Improving Shareholder Value The Investors Approach to Freight Transportation

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Improving Shareholder ValueThe Investors
Approach to Freight Transportation
Laurie Hahn, CFA Deutsche Bank Securities,
Inc. Airfreight Surface Transportation Team
November, 2002
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Summary

• What Drives Investment in Freight Transportation?
• Setting the Economic Backdrop
• Sector Trends Blueprints for Success
• Translation to Market Performance Valuation
• Conclusion
• QA

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What Drives Investment in Freight Transportation?

• Over Time, Stock Performance Broadly Anticipates
  Economic Cycle
• Long Term Themes a Factor in Investment Selection
• Consolidation Big get bigger
• Outsourcing is of increasing importance as supply
  chain becomes more complicated.
• Globalization Nations increasingly cooperative
  in post 9/11 environment, entrance of China to
  WTO.
• Investment Community Still Reeling from Stock
  Market Volatility, Looking For Ideas
• What Will the Market Reward in this Choppy
  Environment?
• Earnings Visibility
• Performance Consistency
• Transparency
• Strong Cash Flow
• Ability to Generate Growth in Tough Times
• Delivering Growth to the Bottom Line

Source Factset, Bloomberg.
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Current Investor Focus is Economy

• Investors Approach Freight Transportation Sector
  as a Cyclical Industry, Even Though Some Sectors
  are More Growth Oriented
• Economic Outlook Manufacturing Recovery
  Stalled, Consumer Slowing Down
• Few Freight Transportation Companies Escaped
  Unscathed from Global Economic Malaise, but Some
  Fared Better than Others.
• Key Themes among Top Performing Companies
• Cost Management
• Ability to Grow Market Share
• Internal
• External
• Fiscally Fit Balance Sheets
• Market Share Dominant
• Trustworthy, Forthright Management Team

Source Factset, Bloomberg.
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Setting The Economic Backdrop Domestic

• U.S. Economy is in Recovery, but Biggest Concern
  is Potential for Double Dip.
• Economic data showing improvement, but recent
  indicators have hit an air pocket.
• Inventories remain lean.
• Manufacturing leading indicators slowing.
• Biggest risk is the potential for a double dip
  recession if end demand does not follow through
  significantly enough to sustain a recovery.
• The forecasted economic recovery is underway, but
  the strength of the economic indicators bears
  watching for signs of renewed weakness.
• Early cyclical stocks remain in favor with
  investors keeping a watchful eye on near-term
  results while taking a longer-term view of
  recovery.
• Have consumers stretched their dollars as far as
  they will go?

Source Bureau of Economic Analysis, Bloomberg.
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Setting The Economic Backdrop International

• International trade rebounding, but West Coast
  port lockout muddling trends.
• Globalization and reliance on the U.S. negatively
  impacted trade flows, but leading indicators have
  turned positive.
• U.S. import and export activity expanding.

Source ISM Survey
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Setting The Economic Backdrop International
Could Lag Domestic

• International ocean volumes disrupted by West
  Coast lockout, but underlying trends indicate
  recovery
• U.S. economic recovery providing boost to
  international trade and ocean volumes.
• Relative strength in consumer spending drives
  imports of goods from Asia, reflected in strength
  at West Coast ports.
• Threat of work stoppage/slowdown by
  Longshoremans union could have driven some
  pre-shipping.
• However, backlog is being cleared and volumes are
  getting back on track.

Source AAR, Port of Long Beach
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Setting the Economic Backdrop Airfreight Could
Lag Ground

• Domestic airfreight in recovery, comparisons
  getting easier
• Underlying demand weak
• reduces need for expedited service.
• shift from air to ground.
• Lower capacity available due to impact of 9/11.
• FAAs actions are for the protection of the
  passenger, freight garnering little attention.
• International airfreight volume recovering, but
  some related to West Coast disruptions
• Before 9/11/01, weakness fuelled by reduced IT
  spending.
• After 9/11/01, same conditions exacerbated by
  reduced reliability of passenger airlines, both
  U.S. and foreign carriers.
• Freight diversions from ocean to air now driving
  short-term strength.

