Taking a Ride with CNF


By Jim Corridore Investors don't seem to be too taken with trucking stocks at the moment. But at Standard & Poor's we see compelling reasons why the shares of one trucker -- CNF (CNF

; recent price, $47.11) -- can materially outperform the overall market over the next 12 months. We expect a continued improvement in operating profitability that should lead to strong earnings-per-share growth over the next few years. But that strength isn't reflected in the current stock price.

CNF reports second-quarter earnings on July 20, and we think chances are good it will beat Street expectations. We see CNF as undervalued relative to peers, and we've assigned the shares our highest investment ranking of 5 STARS, or strong buy.

CNF, through its Con-Way Transportation Services and Menlo Worldwide units, is a $3.7 billion company engaged in regional trucking services, global logistics management, e-commerce fulfillment, and trailer manufacturing.

STEEL WHEELS. Con-Way, with 70% of revenues from continuing operations in 2004, operates next-day, second-day, and transcontinental less-than-truckload (LTL) freight services throughout the U.S., Canada, Puerto Rico, and Mexico. Typically, LTL truckers transport shipments weighing between 100 lbs. and 15,000 lbs. from multiple shippers utilizing a network of freight service centers, tractors, and trailers. In addition, Con-Way also provides expedited transportation, freight forwarding, contract logistics, warehousing, and truckload brokerage services.

Con-Way's revenues grew 18% in 2004, and operating profits improved 34%. The operating profit margin has shown a steady gain for the past few years, from 6.4% in 2002 to 8.3% in 2003 and 9.4% in 2004.

Con-Way has benefited from what we see as a strong environment for LTL trucking -- good demand for shipping services, coupled with relatively tight trucking capacity in the industry. This has allowed LTL truckers to pass along price increases to customers.

THE GM CONNECTION. At the same time, rising fuel prices have largely been transferred to customers in the form of a fuel surcharge. We expect Con-Way to experience about a 10% increase in freight tonnage in 2005, along with about a 3% increase in prices, leading to our expectation that revenues at the unit will rise about 13%.

Menlo Worldwide (30% of CNF revenues) specializes in developing and managing complex supply and distribution networks, including transportation management, warehousing, carriage, and supply-chain consulting. Menlo also has a joint venture with General Motors (GM) named Vector SCM which provides logistics management services to GM.

In 2004, Menlo's revenues grew 9%. Operating profits rose only 4%, hurt by a change in Vector's contract with GM, which made the venture much less profitable. This was offset by an improvement in the core logistics business.

BIG PLUSES. We think Menlo is likely to benefit in 2005 and beyond from management's focus on expanding this business profitably. This was also apparent in the first quarter of 2005, when Menlo's revenues increased 12% and operating margins improved, leading to operating profit growth of 15%.

In our view, CNF is also likely to benefit from a still-growing U.S. economy, a strong pricing environment due to capacity constraints in trucking, and recent efforts to exit unprofitable businesses and restructure the company. The biggest example of CNF's December, 2004, sale of its heavy airfreight forwarding business to UPS (UPS). This segment had been losing money for a long time, and we believe its sale quickly improved operating margins while also boosting CNF's balance sheet. Following the sale, CNF implemented a $300 million share-repurchase plan, which we think will be accretive to earnings and also act as a support to the share price.

Another relatively recent development that we think should allow CNF to significantly improve operations: the appointment of Douglas Stotler as CEO on Apr. 26, after a long search. Stotler was previously CEO of CNF's Con-Way division. We believe he was a good choice for the job, as he obviously has great working knowledge of CNF and should be able to quickly step in and improve operations. In addition, the conclusion of the search should allow CNF to focus on improving operations, in our view.

RAISED ESTIMATES. Largely due to our belief that CNF can continue to build operating margins, we think it should be able to outperform its industry peers in terms of earnings growth over the next few years, despite the potential for a slowdown in the U.S. economy over that time span. In our opinion, the current stock price reflects this.

We recently raised our second-quarter EPS estimate to 98 cents from 90 cents (the Street estimate is 96 cents). We also raised our full-year 2005 and 2006 EPS estimates, largely reflecting our view that CNF will continue to make progress with improving operating margins. Our new EPS estimates are $3.55 for 2005, up from $3.45, and $4 for 2006, up from $3.90.

