ArcBest (ARCB): The Story of the Deal That Ain’t Gonna Happen, The Bailout You’ve Never Heard Of, and A Fight Over $5 Billion In Profits
In a frequently overlooked corner of the trucking industry, investors have missed massive problems. As the American economy begins to wobble, we’ll share a thesis of freight tonnage declines and industry earnings declines that are already underway, massive off-balance sheet liabilities, and a macroeconomic environment we think will be punishing.
Background and History
We are short shares of ArcBest (ARCB). The company is one of a few remaining large less-than-truckload trucking companies. Primarily making up that group is ARCB, TFI International (TFII), Yellow Corp (YELL), Old Dominion Freight Line (ODFL), and the freight division of FedEx (FDX). There are additional competitors, but they aren’t that important to the story at the moment.
You might wonder what is a less-than-truckload (LTL) trucking company and why does it matter? Truckload shipping companies (TL) ship freight that takes up an entire truck on a very predictable schedule that is repeated quite often. The freight is homogenous and tightly packed together. Think all the space in the container is spoken for. The TL trucking industry is very diverse, with an efficient set of competing players that are getting such freight from Point A to Point B (please see appendix).
LTL companies, on the other hand, are focused on optimizing the shipment of freight that is irregular in both its dimensions and its shipping frequency. Think that Peloton you bought during Covid that you don’t use anymore. Big ticket purchases by consumers and changing freight flows during the pandemic propelled a 670% increase in ARCB’s EPS between 2019 and 2022. However, our story begins a little bit before the pandemic.
In 1980 The Motor Carrier Act was passed as part of a sweeping deregulation led by outgoing President Jimmy Carter. This changed the field in trucking tremendously. Incumbents were free to raise prices, benefitting ARCB and YELL. And while that felt great for a while, the landscape quickly became very competitive, and some of those competitors had much lower cost structures.
Out of this competitive landscape emerged one very powerful company with far lower pricing and far lower unit costs. That company is Old Dominion Freight Lines (ODFL). Since about 2005, ODFL has been preying on these incumbent players.
Today the LTL industry generates about $40 billion in revenue and $5 billion in EBIT. EBIT margins are ~10%, and the “apparent” ROIC is 26%.
We say “apparent” because ODFL takes 40%+ of industry profits, and it will, with a very high probability, take more. It’s the top dog in the industry, and it will want to eat.
Controlling about 8-10% of industry profits is ARCB, with its 9-10% ROIC (on sell-side consensus for 2023).
The Covid era was great for all LTL players but the backside of that era is here and it won’t be fun for the industry. Here’s why:
All the LTLs have benefited from the supply chain issues that resulted from Covid disruptions. Inventory velocity slowed massively, which meant more trucking capacity was needed to get goods where they needed to go. Without ready standby capacity, pricing rose quickly, handing the entire industry a profit bonanza we think will unwind for the weakest players in LTL trucking.
Below we see this macroeconomic dynamic in the wholesale inventory / sales ratio we follow. This is all wholesale goods in the economy ex petroleum (because petroleum is very volatile and isn’t really applicable, as freight, to LTL trucking).
We are still in the midst of the second-largest inventory buildup in the last 40+ years, and we have been out of the pandemic for some time. When that lines goes up a lot - not a good thing.
We already see the inventory unwind hurting the LTL industry. Q1 results for Teamsters organizations were terrible (YELL has yet to report) and the industry’s profit pool is now shrinking for the first time in years.
This sudden surge in demand allowed for massive price increases in the last few years. Pricing in 2022 alone was up double-digits. Transport companies will always tell you it’s rising fuel expenses that compel them to increase prices. We acknowledge that and the fact fuel expense for ARCB’s LTL operation (ABF Freight, primarily) rose 43% last year. However, that’s a $114M increase in “fuel and supplies expense” vs a $390M increase in revenue for that unit that came about from pure pricing.
