Ryder System, Inc. (R) Q3 2019 Earnings Report, Transcript and Summary

Good morning, and welcome to the Ryder System Third Quarter 2019 Earnings Release Conference Call. [Operator Instructions]. Today's call is being recorded. If you have any objections, please disconnect at this time. I would now like to introduce Mr. Bob Brunn, Vice President, Investor Relations, Corporate Strategy and Product Strategy for Ryder. Mr. Brunn, you may begin.

Thanks very much. Good morning, and welcome to Ryder's Third Quarter 2019 Earnings Conference Call. I'd like to remind you that during this presentation, you'll hear some forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations and are subject to uncertainty and changes in circumstances. Actual results may differ materially from these expectations due to changes in economic, business, competitive, market, political and regulatory factors. More detailed information about these factors is contained in this morning's earnings release and in Ryder's filings with the Securities and Exchange Commission. This conference call also includes certain non-GAAP financial measures. You'll find reconciliations of each non-GAAP measure to the nearest GAAP measure in the written presentation accompanying this call, which is available on our website at investors.ryder.com. Presenting on today's call are Robert Sanchez, Chairman and Chief Executive Officer; and Scott Parker, Executive Vice President and Chief Financial Officer. Additionally, John Diez, President of Global Fleet Management Solutions; and Steve Sensing, President of Global Supply Chain Solutions and Dedicated Transportation Solutions, are on the call today and available for questions following the presentation. At this time, I'll turn the call over to Robert.

Good morning, everyone, and thanks for joining us. I'm going to start by covering the actions that we took this quarter to lower accounting residual value estimates on vehicles in our fleet. I'll start with some background on the used vehicle market, provide an overview of the change and discuss why we believe this and other actions positions Ryder well for the future. We'll then briefly recap our third quarter results and discuss our current outlook for the business. With that, let's begin with Page 4. Our value proposition is strong and continues to be driven by long-term outsourcing trends in the large transportation and logistics markets. As discussed in our press release today, we expect 2019 and 2020 earnings to be negatively impacted by the continued used vehicle downturn. In the coming slides, I'm going to discuss a change in residual value estimates we've made as a result of market conditions and the associated increase in depreciation we'll see in the near term. The effect of this change in estimate, however, lowers the likelihood and magnitude of negative earnings impacts from used vehicle sales in future years. We expect returns to organically improve as the depreciation impact from these changes lessens in each quarter going forward and as the majority of underperforming leases written prior to 2014 exit the fleet over the next 18 months or so. We began to increase rates in our leases starting in 2014. These leases, with returns that are expected to be at or above our target, will become an increasing part of our portfolio going forward. We're strongly focused on accelerating initiatives to improve return on capital, and all options are on the table in order to achieve this key objective. I'll cover several of our ROC improvement initiatives, including additional lease pricing actions, cost reductions, improved execution in our used vehicle sales and addressing lower-performing accounts. Our new CFO, Scott Parker, is helping in this regard by providing a fresh view of our business model and helping to identify opportunities for improvement. Additionally, our new President of FMS, John Diez, is also identifying return enhancement opportunities, leveraging his proven finance and operations execution experience. Turning to Page 5. This chart illustrates Ryder's used Class 8 tractor sales prices as a percent of their original cost over the past 20 years. As you can see, the used vehicle market is cyclical and is driven by changes in supply and demand, technology and other factors. As noted on the chart, there was a steep increase in tractor pricing during 2012 and 2015, driven by a lack of supply in the market and a change in engine technology. Following the mid-2015 peak, tractor proceeds declined sharply through 2017 to below our accounting residuals as supply entered the market and the freight environment slowed. The used tractor market showed signs of stabilization and improvement during 2018 and early '19. Based on these trends, we had previously anticipated that market prices and the accounting residual values used for depreciation were moving towards alignment, thereby reducing the likelihood of losses at the time of sale or the need for additional accelerated appreciation in future years. Turning to Page 6. As we discussed on the second quarter call, this trend began to change in June when we started seeing softening market