valuexvail 2013 - guowei zhang
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Pennypack CapitalPacer Internatio nal (PACR)
For ValueX Vail 2013
Contact:Guowei ZhangManaging Partnergzhang@pennypackcapital.com
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Introduction
Pacer is an asset-light 3rd party logistics company focusing on
intermodal transportation
$220M market cap; $195M enterprise value
2012 Summary: $1.4B revenue; $9M of EBIT
Intermodal is the movement of goods via different modes of
transportation truck and rail
3rd largest intermodal marketing company in the U.S.
Customers: Big Lots, Costco, Ford, P&G, Toyota, etc.
Investment Thesis: Substantial margin improvementopportunity in a secularly growing industry
An attractive ultralong-term investment
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Introduction (Continued)
Simple illustration of intermodal transportation
Shipper ReceiverOrigin
DrayagePacer
responsible forpickup
Delivery to railintermodal
terminal
Equipment:minimal
Partners:drayage
companies,independent
owner-
operators
RailroadDestination
DrayageTransportation by Railroad
Pacer buys capacity from railroads
Equipment:Containers & Chassis (leased)
Containers (provided by railroads)
Partners:
Railroads
Pacerresponsible for
pickup fromrail intermodal
terminal
Delivery to
destination
Equipment:minimal
Partners:drayage
companies,independent
owner-operators
Pacer Takes Care of Everything in Between
Pacer sells itsservices toshippers
Providestracking
capabilities
and othercustomerservices
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Introduction (Continued)
(Figures in Millions)
Segment Revenue: 1,180$ 238$
2012 Segment EBIT (1): 38 (10)
Business Description:
Capital Intensity: Low Low
have operating leases have operating leases
(1) Does not include $19M of corporate and unallocated expenses
International and
domestic intermodal
services. Include
Mexican cross-borderintermodal services.
International freight
forwarding,
warehouses, ports &
transloading services,highway brokerage.
Intermodal Logistics
Two business segments
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Investment Thesis
Solid secular growth story for the next decade and longer
Strong business model with economies of scale
Low asset intensity
Substantial margin improvement story in Intermodal
Low valuation: nearest competitor is twice the size of PACR inrevenue, but trading at 7x enterprise value
Potential short-term & long-term catalysts
High ROIC business with substantial margin improvementopportunity in a secularly growing industry
An attractive ultralong-term investment
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#1: Solid Secular Growth Story
Intermodal volume grew at a 5.8% CAGR since 1980, much
faster than rail and trucking volume
Forecasted volume and revenue CAGR of 4.7% and 8%,respectively
Source: ATA, IHS Global Insights, Norbridge.
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#1: Solid Secular Growth Story (Continued)
Intermodal is only 2% of the overall transportation industry
($13B market). Meaningful opportunity for penetration
Trucking still represents 80% of the overall transportation market.Intermodal has been and will continue to take share from trucking
Intermodal transportation is 10-20%cheaper than trucking and
has a lower carbon footprint
Rail is 3x-4x more fuel efficient than trucking
Just one long-distance, double-stack train between Chicago and LosAngeles can save 75,000 gallons of fuel by replacing 300 trucks, each
traveling 1,983 miles. Trucking cost continue to go up, which will support market shift
towards intermodal; road congestion is getting worse
Tighter regulation, labor shortage and environmental concerns willcontinue to increase trucking operating cost
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#1: Solid Secular Growth Story (Continued)
CSX believes intermodal investments will expand
addressable market in eastern U.S. by 150%; totalintermodal opportunity of 20m units in the U.S.
Piggybacking off of massive railroad investments
Greenfield and expansion of rail intermodal terminals; conversion of
routes to double-stack
In total, the railroads are spending approximately 17-18% of revenue incapital expenditure ($14B), a large portion of which is to expand theirintermodal networks
Investments by federal and local governments on top of railroad
investments
These investments open up substantial new markets for intermodal
More reliable service attracts new customers switching from trucking
Deeper penetration of intermodal terminals opens up new markets
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#1: Solid Secular Growth Story (Continued)
Intermodal is competitive around 800-1,000 miles, but as
trucking costs go up, the breakeven point is declining
Source: Norbridge.
