JFG Industry Insights: Transportation & Logistics - Part II
Eric Adams, CFA, CAIA
Partner, Co-Chief Investment Officer at Johnson Financial Group, LLC
Transportation & Logistics - Part II
Eric S. Adams, CFA, CAIA
Organization of the Supply Chain
The title of this section may seem oxymoronic as the supply chain currently resembles an unambiguous catastrophe, but I’ll try to lay it out in a logical format. There are many different ways to dissect the supply chain, but my brain enjoys compartmentalization, and to me those compartments appear as such: ocean shipping, air freight, river transport, port management, multimodal (trucking/railroad) land transportation, warehousing, last-mile delivery and supply chain management. Therefore, to kick things off, let’s take to the high seas.
Ocean Shipping
Ocean shipping feels like a logical place to begin as 95% of cargo entering the US arrives by ship, and there exist 360 coastal and inland ports nationwide to aid in the transfer of these goods into and across the country. Global trade was given a shot in the arm with the advent of the shipping container in 1956. Before this lowly and unheralded metal box, it often wasn’t economical to ship goods halfway across the same country, much less halfway across the world. Globalization was further driven by growth within emerging markets, mainly China, through the 1990s and 2000s.
Transport volume of seaborne trade from 1990 to 2020
The disruption that COVID hath wrought created a mix of record windfalls for ocean carriers alongside widespread frustration from shippers who paid dearly for late and/or incomplete delivery of goods desperately needed to serve a Federally-stimulated consumer. Carriers began attempting to lock-in long-term contracts with shippers under these favorable conditions, at the risk of permanently tarnishing shipper relations. However, as a wonderful example of how quickly circumstances can shift in global trade, the cost to ship one container across the Pacific has fallen 82% from this time last year. Falling rates have been caused by softening consumer demand alongside elevated retailer inventories, leading analysts to warn that we may not see the peak holiday season for freight as we do in most years. In the medium-term, carriers may not be doing themselves any favors as new container ship orders are at a record high, and that additional capacity may be delivered during a time of stagnated demand, thereby keeping freight prices depressed. And looking out even further into the future, ocean shippers face serious headwinds, including: 1) China’s pivot toward more of a consumption and services-based economy; 2) the “reshoring” of US manufacturing in order to secure and simplify supply chains; 3) volatile fuel costs; 4) a looming recession; 4) geopolitics (China, Russia, et al); 5) and even the development of 3D printing may increasingly localize the means of production.
Optimists still believe ocean shipping will grow, albeit at a reduced rate. There currently exists a capacity constraint for US companies that want to move production closer to home, and it is more difficult to find established suppliers in Mexico or Central America with the right raw materials and production quality than it is in China or Southeast Asia. Pessimists, on the other hand, believe we’re trending toward drastic and permanent deglobalization (more on that later). Even in the face of a possible prolonged contraction in freight volumes, there are still plenty of attractive investment opportunities aimed at tackling the oh-so-many structural inefficiencies in ocean shipping, which include: the lack of reliability of carrier space, expensive containership financing, costly manual processes, inefficient document flows, and strained relationships between shippers and carriers, among other issues.
Air Freight
Similar to the trends seen within ocean shipping, air freight costs soared to record highs in 2021, peaking at $15.42/kilogram in December as shippers moved aggressively to seek out air freight solutions as ocean capacity dwindled. Global economic pressures, however, have impacted demand to such an extent that air cargo has recently contracted to $6.60/kg for products traveling from Shanghai to North America (a 60% drop in less than a year). Despite this, shippers have been buying new cargo planes on their own, as well converting old planes to cargo carriers, in an effort to build out in-house private fleets (and therefore be less beholden to traditional air carriers). Additionally, ocean carriers are currently scrambling to buy their own planes and/or establish air freight partnerships as their customers, fed up with all that ocean shipping nonsense, are now willing to pay up for the improved reliability of air shipping. Given the fact that cargo capacity on passenger airplanes remains below pre-COVID levels, we could see further proliferation of private fleets. Though the pendulum may have swung a bit too far in the private fleet direction, as the most recent evidence points toward an overabundance of freighter aircraft, just when the cargo market has begun to decline (as previously mentioned). Hopefully the reader is appreciating the full-time job it is keeping up with this rapidly changing environment. (The graphic below clearly illustrates the 2022 air freight slowdown.)
