Digital freight companies continue to create an enormous buzz in the market this year, but differently than we initially anticipated. Since Convoy news broke in October 2023, much has changed.
This light-asset segment has seen intense proliferation and growth in the last 10-15 years. During COVID, this sector grew enormously, with robust margins, solid earnings, and widespread digitization. If you look at the last 5 years, 2019-2023, none can be compared as the market rapidly changed from pre-pandemic to COVID surge and now to sub-optimal results. The market has turned upside down with continued margin squeeze, high wage inflation, and volatile volumes. So, what does all that mean for the sector’s mergers & acquisitions (M&A) activity?
EVOLVING FREIGHT BROKERAGE IN NORTH AMERICA
The word “Digital Freight Brokers” is often widely misused, and the brokerage industry has adapted to new technologies and mousetraps. However, these true digital brokers must show superior unit economics than traditional models. Technology alone doesn’t solve all problems – it helps to automate and become more labor-efficient. Brokers must carefully balance tech stack, customer service, and prudent business models.
Significant Venture Capital (VC) and Private Capital have flown into Digital Freight Companies for the past few years, claiming superior technology stack, power to scale market share, and load volumes. Some of these companies have experienced exponential top-line growth. Many of them are unicorns with robust proforma valuations. As the level of outsourcing grows at more than 3-4 times GDP, and more than 70% of the freight in North America moves Over the Road (OTR), the market presents a massive opportunity for building scale and size. Fragmented broker and carrier markets present a unique opportunity to scale and stack synergistic brokers.
Most 3PLs are embracing technology significantly, especially after COVID. Digital freight companies focus more heavily on data than loads, superior unit economics than mere execution, automation than multiple touch points, and seizing market share rather than quality margin management.
Despite the current headwinds, we think this market is poised to go and grow in the foreseeable future. AI, Machine Learning and automation are becoming pivotal in the industry. Even boutique brokerages are getting digitized. 3PL is a labor play. This is Tech and People’s business in Transportation.
THE CONVOY FACTOR
We will hear a lot about Convoy – what happened, and why did it happen? In the next few months, many articles will be written about Convoy and the state of the market in the brokerage space. To move forward productively, it’s crucial to acknowledge how we got here.
Convoy was a victim of a commoditized industry facing one of its deepest recessions in decades. They invested heavily in talent and building a robust tech stack, which was transformational to the industry. Companies like this made the marketplace highly competitive for price and technology. They raised upwards of a billion dollars, and investors put a lot of faith in their ability to grow, scale, and become pivotal as a game changer with a proforma valuation exceeding $3.8B.
While some of these Digital Freight Brokers underinvested to maximize earnings, some invested heavily on the front-end to spearhead growth. Others took a middle approach by starting with cutting earnings power and then speeding up the margin and EBITDA expansion. The latter option gave these companies the best valuation potential.
In Convoy’s case, they focused primarily on growth in top-line revenue and load volumes and underinvested in margin and profit management. They didn’t have to since the VC-backed approach always got them the liquidity and cash flow they wanted. However, Convoy’s debacle results from investors backing off from spot-centric businesses faced with market vagaries. With VC funds drying up over the last 12-18 months, companies who raised institutional money are starting to feel the pressure.
We learnt recently that Convoy’s tech stack has been acquired by Flexport (terms not disclosed). We don’t know without significant brokerage operating business, how Flexport would monetize this going forward.
MACROECONOMIC ENVIRONMENT
Convoy is not alone in this struggle – The sector faces significant macroeconomic headwinds, rising interest rates, and tightening debt and capital markets. Acknowledging how much the market has changed in our efforts to push through to the other side is essential.
While VC activity has minimized and fundraising for private equity groups has been challenged, infrastructure and debt funds are booming in this market. Leveraged Buyouts (LBOs) have also been debated, and as a result, middle-market private equity investors seem quiet in this otherwise buyer-enthused marketplace.
It’s no news that 3PLs have experienced weaker Profit and Loss Statements (P&Ls) with continued pressure on margins, wage inflation, and volume volatility. As the wallet size of customers has shrunk, pricing power has shifted significantly to shippers. Truck Tonnage Index (TTI) has consistently shown a downward trend since March 2023, dropping to an alarming 4.1% in September. Inventory levels have been high, and there is also a shift in consumer spending to services from goods that have affected freight volumes.
