The trucking industry has typically been thought of as a bellwether for the health of the American economy; increases in consumer and industrial demand result in a greater need to move raw materials and finished goods across the U.S. With that said, the current state of the U.S. trucking industry has mixed implications for the U.S. economic recovery, as well as flow-on effects for truck manufacturers.
Trucking companies, the firms responsible for purchasing trucks and hauling freight, have had to contend with declining truckload spot rates – that is, the prices firms pay trucking companies to transport goods when booked individually through brokers rather than through long-term contracts. According to the online freight marketplace DAT Solutions, spot market rates for dry vans, the most common type of big rig, fell 18 per cent in February 2016 compared to the same month in the prior year.
Weak freight demand and ample truck capacity have contributed to the recent declines in truck spot rates. Shipping demand in the spot market is declining, with DAT Solutions reporting that there was a 29% fall in demand for space on trucks in February from a year ago. At the same time, capacity has increased according to DAT, with truck availability growing 18% in February.
This tough trucking environment, combined with the material decrease in gasoline prices improving the economics of older trucks, has given trucking companies pause when adding new trucks to their fleets. The situation that currently exists is one of heavy duty truck oversupply: there is simply limited freight activity spread amongst too many trucks. However, the inflection point where truck capacity began to overwhelm freight demand has occurred only recently.
The Great Recession saw many trucking companies delay capital expenditures for new trucks and sweat their existing truck fleets, resulting in an increase in the average U.S. Class 8 fleet age. (N.b.: Class 8 is a category of large, heavy duty trucks that weigh 33,001 lbs or more).
The below graph highlights that demand for Class 8 trucks was below an estimated 225k units per year level of replacement demand. As a consequence, there was a more than 200k cumulative shortfall in demand for Class 8 trucks in 2010.
What this means is that there was significant pent-up demand for Class 8 trucks. However, with increasing levels of investment by trucking companies, the resulting boom in Class 8 demand has more than fully offset any previous trucking company underinvestment. Consider that Class 8 truck retail sales reached 253k in 2015, a level materially above replacement demand.
Given the currently weak freight environment for trucking companies, and the fact that many in recent years have already upgraded their fleets, many trucking companies have announced that they are in “zero-capex mode” and will curtail purchases of new trucks. Commentary from two of the largest trucking companies on their quarterly calls provides further insight:
- Knight Transportation CEO during the 4Q15 earnings call: “And when you look at the players, the large carriers who have already reported, one thing we see in common is that fleet additions in that group have ended, and the outlook is basically to be flat, it sounds like, over at least the next year. [i.e., it has become a replacement demand environment in North America]. I think even the best operators have gone backwards a little bit. And I would add us to that group, going backwards a little bit in the average fleet count from third to fourth quarter.”
- Swift Transportation COO during a mid-quarter guidance call in 1Q16: “Again, we’re not planning to add capacity this year via truck count. We intend to grow revenue by improving the utilization of our fleet and elevating our mix of business.”
As a result of the slowdown in demand for trucks by trucking companies, the Class 8 truck cycle has started to turn negative. ACT Research data showed that preliminary Class 8 net orders in March 2016 declined 37% YoY. This is the thirteenth consecutive month of year-on-year declines after twenty-five straight months of increases. In February, it was reported that cancellation rates for Class 8 trucks rose to 18-20% of new orders in four of the past six months – an ominous sign for truck manufacturers.
Navistar International (NYSE: NAV), a U.S. manufacturer of heavy duty trucks which the Montaka team has previously written about, saw its sales decline by 27% in 1Q16. However, the problems at Navistar extend even further than that of the broader truck industry downturn, given its prolific use of trade-ins as a tool to drive new truck sales.
Using trade-ins of used trucks as a way to incentivize new truck sales is commonplace amongst truck OEMs and this in and of itself is not an issue. What is an issue is when a truck OEM takes on more used trucks than it can reasonably hope to sell, or accepts those trucks on terms disadvantageous to itself for the sake of making the truck sale. It is worth recapping the process for a sale made with a trade-in for a truck OEM such as Navistar:
- A trucking company makes a purchase of a truck. In this sale, NAV accepts a trade-in of a used truck from the trucking company.
- NAV might take possession of the used truck or it might enter into what’s called a residual value guarantee (RVG), whereby it will agree to reimburse the customer to the extent that the price received upon future sale of the truck falls short of an agreed residual value.
In the current environment, both of these options create risks for NAV that are not easily detected in the Company’s financial statements.
In the case of NAV taking physical possession of a used truck, the Company will subsequently attempt to clear the truck through wholesale channels (i.e., its dealer network) or try to sell the trucks from one of the Company’s used truck centers (where NAV effectively competes with its own dealer network). NAV has been using these trade-ins to drive sales and its used truck inventory has subsequently expanded to $440m as at 1Q16, a year-on-year increase of $75m. NAV’s dealers are simply unable (or unwilling) to absorb the large number of used trucks NAV has been accepting as trade-ins. NAV is desperately trying to push its used truck inventory problems onto its dealers but it’s worth noting that dealers have no legal obligation to take the trucks.
Virtually any option NAV management chooses to reign in the Company’s rising used truck inventory will be negative for NAV:
- Halting trade-ins will have a deleterious effect on new truck sales;
- Continuing to accept trade-ins will further add to the already heightened used truck inventory levels for NAV, introducing a material risk of asset impairments if used truck values continue to fall. In fact, Rush Enterprises (Nasdaq: RUSHA), a publicly listed U.S. operator of truck dealerships, recently announced a significant write-down of their truck inventory and the RUSHA CEO alluded to future industry-wide write downs on trucks.
The situation for NAV is even worse than the horrible picture painted thus far due to, again, a number of Navistar-specific issues.
In 2008 Navistar pursued an emissions reduction technology, dubbed Exhaust Gas Recirculation (EGR) technology, which was used in its MaxxForce diesel truck engines. The technology was a colossal failure and in 2012 NAV abandoned its EGR technology in favor of the competing Selective Catalytic Reduction (SCR) technology. MaxxForce engines, due to the nature of the EGR technology, raised engine temperatures to unacceptably high levels which accelerated component failures and breakdowns. Interestingly, there are still Navistar trucks operating in the market which sport MaxxForce engines with the legacy EGR technology.
Primary research undertaken by the Montaka team has revealed that many truck dealers refuse to even finance trucks with MaxxForce engines and one industry contact opined that “EGR engines are valueless”. It is worth noting that NAV has taken receipt of more than 16,500 EGR trucks to date and there is currently a glut of these vehicles in NAV’s used truck centers.
The alternative to taking physical possession of the truck – writing an RVG – also creates hidden risks for NAV shareholders. An RVG ordinarily might not become a problem but it poses a risk to the extent that used truck values decline more than NAV anticipated when it wrote the RVG. The danger is that poor risks taken by NAV in the past when guaranteeing residual values might only manifest themselves years down the track. It just so happens that there is an enormous used truck oversupply in North America at present and used truck values are deflating. There is a material risk that many of the RVGs NAV has written, particularly over EGR-trucks whose values may be impaired, are underwater and will produce losses for the company.
NAV has little flexibility to manoeuvre out of its current predicament. The Company’s balance sheet has $3bn of manufacturing debt and $3bn of pension liabilities. Relative to its c.$950 market capitalization, this enormous debt burden removes many of the options for NAV management to turn the ship. It also throws into serious question the ability of NAV to weather, or even survive the current Class 8 truck downturn.
* * *
Montaka is short the shares of Navistar International (NYSE: NAV)
George Hadjia is a Research Analyst with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.