Value Play: Werner Enterprises (Nasdaq: WERN)

Something keeps bringing me back to Omaha, Nebraska – the home of value-investing legend Warren Buffett and his investment vehicle, Berkshire Hathaway, as well as several other outstanding companies. It’s as if the criteria Buffett uses to find Berkshire’s equity investments (e.g., honest and competent management, sustainable competitive advantage, low debt, reasonable valuation) are internalized by other Omaha companies, which cannot help but be swayed to mimic these criteria through their continuous exposure to Buffett’s physical and spiritual presence among them. The Momentum Portfolio already has an Omaha representative in Valmont Industries, but it’s the Value Portfolio’s turn.

Werner Enterprises is the third-largest “truckload” carrier in the United States:

Truckload Carrier	2013 Truckload Revenue	EV-to-EBITDA Ratio	Debt-to-Equity Ratio	Insider Ownership
Swift Transportation (NYSE: SWFT)	$3.05 billion	8.47	569.35	3.66%
Schneider National (private)	$2.32 billion	N/A	N/A	N/A
Werner Enterprises (Nasdaq: WERN)	$1.64 billion	6.16	5.18	38.04%
JB Hunt Transport Services (Nasdaq: JBHT)	$1.62 billion	10.73	69.97	5.97%
Landstar System (Nasdaq: LSTR)	$1.61 billion	12.75	28.45	0.69%

Sources: JOC.com; Bloomberg

The term “truckload” means that the carrier dedicates each truck shipment to a single customer and doesn’t mix loads from different customers in the same truck. In contrast are the “less-than-truckload” carriers, such as FedEx Freight and UPS Freight, that combine individual small deliveries in their trucks. Half of trucking revenue is from one-time, one-way shipments and the other half is from “dedicated” trucking services for a specific customer, which involve long-term contracts for repeat shipments to a retail distribution center or manufacturing facility, including services for products requiring specialized trailers such as flatbed or temperature-controlled trailers (page 43).

The table above makes it clear why I chose Werner out of the top five. It has the cheapest valuation, the lowest amount of debt, and the highest insider ownership. I also like the fact that Werner is run by the founding Werner family —  founder, director, and Chairman Emeritus Clarence Werner, CEO Greg Werner (Clarence’s son), and Chairman Gary Werner (Clarence’s other son). As I wrote in Founder CEOs Are the Best Leaders of Small-Cap Companies, founders love their companies and want them to succeed for the long term, which maximizes shareholder value.

Although trucking leader Swift is also run by its founder (Jerry Moyes), the Moyes family has veto-proof voting control of the company whereas the Werners own a substantial ownership stake of 38% but do not possess voting control. A 1990 study (page 601) found that a company’s market valuation (i.e., ratio of market value to asset replacement cost) rises with increasing insider ownership and hits its highest level when insider ownership hits 37.6% — almost a perfect bull’s-eye for Werner! By contrast, insider ownership above 45%-50% reduces the company’s value (page 59) because when insiders have effective veto power they can unilaterally make decisions that help themselves at the expense of minority shareholders – a negative bull’s-eye for Swift.

Werner operates in three business segments. Logistics services include freight management, brokerage, intermodal (i.e., train and truck), cross border with Mexico (12% of revenue) and, to a lesser extent, cross border with Canada. Logistics is the fastest-growing segment by design because it has the highest profit margins and requires the least capital (i.e., asset light). In the fourth quarter of 2013, logistics revenue growth was a robust 16%, compared to much-slower growth of 1% in the legacy trucking segment.

 Werner Business Segments

Business Segment	Percentage of 2013 Revenue	Goal %
One-Way Truckload	34%	33.3%
Dedicated Truckload	38%	33.3%
Value-Added Logistics Services	28%	33.3%