Brokers who used alternative funding, such as factoring or banks, are already going offside with their covenants, as the factoring and borrowing options are cost-prohibitive in this high-interest environment. Brokers with loads that do not make enough margins are eroding their meager margins with expensive financing costs. Some financial sponsors that made acquisitions in 2022 and 2023 with high debt components may now have troubles in this environment with compressed margins and weaker EBITDA.
However, all hope is not lost. These significant changes to the financing climate and business environment could allow freight brokers to use flexibility within their business model to adjust to new market conditions with the right approach, and buyers may follow suit. So, now the big question is – What happens next?
NEW APPROACHES FROM BUYERS AND SELLERS
It’s like the real estate market – despite high mortgage rates, houses are still being bought or sold. The same can be said for companies, but the game has changed. Acquisitions in the sector are still active, but not in the ways we are accustomed to seeing. Both buyers and sellers are evolving and taking unique approaches to entering the M&A space.
We are certainly in a buyer-friendly market these days. Buy-side projects are highly active in brokerage, freight forwarding, and value-added warehousing/fulfillment/e-commerce segments. Financial sponsors, especially in the middle market, are quieter than usual but are still active in bolt-on/tuck-in acquisitions rather than looking for new platforms. On the other hand, strategic buyers with solid balance sheets are opportunistic in this current landscape.
For sellers out there, it’s important not to wait – time is of the essence. It’s always a good reminder to focus on “Net Present Value Theory” – value received today is worth more than received tomorrow. Unless a seller thinks their business or fundamentals will change and significantly enhance their value in the short term, it’s time to explore options. Clients and sell-side candidates should proactively prepare their companies to showcase critical metrics and maximize their potential value.
As always, there’s no guaranteed crystal ball to know if the market will turn up and steady in 2024. However, despite the current market, it’s comforting to see buyers and capital are still chasing this light-asset brokerage space.
ADAPTING VALUATIONS & DEAL STRUCTURE
Although widespread strain exists in this market space, we continue to see creative solutions from both sides of the table in the foreseeable future. The method and process to evaluate valuations in this industry will differ with every asset, but arriving at an acceptable method for the buyer and seller is critical.
As the last five years have seen a dynamic P&L trajectory, normalization of earnings has become a major factor in valuing a business. Buyers are skeptical about TTM EBITDA (Trailing Twelve Months) as the FTM (Future Twelve Months) still looks uncertain. This has changed the typical valuation process, which was usually based on a normalized EBITDA, to put the focus on sustainability projections and other vital value-adds.
Putting your best foot forward when presenting premium qualities like a lean business model, diversified customer base, niche or differentiated value proposition, solid management team, value-added programs, and non-commoditized business can now be a major differentiator in helping secure a deal.
In this type of market, structured deals are gaining more favor, and it’s a win-win for buyers and sellers. Such structure includes seller notes, rollover equity, phantom stocks, deferred compensation, and cash at close. Customized structures like this can create added security for both sides as the market continues to stabilize.
Finding the best match to meet both companies’ goals is the key to success, especially now. Laying out a solid market map of highly active, liquid, and symbiotic buyers will ensure the process is more result-focused while increasing the certainty of close. By securing a synergistic partner and de-risking as part of the strategy, owners/founders often find the optimal solution to meet their goals.
Investment Bankers and advisors have to be creative and think outside the “box” to get the deals done.
OUTLOOK FOR 2024
Judging from recent deals like Metro Supply Chain acquiring SCI in Canada, Scan Global Logistics acquisition of ENK Logistics Group and Global Critical Logistics acquisition of Time Frame Logistics, buyers and investors seem opportunistic, wanting to look ahead with accretive acquisitions and spearhead freight consolidation. Have we reached the bottom, or is the bottom near? Indications are container traffic has improved since September 2023 and the market is looking more active. We are cautiously optimistic that the market is turning around with positive signals.
We expect to see a big wave of freight consolidation in 2024 across freight forwarders and brokers, especially in the middle market. After the fall of Convoy, we have seen regrouping in the Truckload brokerage space, and we anticipate sellers to get to the market quickly to hedge their risk and protect their value.
Our deep domain expertise in TL Brokerage space as an operator and banker uniquely positions us to understand the market and best strategize for our clients, maximizing their value. We have seen the resilience of North American and European economies, and as the trade cycle changes, we look forward to a high-velocity M&A environment in 2024.
