Larkin Says: As the capacity shortage continues to challenge supply chains, players who are in a position to help shippers and receivers are better positioned than ever to add incremental value. What Do You Say? Click Here to Send Us Your Comments Click Here to See Reader Feedback

New Expert Insight Column on SCDigest: We have partnered with Stifel Financial Corp. to publish its weekly recap of the week in transportation, written by well-known analyst John Larkin. Check the SCDigest home page each Monday morning for the latest edition.

For the full pdf of this research note, including all the graphics, click here.

Key Insights from This Week's Fundamental Research:

• Tight capacity has created a favorable pricing environment for freight brokers and truckers. One thing that has become evident about life in America since the Great Recession is that regardless of how bad things get we will eventually figure out ways to generate more and more freight. In parallel, our ability to supply the capacity required to move that freight is decreasing as less people choose trucking as a career and those driving are increasingly constrained by regulation. Exclusively using driver pay as the lever to add back capacity seems unrealistic as retailers are beginning to balk at the rate increases above and beyond what they've conceded over the past year.

• Those who can leverage technology and operational efficiency to increase capacity are well positioned to gain a strategic advantage moving forward. Eliminating the inefficiencies within the system would seem to require robust technological solutions. For brokers the challenge is to optimally allocate loads to carriers while also considering their routing and future likelihood of a profitable load from a reliable shipper being at their destination; unfortunately this is a monumental challenge. For truckers the challenge is to effectively price, load, and route freight so that customers can enjoy predictable on time delivery; also not easy. Those with premier, continuously improving systems are best positioned to successfully drive further industry consolidation.

Investment Conclusion: As the American economy continues to grow, despite recent warning signals from Asia and Europe, we remain optimistic over the long term, on the transportation & logistics space. As the capacity shortage continues to challenge supply chains, players who are in a position to help shippers and receivers are better positioned than ever to add incremental value. Among our Buy rated names, we believe XPO Logistics (XPO; $37.49), Universal Truckload Services (UACL; $26.34), Swift Transportation (SWFT; $27.23), and Celadon Group (CGI; $21.64) are well positioned to help customers operate supply chains effectively in a transportation and logistics environment challenged by an uneven economic recovery, a worsening driver shortage, and aging, deteriorating infrastructure. Additionally, Quality Distribution (QLTY; $12.25), a bulk tank trucking operation is among our Buy rated names and a good way to play the chemical renaissance currently underway in the U.S., in our view.

Key Insights From the Analysis of Industry Data Feeds

Trucking:

• Spot demand was up on a sequential basis in Week 46. The ITS Market Demand Index (MDI) measured 15.52 in W46 (up 2.9% sequentially). Load-to-truck ratios on DAT were up sequentially in reefer, though flatbed continued its steady decline. Dry van was flat at 3.0x. Reefer showed a significant increase (up from 9.2x in W45 to 9.8x in the current week). Flatbed declined from 16.8x to 15.1x - after having been as high as 50.9x in June.

• Spot rates followed a mixed trend. On DAT's load board, rates were down sequentially in both dry van and flatbed, while they were flat in reefer. On ITS' load board, the overall equipment rate was up $0.03 from the prior week to $2.22. By segment, the trends were in contrast to those noted on DAT - dry van, reefer, and specialized were up while flatbed was down. For all segments and on both load boards, however, rates remain elevated y/y.

• Spot demand has been a bit more tepid in recent weeks than is generally seen in the fall. Spot demand could easily drop below 2013 levels in the 4Q, as imbalanced networks have begun to normalize and as UPS indicated it will not be caught without sufficient capacity this year - no matter what.

Rail

• Class I commodity carloads were down 0.8% y/y during W46. CN, UP, and BNSF performed the softest with
carloads down sequentially by 8.2%, 2.6%, and 1.9%, respectively. Though, despite CN's poor performance on the week it leads the QTD period in y/y carload growth, up 8.4%. Compared to last year CSX has yielded the strongest performance with 6.8% y/y carload growth. In QTD sequential terms (i.e. 4Q14 versus 3Q14) CP and BNSF have had the strongest performance, up 8.0% and 4.3%, respectively.

• Among all Class I rails, the best performing commodity group in W46 in terms of total volume increase was
stone/sand/gravel. Petroleum also remains strong, while a large drop in pulp/paper/lumber and "all other" had a
noticeable impact on total carload volume. Grain remains the worst performer, as the comps are tough against the 2013 bumper crop.

• Intermodal volume was up 0.8% y/y on the week. CP's volume was the most surprising, after having been down 12.2% sequentially in W45, rebounded with a sequential increase of 7.1%. A portion of the previously negative comp is due to the loss of a contract, which was known. Last week, labor issues at the port in Seattle-Tacoma led to delayed ships to the Port of Vancouver. On top of that, some impact was seen from Golden Week in China (holiday occurred in October, but impact is delayed as a result of shipment time). So, it appears that previous drop offs in volume were temporary delays and appear to be recovering (Exhibit 11).

• Total unit volume (i.e. commodity carloads & intermodal units) showed a sequential decline, down 0.1% from W45 but still up 1.3% y/y, largely thanks to strength on the CN.

• Class I performance metrics still remain at depressed levels. High carload demand, matched with infrastructure
challenges have made a correction near impossible. For the 4Q14-to-date, velocity is down 6.9% y/y. Terminal dwell is up 14.0%, and it appears that this congestion has spread east as CSX and NSC are both struggling to deal with strong volume surges in the back half of the year. Cars on line are up 14.0% QTD y/y, with BNSF the largest contributor.

• Over the prior ten years, the rails have generally traded at a premium to the S&P 500 on a P/E basis. In the last nine months, that premium has expanded significantly, and the rails are now collectively trading at a 20% premium to the broader market. Among the specific railroads, CP and KSU are commanding the highest premium, while NSC is receiving the lowest.

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