Softening US truck market resets battle for domestic freight

Softening US truck market resets battle for domestic freight

Spot truckload rates have declined about 20 percent year over year so far in 2019, bringing pricing back to 2017 levels, according to DAT Solutions. Photo credit: Shutterstock.com.

A price fight is brewing that may prompt US shippers to re-examine the value proposition of domestic intermodal rail in their supply chains.

It’s essentially an issue of two markets heading in different directions, shifting the modal balance. Class I railroads are widening their margins by improving service, raising rates on shippers, and slashing expenses. Spot truckload rates declined about 20 percent year over year in April, according to DAT Solutions and Truckstop.com. Truckload contract rates either are rising slightly or flat year over year, depending on carrier and lane, after hitting record highs in 2018.

In a strange inversion of market dynamics, intermodal rail now is the more expensive modal choice in some secondary markets, even though few shippers are willing to pay more for a slower service.

Historically, intermodal rail has been the lower-cost, slower option for shippers — that’s how railroads sold intermodal. The question is whether this recent inversion is a market blip that will soon be corrected or a sign the balance between the modes is changing.

Digital brokers lower truck rates

The struggling truckload spot market is a factor as rates have fallen back to 2017 levels, giving up all the gains of last year. But there are larger structural changes that may drive down shipper rates on spot transactions by lowering markups, although top brokers seem to be fending off these downward pressures.

Digital freight brokers such as Uber Freight, Convoy, and Transfix are bringing small shippers the low rates previously only available to high-volume customers. In April, Amazon launched a brokerage platform that also offers low rates to shippers. Digital brokers lack the overhead of a traditional company and don’t pay a staff to call drivers, allowing them to offer lower rates to shippers.

Let’s say a broker pays a truck driver $850 on a haul. A traditional broker may charge the shipper $1,000 and use the $150 markup to pay commissions and other expenses. A digital broker can charge the shipper $875 and take only a $25 markup. The driver is being paid the same, but the shipper is saving $125.

Is the savings enough for a small shipper to leave their broker to use Amazon, Uber, Convoy, or Transfix? Maybe yes, maybe no. Perhaps the traditional broker will cave on the $150 margin. The shipper would use traditional and digital brokers side by side, adding Amazon or one of the others to its portfolio — a step some not-so-small shippers have taken.

C.H. Robinson Worldwide, Echo Global Logistics, and Hub Group, have been able to expand margins despite these digital competitors. C.H. Robinson reported first-quarter margins expanded 220 basis points to 18.1 percent. Echo’s grew 105 basis points to 18.3 percent, and Hub’s improved 260 basis points to 13.6 percent.

So, there is no guarantee these large traditional brokers will suffer financially as the taxicab industry has. It’s much more complicated to move freight than a person, so there is value to human interaction. A person can handle the nuances better than a computer can. There’s also value to scale, which the large brokers have and their digital competitors lack, at least for now.

Taxicabs haven’t vanished, providing value in certain situations even if they are more expensive. Even with Uber and Amazon, prices generally rise over time because of inflation. Digital disruptors might slow the increase in transportation costs rather than causing rates to plunge.

C.H. Robinson strongly defended its long-term strategy in a May 1 earnings call. Bob Biesterfeld, chief operating officer, noted how companies in the past that have tried to slash margins to unseat incumbents were unsuccessful.

“[First] it was the advent of the internet and online load boards that would bring price and cost transparency and disintermediate brokerage. In the mid 2000s, we had upstart 3PLs [third-party logistics providers] actively pricing freight below market rates in order to take share with large shippers. Recently, we have numerous tech-first brokers promising to lower margins, reducing friction and increasing efficiency,” Biesterfeld said. “But through this long-range cycle, Robinson has maintained our margins quite consistently.”

XPO CEO Bradley Jacobs, however, outlined a future in which margins are compressed but volume will grow enough to increase overall profits.

“I don’t think short-term margins come down. But long term, as costs come out of how brokers do business, a good chunk of those costs savings are going to be passed along to customers and that’s going to degrade margins. Having said that, lower margins on a much larger amount of business can still be a beautiful thing and create a lot of value,” he said on a May 3 earnings call.

