Why
We Own Pacer International
(PACR)
Famed money manager Peter Lynch used to have a tell-tale
indicator of how frugal a company’s management team
was:
“All else being equal, invest in the company with the
fewest color photographs in the annual report.”
This being 2011, I think I’d add the corollary:
“Invest in the company with the most hideous
Powerpoint slides.”
Bonus points for clip art, dissolves, spins, and that
“whoosh” sound effect. Okay, maybe not the noise,
but my point is this:
I want the businesses we own to be focused on operations and
keeping costs low, not making pretty slideshows.
There are exceptions, to be sure, but I am nonetheless drawn
to that homely corporate slideshow - the kind that looks like
it was done late the night before by a drunk, jet-lagged,
one-eyed engineer trying to get even with the CFO.
Which brings us to the slides of Pacer International. And I
believe I’ll just leave it at that.
No, I'm kidding. Pacer’s latest slideshow actually
looks great if you’re not a Powerpoint snob -
appropriately frugal and unabashedly direct.
And you really shouldn’t look to me to be an arbiter
of design, anyway. I painted my office walls purple.
Why Is This a Great Business?
The reality is that management at Pacer has been
impressively focused, and on the right things. Consider the
Pacer shares we own another special situation investment - this
time in the “turnaround” category.
Pacer calls itself a leading “non-asset-based
provider” of logistics services over one of the largest
integrated intermodal networks in North America.
In the human tongue, that means companies that need their
goods shipped over vast distances hire Pacer to handle it all
for them. Pacer matches up companies with high volumes of goods
to ship - like customers Costco and Proctor & Gamble - with
large transportation companies like railroads, cargo ships and
trucking companies. Both sides can ultimately earn much higher
profits if they coordinate and combine delivery schedules,
routes, and warehouses, but the huge number of variables
involved in doing that well demands a highly specialized
logistics quarterback. Thus, the rise of firms like Pacer.
I should also distinguish between the expedited delivery
services you’re probably most familiar with and
Pacer’s business. FedEx works great if you need to
overnight a forgotten passport to Uncle Louie. But it’s
not quite as simple if you need to ship a thousand Toyota Camry
drivetrains from Tegucigalpa to Newfoundland. As cheaply as
possible. To arrive next Thursday. And after swinging through
Topeka for ball bearings. So, Pacer handles a much larger range
of potential variables at a completely different scale of
service.
Most of Pacer’s revenues come from moving freight
over two or more different kinds of transportation
(“intermodal”) - usually rail and truck. But the
company also provides international freight forwarding services
and acts as a broker for regional trucking services, too. The
common thread among all of Pacer’s services is that
every load it ships represents a custom solution. And to
deliver all those customized services, the company taps a
network of over 5,000 independent trucking companies, relies on
contracts with numerous railroads and ocean shippers, and
maintains a fleet of doublestack railcars, containers, and
trucking chassis, too. It doesn’t own them, though. It
leases them.
Being “non-asset-based” means Pacer has
purposely avoided investing a ton of capital in equipment and
facilities. It operates mainly by making attractive long-term
deals with rail, ship, warehouse and truck owners and
specialized equipment providers, too. So the company is in the
enviable position of having full access to a wide range of
freight terminals and facilities, while also having complete
control over large fleets of specialized equipment - without
actually owning any of it. And that’s a key part of why
this business can be such an attractive one to own.
In most businesses, the economics of being a middleman are
poor. It’s almost a business school cliche that all
middlemen eventually get squeezed. Pacer and a few other
third-party logistics or “3PL” firms are
different, however. In fact, the economics of 3PL companies can
be among the most impressive you’ll see. Strong top-line
growth over decades, high profitability and 35%-plus returns on
invested capital are not uncommon thanks to the network effects
inherent in this business.
The more ways Pacer can ship goods between various
locations, the more attractive its services become to those
businesses needing to ship large volumes over vast areas.
Likewise, as the number of companies Pacer provides shipping
services to increases, the more truckers and railroads join
Pacer’s network, in hopes of getting some of that
business. Companies in this industry must also have the
capacity to handle all aspects of shipping goods long-distance
well before they can ever convince a new customer to try them,
and that means years of considerable toil and expense before
ever seeing the first dime. So the benefits of scale also
provide firms like Pacer some insulation from new entrants to
the industry.
The bottom line is that if Pacer gets it right, its business
can have powerful competitive advantages. And yes,
that’s an “if.” While a strong moat is
achievable, Pacer right now has little to point to in the way
of a sustainable competitive advantage. But I believe that is
about to change.
Why is it Cheap?
The challenge for a value investor in finding an attractive
3PL company is that they’re rarely cheap enough to get
excited about. Luckily for us, Pacer fits that bill. I bought
our shares at about $4.75 each, in the middle of the market
drop caused by the Japanese earthquake last month. Shares have
since risen to $5.64, but I believe Pacer is worth closer to $8
a share. So the value is there, but why?
Shares are cheap because Pacer is a turnaround story. About
the only positive thing you can say about the company during
the recent economic downturn was that it survived. A new
management team took over when things looked most bleak,
however, and after first addressing several crises, including a
liquidity crunch, the new team set out to do three things:
1 - Reduce overhead. Costs were way out of whack compared to
competitors.
2 - Invest in a top-shelf IT system. This is absolutely
critical to quarterbacking those deliveries.
3 - Build out its “retail intermodal” business
by shipping right to the customer’s loading dock
door.
