The Investment Case For Old Dominion

By Stephen D. Simpson, CFA | December 06, 2011 AAA

Investors may not be feeling all that confident about the health of the U.S. economy, but that's not really showing up in the transport stocks. Rails and truckers have been doing relatively well, and given that their demand is derived from economic activity, that's an encouraging sign. Old Dominion (Nasdaq:ODFL) is a challenging case for investors. On one hand, this is one of the most interesting and dynamic carriers out there, but the valuation takes a little getting used to for prospective investors.

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Zigging While Others Zag
Trucking is to some extent a commodity business - at least insofar as everyone offers the same basic service (moving your goods from point A to point B), and there is not a lot of room for unique pricing. But, that should not be taken to mean that trucking companies cannot stand out and make different strategic decisions.

To wit, while unions still have a meaningful presence in trucking, that's not the case for Old Dominion or Con-Way (NYSE:CNW). That arguably gives the company flexibility on wages and hiring that a rival like Arkansas Best (Nasdaq:ABFS) does not enjoy. (For related reading on unions, see 6 Things Putting Unions Under Fire.)

What's more, many truckers are actually trying to consolidate their service areas, generate better profitability and conserve capex dollars. Old Dominion is going the other direction - spending aggressively on service centers, tractors and IT systems. This is giving the company the opportunity to not only capture shares, but lay the groundwork for a more profitable enterprise down the line.

Different Is Proving to Be Better
So far, Old Dominion's philosophy seems to be working out. The company has grown to become the 6th-largest less-than-truckload carrier at a time when many carriers are struggling ((like YRC Worldwide (Nasdaq:YRCWD) or pulling out of the direct trucking business (like J.B. Hunt (Nasdaq:JBHT)).

Old Dominion is posting revenue growth in excess of 20% at a time when the industry is growing more at a single-digit rate, and the company is doing it through a combination of tonnage and price growth. Even better, the company is posting profitable growth. Old Dominion has an enviable operating ratio, despite the fact that it keeps adding service centers and has to swallow the overhead costs of these new facilities.

If there are fundamental issues with Old Dominion, they are likely centered in the free cash flow generation. Although Old Dominion's trailing return on invested capital has not always been great, a lot of that has been a byproduct of lower capital turnover and higher capex and the company has started to leverage that better.

On the cash flow front, the company is clearly spending a lot more than its rivals to build its asset base. In a trucking world where capex is often 4 to 5% of revenue, Old Dominion's is around 14%. Companies like Arkansas Best, FedEx (NYSE:FDX) and UPS (NYSE:UPS) have the advantage of leveraging larger already-built asset bases, and don't have to constantly invest the same level of funds. At the same time, this is future leverage for Old Dominion, as free cash flow could leap up in future years as there are fewer demands for new service centers.

The Bottom Line
Simply put, valuing a stock like Old Dominion is a pain in the neck. A simple P/E-based analysis does not really acknowledge the realities of Old Dominion's cash flow situation, while a discounted cash flow model will almost certainly undervalue the company's future cash flow leverage potential. (For related reading, see Top 3 Pitfalls Of Discounted Cash Flow Analysis.)

In times like these, then, a compromise approach like EV/EBITDA can be helpful and it's not uncommon to use this metric in the transports. To that end, Old Dominion is pretty attractively priced, even allowing for the fact that the stock has run well this year and is near a 52-week high. Although buying into this end-of-year melt-up may not be a great idea, Old Dominion is a great transportation growth story that is worth a serious look by most investors.

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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