Source: March 2014 Company Presentation

Although we keep hearing that transporting freight via rail is cheaper than via trucks, that assertion is only true for cheap, bulk commodities like coal. For high-value merchandise, trucks are much-more energy efficient and provide much-better security and protection. In fact, 68% of the nation’s freight tonnage is carried by trucks. The deregulation of the trucking industry in 1980 has generated tremendous productivity  and efficiency gains. Werner is in the forefront of efforts to make trucking more energy efficient. An obvious way to conserve energy is to use modern, energy-efficient trucks. Whereas the average age of Class 8 freight trucks is historically high at 6.6 years (slide no. 16), Werner has an industry-low truck age of only 2.4 years. Werner has always been a technology leader in trucking. In 1992 it was the first trucker to install GPS tracking and in 1998 it was the first to install electronic logging devices (ELD). The company’s capital investments in fleet modernization have crimped near-term profits, but the competitive advantage will boost its earnings growth in future quarters. As CFO John Steele stated last year:

Our CapEx spend for ’13 is estimated to be about 40% lower than 2012 CapEx. In ’10 and ’11, we bought more trucks than normal to reduce the average age of our truck fleet. In 2013, we expect to buy fewer trucks and maintain our truck age in the low 2s.

Over the last 7 years, we put our free cash flow to good use to improve our return to our shareholders. Werner returned $840 million or over $11 per share over this 7-year period. On average, that’s an extra $1.58 per year, or an additional yield of over 7% per year for 7 years.

In ’06 and ’07, our primary emphasis was the repurchase of our shares, and we bought back about 11% of our stock during that period. And then from ’08 to ’12, our free cash flow enabled us to pay large special dividends to our shareholders.

As we move forward, we expect an improving cash flow compared to a declining CapEx will enable us to return additional value to Warner shareholders.

The future business prospects for trucking freight are bright thanks to supply constraints and stronger economic growth, both of which will boost trucking rates. Trucking is a very cyclical business and the cycle is turning up. Industry research firm FTR is “optimistic” about trucking in 2014 and its Trucking Conditions Index in February – weather adjusted – reflects the tightest truck market on record. FTR is warning shippers that any modest uptick rise in industrial activity could act as a “tipping point” to cause truck freight rates to skyrocket. How strong must economic growth be for the tipping point to be exceeded? According to the American Trucking Association, annualized GDP growth in the high 2% range would do it:

 “Expansion in the high 2 percent range, maybe 2.8 or 2.9 percent, might be enough,” said Bob Costello, chief economist for the American Trucking Associations. “But it would have to be consistent, not choppy, inconsistent GDP growth.” That means at least sustaining a higher GDP growth rate across several consecutive quarters. “We’ve seen GDP rise one quarter and fall back the next, and that’s reflected in what fleets will tell you about their business — that freight demand is choppy even on a week-to-week basis,” Costello said. ” 

Higher freight rates are obviously good news for truckers like Werner and bad news for shippers. Even if economic growth doesn’t accelerate, Werner is well protected because 74% of its freight focuses on economic-insensitive retail consumer products (47%) and grocery (27%).

Even better, FTR forecasts that the Trucking Conditions Index will remain positive for the next two years and won’t peak until December 2015. Similarly, Internet Truckstop’s Market Demand Index (MDI) increased 4.8% for the week ended March 28^th, marking the eighth increase for the MDI in the past nine weeks. The March 28^th MDI is up 48% year-over-year, which is the 13^th straight year-over-year gain for the weekly index. Any MDI number above 7.0 is considered favorable to truckers and the current reading is 27.6!

Source: Bloomberg

The main risks involve increased costs from a driver shortage, costly detours caused by a crumbling highway infrastructure, and increased government safety and energy-efficiency regulations. Werner is forced to offer signing bonuses to attract qualified drivers. The driver shortage is so bad that one welfare recipient reportedly would rather stay on welfare than accept a job as a truck driver paying $80,000 per year.

Partly for these reasons, Werner is wisely focusing on cutting costs and improving profitability rather than expanding its trucking fleet size. If and when management decides the time is right to expand and capture more business, increased market share will be easy because the total U.S. market for one-way truckload freight is $280 billion and another $277 billion for dedicated truckload freight (total truck freight market = $557 billion). If you include the $15 billion in revenues from rail/truck intermodal transport, the total truck freight market is $572 billion. Werner’s current market share in the U.S. truck freight market is only 0.3%, so a long runway of future growth potential is available to it when it so chooses.  See slide no. 5 in Werner’s recent investor presentation.