conditions for used tractors. Used tractor conditions continued to worsen in the third quarter and we now expect this downward trend to continue in the near term. This triggered a review and lowering of residual value estimates on power vehicles, which is intended to reflect this downturn and our lowered outlook. For those of you who are less familiar with this area, Page 7 highlights some relevant aspects of how we handle residual value estimates and depreciation. We review residual value estimates and the expected useful lives of vehicles at least annually. Changes in these items may impact our financials in several ways. First, we estimate residual values for vehicles initially at the inception of a lease and then adjust those values over the duration of the lease as needed based on a number of factors to reflect our long-term view of used vehicle sales prices. This determines the vehicle's depreciation, which is taken on a straight-line basis when the vehicle is in operation. We refer to this as policy depreciation. Second, as vehicles approach the end of their useful life, if the market value is expected to be below book value, we may record additional depreciation to better align these values with anticipation -- in anticipation of the upcoming sale. This adjustment if needed is based on our near-term view of market values. We refer to this as accelerated depreciation. Finally, when a vehicle is no longer used in operation and is moved to our used vehicle sales center, we record a downward adjustment to vehicle -- to the vehicle's value if its expected market value is below its estimated residual value at that time. We do not record an upward adjustment if the market value is above the estimated residual value. Instead, those vehicles would see a gain recorded at the time of sale. We refer to this as valuation adjustments. For your reference, the appendix to this presentation includes some additional detail regarding the company's residual value and depreciation policy. Page 8 notes how these items will be impacted by our new estimates of residual values. As a reminder, we last adjusted residual values on January 1 in accordance with our standard annual review. Effective July 1, we further lowered our long-term view of residual values for vehicles expected to be sold starting in late 2021 to reflect more recent multiyear market trends in our outlook. This view now excludes the peak pricing year of 2015. Our view of residual values also now incorporates our expectations for a near-term used vehicle downturn. This revision to our view of long-term residuals will be reflected as a policy depreciation impact. We also lowered our near-term view of residual values for vehicles expected to be sold through late 2021. The estimated residuals on these vehicles have been lowered to below policy depreciation levels to reflect our expectations for a continued near-term vehicle downturn and increased wholesaling activity. Revisions to our view of near-term residuals are reflected as accelerated depreciation. The largest impact of these residual estimate changes is for Class 8 tractors. We also lowered truck residuals, although to a lesser extent, to align with market conditions we saw in the quarter and our revised outlook. Page 9 illustrates the level of our new residual value estimate on tractors for policy depreciation purposes as compared to historical sales prices. The estimate no longer includes the peak sales year of 2015 and incorporates our outlook for a continued market downturn in the near term. The change in estimated residuals, policy depreciation for all power vehicle types represents an 18% reduction from the prior estimate primarily driven by a reduction in tractors. This impact will be recognized over the remaining life of the vehicles. The estimate used for accelerated depreciation, which is applied to vehicles to be sold through late 2021, is at an even lower level than the policy values shown here. The next page details the impact by quarter and year of our change in residual estimates on both policy and accelerated depreciation. As you can see, the negative impact is most significant in the third quarter of 2019, with declining impacts in each quarter thereafter. A total of $177 million in additional depreciation was taken this quarter. This includes $125 million of accelerated depreciation reflecting our updated view of near-term residuals and $52 million of policy depreciation impact reflecting our updated view of long-term residuals. Overall, this change results in earlier recognition of depreciation in 2019 and 2020 that would have been recognized in 2021 or later years under our historical estimation practice. Based on these lower residual value estimates in our current market outlook, going forward, we expect to reduce our need for valuation adjustments to mark down vehicles going into the used vehicle centers or for accelerated depreciation beyond the amounts projected through 2020. Given the impact of this change, we're further intensifying our focus on a number of areas to improve return on capital. Let me provide you a few examples. First, we've taken lease pricing actions