Welcome to the C.H. Robinson third quarter 2014 conference call. At this time, all participants are in a listen-only mode. Following today's presentation, Tim Gagnon will facilitate a review of previously submitted questions. If anyone needs assistance at any time during the conference, please press the star key followed by the number zero. As a reminder, this conference is being recorded today, Wednesday, October 29, 2014. I would now like to turn the conference over to Tim Gagnon, the Director of Investor Relations. Please go ahead.
Thank you, Debbie. Good morning, everyone. On our call this morning will be John Wiehoff, our Chief Executive Officer, and Chad Lindbloom, Chief Financial Officer. John and Chad will provide some prepared remarks on the highlights of our third quarter. We'll follow that with a response to pre-submitted questions we have received after our earnings release yesterday. Please note that there are presentation slides that accompany our call to facilitate our discussion today. The slides can be accessed in the investor relations section of our website, which is located at chrobinson.com. John and Chad will be referring to these slides in their prepared comments. I'd like to remind you that comments made by John, Chad, or others representing C.H. Robinson may contain forward-looking statements which are subject to risks and uncertainties.
Our SEC filings contain additional information about factors that could cause actual results to differ from management's expectations. With that, I will now turn it over to John to begin his prepared comments on Slide 3 with a review of the third quarter 2014 results.
Thank you, Tim. Thanks, everybody, for taking the time to listen to our call. On that slide 3 that highlights our consolidated results for the third quarter of 2014, I'll highlight just a couple of the key metrics that we reference every quarter. Total revenues for the third quarter were up 4.5%. Net revenues grew at 13.9%. The higher net revenue growth was driven by margin expansion that we'll share several comments about to explain further. Income from operations in the quarter was up 15.3%. Net income increased at 16%. Overall, our operating expenses and our income from operations are growing roughly in line with our net revenue growth. There are some variations in the fixed and variable expenses that Chad and I will cover more comments on later. In general, our income grew at the rate of our net revenues.
Our EPS for the quarter was $0.85 compared to $0.69 last year, which represents a 23% growth in EPS for the quarter. As the slide highlights, the variance in the growth in the EPS rate was impacted by a lower effective tax rate this quarter that we'll come back to as well, and our change in capital structure that improved our EPS growth for the quarter. Moving on to slide 4 and our overall transportation results for the quarter. Transportation revenues increased 6.5%, and net revenues were up 14.9% for the third quarter. As we have been for a while, on slide 4, we show a 10-year history of our transportation net revenue margin.
As I've commented in the past, there's a lot going on on this slide because it's total transportation, and it includes not only truckload, which is two-thirds of our revenues, but less than truckload intermodal, as well as our international services. Nonetheless, with all of the margin fluctuations and mix issues that are included, we do find it very helpful to look at the consolidated transportation margins to sort of put the quarter in context to the past. The 16.1% net revenue margin for the quarter, as you can see, represents a 120 basis point improvement from the third quarter last year. If you look at the chart, what you'll also notice is the 14.9% from last year is the lowest number on the 10-year chart here.
While there's a lot going on with cycles and secular changes that we've discussed in the past, the improvement in the quarter to 16.1% represents results that are about the midpoint of the last 10 years from an overall margin standpoint. With that, I think I'll move on to the next slide and talk specifically about truckload transportation. On slide 5, our truckload results for the quarter net revenues increased 15.8% for the quarter and are up 10.6% year to date. The metric that we've been sharing for the last couple of years to try to help understand the margin fluctuations in truckload are highlighted in the upper right-hand corner of slide 5, and they show that on average, our customer pricing for the quarter increased 10% compared to the third quarter of a year ago.
At the same time, our average cost of hire or approximate cost of hire increased 8% compared to the third quarter a year ago. This quarter, similar to what we've talked about in the past with all of the meaningful changes that went on in the truckload market this year, there is quite a range of actual price increases that are driving those averages. Transactional pricing in the quarter continues to be often in excess of 10%, while more committed or contractual pricing averages something more in a mid-single digit type increase. The significant changes in the market with the lack of a lot of surge or flex capacity has resulted in overall price increases, but much more significant price increases for the spot market. The other metric that we talk about is our volume increases. Volume increased 1% for the quarter.
As we talk all the time, taking market share and growing our volume is an important part of our long-term strategy and our approach to the market. We talked at the beginning of this year with all of the meaningful price changes and shifts in capacity in the market, that we were going to be very focused on serving our current customers and serving our committed accounts, and making sure that we are adapting to market conditions. While we would concede that we did not likely take market share during the third quarter of 2014, we think we're doing the right thing to manage our business and to serve our customers, and we still have confidence that in the long term, we'll be able to aggressively grow our volumes and take market share. Moving to slide 6, our LTL results for the quarter. Net revenues in LTL increased 10.6%.
