XPO Logistics and the US Freight Brokerage Industry

On September 9, 2015, XPO Logistics announced that the company would be completing its second major acquisition of the year, purchasing Con-Way for around US$3bn.

Following hot on the heels of the company’s takeover of Norbert Dentressangle in June, this latest purchase means that XPO will become the second largest provider of less-than-truckload (LTL) services in North America, as well as the world’s second largest contract logistics company.

Though these milestones now represent global achievements, with the company gaining a strong position in Europe and decent exposure to Asia, the impact of this latest move will be most keenly felt in the United States. The chief reason for this is that it reflects an increasing push to exploit the North American road freight market, and in doing so, drive consolidation in the industry; a hallmark of XPO Logistics’ CEO Bradley Jacobs.

Road freight is typically a low margin business, particularly when there are few value-added activities involved in providing the service. However, freight brokerage, the sub-segment of the market that XPO Logistics is targeting for expansion, represents a high growth area of opportunity, at approximately 2-3 times US GDP, with significant operating profit margins; for example, the industry leader, C.H. Robinson, achieved an EBIT margin of 5.56% for the 2014 financial year.

Growth in this industry is chiefly a product of two main trends; logistics outsourcing and technological advancement.

Outsourcing

Firstly, logistics outsourcing shows positive signs for growth, with demand for logistics providers remaining high.

This creates two benefits for freight brokers. Firstly, the continued increase in demand for service is in itself a good thing for business, and secondly, the ability of brokers to provide shippers with cost savings is a strong incentive to choose a broker rather than opt to go straight to a carrier.

In essence, this model is based upon bargaining power; by aggregating customer orders as a collective, a broker has greater overall bargaining power than its individual customers, and is therefore able to negotiate a lower rate for each individual shipper, by offering greater volumes to carriers by way of compensation.

This attraction is typically more relevant to smaller shippers, however, there are also benefits for larger customers, as a result of the second major trend in freight brokerage; technological advancement.

Technological Advancement

Advancements in cloud computing have enabled more rapid and sophisticated transportation management systems. Such technology has allowed freight brokerage to advance by accommodating the systems necessary to coordinate the activities of shippers, brokers and contractors, whilst also deploying a greater degree of visibility than has previously been viable. This is also a trend impacting upon other areas of logistics with similar characteristics, such as freight forwarding.

It is this point regarding visibility which has particularly increased the attractiveness of freight brokerage to larger shippers, who now see greater service value in the industry. This is particularly compelling when the companies involved are well recognised players within the industry, such as C.H. Robinson.

IT is now a major part of the game, and it is in recognition of this fact that Bradley Jacobs stated the following at the 2014 Automotive Logistics Global Conference: “what are we? We are an HR company, an IT company that happens to be servicing transportation companies.” XPO Logistics employs approximately 1,000 IT professionals, and disclosed that its 2015 IT budget amounted to $225m.

Threats to the Industry

At this point, whilst I am cheerleading the growth of this industry, there is a looming threat that may halt its expansion, or at least slow it; the truck driver shortage.

Essentially, the issue here is one of supply and demand. Industry executives and analysts have been warning about a shortage in the labour market for truck drivers for some time now, due to factors such as low pay and a lack of interest in the job. This scarcity presents a significant cause for concern amongst brokers.

The simple reason for this is that, as asset-light middlemen in the logistics industry, brokerage companies make their profits by winning contracts for freight transportation at one price, and subcontracting that activity to small trucking companies or owner-operators at a lower price. Ultimately, the ability to offer this business to subcontractors at a lower price is predicated on there being a lot of competition for business amongst the subcontractors, and this in turn is derived from a surplus of labour; ie, the business model relies on rival subcontractors competing for the same business, thus attempting to undercut one another in a race to the bottom.

This is only possible however, when there is a surplus of contractors. When the contractors are few, each has a greater incentive to demand a higher price for their services, as the broker is presented with fewer alternatives to drive the price down. At such times of tight capacity, the broker is forced to accept this higher rate in order to fulfil its customer contracts, though in doing so, will therefore engender smaller profits, unless it raises prices.

Faced with this scenario, which is moving further from the realm of the hypothetical and closer to reality, XPO Logistics’ acquisition of Con-Way begins to make a lot more sense. Here is a purportedly asset-light firm, but now it can safeguard its main business by deploying ‘guaranteed capacity” in the form of its own fleet of trucks, whenever capacity tightens. In this way, XPO hopes to be able to navigate periods of tight capacity in the market by reallocating a substantial portion of order volumes to its own assets, thus ensuring that a certain degree of profitability is attainable.

The company will then be able to use its more flexible brokerage capabilities when labour supply rises, and go back to earning greater margins; the incentive that attracted the company to the business in the first place.

This is an astute move, given that the solutions for labour scarcity are few. One measure that should alleviate the situation is the opening of the US border, in order to allow competition from Mexican truck drivers. Such a move would theoretically prompt an influx of capacity into the market, which would in turn relieve capacity constraints.

Although the charter of the North American Free Trade Agreement (NAFTA) stipulates that Mexican truck drivers are allowed to operate across the country’s border with the USA, full implementation of this guarantee has not been forthcoming from the American side until very recently.

The reasons for this are deeply political. The American trucking unions have been vociferous in their opposition to such measures, as this would in effect, drive down their earning potential by introducing greater competition for services. Another salient trend is the atmosphere of anti-immigration rhetoric whipped up by American politicians, who aim to use popular discontent as a way of promoting their campaigns.

Improvements are on the way though, as it was announced in January 2015 that Mexican drivers who qualified for permits would be allowed to cross the border and operate long-haul in the United States. This will be an evolutionary process however, with the permits system in itself holding back a significant number of drivers (for good or ill), and border checks causing significant delays.

Moreover, the benefits of this liberalisation are likely to be highly regionalised, as a result of two factors; geographical proximity, and the rise in intermodal traffic, which currently bypasses most of the issues associated with the border crossing anyway.

The second initiative which could help combat the shortage is an improvement in driver retention. Whilst Con-Way has been notably successful in this area, many other trucking companies have struggled to retain drivers, posting a significant turnover. The solutions to this issue, however, are mainly based around making improvements to the working conditions and compensation of drivers, and as such, necessitate an increase in spending; thus reducing profitability further, exactly the situation freight brokers are attempting to avoid.

As such, capacity is set to become a problem. Therefore, the situation likely to unfold will be one characterised by M&A. This will in turn lead to two successive outcomes; consolidation, and competition.

At the moment, C.H. Robinson is still far ahead of all rivals in the industry, in revenue terms, but there is a pattern of expansion forming, with XPO joined by UPS (who acquired Coyote Logistics), and Kuehne + Nagel (ReTrans), among others. As Bradley Jacobs himself stated, the industry is currently “begging to be consolidated”, with an extensive number of medium sized companies currently operating in the market, and M&A in the logistics industry as a whole currently at a high point.

The inescapable consequence of this will be more intense competition between the major players, with the potential for new entrants likely to be dictated by their financial clout and technical capabilities. Expertise in the latter could see competition arising from unlikely sources, as with Uber in the taxi industry.

As of now though, it is far too early to say who will come out on top. Nonetheless, with each of the companies mentioned above turning over annual revenues in excess of $13bn per year, the battle for market share is shaping up to be a clash of titans.

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