YRC Worldwide Inc.: Shares Still Heavily Discounted Due To Unfounded Bearish Views (Part 1) (NASDAQ:YRCW)

Introduction

Over the last year, many people have frequently reached out via email, social media, and direct messages expressing interest in our opinion about this company. At no point were our direct messages and Twitter mentions any busier than these last six months as rumors of the company’s supposedly imminent demise became normal conversation across the transportation industry.

So, finally, following another intense reevaluation of the business, Centaur Investments is pleased to share this latest long thesis update on YRC Worldwide, Inc. (YRCW). The near-term price target for the shares has been revised down to $8 from the $10 PT previously suggested in this article.

While the Congressional Oversight Committee’s ongoing inquiry into the Treasury Department’s justifications for approving YRCW’s CARES Act loan may weigh on the company’s stock price in the near term, we are not toning down our previous ‘Conviction Buy’ opinion on the shares. In addition to the Oversight Committee’s public scrutiny, the company has experienced a series of negative attacks from the media which, in our opinion, are based on ancient history and outright unfounded reasoning.

Centaur’s analysis of the facts as presented in this article concludes that, contrary to popular belief, the business was on track to achieving sustainable profitability prior to this pandemic-induced economic crisis. Additionally, the company’s past financial challenges were primarily caused by a combination of historically high cost of debt and need for new fleet equipment due to underinvestment, not mismanagement or neglect, as many seem to believe. Lastly, the company’s poor stock price performance may be linked to widely held bearish views which themselves are affected by multiple cognitive biases.

More specifically, public anchoring to the company’s turbulent past appears to have a role in the market’s inability to acknowledge what has been clear financial progress over the last decade, despite seemingly endless obstacles. The company’s historical income statements as pictured below, perfectly capture sequential operating income improvement. However, that progress has long been overlooked by a market which favors myopic events like net income and earnings per share, often impacted by non-cash accounting math and cyclical factors.

YRCW’s Striking Operating Income Growth

Source: YRC Worldwide’s 10-K SEC filings, via Seeking Alpha

It should be noted that the table above intentionally excludes FY 2019, as several one-time nonrecurring charges weighed on operating income, and can mislead one into thinking that financial improvement has stalled. Browsing through headlines of recent press articles about the company which tend to center on YRCW’s $104 million net loss from last year confirms this is exactly what is happening.

The volume of supporting evidence presented throughout this article should be convincing enough to warrant a positive opinion about the future trajectory of the company. In our view, when the pandemic finally subsides and economic stability returns, YRCW may very well become one of those ‘ten-bagger’ opportunities Peter Lynch lectured about in his books.

Some may not be aware of this fact, but prior to the pandemic, management already had a sound multi-point and multi-year strategy in place. Barring a double-dip period of economic contraction, or an unexpected stalling of the global economic recovery, the two CARES Act loans should adequately bridge the performance gap left by the pandemic, and may even act as a catalyst by accelerating the timeline to achieving sustainable profitability. Management’s strategy, which was refined in 2019, forms the basis of this long thesis and all our prior coverage of this company. In this update, the thesis has been revised to include the latest developments. For those new to Centaur’s research, the key arguments of the long thesis are reiterated below.

Centaur Investments’ Long Thesis on YRCW (Updated August 2020):

1. Industry-wide pricing and capacity discipline will support management’s multi-point strategy while allowing the company to offset cost inflation through periodic contractual and general price increases.
2. Property in suburban metro areas acquired over a century and recorded at cost on the balance sheet is a goldmine of hidden asset value which the market does not seem to realize.
3. YRCW’s 3PL startup venture, HNRY Logistics, provides the company with a new revenue vertical and contribution margin through asset-light services, offering longer term sales growth potential.
4. Revenue equipment replenishment will substantially reduce maintenance and fuel expenses, leading to immediate sequential decline in the company’s operating ratio.
5. Revenue equipment replenishment eliminates need for expensive short-term rental equipment, emergency roadside repairs, and towing services which will deliver cumulative operating ratio improvement.
6. Network optimization efforts will maximize load factor across the company’s network, leading to increased operational efficiency, density, yield, and incremental operating ratio improvement.
7. Software migration to the cloud will deliver efficiency gains and support pricing through improved business visualization, leading to further operating ratio improvement.
8. Labor management synergies gained in the 2019 collective bargaining agreement will partially offset wage inflation, healthcare, welfare, and overtime costs.
9. Workforce consolidation, training, and organizational culture development will improve worker morale, productivity per labor hour, and further reduce overtime costs.
10. Apollo term loan covenant amendment and 2020 CARES Act loan package allows management to focus on their multi-year strategy and clears the runway to sustainable profitability.
11. The two low interest CARES Act loans totaling $700 million substantially reduce the company’s cost of capital while accelerating their fleet replenishment program and technology deployment.
12. The 29.6% U.S. government stake tacitly pressures management to improve operational performance in a timely manner, likely accelerating the timeline to sustainable profitability.
13. Proposed ‘Employee Stock Ownership Plan’ may create a share price floor, reduce share price volatility, and empower employee engagement.
14. Potential interest and amortization savings from deleveraging and replacement of high-interest equipment leases with new lower-rate equipment leases and purchase options.
15. Removal of going concern uncertainty will renew customer interest, deliver sales growth, and allow company to continue defending market share.

Reviewing recent press articles about the company, it’s quite clear that many investors do not understand exactly why the company reported a $104 million net loss for 2019. All they seem to know, and all they seem to care about, is that the company recorded a net loss in the year preceding the pandemic. In the minds of these investors, the net loss means the company was on its way to bankruptcy, despite substantial contradicting evidence. So, let’s review the company’s challenging 2019 fiscal year to pinpoint exactly what contributed to last year’s net loss and follow up with current macroeconomic and industry developments.

First and foremost, entering 2019 YRCW was still in early stages of programs like fleet and equipment replenishment, and cloud-based software deployment. The company has been slowly refreshing its fleet of 14,000 tractors and over 45,000 trailers since 2013. From 2015 onward, the company’s CapEx spending was gradually increased from less than 5% of total annual sales to a steady range of 5% to 7%. This sums up to about $250 million to $350 million per year, based on FY 2018 and FY 2019 total sales, including fuel surcharges. Fiscal year 2018 was a turning point for the company, as record demand for LTL shipping services allowed them to ramp up new equipment orders.

However, 2019 marked the beginning of a freight recession which coincided with the expiration of a major collective bargaining agreement. As management sat at the negotiation table with Teamsters’ leaders, competitors pounced on the opportunity to poach YRC’s customers by spreading rumors of an imminent labor strike which never actually happened. With historically thin operating margins, the downward revenue pressure during labor agreement negotiations meant that earnings would most likely turn negative for the year.

Yet throughout the freight recession, management continued to reinvest in the business, ordered and took delivery of thousands of new pieces of equipment, continued rolling out cloud-based transportation management software, consolidated thousands of corporate-level jobs, and ramped up services of their new asset-light unit, HNRY Logistics.

In May 2019, management finally locked in a new 5-year collective bargaining agreement, with each party walking away from the negotiating table with gains. The Teamsters regained a week of vacation, kept their existing healthcare coverage, and won an 18% wage increase spread over a 5-year period. Meanwhile, the company added abilities to hire part-time labor, non-CDL dock workers, non-CDL box truck drivers, and expanded purchased transportation capacity.

Next, they plowed through the front-loaded expenses of the new labor agreement in the second half of 2019, transferred New Penn’s corporate operations to their headquarters in Kansas, locked in a credit rating upgrade from Moody’s, refinanced a major term loan with a new lender on much favorable terms, consolidated their sales workforce, and implemented a giant enterprise resource planning software migration to the cloud. They did all of this in one year while battling competitors in a slowing economy.

Credit to YRCW’s former CFO, Stephanie Fisher, for spearheading those efforts. Stephanie climbed the ranks at YRCW from a senior accountant role to VP and controller under James Pierson, and then on to CFO. Although the combination of these events would weigh on the company’s earnings, management had to get those costs out of the way quickly to get the business back on track.