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#1: Solid Secular Growth Story (Continued)
Gradual market shift from trucking to rail as service level
and penetration improve
Currently still a significant portion of transportation over2,000 miles done via trucking!
Source: ATA, IHS Global Insights, Norbridge.
%o
fMarketShare
Current Truck Market
Current Rail Intermodal Market
Projected Market Shift
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#2: Strong Business Model
Natural economies of scale through asset utilization.
As revenue grows, margin should structurally improve
Illustrative
Business Model Where is Economies of Scale?
Number of Containers 18,000 More containers means better customer service and full er coverage:
PACR has the 3rd largest fleet in the industry
Container Turn Per Month 1.80 Key driver of profitability is how well containers are utilized.
Total Intermodal Revenue 1,180
Cost of Goods Sold as % of total cost
Rail Cost ~50% 571 Better contracts with rail carriers means better ul timate service for
customers (priority loading, etc.) and potentially lower cost
Drayage (trucking) Cost ~25% 285 Key driver of profitabil ity: Optimization of trucking operations and
density dictate margins
Container/Equipment Cost ~10% 114 Container usage optimization improves margins
Other Cost 107 Network balance, etc.
Total Cost of Goods Sold 1,078
Gross Profit 102
Gross Margin 8.7% LOW MARGIN BUSINESS. SUBSCALE PLAYERS CANNOT COMPETE.
SG&A 64 Substantial SG&A leverage.
EBIT 38
EBIT Margin 3.3% LOW MARGIN BUSINESS. SUBSCALE PLAYERS CANNOT COMPETE.
Note: Unit economics based on 2012 figures. Does not pro forma for the new Mexico auto contract .
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#2: Strong Business Model (Continued)
An example of economies of scale in in-house drayage to
remove empty miles
Non-optimized DrayageIn-House Drayage with
Network Density
This type of economies of scale also occurs in lane density andequipment utilization (balanced box flows, empty box repositioning,chassis utilization)
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#2: Strong Business Model (Continued)
price is not our only weapon that we have here in order to become more efficient and
expand the gross margins. We can also do it through operating efficiencies. We can do itthrough better balance within our dray network. We can do it by handling more of our own
drayage. We can do it by better turn times.
- HUBG CEO on efficiencies, 1Q 2013 earnings call
There are some new players. This is a business of scale and scope and understanding
how to effectively operate in an intermodal environment. It's not a simplistic thing for a newentrant. So the vast majority of the competitive environment is driven by the traditionalplayers. And again, we include ourselves in that. And one other large provider we think iskind of -- are the 2 largest in the space and I think, at this point, the most efficient. And soagain, it's just -- it's difficult for a new entrant with a 1,000 or 2,000 containers to really domuch of anything because you can't necessarily market that. It's not a large enough networkto have much of an impact on your customer base
- HUBG CEO on competition, 1Q 2013 earnings call
Good economies of scale due to fragmentation of
shippers, origins, destination, fragmentation of truckersand the need for asset/network optimization
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#3: Margin Improvement Story
Pacer is substantially underperforming its nearest
competitor in margins
(Figures in Millions)
Revenue: 1,180$ 2,392$
Gross Margin: 8.7% 11.0%
EBIT Margin (3): 1.9% 4.1%
(1) Only intermodal division.
(2) Does not include the Mode division. Results also include truck brokerage and logistics.
(3) PACR: Assumes corporate SG&A allocated on a revenue basis.
PACER(1) HUB (2)
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#3: Margin Improvement Story (Continued)
Scale and business mix explain some of the margin
differential
Business Transformation: Transitioned from wholesale Mostly retail operation
to retail only recently (2010).