Despite a similarly messy situation in air freight as seen in ocean shipping, investment opportunities are limited as the asset-heavy sector is dominated by a handful of very large players (FedEx and UPS, among others). Additionally, many of the passenger carriers have moved into the cargo space, crowding out any compelling opportunities.
River Transport
Unless you grew up overlooking the Mississippi or Ohio Rivers, I’d be willing to bet that you might underestimate the role of the inland marine industry (I certainly did). Particularly when it comes to transporting many of the commodities which serve as crucial inputs to our economy (stuff like oil, gas, coal, fertilizer, corn, soybeans, bunches of others), the river industry’s fleet of towboats and barges plays a vital role. When I say the inland marine system, I’m specifically referring to the 12,000 miles of navigable waterways of the Mississippi River system and its many tributaries (think Ohio, Missouri, Arkansas), as well as the Gulf Intracoastal Waterway. The United States has been blessed with more internal waterways than the combined total of the rest of the world (I had to read that multiple times as well). As a side note, there’s a unique dynamic within river transport as foreign competition is prohibited by the Merchant Marine Act of 1920, also known as the Jones Act. Therefore, this market has little to no correlation to international shipping dynamics.
River transport is by far the most efficient way to move goods through the country. One 15-barge tow boat can move the equivalent of two 216 railcar trains and 1,050 large semi-trucks, and can do it 60% cheaper than rail and 97% cheaper than truck. It can be said with zero exaggeration that river transport was one of the main drivers of our country’s economic development. From an investment standpoint, attractive opportunities exist through owning and leasing out inland marine transportation assets including barges and towboats. This industry shows little correlation to the broader markets and ample recession resilience due to the essential nature of the non-discretionary goods it shuttles around (leasing rates have historically hovered near 100% for these vessels). Additionally, the tax benefits of depreciating real assets boost taxable-equivalent yields, and the rental income can even act as an inflation hedge.
Port Management
The news has been awash with headlines over the past couple years describing the severe port congestion caused by COVID shutdowns, port labor shortages, trucker shortages and, more recently, outright strikes by workers protesting new regulations in California. All of this is problematic as the country’s hundreds of coastal and inland ports play a vital role in the U.S. economy, contributing a whopping 30% of total gross domestic product (GDP). The movement of goods through ports sustains 23.1MM jobs and provides more than $320B in tax revenue to federal, state, and local governments. (For a touch of context, 23.1MM jobs is almost 15% of the entire US workforce). Therefore, the ripple effects of port congestion are immense when goods in containers languish in offshore ocean liners and, even once those goods have been unloaded, they have often just sit there taking up space since there oftentimes are not enough truck drivers to haul them away. Unsurprisingly, these inefficiencies cause very real impacts on consumers and businesses alike. Nike, for example, spends $200MM annually to carry an extra 7 to 14 days’ worth of inventory due to chronic delays and uncertain deliveries caused by port congestion. That’s one heck of a contingency budget. Luckily, ports have experienced some reprieve as the number of ships waiting to unload off North American ports peaked at over 150 in late July and fell below 100 as of mid-October. (Without some context that may not mean much, but all you need to know is that the pre-COVID norm was in the single digits.)
Inland waterways and coastal ports will require a staggering $25 billion in funding over the next decade in order to build and/or sustain adequate and efficient operations. Accommodating full-size vessels requires significant investments in equipment, channel size, terminal layout, cargo handling operations, etc. etc. etc. Ports also must add cranes, increase the size of container yards, supply sufficient power to pull ships into port (insert more etceteras). The complexity involved, as always, opens the door of opportunity for experienced operators and savvy investors. Third-party logistics providers (3PLs), who use technology to simplify some of this complexity, represent a need-to-have business in consistent demand from a broad range of customers in a highly fragmented, essential service industry. Many 3PLs offer to warehouse customers’ products, ‘pick/pack/ship’ said products, and provide specialized transportation services focusing on port drayage (fancy port jargon for short distance hauling). There is currently room for many winners in this fragmented space as the increasingly complex global supply chain has encouraged shippers to outsource logistics to 3PL providers to assist in managing difficult port environments.