Throwing the PSR switch

In the railroad industry, CSX Transportation, Norfolk Southern Railway, and Union Pacific Railroad are implementing precision scheduled railroading (PSR), which emphasizes expanding margins by running fewer but longer trains.

PSR’s core thesis can be explained using a simple analogy. If an airline has 1,000 customers and aircraft capable of holding 200 passengers, it can offer 10 flights of 100 passengers (half empty) or five completely full flights. By choosing the latter, the airline needs fewer planes. Service improves because there are fewer opportunities for something to go wrong. Airlines can charge more for a ticket and also hire fewer pilots and flight attendants. Revenue increases, expenses decrease, and margins expand.

Making the air transport-rail freight comparison, flights are trains, the passengers are containers, and the planes are cars, cranes, switches, and other equipment.

If railroads raise rates at a faster pace than trucking, will intermodal become more expensive than truckload? And will shippers accept such a fundamental shift in pricing?

None of the railroads have said they will surpass dry-van truckload rates to achieve their PSR goals. But they also haven’t directly discounted such a strategy.

“The spot market pricing of trucks really is irrelevant. It’s all about how much we can improve our service,” said CSX CEO Jim Foote on an April 16 earnings call. Although he was talking about the merchandise business, he said moments later that the same applied to intermodal. “The somewhat loosening of the truck market there does not diminish the significance and the value that the railroad plays in the transportation marketplace in intermodal.”

Ravi Shanker, a Morgan Stanley analyst, asked NS the next day whether intermodal pricing must shift with the winds of truckload.

“We are fully committed to testing the limits of market-based pricing. We’ve been able to grow our intermodal franchise in tight truck conditions and in loose truck conditions,” said Alan Shaw, NS vice president of marketing and sales. “There is an inherent advantage to intermodal relative to truck in terms of cost structure.”

Kenny Rocker, UP’s vice president of marketing and sales, would only say he’s bullish on domestic intermodal.

“I can tell you that as the market bears out, we price to that market. And I’ll continue to say that as we get our service product more reliable and also in our intermodal network that we’ll expect that we’ll be able to price accordingly,” he said in an April 18 earnings call.

But an analysis by JOC.com of 115 lanes, weighted to reflect regional market shares, shows on average shippers save about 5 percent using intermodal. Five years ago, it was close to 20 percent nationwide. Although spot represents only about 5 percent of volume, intermodal marketing companies (IMCs) tell JOC.com the same convergence is appearing in the contract market.

In terms of service, railroads can make operational decisions but cannot control the weather. Service becomes poor when snow, floodwaters, or objects cover the tracks. Trucks can detour to another highway; trains are stuck.

Intermodal service isn’t likely to ever beat trucking on door-to-door transit times.

“There are fewer touch points in truckload. The simplest intermodal move has three touch points: an origin dray, a rail move, and a destination dray. In truckload, you’re loaded at origin and unloaded at the destination,” said Billy Hart, managing director of Bluejay Advisors, which assists shippers in negotiating intermodal and truckload contracts.

If rail service can narrow the difference, however, then intermodal rates can be closer to truck.

“One of the things [we] are doing is looking at the current expectations we set for our clients and contemplating changing those and shrinking the number of transit days, which is very positive because it obviously makes us much more competitive when we’re dealing with tight inventory situations,” said David Yeager, CEO of Hub Group.

Pricing based on service

Todd Tranausky, FTR’s vice president of intermodal and rail, said Class I railroads can price intermodal higher than truck only when service becomes exemplary.

“Once they get there, railroads will be able to demonstrate a value proposition against truck. When railroads demonstrate tangible benefits that shippers notice, such as carrying less inventory, needing fewer railcars, then [railroads] can bust the truck pricing cap,” he said.

Others disagree with Tranausky. “We like to say that ‘price gets you through the door, service keeps you there.’ You won’t even get past the door if you can’t win on price,” said Rick LaGore, CEO of InTek Freight and Logistics, a non-asset-based intermodal operating company.