Worries about the performance of transportation stocks in the late stages of an economic cycle are largely to blame for CNF's share price performance so far this year, in our view. Through July 13, CNF's stock has declined 6.8%, vs. an approximate 1% drop in the S&P 500-stock index over the same period. This weak performance came at the same time CNF has been reporting strong growth in revenues and earnings.

WIDER MARGINS. In our opinion, most transportation stocks have seen their valuations contract as investors have looked to exit this sector ahead of an expected cyclical earnings decline. However, we think the economy is still healthy enough to allow for strong revenue and earnings growth for transport stocks in general -- and CNF in particular.

For 2005, we're expecting CNF's revenues to grow about 13%, with margins widening, driven by improved pricing at Con-Way, fixed-cost leverage on the higher revenue base, and improved profitability at the logistics group. We see the operating margin improving to 9% in 2005 from 7.7% in 2004. We estimate EPS of $3.55 in 2005, which would represent 38% growth over 2004 EPS of $2.57, before extraordinary items. For 2006, we project a further rise of 13%, to $4.

Our S&P Core Earnings forecasts are $2.96 for 2005 and $3.37 for 2006, representing a difference of 16.6% and 15.6%, respectively, from our operating EPS estimates. Of this difference, the majority was generated from the gap between what CNF reports as pension expense and what we calculated as actual pension expense. About 15 cents per share of the difference between our S&P Core EPS and operating EPS estimates in 2005 reflects our estimate of the cost to expense stock options. This cost is included in our 2006 EPS estimate, since FASB rules call for options to be expensed by then.

TARGET PRACTICE. In our view, the difference between CNF's operating earnings estimates and S&P Core Earnings estimates isn't out of line with that of most of the company's peers, which still have defined-benefit pension plans. Still, it needs to be recognized that a relatively material difference does exist, largely due to pension accounting. But the difference isn't material enough to change our positive view on the stock.

S&P's 12-month target price of $59 is derived by using both our relative and intrinsic value calculations. Using relative valuation, this target price values the stock at slightly under 15 times our 2006 EPS estimate of $4. That's at the bottom of CNF's historical p-e range and is in line with its trucking industry peers.

The valuation implied in the target price doesn't factor in the fact that CNF gets a significant portion of its revenues and profits from the logistics business, which is generally rewarded with a higher p-e than that of other trucking companies. While we don't think CNF deserves a valuation in line with pure-play logistics companies, the 30% of operating revenues that CNF generated from Menlo Worldwide Logistics argues for a premium valuation to trucking peers, in our view.

STRONG STANDARDS. If CNF is able to continue to improve operations and report consistent revenue and EPS growth, in comparison with very uneven results in the past, we think investors could reward the stock with some material expansion of its p-e multiple, which would make it even more attractive.

In addition to its relative valuation, our strong buy opinion is supported by our

discounted cash-flow (DCF) analysis. Our DCF model implies a fair value of about $60 for the stock, which is close to the figure we arrived at in our relative valuation model.

We see CNF's corporate-governance standards as somewhat better than its peers. Among the favorable factors contributing to this view is the fact that CNF's board of directors includes independent outsiders that control compensation, nominating, and audit committees. Those outsiders meet without the CEO, and the use of stock options and stock-based compensation doesn't seem excessive to us.

RIDING THE CYCLES. Negatives, in our view, include the staggered board of directors and the fact that some directors don't own any common stock in CNF. In general, we don't find these corporate-governance practices a major source of concern.

Risks to our recommendation and target price include the possibility that CNF's business units will be unable to pass along high fuel costs to customers, which could affect revenue growth and profitability. In addition, the trucking industry has historically been highly cyclical, with boom and bust cycles. Investors, recognizing this trend, typically rotate out of trucking stocks in the later stages of an economic cycle, even as earnings growth is still improving.

We think the current economic cycle still has room to run, but this remains a general risk when investing in cyclical stocks. Analyst Corridore follows shares of logistics companies for Standard & Poor's Equity Research Services


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