Trucking
Road freight expenditures grew 23% in 2021 to $831B, and due to trucking’s size and influence on the broader economy, increasing costs in the segment can have a significant impact on consumer inflation (you may have heard something about this in the news recently). When shippers began replenishing their inventories during the height of the pandemic in the face of the lowest inventory-to-sales ratios in almost a decade, a huge surge in road transport demand resulted. Unfortunately for those shippers, trucking capacity suffered one disruption after another (COVID paralysis, followed closely by hyper-stimulated demand, and as already mentioned multiple times, persistent labor shortages).
Similar to ocean carriers, trucking profits soared in 2021, even in the face of rising costs caused by fleet expansion and hiring sufficient drivers to operate that expanded fleet. Also similar to ocean carriers, trucking companies may want to be careful as shippers have already started building out their own captive fleets in response to sky-high prices and poor service. Dissimilar to ocean carriers, however, US trucking companies should benefit from the movement to reshore manufacturing, therefore the long-term growth prospects of the sector appear strong. In the short-term, however, the sector will need to focus on what’s been dubbed the “Trucking Winter”, as spot rates have declined 30% since last year thanks to slowing economic demand. Interesting (and investable) trends to keep an eye on in the trucking universe are the advent of autonomous vehicles as well as technological applications aimed at achieving more fuel-efficient routes and optimized truckloads.
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Railroad
Oh hey whaddya know, port congestion and labor shortages significantly challenged rail transport over the last couple years, as with every other link in the supply chain. The cost to ship by rail increased 19% in 2021, which certainly benefitted operators, though difficulties persisted such as deteriorating network speeds, increasing numbers of idle train cars, as well as a lack of available chassis to carry intermodal containers. Prices are likely to stay elevated for shippers as the railroads are still working to relieve congestion created by increased trucking, though some relief should be experienced as global demand softens.
Rail freight is responsible for carrying almost 10% of national freight by tonnage, and the system includes more than 24,000 diesel-electric locomotives and 1.28MM freight cars. Rail is the primary mode of shipping for a wide variety of bulk commodities such as chemicals, coal, and agriculture products between 750 and 2,000 miles. And the total volume of goods moved by rail is projected to increase by 29% by 2040 thanks to its economic value proposition, truck driver shortages, higher fuel prices and the enhanced focus on ESG (rail is more environmentally friendly by far compared to trucking). This increased choo choo traffic has the potential to create even more congestion in high-volume corridors (and thereby decrease reliability) unless significant investments are made. Projected current and future freight loads are forecasted to outstrip capacity available in regional and short line railroads, which often serve as first-mile and last-mile linkages between US manufacturers and the global marketplace. Even though 2019 was a record year for short line deal activity, much more capital investment is needed. (For its part the government has been supportive, with Congress passing a permanent extension to the 45G Tax Credit in 2021, which provides tax relief to short line and regional railroads.) Investments in efficiency and reliability would go a long way within the rail sector, even relative to other modes of transportation. Precision-dispatching technologies, railyard modernization and automation are just a few areas of much-needed innovation. Finally, the costs and delays of transferring containers between trains or onto trucks could certainly be improved upon though targeted investment.
Well that’s probably more than enough for Part II of the Transportation & Logistics deep dive. In the final installment coming out next month (assuming you all are still with me), we’ll discuss warehousing, last-mile delivery and macro trends, along with where Johnson Financial Group has invested within the Transportation & Logistics sector and where we're seeing continued opportunity.?
Disclaimer:?This industry review is for informational purposes only and investors should determine for themselves whether a particular investment is suitable for their specific needs. Nothing provided on this site constitutes tax advice or legal advice. Individuals should seek the advice of their own tax advisor and/or attorney for specific information regarding tax consequences of investments and/or legal questions. Investments in securities entail risk and are not suitable for all investors.
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