Until then, profit over growth is the focus and, based on slide nos. 23-24, Werner management has very clear financial goals that appear achievable:

Werner Financial Goals

Financial Metric	2013	Goal
Return on Equity	11.7%	15.0%
Return on Assets	6.5%	9.0%
Operating Profit Margin	7.2%	11.0%

The company has grown earnings per share at a 10% annualized rate over the past 27 years (slide no. 22), so it the Werner family has proven itself to be competent asset allocators able to  generate strong shareholder returns. The founder-family CEO, high insider ownership (38%), low debt-to-equity (5.2%), technological leadership, shareholder-friendly return of cash through buybacks and dividends, positive, and focus on profitability over truck growth  all combine to make Werner Enterprises a stock I want to own as a value investor.

The catalyst to buy now is the cyclical nature of trucking, the truck shortage, and the expected macroeconomic strengthening in 2014 and beyond that will enable trucking rates to increase and boost corporate profits.

Werner Enterprises is a buy up to $31; I’m also adding the stock to my Value Portfolio.

 

Momentum Play: VCA Antech  (Nasdaq: WOOF)

The ticker symbol gives it away: this company is for the dogs (in a good way). Raising a child is extremely expensive, with the cost through age 18 estimated at $241,080. If you include the cost of college and lost parental wages, the cost skyrockets to $1.1 million. With childcare costs continuing to rise and the median income of working-class households falling, more adults are opting for pets over children. 

According to Jonathan Last, author of What to Expect When No One’s Expecting:

Americans who’ve opted out of the parenthood club complain that it’s just too expensive and stressful. Pets are in many ways like kids but easier and they make you happier than kids do. They don’t cost as much as kids do. You can board them for a week and go to Paris. But I’ve found, much to my chagrin, that people frown when you try to board your children to take a vacation.

Not having kids frees up a lot of discretionary income that can be used to pamper pets.  A married couple without kids spends much more on pet care than do households that include children, so this “child replacement” trend (54% of pet owners intentionally chose a dog over a child) is great news for pet-care companies. Estimates of the percentage of U.S. households that own at least one pet range anywhere from 62% to 68% to 75%. Since the 1970s, U.S. pet ownership has more than tripled. The number of pets (including fish) in the U.S. now outnumbers children by a factor of more than 4-to-1 (300+ million vs. 74 million). According to author Jonathan Last, pet-care spending is skyrocketing:

The pet market has been steadily increasing in America since the 1980s, with people not only acquiring more furry little dependents, but spending more on them, too.

In 1994 Americans spent $1.7 billion on pets; by 2008 that number had risen to $4.3 billion. By 2010, even in the face of a massive recession, it had climbed over $4.8 billion. The evidence suggests that pets are increasingly treated like actual family members: In 1998, the average dog-owning American household spent $383 on medical care for their dogs; by 2006, that figure had risen to $672.

In 2014, an estimated $52.51 billion will be spent on pets with 29% of this total ($15.25 billion) spent on veterinary care. From 1994 through 2010, the compound annual growth rate in pet-care spending has been a robust 6.7%, with no signs of slowing down anytime soon. As pets replace children, they become more “dear” to their owners and spending on their healthcare becomes more essential and less discretionary. It also helps that the cost of pet healthcare is a much smaller percentage of a household’s discretionary income than the cost of human healthcare. Although . . . for well-heeled pet owners, more sophisticated healthcare for pets is now available, including radiation therapy, bone-marrow transplants, acupuncture treatment and hydrotherapy pools. Such high-end pet care can cost $16,000 or more.

One of the prime beneficiaries of this trend toward pampering pet ownership is VCA Antech, the largest animal healthcare company in both the U.S. and Canada. The company was founded in 1986 under the name Veterinary Centers of America by three ex-employees of AlternaCare, an owner of outpatient surgical centers for humans. All three founders are still with the company and remain in the top management positions: The Antin brothers, Bob and Arthur, are CEO and COO, respectively, and Neil Tauber is responsible for business development (i.e., mergers and acquisitions). Founders make the best CEOs.

One of the advantages of animal healthcare over human healthcare is the certainty of payment for services rendered, with no need to wait for reimbursement from insurance companies. As the company points out in its recent 10-K filing:

Unlike the human healthcare industry, providers of veterinary services are not dependent on third-party payers in order to collect fees. As such, providers of veterinary services typically do not have the problems of extended payment collection cycles or pricing pressures from third-party payers faced by human healthcare providers. Outsourced laboratory testing and diagnostic equipment sales are wholesale businesses that collect payments directly from animal hospitals under standard industry payment terms. Fees for services provided in our animal hospitals are due at the time of service.

