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Landstar: Hauling More Profits

By Jim Corridore Since we see strong price-appreciation potential in the shares of Landstar System (LSTR

; recent price: $42.70), we have Standard & Poor's highest investment recommendation of 5-STARS, or strong buy, on the transportation company's stock. In our view, the business has a superior operating model, along with strong revenue and earnings-growth potential. We expect the company to continue increasing earnings per share, return on equity, and return on invested capital faster than most peers. These factors should reward Landstar with a higher valuation than the stock is currently receiving.

Our 12-month target price for the stock is $55, derived using a combined relative and intrinsic valuation analysis. Our target price implies potential price appreciation of about 30% over the next 12 months, which we think would significantly outperform the S&P SmallCap 600 Index as well as the S&P 1500 during the same period.

Given the transportation sector's cyclical characteristics, investors generally rotate out of these stocks when the economy seems ready to slow. However, S&P thinks the current expansion should continue at least through 2006, making it less likely that Landstar will see a contraction in its valuation over the next 12 months. Instead, we believe the valuation is likely to expand, as investors come to appreciate Landstar's non-asset-based model and to value the company more in line with other non-asset-owning peers in the logistics sector.

BIG LOADS. Year to date through Nov. 4, the S&P Trucking Index fell 1.6%, vs. a 0.7% rise in the S&P 500 and a 1.4% increase in the broad-based S&P Composite 1500 Index. Over the same period, Landstar's stock appreciated 8.2%, outperforming both indexes. Given the factors we discuss below, we believe Landstar should continue to outperform the market and its peers over the next 12 months and show significant price appreciation over that time.

Landstar operates primarily as a non-asset-based provider of truckload (TL) transportation services throughout North America. Truckload carriers transport large shipments, which are generally the only items on a particular truck, from origin through destination. This is distinguished from less-than-truckload carriers, which generally carry smaller shipments from several customers on the same truckload.

Landstar also provides multimodal transportation services, which involves arranging for cargo to be transported over more than one mode of transportation, including air, truck, rail, or ocean.

LOW EXPENDITURE. The company's operating strategy, which we believe is a major competitive advantage, is to limit investment in fixed assets as well as fixed costs by using independent owner-operator drivers and commissioned sales agents. This means Landstar doesn't own any trucks itself. Instead, it contracts with independent owner operators as well as other trucking companies to transport goods.

Landstar compensates its independent contractors with a fixed percentage of the revenues generated per load. In addition, commissioned sales agents are compensated with a percentage of the gross revenue on a shipment, while other third-party truck capacity providers (outside trucking companies) are paid a negotiated rate for each load they haul.

While Landstar does share revenues in this manner, we think the benefits vs. the traditional business model of owning fleets and hiring salaried workers are significant. The company is able to sharply cut its investment in equipment, which means extremely low capital-expenditure requirements. Its business-capacity owners (BCOs -- Landstar's terminology for its independent owner-operators) are responsible for expenses, including fuel and insurance, which limits the company's exposure to rising and falling oil prices.

MALLEABLE MODEL. The system also allows Landstar to have a highly efficient operating structure, as it uses its BCOs on an as-needed basis and doesn't have a fleet of trucks sitting unused during down times. As a result, the company has an almost entirely variable cost model, which can be shifted upward during periods of strong demand or downward during less cyclically strong periods. This is in sharp contrast to the extreme cyclicality in an asset-based trucking model.

Landstar's return on equity (ROE) and return on invested capital (ROIC) over the trailing 12 months ending in the third quarter of 2005 were 52% and 35%, respectively, which we believe is significantly higher than the average of its peers. We attribute this to the company's operating model, strong earnings performance, and what we see as a healthy balance sheet. We expect the company to maintain strong ROE and ROIC for full-year 2005 and in 2006.

Over the past two years, the company has focused on increasing the number of independent agents it contracts with, while eliminating unproductive agent locations. At the end of the third quarter of 2005, Landstar had 1,131 agent locations, up from 1,108 in the year-earlier period.

HURRICANE WINDFALL. During that period, 188 agent locations were added. These generated $23 million in revenues in the third quarter. Over the same period, 165 agent locations were closed. These locations had generated only $543,000 in revenues in the third quarter. The company has said that it has a full pipeline of potential new agent additions, which we expect will continue to aid revenue growth in the future.

At the same time, strong demand for its transportation services, along with price increases aided by relatively tight trucking capacity in the industry, is leading to strong organic growth, in our view. Same-store sales (locations open during both periods) increased 27% in the third quarter.

Overall revenues in the third quarter of 2005 exceeded our projections, benefiting from the company's contracts with the Federal Emergency Management Agency (FEMA) and the Federal Aviation Administration (FAA) for hurricane-related relief. Revenues in the quarter increased 28% (from a year earlier) and included $130 million related to hurricane relief, up from $28 million in the third quarter of 2004. Excluding these revenues in both periods, revenue growth would have been about 13%, which we still see as strong. Given that Landstar doesn't add fuel surcharges to the revenue line like some peers do, we view the quality of revenue growth as high, relative to peers.