Exiting 2019, the downtrend in freight shipments was relentless across the industry, and the business outlook for 2020 remained highly uncertain. The broader economic cycle was running out of steam, and trouble was developing in credit markets. Shortly after the company refinanced their only term loan, the Federal Reserve intervened in the repo market for the first time in a decade.

The company had little margin room for mistakes in a serious downturn, and in December 2019, YRCW’s former CFO, James Pierson, was brought back in. A former managing director at Alvarez & Marsal and FTI Consulting, Pierson had extensive experience navigating turnaround situations in challenging economic environments. He also knew exactly how to balance YRCW’s books better than anyone else.

In addition to the CFO change, in what was a clear effort to curb shareholder dilution, management eliminated three board seats and converted to a mostly cash compensation plan for board members. They also promoted longtime board member, Matthew Doheny, to the chairman role.

Entering 2020, the company was in a much better position to benefit if freight volumes turned back up. Things seemed to be off to a pretty good start, as industry executives noted a more stable freight environment in their full year 2019 earnings reports and conference calls.

Then, an awful once-in-a-century pandemic developed seemingly out of nowhere. Global supply chains were disrupted, financial markets went into full-on panic mode, and YRCW’s CapEx reinvestment plans were put on indefinite hold. Through no fault of their own, progress on the multi-point strategic turnaround was abruptly stalled.

Source: YRC Worldwide, Inc.

Although no one could have predicted this pandemic was going to happen, YRCW was not in the best financial position to ride out the storm. The company’s corporate credit ratings were not competitive enough for them to tap credit markets at the same rates as competitors despite management’s focus on financial discipline. Over the last decade, YRC’s management has not wasted a penny on share buybacks nor funded a single dividend payment with debt.

To make matters worse, efforts to deleverage inadvertently led them to miss the only borrowing window they had available prior to the pandemic. In hindsight, industry sell-side analysts picked the perfect moment to turn bearish on the company, or perhaps the publicity attached to their sell-side research turned those bearish predictions into a self-fulfilling prophecy.

Nevertheless, with 30,000 jobs at the crossroads with creative destruction, YRC’s executive leadership did what anyone else in their position would do. They applied for financial relief under the CARES Act.

To their stroke of luck, the company’s role as the leading freight hauler for the U.S. Department of Defense, the CEO’s inclusion in one of the Trump Administration’s Great American Economic Revival Industry Groups, and pleading from Kansas Senator Jerry Moran, the U.S. Treasury Department ultimately saw the company as a perfect vehicle to inject $700 million directly back into the nation’s economy while protecting the livelihoods of tens of thousands of American workers.

On that note, let’s recap the Q2 2020 trucking industry earnings season, and then turn the discussion over to the current macroeconomic and industry environment. A later section will present a series of compelling arguments for why the company’s stock price may keep trending higher, as we thoroughly examine the multi-point thesis introduced earlier. Towards the end of this article, readers will learn how the $8 price target was determined.

Trucking Industry Earnings Season Recap

The shelter in home period linked to the COVID-19 pandemic took a sizeable bite out of freight shipment volumes in the second quarter of the year. But by the end of May, volumes had quickly stabilized and now appear to be recovering swiftly from the pandemic. Earnings reports from Heartland Express (HTLD), J.B. Hunt (JBHT), and U.S. Xpress (USX) which are industry peers on the truckload and brokerage side, indicated that the extent of economic damage from the pandemic has been minimal. In July, shares of UPS (UPS) rallied strongly following a surprise earnings beat from FedEx (FDX) which benefited from stronger than normal ecommerce activity.

On the LTL side of the industry, earnings results fared better than expected. Industry peers Old Dominion (ODFL), Saia, Inc. (SAIA), and ArcBest Corp. (ARCB), reported smaller year-on-year profits as well as revenue declines, while XPO Logistics (XPO) veered towards a net loss.

YRC Worldwide’s quarterly loss widened over the same period last year. Performance was impacted by a sharper revenue decline than industry peers, as speculation of the company’s survival led to the loss of some customer accounts. However, a combination of layoffs, furloughs, deferred health and welfare expenses, and accrued interest led to a smaller than projected quarterly loss of -$1.09 versus the average Wall Street estimate of -$1.66. These cost reductions helped lift the company’s liquidity position to $303 million compared to $80 million for the same period last year, and $118 million at the end of Q1 2020.

During the conference call, management addressed many of areas covered in our long thesis and shared their perspective about the Congressional Oversight Committee’s inquiry. They also announced that they had already drawn on $245 million of the $300 million made available through ‘Tranche A’ of the CARES Act loan to pay off all the deferred and accrued expenses. Lastly, management elaborated further on their spending plans for the $400 million from ‘Tranche B’ of the CARES Act loan, which is earmarked for new fleet equipment.

The company plans to replace their oldest fleet equipment first with either ‘lightly used’ equipment or completely new equipment ordered to spec. However, the availability of collision-avoidance features, powertrain warranty, and tax credit opportunities on new equipment suggests OEM orders will be the way to go. In a later section, we will discuss the potential cost savings from new equipment, as we explore each point of the long thesis. In the meantime, the current freight environment needs to be addressed.

The Current Transportation Environment

Though shipment volumes have demonstrated weekly improvement since the lockdown period was lifted, recent tonnage and shipping activity remains below 2019 levels. The chart below depicts the monthly U.S. DOT – Freight Services Index published by the Bureau of Transportation Statistics unit of the U.S. Department of Transportation. These data are be used by investors, economists, and analysts to gauge the health of the trucking industry. The index shows that freight services bounced up in May after bottoming out in April, adequately reflecting the economic reopening. Despite all the economic optimism, transportation activity for May was near levels unobserved since 2017. Though the rebound has continued to pick up momentum since June, activity levels remain near 2017 levels.

U.S. DOT – Freight Services Index

A second chart presented below, measures trucking tonnage at the national level. The Truck Tonnage Index is another monthly data series published by the Bureau of Transportation Statistics. This index is based on calculations from the American Trucking Association’s advanced Truck Tonnage Index.

Once again, the index shows the same trend as the Freight Services Index pictured above. Truck tonnage collapsed to 2017 levels in April but started to rebound sharply in May. The small rebound indicates the recovery has not been as robust as transportation company market valuations reflect.

The “ Dow theory” or “ cyclical play theory” may partially explain this detachment of prime transportation company valuations from the fundamental reality. If that is the case, it means investors have positioned themselves to benefit from an upturn in the economic cycle, as trucking firms are typically regarded as the first in line to benefit from an improving economy.

U.S. DOT – Truck Tonnage Index

Source: U.S. DOT, Centaur Investments

Because of the lag in government data, a better measure for tracking freight industry activity is the Cass Freight Index published on a monthly basis by Cass Information Systems. Stifel Nicolaus Transportation Research Director, David Ross, publishes a useful blog post to accompany the data releases. As the illustration below shows, freight shipments continued to rise at a slightly faster pace in June but remain far below 2017 levels despite the lifting of most nationwide lockdown orders, reopening of manufacturing businesses, and resumption of air freight and maritime import activity.

Cass Information Systems – Freight Shipments Index

As the pandemic rattled the market and disrupted global supply chains, Wall Street analysts slashed revenue and earnings estimates across the industry. The lowered hurdles allowed most trucking firms to easily beat analyst targets, powering investor confidence in the sector. Contrary to all the data presented above, stock prices across air freight and logistics have returned 30% over the last year and 31.4% year-to-date. Meanwhile, the S&P 500 has returned 15.8% on a 52-week basis, and just 4.6% on a year-to-date basis, according to Fidelity Investments.

While most trucking firms have reinstated quarterly and full year guidance, management teams remain cautious in their outlooks for the rest of the year. Despite the grim reality, it remains unclear exactly what is sustaining trucking company valuations. Some investors may be betting on essential transportation businesses and ecommerce due to the mass media’s portrayal of panic and impulse buying at big box, grocery, and online retailers, but that behavior is simply not reflected in the data or financial performance. The truth is unemployment remains very high, the pandemic has been relentless, and the economic recovery is simply not as robust as the stock market implies.