We believe the economics of legacy carriers depend very much on the largesse of industry leader ODFL. That company can deploy capital within a few quarters to wound anything within its vast gaze. Here’s why:
On a fair, apples-to-apples comparison (surely with caveats, but pretty darned close), here is the competitive reality of ODFL vs ARCB:
Pricing is 68% lower at ODFL.
Unit costs are 74% lower at ODFL.
Remember the above exhibit. We will return to it shortly.
Why Is This A Good Short Now?
ODFL is recognized as a dominant competitor; we know that. What we think are being missed are the second-order effects here. We believe the market is missing many potentially negative factors in ARCB:
Value investors will often say something like “this only needs to maintain zero growth at 10x earnings to represent a floor in valuation.” To that we would say what happens if earnings get cut in half.
This is not a “new era” in trucking.
We believe we have identified a massive off balance sheet liability most market participants have missed.
Speaking to the first two points, let’s look at a competitive knife fight that could arise here. Let’s say ODFL somehow fails to grow freight tonnage. Actually, we don’t have to imagine that. ODFL’s freight tonnage fell 12% in February..
That was likely intentional. The company took 10% pricing YoY in Q1 2023 (Q4 price was up 17% YoY). ODFL can shed less-desirable freight very quickly and keep the higher-mix revenue. Their contract structure with customers is very predictable in the speed with which carriage contracts are renegotiated and rolled off if pricing is undesirable. ODFL is a fast-moving ship with a big rudder. It can turn on a dime at high speed.
Pricing and Freight Flow Dynamics
We believe this will not go well for ARCB in the next 2-3 years. The situation has started rolling downhill slowly and the slide will pick up speed. The market will recognize competitive issues it does not currently embed in ARCB’s valuation.
As freight flows and inventories normalize, we see ARCB losing the margin improvement it won in the Covid era.
Consolidated EBIT margin in 2022 more than tripled vs 2019 and the equity market believes this is sustainable. Most episodes in market history have their share of such situations. One of our favorites is American Airlines (AAL) CEO Doug Parker saying in 2017: “I don’t think we’re ever going to lose money again…We have an industry that’s going to be profitable in good and bad times.”
Value investors should learn to plug their ears with wax and lash themselves to the mast – this “New Era” siren song enchants them every time. We don’t think the LTL industry has permanently reorganized itself such that every company’s share of the profit has been vouchsafed or cast in stone.
With a supremely dominant competitor present in the $5B+ profit pool that has 68% lower prices and 74% lower unit costs, high-cost carriers are cornered. ODFL controls the field and can, within a short period of 1-2 years, squeeze the profit pool to achieve its profit growth goals.
Looking at recent capex and consensus estimates, we can see very plainly the capital deployment plans of ODFL and its competitors.
ARCB’s capex was 63% higher in 2022 than in 2019. That’s only $57M higher, however. ODFL’s 2022 capex was up 62% vs 2019: an increase of $296M. ODFL last year undertook capex equal to 280% of its depreciation and amortization (consensus is the same capex range this year at ODFL).
That’s appreciable growth in a very slow-growth industry in which freight volumes are now falling.
Due to the fixity of its cost base, even a two-quarter downward flex by ODFL on its pricing could immediately harm (below) ARCB’s 7.5% EBIT margin. ARCB EBIT margin averaged 1.1% from 2010 through 2019. In 2018-2019, EBIT margin averaged 2.7% for ARCB. Clearly, something changed after Covid commenced.
The LTL industry and the US experienced a transport system demand surge created by (1) Elevated levels of big-ticket, goods-based consumption and a (2) a Serious decline in logistics system fluidity. That is unwinding now, and it’s far from over.
The damage done by one year of price investment by ODFL could play out as follows:
Whether suddenly, or more gradually, we believe ARCB has been backed into a corner that it likely won’t be able to get out of.
We believe that on a fundamental basis ARCB is worth $40 per share, as EBIT margins compress. And that’s not even in our worst case scenario, in which we think it could go to zero. But that takes some digging to understand.