Volumes increased approximately 7%. Similar to the truckload service, demand for LTL services and related pricing both increased during the quarter. In our LTL business, we have both customer-specific pricing arrangements that we work with our customers and our carriers, and we have some general rate tariffs that also have increased. This year, unlike some years, there's been multiple increases to some of those general rate tariffs that are in the marketplace, reflective of the fact that customer demand and pricing in the marketplace continues to increase in the LTL mode as well. We commented on the last quarter and would say again this time that driver shortages and some other cost pressures are impacting the LTL carriers that we interact with more significantly than in previous periods, and that is what's driving a portion of the price increases in the marketplace.
I'd make the comment that since our LTL pricing, especially with the larger customers and carriers, tends to be a little bit more automated, we have a little less margin fluctuation quarter to quarter in the LTL results than we do in truckload. Moving to slide 7, our intermodal results for the third quarter. As you can see on slide 7, net revenue for the quarter increased 3.8%, and volume was approximately flat for the quarter. I've discussed in the past, and we continue this year to work on the operational effectiveness of the committed capacity that we have, as well as managing our network more aggressively. We do believe that we were able to improve our efficiency, and that contributed to the net revenue increase by making sure that we're managing our equipment properly and serving the customers in the optimum way.
It's been talked about a lot in our industry, we were also impacted by the railroad service issues that are happening. For us, because we have a smaller network and are managing it more aggressively, that primarily translates into making it more difficult to increase volumes. We're proud of the service that we're able to deliver our customers, despite some of the service issues that are going on within the networks. Moving to slide 8, our global forwarding results for the quarter, ocean, air, and customs results. Net revenues for ocean increased 15.5% in the third quarter. Air net revenues increased 13.1%, and customs brokerage services were up 24% for the quarter. In our global forwarding business, we are just a couple of days away from our November 1st anniversary of two years ago, when we made a significant investment to acquire Phoenix International.
The global forwarding division of Robinson has been through a lot of change the last couple of years, and as we talked last quarter, we're proud of the fact that despite all of that change and investment that's happened over the last couple of years, we have been able to grow our net revenue each quarter over the last couple of years while all that change and investment is going on. I won't grind through a lot of the integration details again, because I've hit those pretty hard in the past. I would sort of summarize it by saying that we feel very good about our first two years, and our integration plan is largely complete, except for some IT initiatives that are going to carry on into 2015 that are fairly important to continue to make our network operate as one and improve our operating efficiencies.
From a team standpoint and a customer standpoint, the offices are all settled. We have one leadership team, we have one network, and we do feel very good about all that has been accomplished over the last couple of years. We also do feel good about the phases of cross-selling and trying to manage our business more aggressively. We've talked about how in year one, it was primarily focused on service contracts and aligning those offices into one network, and how this year we have begun to move into some more aggressive cross-selling and trying to leverage the investments that we've made over the last couple of years. We do feel like those investments are starting to get some traction. Our growth during the quarter and our increased growth rate is a combination of a bunch of things. There's some more favorable market conditions.
There's some current customers that we're getting more freight from, and we do have some demonstrated success in cross-selling, where traditional domestic customers today are more receptive to some of our global forwarding capabilities and pricing based on our increased capabilities. We feel very good about the results from the global forwarding division, and we feel like we are starting to see some of the return of investment that we've made over the last couple of years. Moving to slide 9, our other logistics services results for the third quarter. Net revenues for the quarter increased 18.5%. From a definition standpoint, again, it's helpful to remind that the primary or the largest source of revenue in this category is our transportation management services. It also includes warehousing and small parcel.
This line item, as I think I've said this every quarter, but it probably bears repeating, that this is one of the more important sources of high growth that we have, because not only does it represent an opportunity for us to continue to expand, and we will continue to invest in it, but many of these services are provided to our larger integrated customers, where we also have significant transportation revenue that's derived from them. It's reflective of the fact that for many of our customers, integrating our services and providing them in a more unified way is an important part of how we're changing and how the market is changing and what they're looking for. Moving on to slide 10 and our Sourcing results for the third quarter. Sourcing total revenues were down 8.9% for the quarter. Sourcing net revenues decreased 2.5% for the first quarter.
We've talked throughout this year about a couple of things, that we had lost some committed business from a larger customer that we are cycling through, and that will continue through the remainder of this year. We hope it to end by the end of the year, based on what we know today. We continue to work through that, which is one of the primary reasons for the decline in total revenues. We also have talked about some of the weather-related issues and some of the commodity challenges that we've had in specific items that have created less margin for us and less opportunity due to freezes and floods in certain categories.
What we experienced during the third quarter of this year is a return to a more normal net revenue margin of 7.6%, which again, is probably somewhere in the mid-range of our longer-term margin expectations for this division. That improvement in margin year-over-year is what led the net revenue decline to be less than our total revenues for the sourcing division. That summarizes the comments on our net revenues and our activities by service line. With that, I will turn it over to Chad for some comments on our income statement and other financial information.