A quick review of the YRCW’s stock price performance relative to the industry as illustrated below demonstrates a clear and perhaps much exaggerated divergence in performance from the rest of the industry, despite the sizeable capital injection from the U.S. Treasury. This gap is not a stock market performance gap either, it is a glaring valuation gap affecting all trucking companies perceived as fragile, even though fundamental performance has been similar across the industry. The valuation section presented near the end of this article will further analyze this apparent gap, which may help predict where YRCW’s stock price is headed. For now, please have a look the 3-year stock price performance chart below.

Trucking Industry 3-Year Stock Price Performance Gap

Data by

YCharts

YRCW’s share performance is the purple line at the very bottom of this chart. Despite the obvious open runway for operational improvement and massive liquidity position which were highlighted on multiple occasions during the most recent conference call, the stock price has barely moved to close the performance gap.

Whether or not this divergence is sustainable, it may suggest there is still much investor confusion regarding the company’s current situation. Can one blame investors for their confusion? YRCW is a highly complex case study with multiple moving pieces that must be considered collectively. Forming an investment opinion from social media commentary, attention-seeking articles found through Google searches, or statistics available on financial media platforms like Yahoo Finance is simply not a practical approach.

Even looking at the company’s financial statements in isolation is insufficient. Understanding YRCW requires a complete dissection of every financial report from the last decade down to its last detail hidden in the footnotes. It also requires reading or playing back dozens of earnings calls and transcripts, and combing through years of presentation slides, mid-quarter updates, and 8-K SEC filings while considering economic and demographic changes over years.

Most importantly, one must set aside personal biases, predetermined judgments, misconceptions described by people on social media and in person, and recognize that past performance is not an indicator of similar future results.

In today’s fast-moving markets where speculators make split-second decisions based on patterns in a stock price chart or chatter in a private trading chatroom, few take the time to delve deep into a single company to verify if their considered opinion about a company checks out.

The latter of the three is the precisely what Centaur Investments sets out to do in all of our research. An objective since initiating coverage on YRCW is to offer a variant perception; one that pokes holes into every logically inconsistent bias and bearish assumption commonly shared by the public. In addition to this variant perception, a second objective is to help investors piece together as much of a complete picture as possible about this company from all the noisy information scattered across the internet.

The Bullish Thesis Breakdown

This latest iteration of the long thesis is based on an extensive review of the company’s history, management, property and equipment assets, fleet age and size, service center coverage area, operational and idiosyncratic challenges, cultural challenges, and financial performance over the last 10 years. This is quite possibly the most thorough evaluation of the business on Seeking Alpha, period.

The analysis efforts extended to multiple iterations of financial models which tested different paths the company could take to improve financial performance 5 to 10 years into the future. The conclusions drawn from the analysis suggests there is a considerable value to be extracted from the business’ network, workforce, and property and equipment assets. If investors and analysts would simply give the company the benefit of the doubt, when allowed to work freely, YRC’s management could potentially generate sizable and consistent free cash flow gains over the next decade.

In our view, value has been suppressed by a combination of excess capacity, leverage, high cost of debt entering the financial crisis, and externalities such as the massive output collapse in industrial activity across the U.S. in the aftermath of the Great Recession. Additionally, YRCW’s recovery was also inhibited by an effort to run the company out of business as industry competitors engaged in a series of aggressive short-term price-cutting tactics.

The combination of these factors contributed to persistently poor credit ratings from agencies despite effective decision-making and relentless efforts by former CEO James Welch and current executive leadership to engage in the most efficient capital allocation in perhaps LTL history. These factors fueled a feedback loop of persistently high cost of debt and inability to raise additional capital in equity markets.

Furthermore, the company’s decade-long share price volatility has been more recently exacerbated by popular bearish views towards the company. These bearish views are influenced by multiple cognitive biases due to the complexity of the business’s challenges, as investors consistently compared the company and its unique situation to financially healthier and physically smaller industry competitors which more easily outperformed in the post-recession economic environment.

While the bearish opinions may have been appropriate during the 2008 recession, they remain intact despite a well-defined business strategy, and substantial runway for operational improvement compared to richly valued prime LTL competitors.

Of all the paths to profit improvement tested in our models, the two most rational scenarios arise from achieving full fleet replenishment and maximizing density or load factor within the company’s network. YRCW’s potential for value creation may be further compounded by improved worker productivity, improved business visibility from modern transportation management software, reduced interest expenses in the future, and a decline in cost of capital.

While richly valued industry peers are already near peak operational efficiency levels, efforts to improve on that level of efficiency will only yield marginal operating ratio improvement. YRCW, on the other hand, can potentially experience large operating income gains from essentially any incremental improvement in their operating ratio.

As stated in the introduction, this thesis is largely based on management’s multi-pronged turnaround strategy which we find to be highly realistic. In 2019, after the ratification of a new National Master Freight Agreement (NMFA) with the Teamsters’ Union, management shared their refined strategy for achieving sustainable profitability over a 5-year period during a presentation given at Deutsche Bank’s annual ‘ Global Industrials and Materials Summit.’ The precise reasoning behind each catalyst of the long thesis introduced earlier will be outlined for the reader over the next several paragraphs. After discussing these upside catalysts, we will reveal the supporting financial models behind our own valuation estimate of the business.

ONE: Industrywide pricing and capacity discipline will support multi-point strategy while allowing the company to offset cost inflation through periodic contractual and general price increases.

In the price wars that followed the Great Recession, carriers learned that attempting to undercut one another was a losing formula. Like the old saying goes “an eye for an eye will make the whole world blind,” LTL carriers today are observant of the fact that attempting to undercut one another through aggressive price cutting tactics will only end up hurting everyone.

Currently, the industry has entered a phase where competition is more about service quality and operational efficiency than offering low shipping prices. This is because transportation costs trend up over time, not down. To combat cost inflation, carriers push for periodic general rate increases and strive to lock in higher contract prices each year. Carriers are also constantly looking for ways to cut down costs, increase efficiency, and protect margins.

For example, most carriers today have freight dimensioners installed at strategic points across their networks to help catch uneconomic freight. Additionally, transportation software and real-time market data has dramatically improved market efficiency to the point that carriers can turn capacity on and off much better than they have in the past. This discipline protects market pricing and profit margins for the entire industry, while indirectly supporting YRCW’s turnaround strategy.

TWO: Property in suburban metro areas acquired over a century and recorded at cost on the balance sheet is a goldmine of hidden asset value which the market does not seem to realize.

On this belief that YRCW’s balance sheet understates the intrinsic value of its business assets, Centaur Investments is not alone. This view was emphasized in this investor letter, and this video published last year by the investment team of notable YRCW shareholder, Front Street Capital Management. The striking similarities between Centaur’s long thesis and Front Street’s are entirely coincidental. Centaur Investments was not aware of their investment or thesis until they published the video in June of 2019.

With regard to YRC’s property, while this observation is not exactly an actionable investment catalyst, it does offer an excellent perspective on how undervalued this business is. What is striking here is that when most investors look at the company’s balance sheet, this is what they see:

Sources: YRCW’s 10-K SEC filings, Centaur Investments

That is, they only see the small PP&E value of just $770 million in 2019 and the shrinking total asset figure over time. However, there is a lot more information outside of these financial statements that is easily ignored if one only looks at the balance sheet. Part of that decline can be explained by the retiring or selling of property or depleted equipment, but the dominant part is a quite obviously the steady non-cash outflow of accounting math known as accumulated depreciation.

