”

“Operating cost performance was meaningfully worse than our forecast,” wrote UBS analyst Tom Wadewitz in a client note. “Operating expense rose 1% year-over-year compared to our forecast of an 8% decline.”

Still, after the call, Wadewitz affirmed his bullish view of the stock and wrote that “we believe that CHRW’s scale, tech investments, and balance sheet strength matter.”

Cowen’s Jason Seidel had estimated that Robinson would generate $153.1 million in operating income; the actual result, $109.4 million, was 28.5% lower. 

Prior to the earnings release on April 28, shares of C.H. Robinson closed at $74.01. CHRW gapped lower on the April 29 market open and dropped as low as $68.86 by mid-morning, but pared losses and closed the day at $71.26, or 3.7% lower than the pre-earnings price on a day that the S&P 500 was up 2.64%.

Taking market share?

In the first century AD, Seneca the Younger wrote a letter to his friend Lucilius offering a piece of advice. Lucilius was reading too many different books and spreading himself too thin. Seneca encouraged him to focus and concentrate his studies. “Everywhere is nowhere. When a person spends all his time in foreign travel, he ends by having many acquaintances, but no friends.”

Might the same be said for a market share-taking strategy that crushes profits by 50%? 

Biesterfeld said that Robinson’s 7.5% increase in truckload volumes represented its commitment to taking market share in a quarter when the Cass Freight Index was down between 8% and 9%. 

Robinson regularly compares its truckload volume growth trends to Cass, which can be somewhat misleading because Cass aggregates freight from all modes, including railroad, barge, air and parcel. 

As transportation industry watchers know, in the first quarter of 2020, containerized imports into North America fell dramatically when China shut down due to the coronavirus; later air traffic, and with it, air freight volumes fell precipitously. March, however, saw a massive surge in contracted truckload volumes, which at their peak on March 23 were 29% higher year-over-year. In this case, when volumes in each mode diverged from each other, comparing one’s own truckload volumes to the whole Cass Index is less helpful.

Regardless of the Robinson-Cass comparison, what is still at issue with Robinson’s mantra of taking market share is the wisdom of doing so in the first place, especially when even Robinson’s management do not expect market share gains to yield meaningful pricing power.

The danger is that Robinson may be chasing low-quality revenue and committing itself to occupying indefensible positions; it can’t know for sure because management has not articulated a more precise growth strategy. A thoughtfully explained strategic approach to growth in specific verticals based on margin opportunity, volume stability or a differentiated expertise would be received more favorably than deep price cuts.

It may also be time to think more ambitiously about mergers and acquisitions. Niche tuck-ins will always be available to some degree, but perhaps Robinson should consider acquiring a larger growth engine, more along the lines of its 1999 purchase of American Backhaulers. The middle market in freight brokerage – companies between $100 million and $1 billion in gross revenue – remains a target-rich environment.

Until it is understood what greater market share will enable C.H. Robinson to accomplish, or until it is pursued in a more rational, efficient manner, the anything-goes approach to volume growth brings up another of Seneca’s sayings: “The love of bustle is not industry, but only the restlessness of a hunted mind.”