Thanks, John. I'll begin my remarks on slide 11, which is our summarized income statement. As John mentioned earlier, our total net revenues were up 14%, and our operating income was up 15%. Even though we did achieve a little operating margin expansion, our personnel expenses did grow faster than our net revenues. Our personnel expenses increased approximately 20% or $40 million. Approximately $30 million of these dollars of the increase was caused by increased incentive compensation. Our total equity compensation was up $16 million, and our cash and other incentive plans were up $14 million. Our incentive compensation philosophy and plan stayed relatively consistent with previous years. The increase is based on our increased net revenue and earnings growth. Last year, our incentives were extremely low due to our lack of earnings growth. Most of these plans are based on annual performance.
If our earnings growth continues, our personnel expense will likely continue to grow faster than net revenues for the remainder of the year. The remaining $10 million of the increase was driven by approximately 2% average headcount increase compared to last year's third quarter, and also increases in other personnel-related costs, including slight salary increases. Our SG&A decreased 3.6%. This was primarily by reductions in claims expense and travel expense. Some of this reduction in travel was driven by less integration-related travel from the Phoenix acquisition. Moving on to slide 12. We had a strong free cash flow quarter with cash provided by operations of $177 million in CapEx, including investments in software of $6.3 million. Our debt balance dropped from $900 million at the end of Q2 to $845 million at the end of Q3. Again, this reduction in debt was driven by our strong cash flow.
Moving on to slide 13. We are continuing our capital distribution methodology that we described in our investor day last November. Our goal is to distribute 90% of our net income to shareholders in most environments while maintaining our debt-to-EBITDA ratio in the range of one to one and a half times. These distributions will vary based on our cash flow generations, needs for working capital, and other capital needs. When you look at the table on slide 13, you can see that we have a long track record of achieving this goal of cash distribution. During the quarter, we paid $52.7 million in cash dividends and spent $76.8 million repurchasing shares. Our share repurchases tend to be more weighted towards the second half of the year, which is when we tend to generate the bulk of our cash flow for a year.
With that, I will turn it back to John for our closing prepared comments.
Okay. Finishing off our prepared comments, addressing slide 14 and the bullet points around a look ahead and sharing some thoughts about our future. This quarter, similar to the past, when we think about the fourth quarter or the upcoming quarter, the thing that we find the most helpful or correlating in our world is the North American truckload net revenue metric, which we shared to date in October is up 13% per business day when compared to last year. A couple of percentage points less than the third quarter of this year, but very much in line with the same trend around double-digit net revenue growth and very modest volume growth.
About a year ago, we also held an investor day in New York. That walked through, at that point in time, how we were thinking about our business from a strategy standpoint and from a long-term focus standpoint. When we look at the rest of this year and into next year, our team believes that long range plan and that investor deck that we shared a year ago still remains very valid. For those of you who weren't there or want to be refreshed by it is still available at chrobinson.com under the investor deck. I just want to highlight a few of the things that we talked about a year ago and that we still believe to be true in our business that will impact us in the fourth quarter as well as 2015 and beyond.
Discussion over the last several years about the fact that our business is impacted by both business cycles and secular change in our industry, and that it's very difficult to quantify any of those individual variables, and that it's very easy to confuse the two, because the impacts are oftentimes blended together. While we did have some nice margin expansion during the quarter, it is our expectation that those business cycles of supply and demand, particularly in truckload, will continue to happen and that our margins will continue to fluctuate in future periods in a way that are very difficult to predict. In a lot of ways, we think it's kind of our primary mission to not only manage our business but to help our customers manage through both those shorter-term cycles as well as the longer-term secular changes that are happening.
We do have a lot of interaction with customers and shareholders throughout the quarter where we have talked about the changes in the truckload industry and the fact that there today, in some ways, is less surge capacity or less flexibility in the existing capacity than there has been in many previous periods. The fact that driver shortages and regulatory changes and supply chains may be shortening in some instances rather than expanding, there is a combination of cyclical and secular changes that are still going on, particularly in the truckload sector, that will continue to impact our results. Our core message a year ago was that while things are changing and that there are a lot of things happening in our industry and in the marketplace, we did tap down our long-term expectations from a 15% target to a double-digit EPS growth expectation.
I think the deck that's out there does a nice job of explaining why we still believe there is good market share and good long-term opportunity in the services that we offer. A couple of the other things that are important that I want to reaffirm is that it is very important in our long-term strategy that we take market share. I touched on this in the truckload sector, that we have always had a strategy of adapting to market conditions and working with our customers to do what's right for them and what's right for Robinson at the same time. Over a long period of time, it is very important in all of the services, it is our goal to grow and to take share, and that will continue to be a long-term foundation of how we hold ourselves accountable.
We also will continue to invest in new services and expand aggressively where we see the right opportunity. I commented earlier that after 20 years of offering global forwarding services, we made a significant investment to more than double our presence in the global forwarding division. Two years into that, we feel like that's been a very good investment and will continue to be very positive for our customers and for the Robinson shareholders. Expanding and strengthening our network, we do have a lot of initiatives in North America and around the world to better optimize what we're doing, whether it's determining how to best consolidate or route freight, or how to improve transit times for our customers, or to make revenue more available for some of the capacity providers that we work with. Those are some of the keys.