Property values are recorded at cost on the balance sheet and depreciate over time, and this means balance sheets ignore any sort of fair market value appreciation over decades. Consider this: how is the business able to support $4.5 to $5 billion in sales from just $770 million in property and equipment? This is the part of the answer:

Source: YRC Worldwide’s Deutsche Bank Presentation Slide Deck

YRC Worldwide is a nearly 100-year-old business. Since inception, the company has accumulated a substantial number of real estate properties to build out its hub and spoke network. In that timeline, the company has watched full blown suburban areas grow around many of its service facilities. While they have sold off many properties since the 2008 financial crisis, they still have a larger international coverage than each one of their LTL pure-play competitors.

As of December 31, 2019, the company had a total service facility count of 351 properties. They owned 182 service facilities outright, or about 52% of the total count. Some of the company’s service facilities are in impossible to duplicate industrially-zoned areas right in the middle of residential neighborhoods in some of the most highly populated urban metro areas of North America. These properties were recorded at cost on the balance sheet and were subject to accounting depreciation over decades. It’s usually large institutional investors or hedge funds in particular who tend to notice these glaring property value to market capitalization mismatches.

Source: YRCW’s FY 2019 10-K SEC Filing

But small-cap names do not typically attract much institutional investor attention. To complicate the matter, YRCW’s low price per share, daily trading volume, and total share count fits the perfect profile for day traders. These speculation-driven traders are often more interested in short term events, and naturally tend to overlook the intrinsic value of a company’s balance sheet assets. Of the few institutional groups that have taken note of YRCW’s property, one of them is Apollo Global, the company’s main creditor. This may partly explain why executives at Apollo quickly cooperated with YRC’s management to modify the $600 million term loan covenant during this year’s pandemic.

To confirm if there was a probability that YRC’s PP&E had a higher market value than the depreciated figure found on the balance sheet, Centaur Investments took the map above and manually searched for the properties online. Additionally, an online search for used commercial equipment values was conducted to estimate the fair market value of the company’s fleet. County tax websites and commercial real estate websites such as ‘loopnet.com’ were used for property estimates. Commercial equipment marketplace websites such as ‘truckpaper.com’ were used for fleet equipment estimates. The table below offers three conservative estimates of the fair market value of the YRCW’s property and equipment assets.

Source: Centaur Investments

Ignoring discount rates, potential cash flows, opportunity costs, and other exogenous factors, the PP&E analysis concluded that YRCW minimum average service facility value could be between $1 and $2.5 million. The calculations above assume half of YRCW’s fleet equipment assets are worthless. This is either due to equipment age or because some may be under a lease agreement. The other half of the YRCW’s fleet are assumed to fetch fair market rates. At fair market, the owned portion of YRCW’s fleet may be valued somewhere between $365 million and $688 million. Mixing and matching the different estimates yields a range of valuations starting with the depreciated balance sheet value of $770 million and upward to $1.1 billion. Take a moment consider this range of estimates, relative to the current $200 market capitalization of the business.

Assuming the $700 million CARES Act loan is eventually converted into business assets, the range increases to $1.5 billion to $1.8 billion. However, based on the sizeable profits YRCW has recently booked on small real estate sales, such as the one disclosed on page 78 of their FY 2019 10-K SEC filing, it is entirely possible that the average service facility value may be considerably higher than the calculations shared above. Based these calculations, the market value of the business’s property and equipment alone may be between anywhere between $15 and $17 per share, depending on the assumed diluted share count.

Source: YRCW’s FY 2019 10-K SEC Filing

It is important to make clear that this section is not meant to imply that the company will or should unload property to collect cash. Rather, it is meant to demonstrate how undervalued the company’s shares are, and to provide a better basis on which to assess the company’s total debt balance.

THREE: YRCW’s 3PL startup venture, HNRY Logistics, provides the company with a new sales vertical and contribution margin through new asset-light services, offering longer term sales growth potential.

Another source of hidden asset value comes from YRCW’s HNRY Logistics brokerage venture which the market is still not pricing in at all. The unit actually helped the business offset revenue declines on the LTL side during both FY 2019 and the pandemic. As a multimodal and multiservice unit, HNRY can be thought of as essentially a third-party logistics (3PL) business.

Through HNRY, YRCW is able to capitalize on existing customers that need services which the company’s asset-heavy side is not equipped to offer. These services are outsourced by the company to trusted partners and independent contract carriers.

Wherever possible, HNRY generates additional LTL sales by marketing the entire asset-heavy side of the business to existing and new customers, and contributes margin by securing back-hauls for the long-haul side of the business. This recent announcement of a new dedicated pool distribution contract booked with an unnamed major American retail operation is a perfect example of HNRY’s long-term sales growth potential.

Based on the Deutsche Bank presentation slide deck published last year, HNRY was on track to deliver $200 million in sales for FY 2019 and projected to deliver $300 million in FY 2020 prior to the pandemic. Management is currently targeting for the unit to eventually account for 20% of YRCW’s total revenue mix.

For those who may not be aware, some costs incurred through HNRY are currently imbedded in the purchased transportation line item on the company’s income statement. Purchased transportation expenses as a percentage of total sales have increased by 200 basis points since HNRY Logistics was formed. A derivative calculation can be applied to YRCW’s total sales to reverse-engineer a sales projection for HNRY. Additionally, note 2 on page 7 of the company’s most recent 10-Q SEC filing offers a “revenue disaggregation” which may be also viewed as a decent proxy for HNRY’s sales.

Source: YRCW’s Second Quarter 10-Q SEC, via Seeking Alpha

Though HNRY is now in its second fiscal year, 2020 has turned out to be much more challenging than management had in mind. Even so, the unit should be expected to power revenue growth well beyond 2021.

On a final note, new language included in the labor agreement signed last year authorized an increase in YRCW’s use of purchased transportation. The higher purchased transportation allowance supports multimodal and third-party services offered through HNRY. As an example, in 2019, the company added over 1,000 YRC Freight-branded containers to support multimodal services.

Source: GlobalNewswire

Centaur believes the current equity value of HNRY may currently be somewhere between $50 million and $100 million, as the growth rate of that unit was much higher than YRCW’s asset-heavy business in FY 2019. Once again, take a note of how that figure compares to YRCW’s current market capitalization, which is around $200 million today. If HNRY’s growth rate picks up when the economy rebounds, investors can expect to see the company break out financial performance data for HNRY Logistics as a separate business unit. When that happens, such event would lead to a new sum of the parts valuation for the whole business and drive the market to reprice the shares higher.

FOUR: Revenue equipment replenishment will substantially reduce maintenance and fuel expenses, leading to immediate sequential decline in the company’s operating ratio.

The intuition behind thesis point four is that as the company takes delivery of each new piece of equipment, they will experience immediate gains in gross and operating margin on a sequential quarterly basis.

In the past, the company’s pace of deleveraging and fleet replenishment has not kept up with investor and analyst expectations. Even though operations have improved dramatically since 2009, operating cash flows have simply not been robust enough to support high capital spending on a new fleet equipment. Under normal circumstances, the company could have simply issued a low coupon bond to finance a completely new fleet.

But the company’s less-than-stellar corporate credit rating exiting the financial crisis meant they had to hold off on reinvestment until their operations and financial position stabilized. Though the fleet reinvestment program was started in 2013, the company has been limited to what they could afford through a combination of cash flows and high-interest equipment leases.

Source: Pg. 39 of YRCW’s FY 2019 SEC 10-K filing

Despite the limitations, progress has been slow and steady. Based on delivery counts management has shared on conference calls and industry conferences, Centaur Investments estimates that progress to get the fleet down to the industry average age was around 45% to 50% at mid-2020.

Per management’s comments, each new truck cuts operating expenses by 15% over the truck it replaced. These savings come from reduced fuel consumption and maintenance related expenses. Per YRC’s CFO, the average annual maintenance expense for a 1-year old tractor is between $1,000 and $2,000, compared to $10,000 to $12,000 for the aged tractor it replaces.

At 50% of a fleet size of 14,000 tractors, that means about 7,000 tractors still need to be replaced. Once the fleet is up to par with the industry, the math translates to a minimum of $70 million in maintenance-related cost savings, or approximately $1.25 in EPS going right to the bottom line. Keep in mind that that number is only scratching the surface.