To date, Pacer has largely accomplished those first two
goals, cutting overhead by 17% last year alone, and integrating
four old IT systems that management believes will save the
company $20 million a year. And that third goal?
Is it Cheap for Temporary Reasons?
Pacer is significantly undervalued because the market is
waiting for proof the company can grow that retail intermodal
business. And, candidly, the company is still in the process of
earning back the trust it lost a few years ago under the prior
management team. So some skepticism is understandable. But to
quote Peter Lynch again, “You can’t see the
future through a rear view mirror.”
Prior to the downturn, PACR historically emphasized the
“wholesale” side of its business, or serving a
customer base consisting largely of other shipping
intermediaries, and that meant often shipping goods only as far
as another rail hub or warehouse. Current management, however,
is strongly focused on growing the “retail”
business. That means Pacer will provide door-to-door delivery
service directly to various manufacturers, consumer product
companies and major retailers. That retail service represents
the best economics, the highest potential growth and the most
feasible way to recover revenue Pacer lost during the
downturn.
Why am I optimistic Pacer can pull it off? First, to be
clear, Pacer is not completely out of the woods yet. Most
turnarounds fail to really turn, and though high debt levels
are no longer a threat for the company, Pacer could still face
notable risks if either (1) it is unable to pass future price
increases on to its customers or (2) demand for its services
drops significantly for any reason.
So, real risks exist here. If they did not, shares
wouldn’t be so cheap. I just believe those risks are
low-probability, and that we will be well-compensated for
assuming them at current prices. I also believe those risks
will ultimately be outweighed by a number of fundamental
positives, including:
1 - The caliber and prior experience of the company’s
management team.
2 - Early success in growing its retail intermodal service
in the first quarter of this year - and otherwise surprising
the Street with positive results. Initial efforts are tracking
well.
3 - Management anticipates being able to raise prices 3% to
5% this year. So risk #1 above seems likely to be a
non-factor.
4 - Growth in industrial production and consumer demand will
drive increased use of Pacer’s services. This would
minimize risk #2.
5 - High diesel prices incentivize customers to ship via
rail, as rail consumes only 25% of the fuel used in trucking.
Rail costs are significantly cheaper than trucking over long
distances.
6 - Should demand falter, asset-light businesses have more
durable margins.
7 - Globalization and an increase in the outsourcing of all
corporate shipping will be a considerable top-line tailwind for
years.
8 - The industry is seeing a secular shift from trucking to
intermodal services within the shipping sector. So new business
will also come from customers who used to rely on trucks but
want to move to rail.
9 - Intermodal volume across the industry has been extremely
strong. The intermodal market was actually operating at 100%
capacity in 2010, and, even better, most of the costs of
expanding that capacity are shouldered by the railroads, not
our guys.
10 - There is a high probability that one of Pacer’s
large long-term railroad contracts will be renewed at higher
rates in 2014.
11 - Pacer already has a significant container fleet, which
will be critical to capturing emerging demand.
12 - Trucking is a tough business. Annual driver turnover
exceeds 100% a year, and the industry is chronically short of
drivers. The solution - raising prices and paying drivers more
- makes intramodal services like Pacer’s even more
attractive to customers.
13 - Plenty of room for growth exists, as intermodal
services still represent less than 10% of dry long haul
freight.
14 - Most large customers want to work with multiple
intramodal firms. Exclusive arrangements are rare, which is
good for a company attempting to build a moat based on network
effects.
15 - The company’s primary competitor doubled its
operating margin after making operational and strategic changes
similar to those Pacer is pursuing now. This should serve as
both proof and inspiration for Pacer.
16 - The company’s operating efficiency, and by
extension its profitability, is improving steadily.
“Equipment turns” is a key metric when it
comes to gauging the success of Pacer’s operational
improvements. Those turns tell us how many times per month that
a single container carries cargo (and therefore creates
revenue). Using the same container twice in a month would be
reflected in equipment turns equal to 2, a respectable
benchmark in the industry. Pacer’s equipment turns have
gone from 1.5 two years ago to 1.70 in the first quarter of
this year - an increase all the more pleasing to see given some
tough weather this past winter. I expect those turns to improve
further over time. And should Pacer ever achieve the same 2.4
turns per month as its primary competitor, look out.
Last but not least:
17 - Warren Buffett bought a railroad company last year.
So there’s gotta be something appealing about all
this rail shipping business, no?
In summary, Pacer is a formerly troubled but potentially
advantaged company in mid-turnaround with a solid new
management team that has been executing well to date. If
operations continue to improve, the economics of the business
and the dynamics of the industry will give Pacer the
opportunity to earn an attractive moat around its business.
Uncertainty still exists, but the actual risks to the
company’s operations and finances appear to have
decreased dramatically lately. Pacer has multiple levers to
increase its earnings power, early signs of success are
emerging, and both the top and bottom lines should should
benefit markedly from multiple favorable secular trends. And as
with our other companies, in Pacer we have an attractive stream
of future earnings, a large margin of safety and a high
probability of large gains.
All of which is another way to say: I am of the strong
opinion that Pacer’s future will be considerably
brighter than the market now seems to believe. It will take
some time to realize, of course, but in the interim, all
that’s left to do is wait and see which opinion will
ultimately prove to be more accurate.
Please let me
know if you have any questions.
And if you're reading this in South Florida, don't forget to
mark your calendars for the first annual Islamorada Fishing
Film Festival on Sunday night, May 22nd. Here
is more info. Hope to see you there!
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Cale's
Notes: 