The last bullet point that I want to touch on, though, is the last bullet point on slide 14, talking about our team and our talent a little bit as we head into the remainder of 2014 and 2015. I commented in the past, and we've talked today about our personnel increases and where we're at. As we came into 2014, there were several relevant metrics that kind of shaped our thinking coming into this year. If you look at our three largest divisions within the North America surface trans, we had for about a three or four year period of time in a very balanced market, had been hiring talent at a slightly greater rate of increase than our volume had increased. Volume is the key metric that we correlate a lot of our headcount and talent needs with over time.
While we are proud of our industry-leading efficiency and feel like we were doing a good job, we also knew that we had been adding people fairly aggressively and that we were coming into a period of time where with a harsh winter last year and significant changes in prices, that perhaps it was a prudent way to think about coming into 2015 to leverage some of the experienced talent that we had to serve our customers and be a little less aggressive at going after market share when there were significant market changes going on in the North America truckload market.
We also knew in our global forwarding division that throughout this integration period, that we had done all we could to retain all of the original employees from Phoenix and our legacy forwarding business, and that it had been and still is our goal over time to leverage those resources and become more efficient over time as we improve our processes and become more one network. Similar to the previous year, we felt like there was enough talent and leadership in our global forwarding division that we could go for 2014 without having to add a lot of additional investment. Then in our third largest division, in the sourcing, we talked about the lost business that was there.
All of those things, when you add them up, our leadership guidance and our direction coming into 2014 was that we felt for this year that we could manage ourselves and drive our results without needing to add a lot of talent to our team, which is what you see in our results for the first three quarters of this year. It has never been our long-term strategy to shrink headcount. If you look at that long-term plan that I referenced that is available out there, we talk about people being the foundation of our business. It's a service organization. That absolutely remains true. I think if you look at every successful company in our industry, they are adding people to drive their growth, and we expect to continue to do the same thing. We're very proud of our results for the quarter.
We think we have the best team in the industry, and we're going to continue to invest in that team throughout the remainder of this year and next year, where longer term, we do expect that our headcount growth and our personnel costs will grow in line with our volume and market share gains. We have a lot of productivity initiatives and things that we hope to do to be able to continue to grow our earnings a little faster and try to improve that in the future. At the core of creating long-term value is investing in that team and making sure that we maintain our competitive advantage of an industry-leading position by having the best team that's out there. Those are our prepared comments.
With that, I will turn it over to Tim to take us through some of the questions that have been submitted.
Thanks, John. First, I'd like to just take a minute to thank all the analysts and investors for taking the time yesterday afternoon and last evening to submit some strong questions. We've kind of bundled them or categorized them this morning. John and Chad will respond to some questions that I'll ask them, and we'll get right into that right away here. The first question is for John, and it's picking up on the topic that you just spoke about, and that is headcount. The question reads, why was ending headcount down 103 people sequentially, and what can we expect going forward? How long can we expect headcount to grow slower than volumes and/or net revenues? Which is more important, headcount, volume, shipments, or net revenues?
I did weave some of these into my prepared comments, but I'll reiterate them again because I do think they're fairly important messages that over a long period of time, our investment in talent and people headcount will correlate more with shipment volume across literally all of our services. Adding that talent is a very important growth driver for us that we will be focused on for the remainder of this year and into 2015. As I mentioned, we have a lot of different initiatives to try to continue to make ourselves more productive. As Chad laid out, our variable compensation programs are structured to try to keep our business model in line when our rate of growth of when we add the people varies a little bit.
Okay, thanks, John. The second question's for Chad, and it's on the topic of personnel. How should we think about personnel costs going forward, given the increase of 19% this quarter, primarily tied to variable compensation and increase in the accrual of compensation and profit sharing?
Yeah, I covered this in some detail in my prepared remarks, John mentioned it earlier. It is important to realize that most of our incentive compensation plans are annual plans. Many of these plans are based not only on earnings, but growth in earnings. When you look at last year, profit sharing and some other expenses, bonus growth pools were at zero. This year, as we're experiencing growth, those plans are accruing some expense and some future benefits for our employees. Because of this, our personnel expense is growing faster than net revenue. If our earnings growth continues, that will also continue to be the case in the fourth quarter of 2014. Looking forward to 2015, the year as a whole, if we grow at about the same rate for the year as we grew this year, personnel expense and net revenue should grow closer together.
However, the first quarter of 2014, we didn't have a lot of earnings growth, you could continue to see personnel expenses increasing at a faster rate than net revenue in Q1 of 2015.
Okay, thanks, Chad. The next question is for John. Any change to your long-term growth rate targets?
This speaks to the earlier comments around, yes, a year ago, we did tap down those long-term growth targets from 15% to double-digit EPS growth. In terms of what we laid out a year ago around believing that we can take market share and continue to create long-term shareholder value through double-digit EPS growth, I think we feel very confident that those targets are still valid goals for us to have.
Okay, thanks, John. The next question for Chad. Should we expect a return to a 38% tax rate in the fourth quarter?
