To The Moon

vitpho

Introduction

In today's unpredictable economic landscape, many companies are feeling the pinch. With rate hikes rocking the boat of business activity, even industry stalwarts are navigating choppy waters. Enter RXO – a company witnessing a squeeze on its profits and margins. As economic challenges loom, the freight market's frailty might not let up soon, posing more hurdles for RXO (NYSE:RXO). But here's the silver lining: RXO possesses the resilience to weather these storms and, with time, might just come out on top. So, let's dive in and explore why RXO deserves your close attention.

Truckload Brokerage

Formed in November of the previous year as a spin-off from XPO Logistics (XPO), RXO has established itself as a pivotal player in the truckload brokerage industry. Holding the position of the fourth largest full truckload freight transportation broker in the US, RXO serves as a bridge between shippers and carriers. The company's truck brokerage segment, which brought in a substantial 56% of the total revenue in Q2 2023, remains at the heart of its operations. However, RXO isn't limited to this domain; it extends its services to last mile, managed transportation, and freight forwarding. A notable offering from RXO is its 'RXO Connect' digital platform. This platform gives shippers access to RXO's vast freight transportation network. Simultaneously, truck drivers find utility in it as a mobile app to lock in their transportation loads. While RXO's services span across various sectors, the company boasts a dominant footprint in the retail and e-commerce domain.

However, the year hasn't been a smooth ride for RXO. The economic landscape posed considerable challenges, with adverse effects manifesting in the freight market. The freight and truck brokerage business experienced a downturn in both demand and pricing. The company's financial performance in the recent second quarter underlined these challenges.

Recent Results

In Q2-2023, RXO recorded a substantial 21.45% year-over-year drop in revenues, amounting to $963 million. Concurrently, its gross margin receded from in Q2-2022 21.6% to 18.6% in Q2-2023. The adjusted EBITDA plunged by approximately 62% to $38 million. This decline in EBITDA was reflected in its margin, which contracted from 8.2% the previous year to 3.9%. On the net profit front, the company's GAAP net profit dwindled to a mere $3 million, a stark contrast from the $44 million achieved a year prior. Excluding one-time items, the adjusted net income stood at $10 million, marking a decline from the previous year's $64 million.

However, a nuanced perspective is essential. The year-over-year comparison appears stark, especially when juxtaposed against a period marking RXO's EBITDA peak in the last business cycle. Yet, these figures predominantly underscore the strains of a challenging business milieu. RXO's dip in revenue, earnings, and margins can largely be attributed to the prevailing tough economic factors. High inflation coupled with a dip in business activity led to a reduction in freight rates and a consequent softening of the brokerage gross margin.

There are some positive takeaways despite the challenges. While margins experienced strain, a gross margin of almost 19% remains commendable. RXO's core truck brokerage business reported a 10% rise in volume year-over-year. For the past five years, RXO has consistently expanded its brokerage volume, through both downturns and upswings of the freight cycle, leading to a gain in market share.

RXO Volume & GP Load (RXO)

Image: RXO Investor Presentation

However, due to depressed pricing, gross profit (GP) per load saw a significant decline this year. This is evident in the reduction of overall margins. The quarter concluded with the brokerage division's margin retracting to 15.4% from 20.8% the previous year. Yet, the gross margins for this pivotal segment remain in the decent mid-teen range.

Looking Ahead

These figures highlight that, despite current hurdles, RXO's core operations remain robust and lucrative. The company is still profitable in this challenging phase, and the consistent growth in volumes suggests a potential increase in market share. I believe this is a promising sign for the times ahead.

There are indicators suggesting that the freight cycle may be nearing its trough, with a potential upturn on the horizon. Notably, RXO recorded a modest growth in retail and e-commerce volumes in the second quarter year-over-year — the first such growth since Q3-2022. Truckload revenue per load, which has been on a declining trajectory month-over-month since early-2022, steadied in July.

In a similar vein, GP per load remained relatively unchanged in July compared to June. Factors such as the load-to-truck ratio and an uptick in tender rejections might signal a strengthening in pricing power. These developments could be seen as preliminary indicators of a market rebound. As and when the market does shift, RXO, bolstered by its profitable operations and expanded market share, stands well-poised to benefit from the revival.