The Bailout You’ve Never Heard Of
Lying behind ARCB, YELL, other LTL carriers, and the captive trucking companies at grocers and beverage producers is a deep and hellish financial hole. That hole is called Multi-Employer Pension Plans (MEPPs).
Like many legacy entities that started compensating employees ~75 years ago with promises of postretirement pension and health benefits, these plans are massively under-funded
That is and has been true at auto OEMs, many old-line manufacturers, and in America's large old cities. If you wonder why cities can’t take care of their infrastructure, can’t care for people on the street and in need, and can’t deliver on basic daily operational tasks like plowing snow, it’s because they owe many retired front-line workers the benefits those workers were promised and deserve.
How did this work for the Teamster employee, and why were MEPPs needed? Because Teamsters would switch employers within a collective bargaining agreement and because even in the regulated days, trucking companies went out of business often, all companies employing Teamsters would collectively become obligors to the plans. That secured the workers’ pension benefits when they moved from one company to another within the collective.
Since signing those agreements and since trucking industry deregulation took place, the rate at which Teamsters organizations filed for bankruptcy has been epochal. That’s really bad for the surviving employers in the MEPP plans. They assume the MEPP obligations of companies that file for bankruptcy. They are assigned those obligations on a pro-rata basis, so their obligations grow. These are joint-and-sever liabilities, the dangers to MEPP obligors most could see coming down the track from miles away.
This issue has been hanging over the industry for a decade. It has been greatly abated by a $91 billion bailout you probably haven’t heard of. That bailout was enacted in 2021 legislation titled The Butch Lewis Act as well as The American Rescue Plan.
These Acts greatly abated the danger of massive MEPP under-funding that hung over Teamsters workers and retirees as well as the obligors.
Just one of these MEPPs, the Teamsters Central States, Southeast & Southwest Areas Pension Fund, had negative equity of $47 billion prior to the federal bailout. It had approximately $10B in assets and liabilities of $57B. That fund in late 2022, received direct, no-strings-attached infusion of $36B under these Acts.
Let’s not break out the champagne just yet, because if you followed the math, there’s still an equity hole of $11.6B. That liability, in some parts, is the responsibility of ARCB and YELL. Yellow Corp’s equity value was already destroyed by its pension obligations in the Great Financial Crisis. It basically had to hand over the company to the Teamsters to stay in business.
Check the chart on YELL. The stock peaked at a split-adjusted $470,175 per share in Q1 2005. It now trades at $2.03. YELL had to hand over the company to stay in business because it couldn’t pay its obligations to MEPPs.
United Parcel Service (UPS) affirmed these obligations when it exited the Central States Plan in 2007. It could see the down the pension hole, and it wanted no more part of it, so it paid $6.1B to get out.
We’ve talked to a number of obligors about these plans, and they all have said, ‘It’s not really a liability because we don’t plan on triggering the liability.’
We’ve asked MEPP obligors and the Teamsters for years, “Do the retirees and current workers view their expected benefits as an asset? We think they do. If those parties view the expected benefits as an asset, then there must be liabilities or equity on the other side of the balance sheet.” Companies cannot answer that with a sensible response, in our experience.
We believe ARCB and YELL may each have responsibility for 10% or more of MEPP net liabilities, which in the case of the Central States Pension Plan alone would represent $900M in after-tax liabilities for ARCB and YELL each.
ARCB’s market cap is $2.2B and YELL’s is $105M. We think YELL will eventually go to zero, perhaps in this cycle. This will further encumber ARCB because in a joint-and-sever liability structure such as this, the remaining obligors in a plan take over the liabilities of the failed obligor. So ARCB, in this situation, would be assigned a chunk of YELL’s liabilities. That’s just ONE plan.
We think the net liabilities may be much greater for each company than we have stated above. The companies don’t publish the number anymore, and the plans are opaque with delayed filings.
We grant these are contingent liabilities and would not be triggered until the obligor elects to exit the plans. ARCB continually says these are contingent liabilities. We don’t know exactly what they’re implying, but the industry's history indicates they are liabilities whether or not a cash exit event is triggered. In this case, the liability grows yearly, and even the $91B bailout didn’t fix it.