Our expected tax rate that we've communicated in the past is 38.5%-39%. Obviously, it was lower this quarter with the $5 million foreign tax credit that was generated through a complex set of situations, but basically by repatriating some foreign earnings, generated some tax deductions this quarter. 38.5%-39% is what we believe our normalized ongoing tax rate should be.
A follow-up question about tax for Chad. Were the tax credits received in the third quarter something that will continue in the coming quarters, or were they one-time in nature?
I don't want to call them one time, but they're unusual and will be infrequent. As I just mentioned, it was a set of pretty unique circumstances that generated such a large foreign tax credit during the third quarter.
Okay. For John Wiehoff, this next question related to truckload volumes. Growth year-over-year in the North America truckload market moderated by 200 basis points from the second quarter, as was represented by Cass Shipments as well, and CHRW followed that trend. However, with so many shippers apparently turning to brokers, one might expect CHRW's truckload volume growth to exceed the overall truckload market. Is CHRW undergrowing the market because of selectivity and what business you take on, or capacity constraints in the market?
I think this question speaks to the challenge of sorting out both longer-term secular and shorter-term cyclical issues that we have woven into our business. As I commented earlier, we have adapted to market conditions that have had us repricing a lot of our freight, and we do believe that our approach to changes in the market has impacted our volume growth this year. Yes, the short-term market cycles and how we're approaching the market, we do believe has impacted our volume growth in the current year. The comment about more shippers turning to brokers and being more receptive to 3PL providers, we do believe that to be the case.
In those long-term goals that I referenced several times earlier, one of the things that does give us longer-term confidence that we can continue to take share and create value in the long term is that trend that we think the 3PL model does have more and more applicability, and shippers are more receptive to it, and that is part of what will enable us to be successful in the long term.
Thanks, John. Next question for Chad. Are you experiencing an improvement because of your ability to reprice contracted volume higher? This related to negative loads. Are you seeing an improvement in your negative loads?
Okay, Tim. Our negative loads or loser loads are down sequentially compared to last quarter, and they're also down year-over-year compared to the third quarter of last year. All of these quarters I referenced are in the high single digits, which is higher than our normalized loser loads. When we look at history, it's closer to mid-single digits. I think there's still some room to go. The improvement, yes, is based on the changes in the marketplace, which have allowed us to raise prices or provided us opportunities to raise prices more than we did in previous quarters.
Okay, next question for John. Can you elaborate on the cross-selling benefits you are seeing from the Phoenix integration, highlighting any wins, and talk to the drivers of strong international air and ocean margins? Trying to understand what impact, if any, procurement synergies are having on the result.
When we acquired Phoenix two years ago, one of the very first things that we focused on, because it's required essentially, is the combination of the service contracts and creating greater scale by putting the combined business together. That was one of the first-year successes around seeing some improved pricing around the combined contracting. There are a lot of things, as you know, that impact the margins around how you route the freight, how you distribute it across those contracts, how you consolidate it. A lot of the things that we continue to work on this year and into the future do continue to have an impact on our cost structure and on our margins around how efficient we are in routing the freight and how effective we can be at generating a margin with that. The procurement side has had an impact on synergy.
Some of it was in year one, some of it continues depending upon how you break down your view towards the cost structure and what we're doing. The benefits of cross-selling go more to the customer side that I talked about earlier. We do believe that we have very strong customer relationships in North America, as I mentioned, for 20 years, we've been selling global forwarding services in the North American marketplace. In those bids that we participate in, like every other service, they are very competitive and there are other providers, and it comes down to price and service capabilities. We've had more success recently cross-selling our services, and we think it's from the improved pricing and service capabilities that we've developed over the last couple of years.
We're just going to continue to focus in on that and drive more and more of our account management relationships to take a look at opportunities where we can get involved in the international freight as well.
Thank you, John. A technology question here for Chad. What is the status of the Navisphere rollout? How far along in the process are you domestically and internationally? Have you given guidance on what level of operating efficiency improvement you expect this system could deliver?
As John mentioned in his prepared remarks, we have a significant amount of work done on the integration of Phoenix onto our Navisphere platform, but there is still work ongoing into 2015. In early or mid-2015, we will be at a point where 95 %+ of our net revenues are running through our Navisphere systems from a financial and an online visibility perspective. Future initiatives will include trying to further integrate and improve some of the functionality within Navisphere to make the system even better, both in foreign locations as well as domestic. As far as the guidance on productivity, no, we really haven't given any guidance, and it's really been happening on an ongoing basis, because we have continuous releases throughout the year that we pick up a little bit of the incremental value as we go.
We're not able to really quantify what we expect the future productivity pickups to be and when will they occur.
Thanks, Chad. Next question, also for you, related to margin. 2014 has been an unusual year with respect to transportation gross margins, as they have risen on a percentage basis through the year. Is 16.1% an appropriate placeholder for 2015? Do you believe gross margins can continue to expand sequentially in the fourth quarter as they have expanded sequentially since troughing at 14.9% in the third quarter of 2013?
