Waiting To Back Up The Truck For Old Dominion

By Stephen D. Simpson, CFA | September 20, 2012 AAA

It's not usually a good idea to hang around and hope that a stock you sold too soon once before gives you a second chance. Nevertheless, I do find myself hoping that Old Dominion (Nasdaq:ODFL) gives me that second chance to buy shares in one of the best-run companies and best growth stories in the U.S. trucking industry (and perhaps the U.S. transport sector as a whole). Although this stock has done quite well already this year and valuation looks a little stretched, a pullback could change all of that overnight.

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Doing What it Does Well ... Over and Over Again
When Old Dominion missed in the first quarter of this year, it was definitely an anomaly. Just a quarter later, the company went back to its under-promise/over-deliver pattern.

Revenue in the second quarter was up 13% on 9% tonnage growth and a 4% rate growth, while the company saw another two points of operating ratio improvement. While it seems hard to imagine that the company could further improve ratios substantially (it's pretty much the highest in the sector), this hasn't been the first time someone has mentioned it.

At this point, it looks like the next quarter should be solid. The company instituted a nearly 5% non-contracted rate increase in August and actually underpriced rivals with that hike. FedEx (NYSE:FDX), Con-Way (NYSE:CNW) and Arkansas Best (Nasdaq:ABFS) all hiked rates nearly 7% this summer, while UPS (NYSE:UPS) increased its rates by 6%. Now roughly only one-third of cargo falls under those new rates, but these increases usually set the tone for future contract rate increases (which often capture about two-thirds of the announced hike).

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What About the Numbers?
Although Old Dominion's returns on invested capital and free cash flow margins have generally lagged behind long-term industry averages, those numbers are getting increasingly better. The numbers had previously looked soft, due in large part to the rapid pace of expansion at Old Dominion and the lower capital turnover - it takes money today to build service centers and so on - but the returns build over time.

It seems to me that Old Dominion is definitely seeing improving returns on its investments in centers and equipment. What's more, the company's operating performance suggests that this is a business that has been built to last, by focusing on solid customer service. There's not much that the company can do to improve on its 99% on-time performance, and the recent damage claims rate of 0.4% is also quite solid. Better still, the company has not yet reached saturation with its service centers (although it has 218 of them as of the last quarter), and adding more centers not only supports its capacity but also improves the percentage of cargo that can be delivered in two days or less (currently about two-thirds).

SEE: 5 Must-Have Metrics For Value Investors

The Bottom Line
There's still ample upside for Old Dominion to gain share in the U.S. less-than-truckload market. While Old Dominion has dramatically outpaced industry growth since 2009, there's more business left to capture from larger rivals like Con-Way, YRC Worldwide (Nasdaq:YRCW), FedEx and a small army of less efficient, smaller trucking companies.

Old Dominion's stock doesn't look very cheap from the standpoint of free cash flow, and that's entirely normal within trucking and transports in general. While the company has significantly improved its return on capital, the reality is that it is still making large investments which expand the capital base and dilute those returns (and depress free cash flow) in the short-term. In terms of other metrics such as market share, operating ratio and returns on incremental investment, Old Dominion is doing well.

Using an EV/EBITDA valuation model, Old Dominion looks about 20 to 25% undervalued. That's not quite enough risk-adjusted return for me, even though I believe this is still a strong multi-year growth story. By the same token quality, growth rarely trades cheaply, so investors may find that continuing to wait for Old Dominion to get cheaper is a wait that never pays off.

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

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