While the new tractors being added are safer, fuel efficient, and require less maintenance, the newer rolling stock equipment is better-looking, lighter, stronger, and less costly to repair. Most importantly, every bit in cost savings will help the company add additional capacity to fight back against competitors like Old Dominion who has already added 9 new service facilities this year.

While management is well aware of the potential cost and interest savings, the market seems to want to see the results first. For investors willing to take the risk, the next couple of quarters provide ample time for due diligence, and may be the last window of opportunity to invest in the business while it is still cheap.

FIVE: Revenue equipment replenishment eliminates need for expensive short-term rental equipment, emergency roadside repairs, and towing services which will deliver cumulative operating ratio improvement.

This note on thesis point number five will be brief, as it is relatively straightforward to understand. The notion here is that a side effect of having roughly 7,000 tractors over 5 years old means there is a higher probability of roadside breakdowns, and expensive repair and towing bills. It also means having to tap high-cost rental equipment to support daily operations each time a truck is out of service needing repair. As the company phases in new equipment over the next 4 to 6 quarters, these added costs and associated risks will start to fall off and further contribute to operating ratio improvement. As these risks and costs decline, the market in theory should further reprice the company’s shares higher.

SIX: Network optimization efforts will maximize load factor across the company’s network, leading to increased operational efficiency, density, yield, and incremental operating ratio improvement.

Some investors seem to think that YRCW’s network is somehow working against the business, and that’s a wrong way to look at it. Most businesses are generally always looking for ways to improve the way they operate. Over the last year and a half, management has taken steps to improve its network and reallocate business value by eliminating duplicate service facilities across the network, and redesigning line haul operations to help build network density.

The company’s engineers are also improving line-haul operations in close regional segments to increase the availability of next-day service offerings. These services reduce the number of stops required and the probability of damaged freight due to less freight handling. Most importantly, next-day services support higher margin business which translates to additional free cash flow.

These actions are different from having to downsize the company following the 2007-2008 financial crisis. This optimization program is not a capital-raising effort to cover debt or interest expenses, and certainly not an effort to resize the business due to a collapse in demand. Instead, this program was specifically designed to build load density across the network. Density is something other LTL carriers have had for the last 10 years, and it’s why they have been so profitable. For supporting evidence, here is a recent quote from Gregg Grant, Old Dominion’s CEO:

“…we can continue to drive this operating ratio lower once the density factors come back, but it’s the density and the yield and both of those generally require a positive economic backdrop to support each.”

During the 2018 peak LTL freight environment, YRCW was at less than 30% into their fleet replenishment program, and still developing their network strategy. As a result, the company was unable to fully capitalize on that market like competitors did. The company’s disappointing financial performance during in that season led to analysts’ downgrades, and sent the stock plummeting back down to single digits.

Today, the process is nearly complete, as the network was down to 335 facilities at the end of the second quarter from 351 at the beginning of the year. According to CEO Darren Hawkins, the process should be completed by the end of the year with the final service facility count down to 325.

In the process of improving freight flows across the network, management is looking for cost savings from redundant buildings leases and selling underutilized property they own. Some proceeds may go towards paying down debt, other times towards new equipment or technology. Management is always transparent on how proceeds will be distributed.

Source: YRC Worldwide, Inc.

In Centaur’s view, company’s objective seems pretty clear, they’re looking towards the next economic boom, and they’re positioning the company to take advantage of it. When that time comes, the tables will turn. With the company in the right position to capitalize on higher volumes, profit growth, analyst upgrades, and renewed institutional investor interest are sure to follow.

SEVEN: Software migration to the cloud will deliver efficiency gains and support pricing through improved business visualization, leading to further operating ratio improvement.

Adding to the benefits of having a new fleet and more efficient network operations, cloud-based software is critical to extracting additional value from the business. As discussed in this Forbes article, the company managed to eke out enough operating cash to pay down about 60% of its long-term debt and still reinvest back into the business despite relying on multiple legacy on-premises software packages.

The company-wide transportation management and enterprise resource planning software roll-out over the last year has temporarily added costs, but should dramatically improve visibility over the business. Going from legacy to real-time data should allow management and engineers to pinpoint exactly which areas of the network need further improvement, and examine how productive the workforce is.

At the same time, the mountains of real-time data may help the company properly bill customers for driver delays and freight discrepancies, while providing leverage for negotiating better contract rates.

The notion here is real-time cloud-based-data will build onto the other operational areas discussed, and inevitably translate into lower operating expenses, operating ratio improvement, profit growth, and high returns for shareholders. Lastly, all the incremental returns from modernizing the business will have a greater impact on YRCW’s bottom line, than the efforts prime competitors are undertaking to improve on their all-time low operating ratios.

EIGHT: Labor management synergies gained in the 2019 collective bargaining agreement will partially offset wage inflation, healthcare, welfare, and overtime costs.

Labor management has historically been an area where YRC executives had relatively little control compared to competitors. Old Dominion is a great example of this divergence in labor costs. Naturally, figuring out what ODFL does right helps to pinpoint where YRCW does not do as well. It seems as though every ODFL earnings call Q&A is filled with analysts trying to figure out what makes ODFL so efficient and what the company’s operating ratio will look like several quarters down the road. During the Q1 2020 conference call, Old Dominion’s CFO, Adam Satterfield perfectly described the advantage LTL competitors have had over YRCW in the past, as he addressed an analyst question about variable costs. Satterfield said:

“Over time, the operating ratio level that we’ve improved, most of the improvement has come in those direct operating costs, which most of which are variable. So, we’ve got an improvement over the years, and our overhead costs have stayed relatively consistent as a percent of revenue. But we’ve always, in our history, tried to work on operating efficiencies, and we have a continuous improvement process that focuses on quality and we’ve always made efforts through technology improvements and just general process improvement to try to optimize mainly labor cost as a percent of revenue. And so that’s just that’s been a focus. It will continue to be a focus.”

The key words to focus on from this quote above are: “optimize labor cost as a percent of revenue.” YRCW’s labor cost challenges can be directly linked to their previous collective bargaining agreement with the Teamsters. In the labor agreement ratified last year, the company new gained language which allows management more control over labor utilization.

Specifically, management can now hire non-CDL employees at lower wages and increase usage of purchased transportation. In our research, we noticed that most non-union LTL carriers have strict limitations on overtime hours and overtime pay per hour. Most of YRC’s competitors pay their workers the same regular rate per hour for each overtime hour worked. Better yet, most of YRC’s LTL competitors are so well-staffed, they do not allow workers to put in overtime hours at all.

This contrasts with YRCW’s labor policies. YRCW pays it workers regular pay plus half, and in certain cases up to double and triple their regular hourly pay for overtime when holiday or weekend work is required. With an optimal network in place, a modern fleet, cloud-based software, real-time data, increased purchase transportation budget, and labor flexibility, the only missing ingredient is a larger headcount of experienced and well-trained employees.

This is not something easily or quickly accomplished, but contrary to popular misconceptions about unionized LTL, labor costs can certainly be brought down closer to the industry average. Centaur Investments believes these synergies will lower YRCW’s labor cost as a percent of revenue, and result in tens of millions of dollars in reduced operating expenses per year. These savings should further contribute to net income growth and high returns for shareholders. Point number nine below, builds on to the synergies gained in the labor agreement.

NINE: Workforce consolidation, training, and organizational culture development will improve worker morale, productivity per labor hour, and further reduce overtime costs.

Another area where the company has opportunity for improvement is in its workforce. The intuition here is that workforce consolidation in combination with cloud-based resource planning will facilitate recruiting, hiring, training, and creation of new sales opportunities for the company.

Last year, the company trimmed dozens of corporate-level executive positions, and shuttered their New Penn headquarters, transferring most of those office operations to their Kansas-based headquarters. They also consolidated their entire sales force which operated independently at each of YRCW’s regional companies. After consolidation, the sales workforce is now cross-selling all five regional brand company services to customers across North America.