When you think about it, most liabilities are contingent. A company with lease liabilities on its balance sheet could say they’re contingent too. They’re contingent on the company staying in business, using the leased assets, and paying its rent. Or in Chapter 11, the bankruptcy estate would owe a sum to the lessor in the neighborhood of the stated lease liability. We can play this game all day.
Interestingly, this liability doesn’t appear on the balance sheet (or even footnotes, despite its materiality), and the accretion of net liabilities, which occurs as surely as the Sun rises in the East, does not pass through obligors’ income statements.
If net liability accretion for JUST the Central States Plan were passed through ARCB’s income statement in 2019, it would have consumed 160% of EBIT. If it were passed through our 2023E to 2025E pretax, it would consume 30% to 40% of EBIT.
And Now The Deal That Ain’t Gonna Happen
In February 2023, rival Teamsters LTL trucker TFI International announced it had acquired a 4% equity stake in ARCB. ARCB’s stock surged 17% as a result. The sell-side was all agog at how marvellous this would be for ARCB and TFI. The synergies! Oh, the synergies would be so beautiful.
Having talked with TFI, we don’t think they’re dummies. We believe the chance they acquire ARCB is about zero. We have to entertain all potential outcomes as investors, but this liability can’t just be wished away. TFI won’t want to jump into this actuarial hellhole of financial liabilities that could represent a huge portion of ARCB’s enterprise value and cash flow NPV.
We’ve talked with both TFI and ArcBest and maintain our position: this is the acquisition that ain’t gonna happen. We believe TFII would be committing a major financial blunder to strap itself to an actuarial nuclear weapon. They did not do that in acquiring UPS’ Overnite LTL business. Those Teamsters who came to TFII had their pension placed in a plan remote from MEPP liabilities.
ARCB’s pension issue is totally different. TFI’s interest in ARCB is not at all similar to the UPS deal. The Teamsters will press their rights and have them affirmed in any potential or actual change of control in ARCB.
We believe ARCB’s contingent liabilities may reach $1.5B after tax. That’s $62 per share on an $85 stock ($1.5B after tax). The stock was trading at $27 before the pandemic began.
YELL is a zero, we believe, with a $75M market cap, $1.4B in net debt, and MEPP liabilities similar to ARCB.
What Makes Us Wrong
Pricing is still robust in the industry even as the economy has cooled. We think the consolidated nature of LTL allows for that pricing solidity and that would make us wrong if it continues for a few years. Maybe it truly is a new era in LTL trucking. We are skeptical of that. For the month of February, 2023, data from the American Trucking Association (published on Bloomberg) indicates LTL tonnage tonnage fell 9% YoY.
ODFL may enjoy floating far under the Teamsters’ organization price umbrella, and everyone plays nicely. If that’s the case, an earnings power of $10 for ARCB may be a baseline for growth. In that case, this is an efficiently priced long. The slope of EPS growth would be roughly equal to cost of equity and equity will not generate excess return to longs. It would thus fail to deliver excess return of any kind to shorts. Continuation of the competitive environment with no upset, is an acceptable risk.
We could be wrong on the Teamsters’ response. They may work out something between ARCB and TFII. We doubt it, however. There is a large retired beneficiary population to serve and then there are currently-working beneficiaries whose contributions keep the fund solvent. They are one of the most powerful labor blocs in US history and are professionally managed. Furthermore, when obligors seek to minimize their responsibilities with overly technical descriptions of the liabilities, even when the last 16 years of industry history have done nothing but totally affirm those liabilities, well, that’s not a great look to your counterparty (the Teamsters). It’s a total non-starter, in our opinion.
Conclusion
With respect to the Teamsters and ArcBest management, we are short the stock. We believe the sell-side is vastly misguided on this as an acquisition candidate and we believe the liabilities are very real. We believe we are watching a slow-motion train wreck with regards to freight tonnage and revenue declines, and we do not think this will end well. We see 65% downside fundamentally, and think it could be much worse in certain scenarios.