A few shippers, speaking to JOC.com on the condition of anonymity, agreed with LaGore that it would be a non-starter even if intermodal service were impeccable.

“You can’t divorce yourself of what shippers perceive your value to be, which is cheaper than truck. You may want to divorce yourself from truck rates, but the market dynamics driven by the shippers won’t allow it,” LaGore said.

Yeager expressed confidence that its eastern railroad partner will price intermodal properly.

“We have a very clear understanding of where our prices are right now in the market in the East and where they’re going,” he said. “I think that Norfolk Southern understands the market very well and is actively pursuing to optimize their value.”

But intermodal shippers in a number of secondary markets are already seeing higher prices than truck because of a combination of a soft truckload market and greater use of digital brokerage services.

Spot intermodal rates from Charlotte to Chicago, for example, are 20 to 30 cents per mile higher, according to data from InTek and other 3PLs. The all-in shipper rate for a truck hovers around $1,050 on this 770-mile lane, while intermodal rates are about $1,300. An IMC would have to slash almost 20 percent off the current spot price just to match prevailing truck rates. It would have to cut rates 27 percent to reduce intermodal to $950.

From Jacksonville, Florida, to Dallas, about 1,000 miles, truckload rates are about $1,300 while intermodal rates are about $1,800 to $2,000.

Larry Gross, intermodal analyst with Gross Transportation Consulting, believes CSX might exit the secondary markets altogether. The term railroads use is “lane rationalization.”

“CSX is going to focus on running big trains over a simpler network between major cities. Then they can say, ‘we will do it very, very well, so we can charge a higher rate and grow business in large markets,’” he said. “But you can’t pursue this strategy of knocking off insufficiently profitable secondary lanes forever or you end up with only a skeletal network.”

“Over the long term, I think secondary markets will disappear, and the railroads will be able to service the heck out of the major markets with so much available equipment,” LaGore added.

Trucks are even challenging intermodal in major lanes. LaGore lost a Los Angeles-to-Chicago customer to truck rates. He said there were opportunities to win intermodal contract business this January but railroads pushed too hard for high single-digit rate increases. He said this position softened somewhat after shippers began converting from intermodal to truck.

Hub Group’s CEO has a different view.

“In the first quarter we [negotiated agreements on] about just under 40 percent of our business and we were in the high single digits from an increase perspective in price. In April, it’s a little lower, but I mean it’s incidental,” Yeager said. “So, we’ll see how it unfolds, but I would say minimally we expect mid-single-digit increases for the year.”

Growth versus margins

Railroads like to show off operating ratio when using PSR or expenses as a percentage of revenue (before taxes, etc.). If a railroad generates $100 million in revenue, for example, and its operating expenses are $60 million, then operating ratio is 60. This is the yardstick railroads (and publicly owned trucking companies) use to quantify shareholder value, and investors prefer lower ratios.

Let’s say a Class I railroad targets an operating ratio of 55. What if the only way to reach this goal was to price intermodal higher than truck? It could keep intermodal rates below truck rates to increase volume, but operating ratios would deteriorate. What would CSX, NS, or UP decide?

It’s possible the railroad would push intermodal rates higher to maintain operating ratios and eliminate service if shippers convert back to truck.

But Gilbert Lamphere, a former Class I rail board member, told Credit Suisse that operating ratio (OR) is a consequence, not an end goal of PSR. Improving margins by slashing enough to reduce top-line revenue isn't a PSR philosophy.

"While the O.R. is a widely used benchmark for evaluating rail performance, Mr. Lamphere cautioned against favoring expense reduction over revenue growth, as it is only one lever to improve [return on assets] and shareholder value. The other levers are revenue growth in the form of pricing, volumes, and high-margin non-freight revenues," according to a synopsis by Credit Suisse analyst Allison Landry.

Shippers should watch this closely because if railroads eliminate domestic intermodal in more secondary markets, then many will have to adjust their supply chains, like they had to do when CSX began trimming lower-volume lanes in 2017.

Change is coming down the tracks.

Contact Ari Ashe at ari.ashe@ihsmarkit.com and follow him on Twitter: @arijashe.