Centaur Investments views these changes as efforts by YRCW’s executive leadership and board to streamline the entire business’ organizational structure. We believe management will continue to work their way from the top of the company’s organization chart down to the service facility operating levels. In doing so, they will effectively eliminate ‘bad apples’ from the business, onboard more engaged lower-level and middle-level managers, and motivate the rest of the workforce to improve performance.

In thesis point seven, we linked to a Forbes article about all the cloud-based enterprise resource planning software YRCW has been rolling out company-wide. The software will allow managers to keep track of employee productivity and provide essential data for performance evaluations and training. As an example of the power of these tools, managers at service facilities can break out individual productivity data with dock workers and pickup and delivery drivers and incentivize them to increase individual productivity by holding each other accountable.

These are solutions that competitors already have in place, but YRCW can still tap into to improve culture, labor utilization, and labor cost per revenue. While competitors will mostly maintain their top-level performance, YRC can potentially experience substantial operational efficiency gains from these new labor resources. For investors who think culture development is impossible at a unionized LTL carrier, YRC’s unionized LTL peers at ArcBest Corp., FedEx, UPS, and XPO Logistics are perfect examples that it is certainly possible. Keep in mind that unionized LTL peers do not have taxpayer ownership to think about.

Source: Slide 6 from YRC Worldwide’s June 2019 Presentation

Finally, investors must understand that YRCW’s distressed condition discouraged high skilled and experienced workers from making YRCW their first choice of employment. The company’s older than industry average fleet equipment also played a role in deterring experienced applicants.

Still, nothing was more challenging than having to recruit drivers and dock workers as the U.S. unemployment rate hovered near all-time low in recent years. The low unemployment rate meant YRCW had to compete in a shrinking labor pool of skilled workers, while many of candidates potentially considered YRC their last choice. When the LTL market heated up in 2018, the entire industry was hiring whoever they could from that shrinking labor pool and training them on the fly.

Things could not more different today. The national unemployment rate is over 10%, and employment is down across the industry due to lower demand and capacity requirements. The new equipment and technology the company is introducing may help the company attract higher skilled workers, as well as lower and middle-level management. Centaur Investments believes that as YRCW’s operations improve their reputation will also improve. With an improved image and generous health and welfare benefits guaranteed by collective bargaining agreements, YRCW could quickly go from being an experienced job seeker’s last choice to their first.

TEN: Apollo term loan covenant amendment and 2020 CARES Act loan package allows management to focus on their multi-year strategy and clears the runway to sustainable profitability.

On April 8, the company filed an 8-K with the SEC announcing they had amended the debt covenant on their $600 million term loan which they refinanced last year through Apollo Global Management, Inc. (APO). In order to manage liquidity during the government-mandated lockdown period, the company requested a six-month window to allow for payment-in-kind interest payments, and a temporary waiver on the $200 million minimum adjusted EBITDA requirement through the end of the year. While the creditor agreed to work with the company through the pandemic, they imposed a high interest rate penalty which led to a 510 basis point increase in effective interest over the original terms. The company’s most recent 10-Q filing shows the effective interest rate on the term loan was 15.1% at Q2-end 2020 versus 10% at Q1-end 2020.

Source: YRCW’s Q2 2020 SEC 10-Q filing

Shortly after the CARES Act loan announcement, the company quietly filed another 8-K with the SEC in which they announced the covenant on their $600 million term loan with Apollo Global had been amended for a second time in 2020. Though it may not have seemed like much of a catalyst, the amendment completely lowered all near-term hurdles for the company and in turn, likely eliminated any serious investment risks through FY 2024. The amendment restored the original interest rate arrangement, allowed for a 100 basis point reduction on interest paid in cash, and lowered the minimum EBITDA requirement to $100 million through December 31, 2021.

Though the EBITDA covenant requirement steps back up to $200 million on March 31, 2022, the timeline and relatively low liquidity requirement of $125 million means company management can focus completely on executing their multi-point turnaround strategy. Centaur Investments believes that as the economic outlook improves and business operations see sequential quarterly improvement, the market will gradually lower the discount rate on the business’s equity. In Layman’s terms, this means sustained upward stock price momentum.

ELEVEN: The two low interest CARES Act loans totaling $700 million substantially reduce the company’s cost of capital while accelerating their fleet replenishment program and technology deployment.

An overwhelmingly important component of the list of catalyst drivers is the CARES Act loan which the Treasury Department announced on July 1, 2020. The first tranche of $300 million steers the company back on path towards profit improvement, by covering all deferred expenses linked to the pandemic. The second tranche of $400 million covers their annual CapEx budget of $250 to $350 million.

As explained in thesis point four, YRCW normally supports their CapEx budget through a combination of cash and high-interest bearing equipment leases, with roughly half of CapEx spending going towards fleet replenishment. The other half funds technology investment in hardware such as dock tablets, and cloud-based transportation management software. Because the company’s old fleet is their Achilles heel, the budget constraint led to slow progress on fleet replenishment.

So, what makes the CARES Act loan such a game changer for the business is that the full $400 million is specifically for buying new tractors and trailers. The low interest on the loan enables the company to cut back high-interest bearing equipment leases in addition to the benefits from lower maintenance expenses. Altogether, this dramatically reduces the timeline for returning to profitability and it lowers the overall investment risk.

TWELVE: The 29.6% U.S. government stake tacitly pressures management to improve operational performance in a timely manner, likely accelerating the timeline to sustainable profitability.

The U.S. auto industry’s progress since the great recession may serve as an example of the positive effects that come with government ownership of a publicly traded business. Centaur Investments studied Ally Financial (NYSE:ALLY), General Motors (NYSE:GM), and Fiat Chrysler (NYSE:FCAU) to evaluate whether those businesses improved after securing TARP funding.

Our assessment concluded that operations, profitability, and long-term focus improved substantially after those companies received TARP bailouts. For example, GM turned their Chevrolet Volt EV concept into a production model and is now a leading contender in the race to electrification and autonomous transport. Chrysler, on the other hand, focused on improving quality and building high-margin performance vehicles. Chrysler’s strategy was so successful, it contributed to the improvement in European brands like Alfa Romeo and Maserati. Ally Financial became a leading consumer finance powerhouse, and eventually secured investment-grade credit ratings from S&P and Fitch.

In our view, congressional and taxpayer scrutiny pressured executive leadership at each company. The public scrutiny heightened management’s incentives to strengthen their business and that maximized shareholder returns. Since the government sold off its stake in each company, all three have demonstrated financial discipline, strong profitability, and much improved product and service quality. GM’s resilience after facing a massive production outage due to a labor dispute with the United Auto Workers last year, serves as supporting evidence of these observations.

Because YRCW currently faces similar pressures to what the automakers experienced, the phenomenal changes observed in GM, FCAU, and ALLY may certainly be replicated at YRCW. If and when these changes become apparent, new investors will be attracted to the shares and that should power further stock price appreciation.

THIRTEEN: Proposed ‘Employee Stock Ownership Plan’ may create a share price floor, reduce share price volatility, and empower employee engagement.

As a case in point to thesis item twelve discussed above, the U.S. Treasury Secretary has already demonstrated one way the government stake helps the business. Last month, Steven Mnuchin sent out a late night Tweet disclosing some details of a phone conversation he had with Darren Hawkins, YRCW’s CEO.

Apparently, the company’s board of directors is considering introducing an employee stock ownership program. Surprisingly, YRCW does not have an ESOP in place for employees to take ownership in the business. The implementation of such a program could put a floor on the stock price and help reduce volatility by repelling speculative day traders. ESOP demand may also drive upward share price momentum through increased investor bidding as the supply of available shares in the open market declines.

There are other indirect benefits as well, for example, the positive impact equity ownership has had on Starbucks’ (NASDAQ:SBUX) corporate culture is a well-documented phenomenon. As a more directly comparable example, YRC’s unionized LTL competitor ArcBest has had an ESOP in place for years, and the positive effect that program has had on the company’s unionized workforce and share price performance is indisputable.