Source Air Transport Association
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Fuel Prices Trending Higher

• Fuel prices now above 2001 levels.
• Fuel prices swinging back to a negative to
  earnings as comparisons become difficult.
• Outlook uncertain due to prospect of war with
  Iraq.
• Most companies protected from current rise in
  fuel prices to some degree by derivative hedging,
  advance purchase contracts, and/or fuel
  surcharges.

Source Energy Information Administration.
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Railroad Sector

• Yield Improvement and Cost Control Focus Could
  Drive Dramatic Operating Leverage.
• Eastern rails stand to benefit the most, as
  service levels improve and excess costs taken
  out.
• Western and Canadian rails could improve margins,
  but earnings recovery will likely be less
  dramatic.
• Risk remains for price discounting in some
  commodities.
• Market Share Gains over Long Term Driven by Truck
  Conversion, and Possibly Consolidation.
• Service enhancements make rails more attractive
  to truck customers.
• Small acquisitions likely, long-term possibility
  of West-East merger, in which case Eastern rails
  would likely be targets.
• Focus on Improving Service Levels, Cost
  Reductions.
• Most rails improving service levels dramatically,
  Eastern rails have most upside potential here.
• Reducing excess costs, railroad retirement reform
  helping to lower labor expenses.
• Increased Attention Given to Alliances and
  Inter-Line Agreements.
• Provides market share opportunities without the
  complications of a large scale merger.
• Fuel Prices Back at Higher Levels.

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Long Term Industry Trends Risks

• Excess Capacity Plagues Railroad Industry.
• Track and revenue equipment are biggest problems.
• Fleet and track rationalization programs.
• Rails replacing older equipment with new, higher
  horsepower locomotives, higher capacity freight
  cars.
• Focus Improved Returns, Earning Cost of Capital.
• Capital intensive nature of business and years of
  depressed earnings have caused anemic returns.
• Most railroads are not earning their cost of
  capital.
• In the near term, the U.S. economy will drive
  returns.
• Capacity rationalization, operating improvements,
  and yield enhancement will drive returns.
• Key to attaining long-term adequate returns is
  reducing overall capital investment in the
  industry.
• Focus on Long-Term Pricing Improvements.
• Pricing will follow consistent improvements in
  service levels.
• More premium products garner higher prices.

• Labor Concerns
• Negotiations ongoing due to unresolved issues.
• One-day strike possible, but likely immaterial .
• Aggressive Pricing
• Irrational competition still risk, particularly
  in West.
• Eastern carriers most rational, Western carriers
  still competitive on coal, auto, and chemicals
  contracts.
• What if Economy Falls into Double Dip Pattern?
• Potential significant, but less than in previous
  cycles, as inventories remain lean.
• Monetary and Fiscal stimulus.
• Commodity Risks
• Coal remains spotty, but comparisons improving.
• Long term coal outlook solid.
• Grain crop outlook poor, but high prices could
  boost grain exports out of inventory in U.S., so
  carloads may rebound later this year or early
  2003,
• Automotive volumes currently strong.
• We still fear that automotive manufacturers may
  have robbed Peter (2003 sales) to pay Paul
  (2001/2002 sales) with recent financing
  incentives.

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Blueprint for Success Railroad Sector

• Efficient, fluid railway network
• Well thought our operating plan
• Capable, up to date IT systems
• Measurable operating parameters
• Superior service levels
• Leads to higher prices
• Ability to compete with trucks
• Yield management strategy
• Rational pricing
• Focus on most profitable rail moves
• Innovative product development
• Products that compete with truck service
• Products that focus on fastest growing areas (I.e
  intermodal)
• Truck alliances

• Streamlined network
• Reduce excess capacity
• Sell non-core assets
• Ability to translate operating performance to
  superior returns
• Potential to earn cost of capital
• Positive free cash flow generation
• Improving balance sheet
• Strengthening cash balances
• Reasonable debt level
• Superior cost management
• Well-respected, capable management team

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Truckload (TL) Sector - Survival of the Fittest