Yeah. I would refer you back to slide 4, which shows you a 10-year history of our transportation net revenues by quarter and by year. When you look back there, you'll see that usually the first quarter is the highest quarter for total transportation net revenue. 2014 was unusual to have it be the lowest, and that had to do with the market dynamics and cyclicality. When you look when the market finally shifted and demand started to increase relative to supply, you'll see that we did return to what we would consider a more normal, or as John mentioned, we're roughly at the average of our net revenue margins. What will they do in the future? The market will be a big part of determining that. Is 16.1% a good estimate?
I'd say it's in the midpoint, as far as what happens next year, it would more depend on what happens in the marketplace.
Okay. Thanks, Chad. Next question for John. The publicly traded truckload carriers signaled in third quarter earnings conference calls and releases a continued tightness in truck capacity and an otherwise strong demand environment. Are you experiencing similar outcomes, and can you talk a bit about how these market fundamentals are impacting the truckload brokerage market?
Throughout all of this year, we have continued to see the truck market conditions be a little bit tighter than what we had seen over the previous three or four years prior to that. We do believe and agree with a lot of the truckload providers that are being referenced here, that if you look at the underlying cost structure and demographics of the trucking industry, the driver shortage is a very real thing. The new equipment costs a lot more. There is a lot of cost pressure in the industry. In that difficult-to-predict assessment of supply and demand and where pricing will go, assuming demand stays stable or increases, we do believe that truckload pricing is going to continue to have pressure on it and will continue to rise under the current environment. How is that impacting the truckload brokerage market?
As I said earlier, shippers are very focused, and we are very focused today on having appropriate plans for your known freight or your committed freight, because planning has as big a premium as ever to make sure that in a tight market, you've got the capacity that you needed secured. It also means that where there is surge freight or unexpected freight or transactional opportunities, that it's generally at a much higher price than a committed or contracted shipment would be in today's market. One of the effects of what's happening is it's creating a premium on planning, and that's one of the primary ways that we're working with our customers more aggressively, is to make sure that lead times and route guides are well established and that commitments are understood and worked with.
Doing the best we can to try to serve incremental needs when additional capacity typically has a pretty significant premium to it.
Okay. Thanks, John. Next question, again, for you. How should we think about your plan to build out a European Union truckload operation in light of the disappointing macro data from the region? Are you less interested now, or are you looking to invest countercyclically to be positioned better once the region gets back on track? When do you think this business could become a meaningful contributor to growth, and how should we think about the eventual margin profile?
A lot of good questions in there. For starters, we would validate the notion that the macro data on Europe does translate into some more difficult conditions in the trucking market. It has been pretty difficult the last couple of years, with a lot of declining prices and declining demand on the truckload side in a lot of the parts of Europe, but especially in Western Europe. Combining that with a lot of lower-cost capacity coming in from the East and supply chains changing, it is a pretty difficult environment to grow the business right now. We have not changed our long-term commitment. We've been at it for a little over 20 years, and we do continue to invest in building our European Surface Transportation business by opening offices and by hiring salespeople and going after building a presence in the market.
We have backed off a little bit in our rate of some of those activities, just to make sure that we're investing proportionate to the market demand that is there. From a margin standpoint, I think we've been very open that while we're profitable in Europe, with the scale of the business relative to the overhead and the investment that we have today, it's not anywhere near the North American profitability metrics. Our goal is to continue to invest even in a difficult time, position ourselves to build out our network for better growth periods so that we can be in a good spot to take advantage of the market conditions when they turn, but be prudent along the way to make sure that we're building a strong foundation and being responsible with our expenses along the way.
Thank you, John. Next question for Chad. Did your truckload length of haul continue to shrink in the third quarter?
Yes, it did, both sequentially and compared to last year's third quarter. Compared to last year's third quarter, our length of haul is down about 4%. We believe our length of haul is shortening more than the market is as a total. The primary driver of that is our fastest-growing volume segment is freight of 500 miles or less. A lot of that freight is coming with the increased integrated relationships that John mentioned earlier.
Thanks, Chad. Next question for John. In prior communications, CHRW has targeted 2.5x debt to EBITDA for the right acquisition. Under what conditions, if any, would CHRW consider a purchase that would either be dilutive or exceed this leverage threshold?
We haven't really talked about or explored anything to date that would have us thinking that way. I think, like any company, you probably have to stay open-minded to if the right sort of opportunity came along that we felt could really create value in the long term, but in the short term would be more dilutive. It could possibly be a technology business or something that had less revenue or earnings today, but had a very positive impact on us, or some competitive threat that was more of a defensive move, I think could be likely scenarios where we might consider thinking about different valuation parameters.
The foundation of our thinking has been, and remains today, that if we have confidence in our plan, which we do, that we can create long-term shareholder value by growing primarily organically with some investments that are valued properly and thoroughly integrated into our global network, that that's what our core growth strategy will be.
Thanks, John. Next question is a capital allocation question for Chad. You haven't raised the dividend since the fourth quarter of 2012. For Q4 2013, the first time in a fourth quarter, you haven't raised it since 2007. What can we expect in the fourth quarter of 2014, and when will we hear a definitive announcement?