to improve returns. As some of you will recall, well before the current change in residual estimates for accounting purposes, we lowered the residuals we were using for pricing purposes. Beginning in late 2017, we increased lease rates in several stages on all power vehicles by reducing residual value assumptions used for pricing purposes. Tractor residuals used for pricing purposes are currently at historically low levels, and we continue to pursue opportunities to further optimize pricing to drive higher returns going forward. Page 12 provides insights into our expectations for improving lease performance over time. This is anticipated because the pricing actions we've already taken are expected to manifest in higher portfolio returns as the portfolio turns over into more recent model years. Leases signed prior to 2014 are now expected to result in returns below our target level for two reasons. First, they've been negatively impacted by maintenance costs on the early model years of the post-2010 emissions technology then turned out to be higher than anticipated. Second, these vehicles as they come off lease are now expected to be sold in a down market at below price levels. The negative P&L impact of these vehicles will largely end by 2020 as these vintages account for the majority of the accelerated depreciation now projected. Leases signed between 2014 and 2017 are expected to yield returns at or above our target. These leases are benefiting from better-than-priced maintenance costs since we raised pricing related to maintenance costs several years ago and we're seeing positive results in that area. Leases signed after 2017 are expected to see returns above our target levels. In addition to better-than-priced maintenance performance, these leases are also benefiting from better overall cost performance and reduced residual value assumptions used for pricing purposes. As a result of our pricing and cost actions since 2014, we expect the performance of our lease portfolio to organically improve over time as the portfolio turns over to more recent and higher returning vintage years. In addition to these lease pricing actions, we're driving a number of other initiatives to improve return on capital, as shown on Page 13. We're expanding our retail used vehicle network capacity in order to maximize price. This includes expanding our -- expanding into new retail sales locations and increasing our inside sales team. Additionally, this year, we're launching an upgraded -- later this year, we're launching an upgraded used vehicle website, which will expand its capabilities and includes facilitating a sales transaction and enhancing the user experience. We're also exploring structural options to share residual value risk, new partnerships and utilization of capital market alternatives. We remain focused on our core -- on our cost structure and are encouraged by our cost savings initiatives that are ahead of plan -- that are on or ahead of plan. The most significant of these initiatives is the multi-year $75 million annual maintenance cost savings initiative we announced earlier this year. I'm pleased to update you that we're tracking ahead of the $20 million of benefit that we had projected for 2019 and expect total savings to exceed our original expectation. Additionally, we're on track with our zero-based budgeting cost savings for this year and anticipate additional savings opportunities in future years. The team is focused on pruning lower-return accounts and assets to drive higher return on capital over time. We're also looking to accelerate growth in the higher-return supply chain and dedicated businesses. I'll turn the call over now to Scott for a condensed recap of our third quarter 2019 results.

Thanks, Robert. Turning to Page 15. Comparable earnings per share from continuing operations was a negative $1.49 for the third quarter, down $3.16 from the prior year. The loss included $3.01 of higher depreciation expense; a noncash item related to the reduced vehicle residual value estimates. Operating revenue, which excludes fuel and subcontracted transportation revenue, increased by 5% to a record $1.8 billion. Page 16 includes additional financial information for the third quarter. Comparable EBITDA was up 12% from the prior year, primarily reflecting the earnings contribution from our growing portfolio of contractual lease, Dedicated and Supply Chain business. The average number of diluted shares outstanding for the quarter was 52.3 million, down slightly from the prior year. We began repurchasing shares under a 2-year, 1.5 million-share anti-dilutive repurchase program in February 2018. During the quarter, we bought approximately 63,000 shares at an average price of $51.13. Excluding pension costs and other items, our comparable tax rate was negative 7%, reflecting the impact from residual value estimate changes. The return on capital spread was negative 140 basis points while ROE was 5.5%, including the impact from the residual value estimate changes. I'll now turn to Page 17 and discuss key trends we saw in each of the business segments. Fleet Management Solutions' operating