Knight-Swift Transportation misses earnings mark with lagging refrigerated segment

Knight-Swift Transportation Holdings Inc. KNX reported revenue growth and rising income across much of the company, with the notable exception of Swift's refrigerated segment, during its second quarter 2018 earnings call.

The company, which merged last year, reported $1.3 billion in total revenue, a 5.2 percent increase over what Knight and Swift reported separately for the second quarter of 2017. This quarter combined adjusted operating income ballooned to $135 million, a 47 percent jump from what each entity reported in the second quarter of 2017.

"Our year-over-year combined revenue growth was achieved despite shedding some underperforming business and implementing more stringent driver driving higher requirements at Swift," Knight-Swift Chief Financial Officer Adam Miller said. "We believe our ability to convert increases in revenue per mile into meaningful improvement in operating income demonstrates the type of industry-leading operating leverage we continue to see in each of our segments."

Knight's "remarkable" operating ratio

Knight's trucking business boasted a 77.7 percent operating ratio during the second quarter. That number includes the first full quarter of Abilene Motor Express, which performed at an 82.4 percent operating ratio.

"When we look at this quarter, this is arguably the best quarter in Knight Transportation's history, given that it was done with a fuel headwind due to rising fuel prices," Knight-Swift CEO Dave Jackson said. "It was achieved with rates being up, with miles per tractor being up meaningfully. With even the fleet size growing, our driver turnover in the Knight Transportation business is at record lows right now."

Jackson said he expects Knight to continue operating in the 70s throughout the third and fourth quarters, then into 2019.

Foundational changes at Swift

Swift saw an operating ratio of 87.4 percent in its truckload segment, 85.4 percent in its dedicated segment, 98 percent in its refridgerated segment and 95.6 percent in its intermodal segment.

"Here's what I am seeing, I'm seeing very much we are improving our market execution at Swift. I've always felt like Swift was an industry leader in size and I felt like Swift should be an industry leader in market execution," Knight-Swift Executive Chairman Kevin Knight said.  "And I can tell you that with our line haul rates up 14.7 percent year-over-year, I'm pleased with the progress that we've made so far."

Knight explained that Swift is undergoing "foundational changes" since the merger. These changes include things like making driver selection stricter and creating a more profit-minded culture.

Since imposing higher standards on drivers, Swift has seen safety improve. Driver counts are continuing to climb, even during the typical summer recruitment slowdown, according to Knight.

"I just want to tell you, these are foundational changes. Foundational changes actually make my job more difficult. They don't make it easier," Knight said. "When you have to make foundational changes and you have the intestinal fortitude to actually make those changes in spite of the fact that they're going to make your life and your short-term look not quite so handsome. That's what our culture is all about and that's what we've chosen to do."

Swift's struggling refrigerated business

Knight was clear from early on in the call that Swift's refrigerated business was not performing well, with a 98 percent operating ratio. However, he was optimistic about the future of the segment.

"I think we're doing a really good job of improving the profit-minded culture that's really started to help improve the margins in each of our businesses with the exception of the refrigerated business. And that's a unique business the way Swift has set up," Knight said. "But I can honestly tell you that we've got our arms around it, and that we're in the process of now taking the steps and the actions that we need to take in order to get the refrigerated business performing at a very good return on invested capital. But it's just going to take a little bit longer than some of the other Swift businesses."

He later noted that part of the refrigerated business was performing well, including to OTR portion, while others parts of the business were lagging behind. The OTR portion of the refrigerated business saw rate improvements of 14 percent.

When analysts pushed Miller and Knight about to talk about why the refrigerated business was struggling and what exactly was being done to improve it, both leaders skirted the issue.

They reemphasized the Swift businesses that are thriving, and reminded investors that working everything out post-merger will take some time. Miller and Knight declined to identify the specific portion of the business that was struggling and did not provide any specifics about their intended fix.

"We won't discuss the specifics. But, what I will say is that basically, we have identified the areas that need support in that business," Knight said. "And we know the things that we need to do in order to get that business where it needs to get. So literally, if we do really well, we'll get it where it needs to be in two to three or four quarters. If it takes us a little longer, it might take us a year or two. But I don't expect that it will."

Knight-Swift is reporting an expected adjusted EPS of $0.56 to $0.60 in the third quarter and $0.68 to $0.72 in the fourth quarter.

Deutsche Bank has lowered its 2018 and 2019 EPS estimates by 5 percent and 7 percent, respectively, to $2.28 and $2.81.

"Total EBIT missed our model by 9 percent, with Knight EBIT 20 percent better offset by a 25 percent miss at Swift. Over half of the EBIT miss at SWFT came within the company's Refrigerated segment, which is a relatively small piece of the business and where results are behind expectations but ‘significant progress' is being made," a Deutsche Bank report reads. "Expectations were high, making today's miss that much more disappointing. We feel compelled to note that high expectations were not set by analysts in a vacuum, as mgmt. tried to suggest on the call; but rather gleaned from company mgmt."

Knight-Swift's stock has not been remains at buy.

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