TOUGH ACT TO FOLLOW. Despite its low fixed-cost model, we think Landstar has been very successful in improving its operating margins, leveraging a higher revenue base. Operating margins in the third quarter of 2005 widened by 190 basis points, to 8.7%. Third-quarter EPS of 60 cents increased 71% and handily beat our 40 cents estimate.

We expect solid year-over-year revenue growth in the fourth quarter, also related to hurricane relief, strong organic demand, new sales-agent locations, and price increases. For full-year 2005, we forecast revenue growth of 17%, to $2.4 billion. We see full-year 2005 EBITDA margins widening to 8%, from 6.6% in 2004, and EPS growth of 51%, to $1.75, from $1.16 in 2004.

In 2006, the recent high level of revenues related to hurricanes Katrina and Rita is likely to create a tough comparison in the second half of the year. However, we still see strong volume growth, price increases, and new agent additions resulting in 10% top-line growth. We anticipate EBITDA margins widening to 8.4%, from 8%, and forecast EPS growth of 14%, to $2. This excludes any potential revenues and earnings from future disaster relief with either the FAA or FEMA.

QUALITY EARNINGS. Stock buybacks could also help boost EPS growth. Landstar has authorization to repurchase an additional 2.5 million common shares, on top of the 2.9 million common shares the company has bought back in the past nine months.

Landstar initiated a quarterly dividend of 2.5 cents a share in August, 2005. While this dividend is modest, we think the company is likely to increase the dividend rate in the future.

With no defined-benefit pension plan and what we see as restrained use of options, we believe that Landstar's quality of reported earnings is high relative to many transportation outfits we cover. The company's use of options has been stable over time, in our view, and we expect this to continue. We have included our 6 cents per share estimate of the cost of expensing options in our 2006 EPS estimate of $2, so our S&P Core Earnings estimate for 2006 is the same as our operating earnings estimate. For 2005, our S&P Core EPS estimate is $1.69, which represents a 3.4% difference from our operating earnings estimate of $1.75.

EPS RISING. The company is currently trading at a p-e of 25 times trailing 12-month EPS of $1.67 and 24 times our 2005 EPS estimate of $1.75. These multiples are significantly below peers, in our opinion. We estimate the average forward p-e multiple of non-asset-based transportation companies in our coverage universe is 29, based on 2005 earnings estimates.

Meanwhile, we think Landstar is likely to increase EPS at a compound annual growth rate (CAGR) of 18% over the next three years (after growing an estimated 51% in 2005). We think this is faster than the company's peers are likely to grow, on average. Landstar's p-e-to-growth (PEG) ratio is 1.3, based on our 2005 EPS estimate of $1.75 and our 18% estimated EPS CAGR, vs. 1.5 for peers. Giving Landstar a peer-average p-e of 29 times forward earnings, and pushing that valuation out 12 months based on our 2006 EPS estimate of $2 implies a price of $58.

Our discounted-cash-flow model, which assumes a weighted average cost of capital of 7.5%, and cash-flow growth of 18% for five years (after expected 50% cash-flow growth in 2005 on strong expected EPS growth), followed by 10% for the next five years and 4% growth in perpetuity, implies an intrinsic value for the stock of about $52.

Averaging our two valuation calculations, we arrive at our 12-month target price of $55. Our target price implies potential price appreciation of 30% over the current stock price.

SECTOR SHOCK? We view Landstar's corporate-governance practices as similar to other companies in its industry, and not a cause for concern. Among the positive practices, in our view, we like that independent directors meet without the CEO present and comprise the audit and compensation committees. We also don't see the company's stock-option plan as excessive. However, the company uses a staggered board of directors, and former CEO Jeffrey Crowe sits on the board.

Risks to our recommendation and target price include the possibility that tight industry capacity could restrain Landstar's ability to source necessary capacity and make it more costly for the company to do so. A slowdown in the overall U.S. economy could lead to a sector rotation away from transportation stocks, which may lead to a material correction in the stock. Insurance is also a risk, since Landstar is self-insured for the first $5 million of liability per accident. However, as the company recently lowered this from $10 million per accident, this risk has lessened, in our view.

We believe Landstar will continue its recent track record of strong growth in revenue, earnings, ROE, and ROIC. We think it should see some material p-e expansion, as investors come to more fully understand the company's non-asset-based model and value the shares more in line with other non-asset-based peers. We see the company's quality of earnings as high and think that its operating model lessens some of the risks inherent in the cyclical transportation industry.

Corridore follows transportation stocks for Standard & Poor's Equity Research

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