Sometimes it's tempting to just say “okay, valuation doesn't matter”, throw caution to the wind, and go into a growth story like J.B. Hunt (Nasdaq:JBHT). After all, with seemingly every quarter this company demonstrates why it's one of the leaders in the still-growing intermodal space. While the stock did lag the S&P 500 over the last quarter, it continues to enjoy rich multiples and ample support on the sell-side. Even though I really do like this company and wish I had bought the stock four years ago, I still can't resolve the valuation in light of the probable returns and cash flow that this business will produce.
 
A Minor Miss Won't Matter
Typically, expensive growth stocks suffer when the companies miss estimates and particularly when the misses start stacking up consecutively. Even though this is the second straight miss at J.B. Hunt and the third in four quarters, I don't expect any major revisions or weakness in the stock – the misses haven't been that bad, the long-term bull thesis is still intact, and there's a solid reserve of investor goodwill in place.
 
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Revenue rose more than 9% this quarter, which missed the average Wall Street guess, but not by much (less than 2%). The intermodal business (more than 60% of revenue) saw 12% growth this quarter on 12% load growth. The DCS business saw 13% growth as reported (or 16% ex-fuel charges), and the truck brokerage business (ICS) saw 20% overall revenue growth as strong load growth (up 29%) offset ongoing price weakness. Last and certainly least, revenue from the trucking business continues to erode rapidly (down 20%) as the company further reduces its fleet size. 
 
Like revenue, profits were very slightly softer than expected, but not to such a degree as to be a real worry. Operating income rose 7% and the operating margin fell 20bp from the year-ago level, but the margin improved a full point sequentially as the company works through some contract start-up costs in the DCS business. Intermodal profits were up nicely (segment income up 19%), while trucking continues to decline (down two-thirds from last year).
 
Improving Value In A Growing Business
Although I have my issues with the valuation on this stock, I understand why investors are bullish about this company's prospects, particularly in the intermodal business. J.B. Hunt does have competition from companies like Pacer (Nasdaq:PACR) and Hub Group (Nasdaq:HUBG), but scale works in favor of J.B. Hunt – the bigger J.B. Hunt is, the more rail carriers like Norfolk Southern (NYSE:NSC) and Berkshire's (NYSE:BRK.A) Burlington Northern are willing to give them a break on pricing due to the volumes that J.B. Hunt can deliver for their growing (and profitable) intermodal businesses. J.B. Hunt can then share some of those savings with customers (who would pay more if they tried to arrange transportation with the rails on their own, or through smaller intermediaries) and keep some of it for themselves.
 
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Intermodal is still a significantly under-penetrated opportunity, and it is likely to facilitate ongoing cargo share shifts from truck to rail, where fuel costs are lower and operating efficiencies higher. Though there will always be a need for short-haul and less-than-truckload trucking (good for the likes of Old Dominion (Nasdaq:ODFL)), I believe we can see double-digit and high single-digit growth from J.B. Hunt for some time, with some of those same trends benefiting Pacer and Hub Group as well. As competition intensifies, though, I do have my doubts that intermodal operations will offer substantially better long-term cash flow than trucking, rail, or freight brokerage – there just aren't many places in transportation that offer wide margins for any real length of time.
 
The Bottom Line
Between intermodal and the DCS business (essentially a customized trucking operation), I think J.B. Hunt has positioned itself very well for the changes that are occurring in the U.S. land transportation industry. Moreover, we're also talking about a company that has produced double-digit returns on invested capital since 2004 and returns better than 18% for two years running.
 
The problem is how all of that growth and quality plays out in a valuation model. Even if I go with a forecast of 9% long-term revenue growth, over 20% long-term free cash flow growth, and a below-average discount rate (meaning more advantageous for the stock valuation), the suggested fair value is only in the mid-$50s or $60 if you choose to ignore the net debt on the balance sheet. To get an appealing fair value today, you have to assume both a Coca-Cola-like level of operating risk (which I believe is much too aggressive) and long-term free cash flow CAGR of 25% a year for a decade. Then again, the stock is trading with an EV/EBITDA below its EBITDA growth rate and, like the better-known PEG ratio, that can point to relatively undervalued growth stocks.
 
I know better than to sell a winner just because it's expensive, and I'm not saying J.B. Hunt shareholders should sell their shares. What I am saying, though, is that it seems like Wall Street is very much on board with the bull story here and I just don't see what the company can do to outgrow/outperform expectations from here.

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