XPO Logistics Inc (NYSE: XPO) generated a below average return on equity of 9.0% over the past twelve months, while the Industrials sector returned 10.1%. Even though XPO’s performance is subpar relative to its peers, it’s useful to understand what’s really driving the company’s low ROE and how it’s trending. Understanding these components may change your views on XPO and its future prospects.
XPO’s Return On Equity
Return on equity represents the percentage return a company generates on the money shareholders have invested. Return on equity or ROE is defined as follows:
ROE = Net Income To Common / Average Total Common Equity
A higher return on equity suggests management is utilizing the capital invested by shareholders efficiently. However, it is important to note that ROE can be “manufactured” by management with the use of leverage or debt.
XPO’s historical ROE trends are highlighted in the chart below.
source: finbox.io data explorer – ROE
It appears that the return on equity of XPO has generally been increasing over the last few years. ROE increased from -10.6% to 2.1% in fiscal year 2016, increased to 9.0% in 2017 and the LTM period is also its latest fiscal year. So what’s causing the general improvement?
What’s Driving XPO’s Improving Return On Equity
The DuPont analysis is simply a separate way to calculate a company’s ROE:
ROE = Net Profit Margin * Asset Turnover * Equity Multiplier
Created by the DuPont Corporation in the 1920s, the analysis is a useful tool that helps determine what’s responsible for changes in a company’s ROE. It highlights that a firm’s ROE is affected by three things: profit margin, asset turnover, and its equity multiplier or financial leverage.
Analyzing changes in these three items over time allows investors to figure out if operating efficiency, asset use efficiency or the use of leverage is what’s causing changes in ROE. Strong companies should have ROE that is increasing because its net profit margin and/or asset turnover is increasing. On the other hand, a company may not be as strong as investors would otherwise think if ROE is increasing from the use of leverage or debt.
So let’s take a closer look at what’s driving XPO’s returns.
XPO’s Net Profit Margin
A promising sign for shareholders, XPO’s net profit margin has increased each year since 2015. Margins increased from -3.2% to 0.4% in fiscal year 2016, increased to 2.0% in 2017 and the LTM period is also its latest fiscal year.
As a result, the company’s improving margins help explain, at least partially, why ROE is also improving. Now let’s take a look at XPO’s efficiency performance.
XPO’s Asset Turnover
It appears that asset turnover of XPO has generally been increasing over the last few years. Turnover increased from 0.99x to 1.20x in fiscal year 2016, increased to 1.27x in 2017 and the LTM period is also its latest fiscal year.
source: data explorer – asset turnover
Therefore, the company’s increasing asset turnover ratio helps explain, at least in part, why ROE is also increasing.
Finally, the DuPont constituents that make up XPO’s ROE are shown in the table below. Note that the table also compares XPO to a peer group that includes FedEx Corporation (NYSE: FDX), United Parcel Service, Inc. (NYSE: UPS), Radiant Logistics, Inc. (NYSE: RLGT) and C.H. Robinson Worldwide, Inc. (NASDAQ: CHRW).
source: finbox.io’s DuPont model
In conclusion, the DuPont analysis has helped us better understand that XPO’s general improvement in return on equity is the result of steadily improving net profit margin, an improving asset turnover ratio and declining leverage. Therefore when looking at the core operations of the business, XPO shareholders have reason to be excited due to the company’s steady improvement profitability along with a general improvement in operational efficiency and declining leverage.
The DuPont approach is a helpful tool when analyzing how well management is utilizing shareholder capital. However, it doesn’t necessarily tell the whole story. For example, how do the company’s ROE trends compare to its peers or sector? How about in absolute returns? I recommend that investors continue to research XPO to gain a better understanding of its fundamentals before making an investment decision.
As of this writing, I did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.