Moving up in the value chain.
Wholesale Retail
PACER HUB
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#3: Margin Improvement Story (Continued)
Scale and business mix explain some of the margin
differential
Scale: Need to continue to build HUB is effectively twice as large
retail salesforce as transition as Pacer in intermodal
to retail is new
Business Mix: Strong in transcon and HUB is 1/3 local east, which means
north/south. faster container turn
Weak in local east Box turn is 2.4
Box turn is 1.8
Rail Cost: NA HUB may have cheaper rail
contracts due to size??
Drayage Cost: NA Because of size, has better
density for trucking, which minimizes
empty miles
Equipment: Leases containers Leases and owns containers.
PACER HUB
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#3: Margin Improvement Story (Continued)
Management wants to get to HUBGs margin levels and is
active in improving margins.
Sales: Aggressive at reducing low margin business.
Rail: Working collaboratively with rail partners to bid for new business
This improves pricing vs. rail cost visibility
Dray: Improve carrier mix
Improve street efficiency
Accessorial management
Equipment: Improve equipment utilization
Network: Improve network balance
SG&A: Aggressive at controlling SG&A
Lean processes
Margin Improvement Actions
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#3: Margin Improvement Story (Continued)
Pacer and HUB both focused on getting better pricing
The decline in domestic revenues is mostly a result of our efforts in the second half of last year to
pare low-margin freight that we had won in the first half of that same year, but later becameunattractive due to large unexpected rail cost increases in Transcon lanes. As we described in boththe third and fourth quarters of last year, we repriced much of that business and as a result, someof that volume went away. Additionally, our approach to this year's bid season has been to be very
disciplined in our pricing.
- PACR COO, 1Q 2013 earnings call
We certainly saw some business in which we were the incumbent, that went out to the market andcame back at prices that were simply not compensatory for us. And it's hard to walk away frombusiness, but the right answer isn't always yes. Sometimes the right answer is no, contrary to whatmany of our sales people believe.
- HUBG CEO, 1Q 2013 earnings call
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#3: Margin Improvement Story (Continued)
Margin improvement is starting to show up in the results,
but 2012 is an easy comparison
-2.5%-2.0%
-1.5%
-1.0%
-0.5%
0.0%
0.5%
1.0%
1Q 2012 2Q 2012 3Q 2012 4Q 2012 1Q 2013
YoY Margin Changes
GM YoY Chg. EBIT Margin YoY Chg.
Margins were substantially depressed in 2012 due to mismatch of railcost vs. pricing (more on this later)
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#4: Low Valuation
Headline valuation is misleading as it includes losses
from the Logistics divisionValuation
Headline Excluding
Valuation Logistics (1)(2)
2012
EV/EBITDA 11.3x 6.4x
EV/EBIT 21.0x 8.6x
P/E 53.0x 17.0x
2013E
EV/EBITDA 7.8x 5.6x
EV/EBIT 11.0x 7.1x
P/E 20.6x 13.3x
Normalized FCF Yield (3) 6.0% 8.7%
(1) Assumes corporate costs are allocated into segment results based on segment revenue.
(2) Assumes tax rate of 40%.
(3) Exclude 1x working capital benefit in 2013.
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#4: Low Valuation (Continued)
Logistics division is undergoing a turnaround. A
perennial money loser that should be divested ifturnaround is not successful
2005 2006 2007 2008 2009 2010 2011 2012 2013E
Revenue 458 397 402 456 386 422 304 238 232
Segment EBIT 5 2 4 (0) (4) 1 (2) (10) (7)
Managements rationale for keeping Logistics division:
Logistics division completes Pacers comprehensive service offering
New management and sales force hired. Needs time for turnaround
My take:
Logistics division has very little synergy with Intermodal
A low-cost option on the turnaround: currently no value is assignedto the Logistics division. Low capital intensity business that does notcost much to wait for an eventual turnaround.
