RXO (NYSE:RXO) is a truckload broker that operates solely in the for-hire truckload transportation industry, which is notoriously competitive and decentralized. I anticipate RXO’s continued market share gains within this sizable industry to be driven by the company’s dedication to investing heavily in technology and automation. In fact, RXO was an early adopter of digital business practices. However, it’s not easy to evaluate and contrast different online freight markets. The only way, in my opinion, for RXO to convince the market that its digital investments are significantly superior to peers is to report higher margins and growth, both of which take time to materialize in the financials. RXO is also exposed to the outsourced final mile delivery market in the United States, as well as the managed transportation market for large and bulky items. This has enabled RXO to enjoy outsized growth in as freight forwarding growth accelerated during the pandemic, which I expect is going to normalize over the near-term. I think the first thing investors wanted to know about RXO was how macro has impacted the business and what is the current situation in the freight market. I believe management comments in the latest earnings confirmed what most investors already knew, namely that the freight market is difficult, that the spot truck market is under extreme pressure and is still bottoming out, and that there is still excess capacity in the market. With supply leaving the market and inventory restocking still a possibility, management is cautiously optimistic about 2H23’s prospects. That said, given the current climate of uncertainty and volatility, I believe it is best to wait to make any major moves until 2H23. In addition, I think it’s important to point out that RXO stock is not trading at a low multiple. Compared to its peers in the trucking industry, which typically trade in the mid-teens multiple of forward earnings, RXO’s current multiple of 22x is relatively high.
Market share and profitability
In the long run, I anticipate that truck brokerages will achieve a much higher market share of the massive $400 billion for-hire truckload market that what it has today. This growth is expected to occur over the next several years. Apart from the overall for-hire truckload industry growth, I also expect RXO to sustained market leadership in the truck brokerage sector at the expense of rival firms with fewer resources and a less developed expertise. RXO’s access to capacity, including more than 120,000 carriers and 1.5 million trucks, is a major factor to achieving this market share gain. Practically, for RXO to gain market share from less established competitors, I’d say now is a good time to launch a full-scale attack because of the current unstable and weak business climate, which weaker peers will face disproportionate disadvantages. Assuming management follows my expectations, we can expect an increase in volumes in the near future (1/2Q23) with less profitable freight causing a decrease in gross profit per load. However, in the second half of 2023, the ratio of loads to trucks and spot rates should improve. If circumstances improve, RXO will also have the ability to adjust the current agreement in order to increase its exposure to spot rates and regain a greater gross profit per shipment.
Management is still optimistic about reaching its $500 million adjusted EBITDA target by 2027, and I agree that they have several tools at their disposal to make that happen. There are five main forces at work, all of which will help ROX reach its $500 million goal. First, there is the baseline expansion of the for-hire truckload industry, which I anticipate to expand by a rate similar to that of the GDP, or low single digits. Second, I think the truck brokerage industry will keep eating away at the truck load industry. Third, RXO should maintain its share growth in the truck brokerage market by absorbing the market share of less formidable competitors. The use of RXO’s digital capabilities and other fixed-cost line should also lead to a modest increase in the company’s EBITDA margin over the forecasted time period.
RXO’s asset-light business model results in high free cash flow. Management stressed that RXO would maintain a 50% FCF conversion rate across business cycles (from adj EBITDA). The strong counter-cyclical dynamics of RXO FCF profile is an advantage. During times of rapid expansion, the FCF conversion rate would be closer to 40%, while in more tranquil times, it could approach 60%. Also, the most recent quarterly results show that FCF conversion was just north of 90% in the fourth quarter, and FY22 FCF conversion was 85%. This strategy seems to be effective, as RXO is able to reinvest during downturns and gain market share from competitors, resulting in higher growth rates during boom times. The high FCF conversion rate also provides a channel for RXO to return excess cash to shareholders. Considering that RXO has been publicly traded for just five months, it’s not unexpected that they haven’t implemented a program to buy back shares yet. Nonetheless, I would not be surprise to hear an announcement regarding it soon.
Brokerage firms now face stiffer competition from new entrants, who are gaining market share in part by offering guaranteed rates at a fixed margin and increasing price transparency through improved connectivity with shippers. Margin pressures in the industry as a whole and RXO’s future profitability could be affected by greater price transparency and reduced volatility.
RXO’s dedication to technology and automation, coupled with its access to capacity, puts the company in a strong position to gain market share in the highly competitive truck brokerage sector. While the current climate of uncertainty and volatility may impact near-term performance, management remains optimistic about the company’s long-term growth prospects, with a target of achieving $500 million in adjusted EBITDA by 2027. However, I believe the right move, as an investor, is to wait for more concrete evidence that things are turning for the better (most likely in 2H23), before investing. This is especially when the relative valuation is cheap.