• TL industry remains a more difficult operating
  environment compared to the LTL industry.
• Tentatively recovering economy.
• Weak used truck values..little change on this
  front, but engine emissions deadline and possible
  associated purchases in used truck market could
  provide long needed support to used tractor
  values.
• Rising operating costs.
• Higher insurance rates, especially in light of
  9/11.
• Higher equipment costs-potentially higher
  maintenance costs as equipment trade cycle is
  lengthened versus higher capitalization costs as
  carriers relaize losses or lower gains on sale of
  equipment.
• Several carriers accelerating depreciation
  schedules - adds excess costs.
• Spectre of new engine emissions could increase
  costs for companies by as much as 5,000 per
  tractor.
• Downturn causing shakeout in industry, creating
  opportunity for dominant players.
• Convergence of weak economy and rising costs
  could create a truckload renaissance over the
  next few years.
• Pricing still weak for core carriers, but most
  are now trying to extract rate increases of 2 to
  4 from select customers and lanes.
• We believe the core carriers have the
  resources/economies of scale to emerge from
  downturn and benefit over the long term by way of
  better pricing conditions and market share gains.

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Long Term Industry Trends Risks

• Capacity Rationalization.
• Rising costs.
• Stringent control of fleet additions.
• New barriers to entry
• Insurance
• Lack of Financing
• Record company failures.
• Pricing Discipline.
• Broad effort by TL participants to raise prices.
• Recognition of necessity to recoup higher costs.
• Tighter capacity shifting pricing power to
  carriers
• Core Carrier Consolidation.
• Alive and well as supply chain becomes more
  complex.
• Security concerns following 9/11.
• Driven by simple need for large scale capacity
• Private Fleet Conversions

• Driver Shortage
• Likely to return to forefront.
• Will ultimately lead to higher labor costs.
• Owner operator market may be permanently
  impaired.
• What if Economy Falls into Double Dip Pattern?
• Potential significant, but less than in previous
  cycles, as inventories remain lean.
• Monetary and Fiscal stimulus.
• Will Price Increases Cover Cost Increases?
• Insurance cost increases have not abated.
• Labor costs could rise over the long term.
• New emissions standards pushing up cost of
  equipment.
• Weak used tractor values have pushed up the
  overall cost of equipment replacement.
• Regulatory Issues
• New engines - higher overall cost, lower fuel
  efficiency, reduced warranty.
• Hours of service rules may come back to haunt the
  industry.

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Trucking Company Failures Could Drive 20 of
Capacity Out of Market

• Difficult operating environment forcing many
  small truckers out of the industry.
• Failures have skyrocketed over the past few
  quarters and dont seem to be letting up.
• Several large failures have occurred or may be
  imminent Trism, Patriot, Burlington Motor
  Carriers, and Transit Group.
• Long term benefits to our universe include
  rational capacity, improved pricing power, and
  market share gains.

Source ATA, A.G. Edwards, Dun Bradstreet
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Blueprint for Success Truckload Sector

• Dominant leadership position in the industry
• Broad geographical coverage
• Superior service levels
• Ability to provide capacity
• Yield Management
• Rational pricing
• Rational capacity management
• Successful acquisition strategy and integration
  record
• Proven internal growth track record
• Aggressively taking market share
• Ability to manage growth profitably
• Well-respected, capable management team

• Stringent cost management
• Superior purchasing power
• Control of discretionary costs
• Ability to recruit and retain drivers
• Managing through counter-cyclical driver shortage
• Operating ratio in the low 90s or 80s
• Earnings growth in line to better than top-line
  growth
• Flexible balance sheet with reasonable debt
  levels
• Facilitates growth
• Allows flexibility in tough times

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Less-than-Truckload (LTL) Sector - Christmas Came
Early this Year

• Failure of major national carrier driving
  dramatic market share gains, primarily at the
  national LTL carriers but to a lesser extent at
  the regional LTL carriers.
• The most important implication for the industry
  is a healthier pricing environment.
• Operating leverage could drive dramatic earnings
  growth in near term at the national LTL carriers
  despite the soft economy.
• We expect further momentum to build once a more
  robust economic recovery is underway.
• The key to the health of the LTL industry today
  is a healthy pricing environment brought about by
  capacity rationalization.
• CF closure likely to clean up any remaining
  competitive pricing conditions that resulted from
  the weak economy.
• All carriers implemented general rate increases
  of 5 to 6 ahead of peak shipping season.
• Upcoming contract negotiations likely to reflect
  tight capacity situation created by CF closure.
• Expense management techniques and service levels
  have improved in the last decade, particularly at
  the unionized carriers.