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#4: Low Valuation (Continued)
Pacer trades at a substantial discount to HUB. Current
valuation seems to assume no margin improvementpotential. I believe that Pacers valuation will increase
once execution is provenPacer
Excluding Pacer
Logistics (1)(2) HUB Discount
2012EV/Sales 0.16x 0.43x -61%
EV/EBITDA 6.4x 9.9x -36%
EV/EBIT 8.6x 11.8x -27%
P/E 17.0x 19.9x -14%
2013E
EV/EBITDA 5.6x 8.9x -37%
EV/EBIT 7.1x 10.5x -33%
P/E 13.3x 17.4x -23%
Normalized FCF Yield (3) 8.7% 5.9% -33%
(1) Assumes corporate costs are allocated into segment results based on segment revenue.
(2) Assumes tax rate of 40%.
(3) Pacer: normalized for 1x working capital benefi t. HUB: normalized capex.
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#5: Short-Term Catalyst
Divestiture of Logistics division if turnaround is
unsuccessful
No value is currently assigned to the Logistics division
A potential divestiture, even for a nominal amount, will be beneficialto Pacer
Focuses managements attention on the Intermodal division
Eliminates near-term P&L losses
Improves headline valuation
But would be much better if the turnaround is successful!
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#5: Long-Term Catalyst
Economies of scale motivates greater industry
consolidation. Would not be surprised if M&A activityoccurs
Rationales for industry consolidation
Greater and more flexible asset base provides better customer service
Greater economies of scale, better efficiency, better margins
Greater negotiating leverage with railroads and customers
Less industry competition
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Investment Thesis Summary
A combination of positive forces
Steady secular growth
and penetration of
intermodal
8% Revenue CAGR
Structural improvement
in margins due to
economies of scale
Good Moat
Potential improvement
in intermodal margins
Doubling of
margins?
Valuation improvement due to better execution
Closing of value gap Between HUB and Pacer
Near-term catalyst
Divest Logistics;
or success in its
turnaround
Long-term catalyst
Industry
consolidation
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Investment Risks
Industry risks
Ability to pass on rail and trucking cost increases
Railroads as good partners?
Cyclical business; high operating leverage
Independent contractors vs. employees in drayage operations
Company specific risks
Substantial execution risks in margin improvement
Failure in turning around the Logistics division
Lack of exposure to local east intermodal market, which is growing rapidly
Lack of clarity in new auto contract with UNP; exposure to the auto industry,which represents 40% of total sales
Panama canal expansion in 2015 and potential traffic shift to the eastern U.S.market, where Pacer is underrepresented
Tumultuous company history
Right industry, but wrong company?
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Risk #1: Ability to Pass on Cost Increases
In 2012 intermodal marketing companies operated in acompetitive bidding environment and lost margins due to theinability to match pricing with rail cost increases
Rail and trucking costs expected to increase for the foreseeablefuture due to the need to generate an attractive ROI on railinvestments and higher labor and equipment costs for truckers
Mitigating factors:
Industry is becoming more concentrated. Top 4 now represent closeto 50% of the overall intermodal market
Participants are disciplined and are giving up low margin business
Railroads are looking for intermodal to grow (now 40% of total railvolume) and will adjust pricing to drive volume
Can Pacer pass on rail and trucking cost increases to
customers?
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Risk #2: Railroads as Good Partners?