We've talked about for quite a long time now that our dividend payout ratio target is 45%. You're right, we do tend to raise the dividend for the fourth quarter dividend. The reason why it didn't go up last year is because our earnings didn't grow. When we look forward to the fourth quarter of this year, we will be reviewing our dividend again at the fourth quarter board meeting, and the announcement of what our dividend will be for Q4 of this year will be in early December.
Thanks, Chad. Next question for John. In truck, what was the mix of contractual business versus spot in the third quarter, and how does that compare to the third quarter of 2013?
This is a question that we get often, and the way we have answered it remains valid that compared to some truckload providers or maybe even some other 3PLs in our world, there's not a clean definitional break between contractual and spot market type business. We have a wide variety of commitments and contracts, so we can generalize about it, but it's really hard to put percentages on it. We get a lot of incremental freight from our contracted relationships, and we get a lot of pre-priced opportunities where even though it may be considered spot market freight, there are existing quotes out there, and the freight will move along those existing prices until there's a change in the marketplace, but there's no real firm commitment to do that.
From a generalizing standpoint, what we talked about from really 2010 all the way through 2013 last year, that our business was moving to more and more contracted or committed relationships. The changes this year have resulted in a slightly greater mix of our freight being priced more frequently or fluidly into what we would classify as spot market. Longer term, our estimate had always been that we are roughly 50/50 in terms of a mix of freight, and that during that four-year period of time, up until a year ago, that we were trending higher than that, maybe 60/40 or 70/30, and that this year it's probably trending something back closer towards a more balanced view. Again, that all depends upon your definition and categorization of what's contracted or what's committed versus what is a true spot market opportunity.
Thanks, John. Next question again for you related to intermodal. Does the extremely tight driver situation make you more or less interested in increasing your intermodal presence? Intermodal has obviously had some real challenges with the rail service issues. How is this impacting your business and your thoughts on becoming a more active player in this space? Are you more interested in acquiring an existing player to quickly establish a meaningful presence or leaning more towards building it on your own?
I would say that in general, over the last three or four years, with the changes that have gone on in both the truckload and rail industry, that our appetite for intermodal is probably greater than it was even three or four years ago. It has always been an important part of our portfolio, but particularly in those longer length of hauls and increasing fuel prices and other things like that from just a long-term strategy standpoint, intermodal is as important as it's ever been, maybe slightly more important than versus several years ago. The current environment around railroad service issues and some of the pain that comes with the lessened efficiency of assets that you owned and the way you can serve your customers in this environment points out some of the risk of the business model that it takes to be larger and drive scale advantages in intermodal.
From the standpoint of building it ourselves, we feel like we have done a nice job of improving our operations and becoming more efficient and serving our customers. Growth has been the more challenging part, because every time you grow your network, you have to either invest in some more boxes or look at how you're going to do things differently to kind of drive that growth. I would say we're mixed or neutral as to whether organic growth or acquisition is the right path to go. We've been wrestling with that for a while, and it just kind of comes down to perpetually looking at the opportunities that exist and trying to make a decision on which path forward will help us grow better.
One more for you here, John, on LTL. One of the larger LTL carriers talked about increasing 3PL blanket rates in a similar fashion to the general rate increases. What type of an impact on net revenue margin would this have on your business?
Almost all of the larger LTL carriers that we deal with, we do have what's called a general rate tariff, or a general pricing for customers of all different sorts and classes. As I mentioned earlier, when those LTL providers do general rate increases, they apply to general rate tariffs or 3PL blanket rates. I guess the way the question was phrased would apply to us as well, too. That's very similar to any other transportation offering that we have. When our cost of hire goes up, that impact on us is either that if we do nothing, we have some margin compression. If we're able to pass that along to our customer, we can keep our margins stable by passing that through in the marketplace.
Because a lot of our larger LTL customers do have customer-specific pricing with some of the LTL carriers, it's a little bit easier on the LTL side that I mentioned earlier to make sure that rates adjust simultaneously or at least closer to each other. There's probably just a little bit less volatility in our LTL margin fluctuations, at least for some of those larger accounts. It happens in greater volume versus a single truckload shipment at a time. Basically, it works like the other modes, that when we get those price increases, we have to react to them and see if that causes any changes to our routing or how we might service that account, or if it's an increase that we have to consider trying to pass along to the customer, and if so, can we do that?
The next question is for Chad. Overall gross operating margins are holding at 38% level from C.H. standalone in the 40s. As you noted, there would be pressure with more people-intensive business. Would you expect these levels to hold, or could they accrete as you gain synergies?
Right. Just some background on that. We talked a lot about when we acquired Phoenix. Phoenix's operating income to net revenue was kind of at the industry gold standard or benchmark of 30% operating income to net revenue. In round numbers, that's 10% lower than Robinson prior to Phoenix operating income to net revenue. Phoenix was about 10% the size of Robinson, so that's 1% dilution right there. There's also about an 8% dilution from the increased amortization expense for deal-related intangibles that came with the Phoenix acquisition. That reconciles from 40- 38. I do believe that in most operating environments, this 38% is attainable to continue to generate. If I refer again back to our investor presentation at our investor day last November, if you look at our expected growth rates for net revenue and operating income, they are the same.