Increased employee stock ownership may help deliver cultural change at YRCW, as employees tend to become more engaged when they directly benefit from share price appreciation. An ESOP may also help recruit and retain experienced workers. Lastly, as new employees see others benefit from share price appreciation, they will be motivated to take part in the program as well, driving a positive feedback loop for all stakeholders involved.

FOURTEEN: Potential interest and amortization savings from deleveraging and replacement of high-interest equipment leases with lower-rate leasing and purchase options.

The price target of $8 mentioned in the introduction was derived through a discounted cash flow analysis which factored in extremely conservative growth rates and did not account for a lower cost of capital. Some investors may not realize that the CARES Act loan actually lowers the company’s overall weighted average cost of debt from nearly 12% to 8.1%. The incremental returns on capital investments should free up substantial free cash flow to deleverage. A key area where the business can focus deleveraging efforts on is high-interest equipment leases, as mentioned earlier in thesis item number four.

Per the new capital structure and company SEC filings, we believe the CARES Act loan will allow the business to obtain new equipment leases on much more favorable terms. As the capital structure table below shows, for every 100-basis point decline in the effective interest rate on equipment leases, the weighted average cost of debt declines by 14 basis points. The table calculates several examples. The first calculation shows that lowering the 16.6% effective rate to 8.3% would lower overall WACD by 120 basis points. That translates to an interest expense decline of $18.8 million per year, from the projected total annual interest expenses including the CARES Act.

Source: Centaur Investments

A second calculation shows that if the company were to eliminate equipment leases altogether, that would lower WACD by nearly 140 basis points from 8.1% to just 6.7%. That decline translates to a total interest expense decline of $22 million per year. The company can accomplish this by simply purchasing new fleet equipment with the proceeds from Tranche B of the CARES Act loan, and all future equipment with excess cash flows freed up by the upgraded fleet itself, and other synergies from the multi-year strategy. These basic calculations demonstrate exactly why the CARES Act loan is a game changer for the company, and a boon to U.S. taxpayers’ new stake in the business.

Prospective investors should take these scenarios into account when evaluating the company’s overall debt balance and interest expenses in their mental or quantitative models, instead of categorically writing it off as a zombie company. The valuation model which will be shared later in this article does not speculate on how management will address the leverage situation, but still arrives at a valuation much higher than the current market capitalization. Lastly, considering James Pierson’s track record managing YRC’s books, it’s safe to assume he will make optimal decisions when it comes to capital allocation.

FIFTEEN: Removal of going concern uncertainty will renew customer interest, deliver sales growth, and allow company to continue defending market share.

The last item on the long thesis list is the simple notion that YRCW’s competitors have officially run out of rumors and stories to entertain YRCW’s customers with, as they try and win new business. On July 1, 2020, any former customers woke up to a whole new perspective of YRCW’s executive management’s capabilities. They also had an entirely new take on the ethics and business practices of the salesman that convinced them to leave YRCW.

The announcement of the $700 million CARES Act loan shook the industry and upset a lot of longtime YRCW haters. Looking ahead, the open runway for the company makes the future seem simple to predict. As operations improve, service quality will improve, the company’s culture will improve, and all these changes will drive more customers to do business with YRCW than ever before.

Going back to the central theme of this long thesis, YRCW’s size, scale, and network coverage in absolute terms, means it has far more opportunity to unlock existing value than any one of its LTL competitors. As you think about each of these 15 arguments, consider that the most efficient LTL carrier based on operating ratio currently trades for nearly 38x earnings and 5.7x its annual sales. The most directly comparable unionized LTL carrier, ArcBest, trades for nearly 30x earnings and 0.3x annual sales. YRCW, on the other hand, barely trades for a nickel per dollar in sales.

At these valuations, YRCW is in the best position to reward investors with outsized returns due to its suppressed market valuation relative to its actual size. Conversely, the rest of the LTL peer group has almost no room for operational improvement and forward growth seems fully priced in. This means the other carriers in this industry are likely better positioned to disappoint shareholders than they are to sustain outsized share price performance.

Think of this thesis as you would a formula one racing championship, where every nut and bolt, every team member, and every race helps rack up enough points to move up in ranking. In Centaur’s view, the combination of each one of the thesis points detailed in this article will lead to considerable operating ratio improvement and ultimately sustainable profitability. If all works well, the company will eventually be in a position to where they have enough margin room to absorb short-term events like bad weather or a slower than typical LTL cycle, yielding positive full-year net income each year beyond FY 2022.

Centaur’s Intrinsic Equity Valuation Assessment

In this section, all the arguments presented throughout this entire article will be condensed into a simplified financial model. We continue to believe that a discounted cash flow model approach to valuation is the best way to value the firm’s equity due to the company’s unique situation. Price-to-earnings and other multiple are not reasonably applicable due to the company’s negative earnings and the industry’s lofty valuations. Nevertheless, a basic multiple analysis is also included in this section.

In this latest iteration of the financial model presented in all prior articles, substantial revisions have been made. In addition to complete data for FY 2019 and 6 months’ worth of financial data for FY 2020, a substantial decline in total revenue, net income, and free cash outflows are now projected for FY 2020 and FY 2021. These changes were deemed necessary to properly reflect the company’s current situation and new risks relative to last year.

The model assumes sales growth will return in 2021, but the 4 to 6 quarters in lag between new equipment orders and actual delivery will delay return to profitability. Additionally, the sizeable capital investments and working capital commitments are expected to weight on free cash flow in FY 2021.

Beyond 2021, the ramp up in fleet replenishment, higher load factor, growth into capital structure, and lower cost of capital are forecast to contribute meaningfully to net income and free cash flow. Lastly, the model has CapEx and working capital stabilizing beyond 2022, as the fleet age catches up to the industry average, and the company’s software migration to the cloud is complete.

The table below shows Centaur Investments’ projections for free cash flow as applied in a 10-year horizon discounted cash flow valuation model.

YRCW – Free Cash Flow Model

Source: Centaur Investments

The process of arriving at the free cash flow model pictured above, started with review of well over 10 years of annual and quarterly financial data for YRCW. Assumptions were drawn from the yearly and quarterly changes in each line item, as well as feedback shared by company management during conference calls and presentations. These assumptions were used to project financial performance 10 years into the future. After that, several iterations of the model were produced before arriving at the most conservative and rational one presented here.

Prospective investors are encouraged to model out the company’s financial statements to the same 10-year horizon period, to assess for themselves the gigantic effect on operating income each 100-basis point decline in the company’s operating ratio will have. The positive effect on net income and free cash flow caused by getting the OR down to reasonable levels such as 95% to 93%, is quite remarkable and is something investors need to see for themselves. For pragmatic purposes, the model observed here keeps the company’s operating ratio above 96% through year 10.

YRCW – Discounted Cash Flow Model

The discounted cash flow model below included substantial revisions to the company’s capital structure. Although the new CARES Act loan dramatically lowers overall cost of debt, that new cost of debt calculation is not reflected in the model due to the uncertain outcome of the Congressional Oversight Committee scrutiny of the loan terms.

Centaur Investments believes that any interference in the loan terms would be detrimental to all stakeholders, including the thousands of middle-aged rank-and-file workers who have dedicated decades of their lives to YRCW companies. As these hard-working Americans anxiously await retirement, the quality of their livelihoods at retirement depends on this company’s survival. For them, there is no starting over, even if the industry could absorb YRCW’s customers without service disruptions. Seeing things from this perspective, makes the creative destruction some investors wish for seem unfair and perhaps outright inhumane.

Any attempts by the Oversight Committee to alter the rates on the two CARES Act loans would adversely affect the company’s ability to service its debt, and dramatically reduce the probability of realizing the high investment returns projected in this thesis. Due to this reasoning, it seems reasonably improbable that the Oversight Committee will attempt to alter the terms of the two CARES Act loans.

