Knight-Swift Transportation (KNX) is the largest truckload trucking company operating in North America. Knight-Swift was the culmination of a long sought combination between Knight Transportation and Swift Transportation, two companies that share a long and linked history based on the past relationships between the founders of each firm. The present focus is on building and refining the core business as the company attempts to cross pollinate best practices across both organizations to drive increased efficiency and service.

However, the combination also resulted in the combined company inheriting a longstanding thorn in the side of Swift shareholders in the form of Jerry Moyes’ various transactions backed by the company’s shares. The variable prepaid forward contracts – in essence a form of stock loan – presented the possibility that significant quantities of the company’s shares could be liquidated in satisfaction of the contracts under certain conditions.

Ironically, the market crash resulting from the advent of coronavirus may have saved Knight-Swift shareholders from such a potentially expensive fate and driven a portion of the strong rebound in the shares over the last few months. A large portion of the company’s shares, approximately 17% (refer to page III-35 of the annual report), were pledged by Swift’s founder to back the contracts and other various loans in such a way that a rising share price could have proven devastating to his interests and, by extension, common shareholders. The decline in the share price just as it was about to exceed certain thresholds prevented possibly sizable share liquidations while the expiration of the contracts, so far as shareholders are presently aware, eliminates a significant overhang weighing on valuation.

The Moyes Interests

Annual reports are often littered with boilerplate risk factor nonsense along the lines of the world could end and, if the world should end, the world ending could have a materially adverse impact on our operations and profitability. Ironically, the boilerplate often makes it easier to bury the relevant which contradicts the purpose of having a risks statement in the annual report, but this is a topic for another discussion. In the case of Knight-Swift (and Swift before the combination), one such risk factor has been particularly notable to the Moyes Interests.

In short, the disclosure relates to the extensive leveraging of the Moyes Interests’ concentrated position in the company – which represents nearly a quarter of outstanding shares – and the potential risks for shareholders in the event satisfaction of those loans resulted in a rapid liquidation of a significant block of the shares in the public markets.

Swift, before the combination with Knight, was effectively controlled by Moyes and related entities (the “Moyes Interests”) through a large shareholding position and supervoting shares. A large portion of these shares had been pledged at various times for loans supporting other Moyes ventures which has long been a point of consternation for analysts and shareholders. Swift Transportation’s board rather half-heartedly attempted to resolve the situation from time to time through limitations on pledging shares but these efforts were mostly semantics given Jerry Moyes effectively controlled the company and the board granted frequent waivers (refer to Swift Transportation’s annual report for 2016, pages 26 and 27).

However, a requirement for the combination of Knight and Swift was that the supervoting shares be converted into Class A common shares and that Moyes and the related parties could not pledge the company’s shares in the future in similar transactions thus attempting to limit an indefinite extension of the overhang for the combined company. Nonetheless, the legacy positions continued until their expiration and, despite the share conversion, the Moyes interests still collectively controlled nearly a quarter of the combined company’s shares at the end of the last fiscal year. A full three quarters of those shares were committed to back variable prepaid forward contracts.

In simplified terms a variable prepaid forward contract (VPF) is essentially a loan against a company’s shares to a holder of a concentrated position. The forward contract holder (the lender) typically prepays to the seller (the borrower) a significant portion of the forward contract price per share with the expectation that the forward contract will be settled either in cash or shares at the defined futures contract date. The objective for the seller/borrower is to create liquidity while retaining the concentrated position in the underlying company. The holder/lender often hedges the position by selling short an equivalent number of shares in the open market.

However, volatility in the underlying company’s share price can result in significant risks for the seller/borrower though not those applicable for a more traditional margin loan against shares. A margin loan would result in the risk of loss of the concentrated position if the shares declined in value. However, in the context of a VPF, the reverse is the case as risk for the seller/borrower rises as share value increases.

A simplified example may help illustrate the issue. A concentrated position holder has a position valued at $100 in a company. In order to gain liquidity without selling the position, the holder enters into a variable prepaid forward contract (ignoring the variable component for the moment) to sell the position for $100 at a future date in return for an immediate $80 in liquidity. In the future, on satisfaction of the contract, the seller/borrower could thus either deliver the shares and receive the balance of the forward contract price ($20) or settle in cash by paying back the $80 assuming no intervening change in the share price.

In the event the value of the shares fall, however, to say $50, the seller/borrower actually benefits with respect to the forward contract. The seller/borrower would still receive the balance of $20 on settlement of the forward contract but would only need to deliver either the shares or $50. In combination with the balance of the forward contract price, the seller/borrower only needs to come up with $30 in cash (less than was received initially) to settle the forward contract and keep the concentrated position intact.