That said, I believe pinpointing the timing of this potential shift remains elusive, especially given the prevailing ambiguities in the US economy. While certain industry indicators are encouraging, they don't conclusively establish that the freight cycle has hit its nadir. Freight rates continue to be under duress, and the timeline for their stabilization and eventual ascent remains cloudy.

The US economy, mirroring the mixed cues from RXO, is in a complex phase. Despite the Federal Reserve’s proactive interest rate hikes that curbed inflation, the economy has evaded a recession and a significant uptick in unemployment.

From nearly zero in March of the previous year, the US central bank has incrementally increased rates to the present bracket of 5.25%-5.50%. As of July, the PCE Price Index, the Fed's favored inflation measure, clocked in at 3.3% (annualized), a decrease from 7% almost a year prior. Consequently, the so called ‘soft-landing’ scenario seems increasingly likely. Given the deceleration in inflation, there's a prevalent expectation for the Fed to maintain rates this September, as evident from the CME Group's FedWatch Tool predicting a 93% likelihood of rate stability.

However, I think it's premature to infer from this that rate hikes are off the table. As evidenced in this cycle, the Fed's actions hinge significantly on data. With inflation not yet aligning with the central bank's 2% target and potential pricing volatilities lurking, the Fed may recalibrate its strategy. The economic trajectory will also be influenced by external factors such as the muted economic vigor in China and the European slowdown, notably with Germany entering a recession. Additionally, the potential autoworkers' strike Potential UAW strike could cut production, push up vehicle prices, analysts say sway economic data. At present, the focus remains on how the data turns out, which will steer subsequent policy decisions.

From RXO’s perspective, I think the primary concern would stem from dips in consumer demand and business activity, and we got that from the latest S&P Global Flash US Composite PMI. The key index tracks both manufacturing and services sectors. The index dipped to a six-month low at 50.4 in August, descending from 52 in July. Hovering slightly above 50, this suggests that both sectors experienced only marginal growth, pointing to a tepid demand for services and manufactured goods.

The central bank might interpret these developments as positive strides, considering that a deceleration in activity could lead to lower levels of inflation in the future. However, this isn't favorable for RXO, which fundamentally relies on robust industrial production and consumer demand. A decline in business activity could either perpetuate the strain on freight rates or potentially worsen it. Consequently, this may adversely affect RXO’s revenues, earnings, and margins.

On the upside, I think RXO appears well-positioned to navigate these challenges. As highlighted earlier, it maintains profitability, and its cornerstone brokerage business has been resilient amidst the downturn. The company also touts healthy free cash flows; in the year's first six months, RXO reported free cash flows of $38 million. When discounting one-time transactions, integration, and restructuring costs, this figure elevates to $51 million for the first half of 2023.

Such robust free cash flow has fortified RXO's financial health. While its long-term debt held constant at $455 million this year, cash reserves swelled from $98 million at 2022's close to $124 million by Q2-2023's end. Consequently, RXO's net debt (debt minus cash) reduced by 7.3%. The firm also boasts a clear slate regarding impending debt obligations. Most of its debt pertains to 7.5% Senior Notes due in 2027, with the remainder tied to a Term Loan Credit Agreement, also maturing in 2027. I believe RXO's liquidity is commendably robust at $624 million, encompassing both its cash reserve and an accessible $500 million via a revolving credit line. In my view, this provides RXO with a substantial buffer to weather potential economic storms.

Conclusion

RXO is undoubtedly navigating through rough waters, as seen with the decline in its earnings and margins. There's a possibility that the road ahead could become even more challenging if the economic conditions worsen. This potential turbulence might cast shadows on the company’s stock value, which is why I believe investors should stay on the sidelines for now. Nonetheless, RXO's robust balance sheet and its consistent market share gains are shining points. It's a stock worth monitoring closely, and I remain optimistic that when the economic atmosphere does improve, RXO is well-placed to thrive.