Nevertheless, that risk has been embedded in the DCF model in two ways. First, the expected market return has been increased from 11% to 20%, to reflect opportunity costs and inherent risks. Secondly, the company’s overall cost of debt was reduced by 100 basis 11.3%, instead of the 420-basis point reduction which the CARES Act loans call for. The cost of debt will be lowered again when it can be confirmed with absolute certainty that the terms of CARES Act loan will not be altered.

Source: Centaur Investments

As the DCF valuation above shows, this latest assessment of the business concludes that the company’s equity should be valued closer to $408 million. Factoring in the U.S. Treasury Department’s newly issued shares, the valuation yields a price target $8, compared to the $10 suggested a year ago. This implies the shares still have near term upside opportunity of 100% from the $4 quoted at market close on August 12, 2020.

Even though the company’s second quarter earnings surprised to the upside, investors should expect to see third quarter results impacted by expenses deferred or accrued during the second quarter. With the company having recalled most of its workforce previously on furlough or layoff status, operating expenses are trending higher in the third quarter. The deferrals, accruals, and paid-in-kind interest charges from the second quarter combined with normalized operating expenses in the third quarter may lead to a larger than expected earnings loss. Therefore, investors should not be surprised to see the shares trade flat or decline after Q3 earnings are reported.

However, If YRCW’s Q3 financial performance is better than expected or there is a market-moving catalyst such as a vaccine, the shares may start trekking toward double-digits by the end of the year. All else equal, Centaur’s price target for the shares stands firm at $8. This is a considerably cheap valuation, considering all the information presented throughout this article, as well as YRC’s ample liquidity, hidden real estate value, low risk of covenant breach, and no expected loan repayments until 2024.

YRCW – Industry Multiple Analysis

Even though the market remains resilient despite an ongoing pandemic, investors must recognize that the we are experiencing a period of extreme uncertainty. In addition to the pandemic, the economic recovery hinges on congress’s ability to pass a second stimulus package in a timely manner. Additionally, with a major presidential election coming up in the U.S., there is little ability to predict how the market will behave as we approach November.

The transportation industry data shared early in the article shows that despite the reopening of the economy, freight volumes and overall business activity remain subdued. In spite of these realities, the stock price multiples for transportation companies prove that the market is no longer pricing in the period of supply-demand destruction from the second quarter of the year.

On the contrary, investors are increasingly betting on a v-shaped economic recovery. For added perspective, transportation industry multiples and other relevant data necessary to cross-compare transportation companies are presented in the image below.

YRCW’s Industry Comps

Source: Seeking Alpha, Centaur Investments

The spreadsheet emphasizes the clear divergence in valuations between prime transportation companies and those perceived as risky. In our view, the valuation gap is so wide it seems unsustainable. There are two ways we see that valuation gap tightening, and these are: 1.) large-cap transportation shares remain flat or continue to increase at a slower pace while small cap transportation shares outperform, or 2.) small-cap transportation shares remain flat while large-cap transportation shares decline.

Centaur Investments believes that the industry average enterprise-value-to-EBITDA multiple may be applied to YRCW to obtain a second valuation estimate. In the enterprise value (“EV”) calculation for YRCW, the company’s right-of-use operating leases were backed out of the debt calculation. This debt was automatically added by financial data feeds which ignore accounting rule changes. The addition of this debt was due to a 2016 FASB accounting standards update for leases which became effective in 2019 (See: ASU 2016-02.)

After this minor EV recalculation, applying the industry average EV/EBITDA multiple to YRCW yields an implied stock price of $7.85 which suggests there is an additional 96% upside for the shares. Restricting the multiple analysis to the companies highlighted in blue returns average multiples for the less-than-truckload (“LTL”) category. Applying this EV/EBITDA LTL average to YRCW yields a price target of $8.10. Note how both of these approaches leads to price targets that are very close to the price suggested in our DCF model.

Near-term downside risks are currently linked to the four following disruptive events:

1. a sudden unexpected economic deterioration arising from a market panic,
2. inability for congress to reach a consensus on a second economic stimulus package,
3. a continued or worsening COVID-19 infection wave with no vaccine approval in sight,
4. market volatility due to election outcome uncertainly,
5. and interference from the Congressional Oversight Committee’s inquiry into YRCW’s CARES Act loan.

Centaur Investments believes that, currently, the pandemic and uncertain economic recovery present a greater near-term risk to shareholders than the Oversight Committee’s inquiry. Nevertheless, it is nearly impossible to predict which direction speculators will send YRCW’s stock price in the event that any one of the above-mentioned downside catalysts materializes. The absolute worst case scenario for shareholders involves the Oversight Committee attempting to alter the terms of or revoke altogether the company’s CARES Act loan package. However, that outcome seems highly improbable. In our opinion, downside risks 1-4 from the list above are far more realistic and could trim about 37% from YRCW’s current 5.6x EV/EBITDA valuation. Such an event could send the shares down to about $2.50 from the current $4 share price. (Rough Calculation: 5.6 x 0.63 = 3.53; $4/5.6 = 0.71 x 3.53 = $2.52)

Closing Remarks

We are experiencing a strange investment environment as Robinhood traders bid up bankrupt companies like Hertz, and support stock prices of much riskier non-essential businesses like travel and hospitality, casinos and entertainment, and energy companies which will exit this recession many times more seriously over-leveraged than YRCW. Yet these companies generate more investor interest and attract valuations substantially higher than this large LTL carrier trusted by the U.S. Department of Defense. At just $200 million, the company’s current market capitalization is far less than the value of its physical assets and cash balance of nearly $700 million.

While some investors may see YRCW as a company that was well on its way out of business long before this COVID-19 induced economic downturn, the arguments presented in this article dispute those views. Further, the substantial volume of supporting evidence proves that YRCW’s has come a long way since the 2008 financial crisis. The fact remains, management was in process of executing a massive multi-point and multi-year strategy, and far along on the path towards achieving sustainable profitability precisely when the pandemic hit.

Yet despite all the publicly available material presented throughout this article, speculators continue to mistakenly write the company off as though the entire $700 million CARES Act loan were simply to plug a hole in their payroll. Watching the shares peak at $4.50 in pre-market trading and sell off below $3 immediately following the CARES Act loan announcement was absolutely baffling. The following week, NASDAQ regulators had to add the company ticker to their short sale-related circuit breaker twice due speculative attack on the shares. Though daily short interest has declined to 10% from the +21% observed throughout June and July, speculators continue to take the stock down after every positive announcement for no apparent reason.

So, why exactly are the shares trading so erratically and seemingly detached from reality? As stated multiple times throughout this article, Centaur Investments believes it is due to a serious case of collective cognitive bias that dates back to the 2008 financial crisis. The bias is so widespread, even experienced industry insiders believe in serious misconceptions about the company.

In closing, we would like to share that YRCW’s case is so bizarre and complex that our thesis had to be broken out into two parts. If you made it this far, you have just completed part one. We shared an updated 15-point thesis and the supporting evidence necessary to argue why we firmly believe YRCW will be continuously repriced higher by the market. We also shared the intuition behind our estimated equity valuation of the business and $8 price target, and also discussed the inherent risks to this investment opportunity.

Part two will address YRCW’s leverage, pension funds, Congressional Oversight Committee inquiry, and pending Department of Justice Lawsuit decision. It will also introduce a newly developed behavioral finance component of our long thesis. This behavioral component casts a spotlight on several cognitive biases we believe contribute to the extreme share price discount by exploring and refuting the most popular bearish views towards YRCW. In the meantime, feel free to sound off in the comments below, send a direct message, and follow Centaur Investments on Seeking Alpha for regular updates.

Disclosure: I am/we are long YRCW, AND SHORT JBHT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Past performance is not an indicator of future performance. This post is illustrative and educational and is not a specific offer of products or services. Information in this article is not an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented is believed to be factual and up to date, but I/We do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author(s) as of the date of publication and are subject to change. Please conduct your own due diligence prior to investing in any of the securities mentioned in this article.