In 2013, over 99% of our animal hospital services were paid at the time of service. In addition, over the past three fiscal years our bad debt expense has averaged less than 1% of total revenue.

In 1987, VCA Antech purchased its first animal hospital in West Los Angeles, California and the Antech diagnostics laboratory division was added in 1988 with the purchase of a single laboratory in West Los Angeles.  Today the animal hospital division operates or manages 609 animal hospitals serving 41 states and four Canadian provinces and the veterinary diagnostic laboratory division operates 56 laboratories serving over 16,000 clients, including standard animal hospitals, large animal practices, universities and other government organizations in all 50 states and Alberta, Canada. Since the company only owns 609 hospitals, the vast majority of the laboratory division’s business (85% of revenue) is with independent hospitals, so it is a stand-alone business that does not rely on company-owned hospitals for its livelihood. Still, it is nice to have some vertical integration and be able to steer all VCA Antech animal hospital clients to the company’s own laboratories for high-margin testing services.

VCA Antech has a “roll up” business model similar to U.S. Physical Therapy, in that growth is primarily through acquisition of small veterinary clinics. As the company points out in its most-recent 10-K filing (page 4):

According to the American Veterinary Medical Association, the U.S. market for veterinary services is highly fragmented with more than 53,000 veterinarians practicing at the end of 2013. We have estimated that there are over 26,000 companion animal hospitals operating at the end of 2013.

Although most animal hospitals are single-site, sole-practitioner facilities, we believe veterinarians are gravitating toward larger, multi-doctor animal hospitals that provide state-of-the-art facilities, treatments, methods and pharmaceuticals to enhance the services they can provide their clients.

In 2013 alone, the company acquired 20 independent animal hospitals with annualized revenue of $60.4 million. These acquisitions, plus the opening of VCA West Los Angeles, a state-of-the-art animal hospital that is probably the most advanced in the world, helped the company’s fourth-quarter revenue reach a record high.

The company operates four businesses, but two generate the vast majority of revenue:

VCA Antech Business Segments

Business Segment	Percentage of Revenue	Gross Profit Margin	Operating Profit Margin	1-Year Revenue Growth
Animal Hospital	78.6%	14.7%	14.6%	6.5%
Diagnostic Laboratory	19.1%	47.5%	10.2%	5.2%

 Source: 10-K Filing

The remaining 2.3% of revenue is generated from: (1) the Sound-Eklin operating unit, which is the largest supplier of diagnostic imaging equipment and other medical technology products for the veterinary market; and (2) VetSTREET, an Internet website that provides third-party veterinarians with marketing services, client communications, and continuing education. The website has collected email addresses for over 10% of the pet owners in the U.S. (6 million households), which is a valuable marketing asset in its own right.

VCA Antech’s Stock-Price Momentum

Although VCA Antech’s stock performance has lagged over the past five years since the 2008-09 recession, but that is understandable given the economically-sensitive and discretionary nature of pet-care spending. The economic downturn hurt sales as revenue per hospital for those open more than a year fell for 10 consecutive quarters from 2009 to 2011.

With an improving economy, the company’s fortunes have recently turned around for the better. Revenues are increasing again and analysts expect earnings to grow 13% annually over the next five years – a huge improvement over the anemic 0.5% annual growth over the past five years. And the stock has handily outperformed the S&P 500 over the past year by more than double (42.3% vs. 23.1%):

Source: Bloomberg

Value Plus Momentum  = Buy

The company has a manageable debt load of less than half equity (46%) and insiders collectively own a decent 4.4% ownership stake – founder CEO Bob Antin owns the majority of insider shares with 3.1%.

Despite the stock’s positive price momentum over the past year, valuation remains reasonable at an EV-to-EBITDA ratio of less than 10 times and a P/E ratio that is less than the company’s five-year average. Price momentum combined with reasonable valuation promises more capital appreciation in the future.

VCA Antech is a buy up to $40; I’m also adding the stock to my Momentum Portfolio.