There is definitely increased competition. Our net revenue margins going forward will also impact that operating income to net revenue. Generally, going forward, we expect the two to grow together. However, we are managing for efficiency every day and looking for ways to improve that metric.
Thanks, Chad. Next question is for John, related to competition. Can you discuss the current competitive environment in the truck brokerage market, and are you concerned about other participants being willing to do the same business for a significantly smaller margin going forward?
One of the longer-term changes that we've talked about over the last several years is the recognition that the space has become more competitive. There's specific examples of new competitors that exist today that didn't exist five years ago. The challenge for us is to manage all that incremental competition with what we also believe is increased opportunity with shippers and a greater acceptance to the 3PL and brokerage market that exists out there. It is more competitive. It will remain more competitive. We do believe that some of those newer competitors have been very aggressive about going after market share with less focus on profitability and willing to accept less margin than we have been able to earn historically. Obviously, they may be able to do that for a shorter period of time, or I don't know how sustainable it will be.
We also believe that we have some pretty meaningful competitive advantages with our scale and our technology and things that we can continue to leverage. It does put pressure on us to stay that industry leader and to continue to invest and be smart about what we do and make sure that we're pricing competitively with our customers to make sure that we continue to grow with them too. Yes, it's a concern. It's been around for a couple of years now, and I think we're reacting to it, and hopefully, it'll be something that we can manage successfully going forward.
Thanks, John. Next question for Chad around the tax rate. Why did you state that the lower tax rate year-over-year helped EPS by $0.03? The difference between 36.6% and last year's 38% was approximately $2.8 million and divided into the shares, it seems like $0.02 And not $0.03.
Okay. Last year's 38% was slightly lower than our overall expected tax rate. You're comparing it to what was a lower base. The way that we calculated the $0.03 is the actual tax benefits that we believe were unusual were $5 million. That divided by our share count is $0.03.
Okay, thanks, Chad. Next question for John. How do you balance use of cash and paying down debt versus buying back stock? Given the change in the market demand, would you consider further acquisition candidates or not at this time?
We are very much open to looking at acquisitions at this point in time. We are actively looking. As I've said before, we believe that we are appropriate in having a more selective approach to make sure that we do the right sort of deals at the right price and grow our business in a long-term stable way. In terms of what do we do with our cash, we added that capital management strategy slide to the deck just to sort of reemphasize that our capital management philosophy has been to essentially, through dividends and share repurchases, distribute whatever we generate every year above and beyond any acquisitions that we do.
Because of the fact that, if you go back five years on that slide, we had accumulated some cash that what you see beyond our ongoing annual capital distribution plan is the fact that we did distribute some of that excess cash, and then last year, through our ASR transaction, we swung to somewhere around one times turn of debt that we added to the balance sheet. The way we're managing things today is assuming that level of debt that we're carrying will remain rather stable and just going on with our normal policy that Chad articulated about the 90% current year earnings distribution target. We would consider changing that leverage ratio and that amount of debt for the right type of acquisition that comes along, and we are actively looking for something like that at this point in time.
Thanks, John. Next question is for Chad. Depreciation expense declined sequentially. How should we be thinking about this? Is this a trend you expect to continue in Q4?
Okay. That question is the combination of depreciation and amortization, I believe. The sequential decline has to do with some acquisition-related intangibles that were acquired and being amortized. Those acquisitions happened between five and seven years ago, and the amortization expense for certain intangible assets did end. Yes, that lower amount will continue. In addition, there is another acquisition-related intangible from five years ago that ended during the quarter, and that will reduce next quarter by about $200,000. Those are just the impacts of those specific acquisition amortizations. Obviously, depreciation and amortization will fluctuate as we acquire and add new assets and retire old assets.
Thanks, Chad. The last question here is for John, related to sourcing. When do you expect the year-over-year negative impacts of your large customer and sourcing to abate?
I might have mentioned this earlier, we do know and anticipate that in the fourth quarter of this year that we will have some continuing comparison challenges for that business cycling out. From what we know of today, we hope to have a fresh start into 2015 and be able to return to more normal growth activity. We win and lose every day, hopefully, that'll be the case when we come into 2015. We do know for sure there's at least one more quarter of some comparison challenges.
Okay. Thanks, John and Chad. That takes us to the end of the hour here, and we're out of time. Unfortunately, we weren't able to get to all of the questions today. We really appreciate the submissions that were made. Thank you for participating in our third quarter 2014 conference call. The call will be available for replay in the investor relations section of the C. H. Robinson website at www.chrobinson.com. It will also be available by dialing 888-203-1112 and entering the passcode 8557362. The replay will be available at approximately 7:00 P.M. Eastern Time this evening. If you have additional questions, please call me, Tim Gagnon, at 952-683-5007, or contact me by email at tim.gagnon@chrobinson.com. Thank you again. Have a good day.
Ladies and gentlemen, thank you for your participation. This does conclude today's conference.