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3PL Part 1 – Overview

June 27th, 2012 | Posted by Torin in Logistics

I recently wrote up my investment thesis for Radiant Logistics (AMEX:RLGT) on the Monte Sol website as well as on www.SumZero.com. The write-up is a succinct case for investing in RLGT. I’ve done a lot of research on the third-party logistics (“3PL”) industry, but for brevity’s sake I excluded most of it from the write-up.

So I’m going to use this blog as a place to expand on that research. I think the 3PL industry—but only a part of it—is going to make some smart investors and business people very wealthy in the coming years. The purpose of this series of posts is to explain which part and why.

3PL Part 1 – Overview

Third-party logistics, or “3PL”, involves arranging the transport and/or storage of someone else’s goods. Third-party logistics companies serve as middle men between companies that want to have goods moved (the customers) and companies that do the moving (the shippers). If you, the reader, want to ship a parcel somewhere, all you have to do is take it to UPS, FedEx, or DHL. But what if you want to ship a truckload of goods from Seattle to Bozeman? Who do you call? There are more than one million trucking companies in the United States. And what if your shipment’s destination is not Bozeman but Bangladesh?

Or let’s say you run a small or mid-sized business. Your company is great at designing products, or selling products, yet you seem to spend a lot of your time, money, and energy just figuring out how to move your inventory from the port to the warehouse to the retail location. Isn’t there someone who can take care of all of that so that you can focus solely on your products and your customers?

Enter the 3PLs. These are companies that don’t typically own transportation assets like trucks and containers. Instead, they have relationships with thousands of shippers—trucking companies, railroads, and air and ocean cargo companies. The most common type of 3PL is a freight broker. A freight broker evaluates its customer’s shipping needs and then polls its own network of shippers with whom it has relationships, in order to figure out how to get the cargo to its destination cheaply and on-time. In some cases this might involve just one shipper, and in some cases it might involve multiple shippers and multiple transport modes (ocean then rail then truck, for instance).

Different brokers are good at different things. Some brokers focus on trucking while others focus on air freight. Some focus on domestic freight while others focus on cross-border freight. Some focus on slow-moving freight while others focus on time-definite freight. Some focus on the food industry while others focus on autos. And so on. In some cases freight brokers contract with shipping companies on a freelance basis, and in some cases the two parties have an ongoing, or even exclusive, arrangement. The same is true for the customer-broker relationship. Sometimes the two parties only transact a few times a year, and sometimes they do business together every day. It all depends.

Freight brokers serve a number of purposes. The most fundamental purpose is the aggregation and matching of supply and demand. The brokers obviate the need for each customer to call each shipper, something which would be terribly inefficient. Brokers also increase customers’ purchasing power by pooling orders, and decrease costly “deadhead” miles by finding secondary shipping customer who have cargo to ship ‘back’ on the return journey. As compensation for their services, brokers take a cut of the shipping fee, typically 20% or so.

In addition to brokers, there are many other types of 3PLs as well. Freight forwarders, for instance, assemble cargo from multiple shipping customers into one load in order to take advantage of bulk shipping rates. Customs brokers take care of the customs process for cross-border freight. “Reverse” logistics 3PLs handle product recalls, refurbishment, or recycling for their customers. At its most complex, third-party logistics can involve the outsourcing of virtually the entire supply chain, up to and including warehousing, distribution, and even light assembly.

Armstrong & Associates, an independent research firm dedicated to the 3PL industry, estimates that the U.S. 3PL market is about $140 billion in size on a gross revenue basis. “Gross” revenue refers the total cost of shipment, including what is paid to the shipper, as opposed to “net” revenue, which refers only to the broker’s ~20% share. So while gross revenue is ~$140 billion for the 3PL industry, the actual share of revenue kept by the 3PLs is probably closer to $30 billion.

A&A breaks down the 3PL industry into four subsectors: domestic transportation management (about $40 billion in size on a gross revenue basis), international transportation management (also $40 billion), value-added warehousing ($35 billion), and dedicated contract carriage (~$10 billion), which is essentially another form of domestic transportation.

Despite being quite large, the 3PL industry has grown at an impressive 11% CAGR for the last fifteen years, even with the interruption of the global financial crisis. Growth has been driven mainly by two things: the increasing globalization of trade, and greater adoption of supply chain outsourcing by large corporations. In 2001 only 46% of Fortune 500 companies used 3PLs, but by 2008 that usage rate had increased to 77%, and my guess is the rate is probably closer to 85% today. The chart below, which is in billions of U.S. dollars, provides a good visual representation of the industry’s growth.

The 3PL industry is extremely fragmented. Domestic U.S. trucking is a $650 billion business, yet C.H. Robinson (CHRW), the largest truck broker in the U.S., generates just $9 billion of gross transportation revenue. That means it only brokers 2.5% or so of U.S. truck freight. Landstar (LSTR) is probably the second-largest truck broker in the U.S., and its $2.7 billion of truck brokerage revenue accounts for less than 1% of total U.S. truck freight.

Why is the industry so fragmented? There are many reasons, but the big ones seem to be the fragmentation of the trucking industry itself (there are more than 1.2 million trucking companies in the U.S., and 90% of them operate less than seven trucks) and the cost of growth to brokers. The first reason is fairly self-explanatory: since the trucking industry is fragmented, the truck brokerage industry, which has grown up alongside it, is too.

The second reason, the cost of growth, bears a little more explanation. Most small brokers cannot grow quickly because they cannot fund the associated increase in working capital. Freight brokers extend credit to their customers as an inducement to do business. A consequence of this practice is that when a broker books a load of cargo, it must pay the shipping company before it receives actual payment from the customer. As a result most freight brokers have accounts receivable balances (which is the money owed to the broker by its customers) that are 50% to 100% larger than their accounts payable balances (the money the broker owes to shipping companies).

Why is this such a big deal? Well, the receivables/payables difference is usually equal to about 5% of gross sales. Take a small broker with $50M of gross revenue and $1M of EBITDA (2% margin). If this broker’s sales grow by 30%, to $65M, the increase in working capital is going to be about $750k (the $15M increase in sales multiplied by the 5% accounts receivable/payable difference). Because this fictitious broker’s $1M of EBITDA equals about $500k of after-tax income, growing 30% in a year actually requires more incremental working capital than the business itself produces in profits.

This is a difficult problem for small brokers to overcome, and makes it hard for small brokers to grow large. The only obvious solutions are to A) increase sales or profit margins and thereby profits, or B) establish a relationship with a large and willing lender. Unfortunately for the small brokers, both of those things are hard to do without having size and scale in the first place.

Because growing as a freight broker is so hard when you’re small, the industry has tens of thousands of tiny brokers that each focus on one or a few shipping lanes and/or shipping modes, but relatively few large brokers with global, diversified service offerings. That leaves the industry ripe for consolidation, something I am going to talk about in more detail in future parts.

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