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Blueprint for Success Less-than-Truckload Sector

• Dominant leadership position in the industry
• Broad product offering
• Broad geographical coverage
• Superior service levels
• Strong business plan
• Barriers to entry
• Market penetration (density)
• Strong IT capabilities
• Yield management
• Costing system
• Annual general rate increases
• Increased focus on mid-sized accounts
• Well-respected, capable management team

• Focus on growth markets
• Regional market growing faster than national
  (JIT, regionalized distribution patterns)
• Specialized/premium products
• Cost management
• Ability to react quickly to volume changes
• Managing costs on a more variable basis
• Strong cash flow generation
• Positive free cash flow
• Growing EBITDA
• Strengthening balance sheet
• Significant cash balances
• Reasonable debt levels

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Airfreight and Logistics Sector

• Long-term themes of outsourcing, mode neutrality,
  globalization, and consolidation should benefit
  the best in class airfreight and logistics
  providers.
• Given the disruption associated with 9/11, Supply
  Chain Management more important than ever.
• Modal shift to less expensive delivery options
• International Airfreight to Ocean Freight
• Domestic Airfreight to Ground Transportation
• Fuelled by weak economy but may be a longer-term
  trend
• Weak U.S. economy filtered into international
  economies, pressuring global logistics players.
• Transaction volume weak.
• Bid process lengthening, decision makers
  paralyzed by events of 9/11.
• International recovery could lag domestic
• Softest industries include technology and
  telecommunications.
• Asset based airfreight carriers suffered the
  most, particularly the heavy freight carriers
• Integrators were somewhat cushioned by broad
  product mix and ability to offer deferred/ground
  delivery services
• Variable cost business model may not be so
  variable after all.
• How deep do you want to cut?
• Can you respond to a pickup in activity?
• Costs of doing global business rising with new
  security measures following 9/11

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Blueprint for Success Logistics Sector

• Dominant leadership position in the industry
• Broad product offering
• Broad geographical coverage
• Specific market niche
• Strong business plan
• Barriers to entry
• Blue-chip customer/vendor base
• Successful acquisition strategy and integration
  record
• Well-respected, capable management team

• Top-line growth in excess of industry growth
• Stable net revenue margins
• Rising operating margin
• Earnings growth in line to better than top-line
  growth
• Strong cash flow generation, positive free cash
  flow and growing EBITDA
• Strong balance sheet with significant cash
  balances and little to no debt

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Blueprint for Success Airfreight Sector

• Dominant leadership position in the industry
• Broad product offering
• Ability to provide deferred/ground service in
  weak environment
• Broad geographical coverage
• Strong business plan
• Barriers to entry
• Blue-chip customer/vendor base
• Capacity management
• Successful acquisition strategy and integration
  record
• Well-respected, capable management team

• Top-line growth in excess of industry growth
• Effective discretionary cost management
• Ability to react quickly to volume changes
• Earnings growth in line to better than top-line
  growth
• Strong cash flow generation
• Positive free cash flow
• Growing EBITDA
• Strong balance sheet
• Significant cash balances
• Reasonable debt level

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Transportation Sub-sector Valuations
Source Factset.
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Conclusion

• Investors View Transportation from Cyclical
  Standpoint
• Favor High Quality Companies with Stable
  Earnings, Compelling Long-Term Prospects
• Capitalize on Longer-Term Growth Themes
  Consolidation, Globalization, Outsourcing
• Marketplace Will Reward Companies with
  Outstanding Fundamentals and Growth
  Characteristics

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QA
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