However, in the event the share price rose to $200, the situation is far different. In this case, while the seller/borrower would still receive $20 it would be necessary to deliver either the shares or $200 in cash to settle the forward contract. The seller/borrower in this scenario would need to come up with $100 in cash beyond the cash initially received to preserve the concentrated position. Alternately, part of the concentrated position could be sold or delivered in satisfaction, but these outcomes would obviate the original purpose and, likely, result in a repressed share price as large blocks of shares are sold into the market. A large capital gain tax bill associated with the sale of a concentrated position with a low basis (typical for shares of founders) would only aggravate the situation.

Alternately, had the seller/borrower assumed it would be possible to extend the prepaid forward contract by settling through a subsequent forward contract (essentially reborrowing the funds), a settlement in shares or through the sale of shares could be necessary should the borrower either be unable to find a counterparty willing to enter into a new prepaid forward contract or have subsequently entered into an agreement (as was the case upon the Knight-Swift merger) wherein the borrower could no longer hedge or pledge the shares.

Moreover, some VPF agreements include acceleration or early termination clauses based on share prices, in part for this reason, in which case the seller/borrower would either need to come up with cash for settlement before the anticipated settlement date or transfer a portion of shares which would then likely be sold on the open market or, in the event the lender is short the shares as a hedge, to close the short positions.

Indeed, this was the situation which faced the Moyes Interests towards the end of last year and into the beginning of the current year. The floor prices on the Moyes Interests VPF contacts, which represent the minimum amount the seller would receive on settlement of the forward contract, ranged from $43.20 to $45.50 while maturities ranged from March 2020 to July 2020. In addition, the VPFs incorporated a trigger price of $39.53 (at which point the holder/lender could require additional cash deposits for collateral) and early termination price of $41.70 (at which point the holder/lender could accelerate settlement of the contracts). The company’s common shares closing at $37.00 at the end of the year and rising to nearly $40.00 by February risked accelerating collateral payments and possibly settlement of the contracts.

The impact of coronavirus – and the decline of the company’s shares to around $32.50 by the end of March, significantly reduced the risk to the Moyes Interests presented by the rising share price potentially saving shareholders from additional stress and the possibility of liquidation of part of the position. It’s unclear what proportion of the VPF contracts matured during each of the months within the maturity window, but assuming the contracts matured at the end of the month, the gain for the Moyes Interests due to the precipitous slide in the company’s shares could have proven significant and the Moyes Interests may ultimately have been able to settle the VPF contacts with far less cash (or far fewer shares) than would have otherwise been the case absent coronavirus.

The exact impact – and magnitude of any potential risk – will likely never be discernible despite the company’s return to lofty valuations in the last month. Nonetheless, it’s worth noting that the counterparty to the Moyes transactions had indicated that it has sold short substantially all of the shares underlying the VPFs (also per the disclosures on page III-35), thus effectively hedging its position, and the presumable closing of those positions between March and July as the contracts expired likely didn’t hurt share performance in the last quarter.

The Broader View

Knight-Swift is a solid company with a compelling market position even as economic conditions remain comparatively weak. The conditions are reflected in the company’s revenues and pricing power which generally weakened last year and show muted performance in the current year. We expect this relatively lackluster revenue and earnings performance to persist even should earnings rebound on lower competitive freight capacity as lower freight volumes push independent and smaller truckers to the sidelines. It’s difficult to foresee persistently positive earnings growth at a rate which would justify the current valuation. The probable termination of the variable forward contracts against which shares were pledged doesn’t change our view although it does lessen the risks for shareholders on a going forward basis.

Conclusion

Knight-Swift has held up surprisingly well for a company with material exposure to economic conditions and, moreso, price sensitivity to changes in shipping capacity versus shipping volume. We don’t entirely share recent optimism by some analysts that trucking will experience significant strength in the near to intermediate term as overcapacity will likely erode pricing and profitability.

In any case, the present valuation appears rich given the rather fast return to pre-coronavirus levels. A portion of this strength is likely attributable to exogenous factors related to the closure of at least some of the variable prepaid forward contracts. A further boost may be experienced as the balance of these contracts mature through the end of the month (assuming they have not all already matured) though the magnitude is likely to be less significant than in the last few months. However, at nearly 25 times projected current year earnings and nearly 20 times next year’s projected earnings, the company’s shares have exceeded a valuation with which we are comfortable with based on fundamentals and we closed our positions shortly before the company’s earnings report last week in favor of more value oriented opportunities.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.





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