UNP is Pacers rail partner in western U.S. Pacer leases UNP
equipment. UNP accounts for the majority of Pacers rail costs
UNP and other railroads have their own intermodal marketingoperations that sometimes compete with Pacer
Railroads offer container capacity to the intermodal industry
Railroad performance may suffer
Mitigating factors:
Railroads are highly dependent on intermodal for growth Railroads intermodal marketing operations are more wholesale
focused. They lack national coverage and are dependent on retailintermodal marketing companies for business
Potential forward integration is not likely given railroads historical
failure at retail intermodal. Minimal experience in sales
IMCs are highly dependent on their rail partners
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Risk #3: Cyclical Business, High Operating Leverage
HUB revenue fell 20% in 2009. EBIT margin down 140bps
Pacer revenue fell 27% in 2009, although part of this was due tothe wholesale to retail transition
Mitigating factors:
Transportation industry is highly cyclical. High operating
leverage introduces sharp volatility in earnings
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Pennypack Recession Indicator - Leading
Recessions Indicator
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Risk #4: Independent Contractors vs. Employees
Most of the drayage operations is currently performed byindependent owner-operators
Change to employee status will require a change in financial and
business model more capital intensive, but offset by bettermargins
Different risk and liability profile
Mitigating factors:
Short-term disruption, but doesnt take away from the industry story
Eliminates small competitors
Government authorities may assert that independent
owner-operators are employees
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Risk #5: Substantial Execution Risks
Pacers transition from wholesale to retail operations occurred
recently. Completion only happened two quarters ago with the
new Mexico auto contract Management team is unproven in execution
Mitigating factors:
Taking the right steps so far
Current valuation doesnt assume margin improvement
Transition from wholesale to retail operations was painful.
Can Pacer improve margins? What happens if Pacerdoesnt improve margins?
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Risk #6: Failure in Turning Around Logistics
Logistics division is subscale
Undergoing its own transition from wholesale to retail in theinternational freight forwarding business
New management and sales team need time to turn leads intorevenue
Failure in turning around operations will result in poor headlineand short-term profitability impact
Mitigating factors:
Management will shut down or sell the division if turnaround is notsuccessful
Failure in turning around the Logistics division will impact
short-term earnings
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Risk #7: Lack Local East Exposure
Local east is growing rapidly due to railroad investments to openup secondary markets. This is a huge growth opportunity thatPacer is currently missing out on
Pacers local east offerings are not competitive given low drayage
density
Mitigating factors:
This also represents a large opportunity for growth. Current salesforce is not adept at converting trucking customers to intermodal.
Need substantial dedication in sales effort Although Pacer is weak in local east, it is very strong in north/south
lanes, which will take advantage of huge growth in near-shoring andthe Mexican cross-border market
CSX, Pacers eastern rail partner, may lower rail costs to improve
intermodal volume, which benefits Pacer
Pacers local east business is small and not competitive
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Risk #8: Lack of Clarity on New Auto Contract
New Mexican auto contract changes the role of Pacer from awholesale intermodal marketing provider to a network manager
for UNPs auto business
Although margin contribution will be the same in 2013, future revenueand profitability is uncertain
over the remaining term of the agreement, our revenue and margin
for the services and equipment provided under the agreement declineabsent growth in our retail direct US-Mexico business - Pacer 10Q
Mitigating factors:
New contract allows Pacer to sell directly to intermodal customers,which was generally not feasible under the old contract
Allows management to offset any potential drop in revenue specifiedin the contract with new Mexican cross-border business, which is
growing rapidly
The recently renegotiated Mexican auto contract with UNP
lacks details
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Risk #9: Panama Canal Expansion
Doubling of Panama Canal capacity by 2015
Benefits east coast ports and reduces demand for west coastports
Mitigating factors:
Its up to the railroads to make intermodal transportation competitive.
UNP plans to protect its intermodal franchise
This may involve the reduction of rail pricing to offset any potential
drop in demand
Panama Canal expansion will shift volume to the local
east market, which is not Pacers strength
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Risk #10: Tumultuous Company History
Painful transformationwhats different now? Is this the
wrong company in a good industry?
Explanation:
Renegotiation ofbelow-market UNPcontract in 2009
Transition to retailand loss of allwholesale business
Difference now:
Delevered
substantially. Nowin net cash position
Transition to retailcomplete
Cleaner story
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