revenue, which excludes fuel, increased 7% organically with growth in all product lines. ChoiceLease revenue increased 9% primarily due to fleet growth and, to a lesser extent, higher rates on replacement vehicles. The lease fleet increased by 2,900 vehicles during the quarter and by 10,900 year-to-date, reflecting outsourcing trends and ongoing sales and marketing initiatives. This also includes a higher number of vehicles waiting out service for sale due to the increased lease replacement activity this year. Approximately 40% of the lease fleet growth is coming from customers new to outsourcing as we continue to penetrate the non-outsourced market. Commercial rental revenue was up 2%, driven by higher pricing. Rental utilization was 74%, down from an unusually high 80.4% in the prior year, primarily reflecting lower tractor demand. We worked throughout the quarter and continue to work on adjusting our fleet size to meet current demand levels that are below our original expectations for the year. FMS earnings before tax showed a loss of $109 million, primarily reflecting higher noncash depreciation expense of $177 million due to the impact of the residual value estimate changes as well as lower rental utilization. Lease results benefited from fleet growth while both lease and rental benefited from lower maintenance costs. Turning to Page 18. Used vehicle results for the quarter were down due to lower pricing and increased wholesaling activity. We sold 5,300 used vehicles during the quarter, up 29% versus the prior year and up 4% sequentially. Used vehicle inventory totaled 7,300 vehicles at quarter end, within our target range of 7,000 to 9,000 vehicles. Inventory increased by 1,100 vehicles compared to the prior year, reflecting a greater number of units coming off-lease this year as expected. Used vehicle inventory decreased 1,000 vehicles sequentially. Proceeds per vehicle sold were down 8% for tractors and down 10% for trucks compared to a year ago. Sequentially, tractor pricing was down 15%, and truck pricing was down 2%. Turning to Supply Chain on Page 19. Operating revenue decreased 2% driven by previously announced lost business, partially offset by higher pricing. Earnings before tax were down 5% due to a $3.8 million impact from residual value estimate changes for vehicles used by Supply Chain business. The decline was partially offset by improved operating performance. On Page 20, our Dedicated business grew strongly, with operating revenue up 11% driven by new business. Earnings increased due to revenue growth and improved operating performance, partially offset by a $7 million impact from residual value estimate changes for vehicles used by DTS. Turning to Page 21. Year-to-date gross capital expenditures totaled $3 billion, up by $700 million from the prior year. This increase reflects higher planned investments to grow and refresh the contractual lease fleet while rental CapEx decline. Year-to-date proceeds from sales were up $111 million, including $43 million from a sale of property in the second quarter. Net capital expenditures increased by $591 million to $2.6 billion, reflecting our contractual lease growth. Turning to the next page. We generated cash from operating activities of nearly $1.6 billion year-to-date, up approximately $300 million or 25%. Free cash flow was negative $965 million year-to-date, down from the prior year of negative $633 million, primarily reflecting increased capital spending to grow the lease fleet and normalized levels of lease and rental replacement spending. Debt-to-equity increased to 313% due to capital spending and a reduction in equity due to the increased depreciation from the residual value estimate change. Balance sheet leverage is above our target of 250% to 300% and is expected to increase to around 330% at year-end, primarily due to the earnings impact from the residual value estimate changes. Leverage is anticipated to come down over time as we move past the near-term impacts of the residual value change. As such, we do not expect the current above-target leverage to limit our ability to support profitable growth in our contractual lease business. At this point, I'll hand it back to Robert to cover the outlook.

Thanks, Scott. Our fourth quarter comparable EPS forecast ranges from a loss of $0.03 to a profit of $0.07 and includes a $0.95 impact from the change in residual value estimates, the impact from a labor strike at a customer in our Supply Chain segment and weaker rental demand combined with elevated vehicle help servicing activity. Overall, we continue to benefit from long-term outsourcing trends in transportation and logistics as well as our sales and marketing initiatives. We expect strong full year sales in our contractual lease Dedicated and Supply Chain businesses, although below last year's record levels. The slowdown in our transactional commercial rental and used vehicle businesses that we experienced in the third quarter is expected to continue primarily driven by softer freight conditions. Although the negative impact from our change in residual value estimates will continue to be significant in the fourth quarter, the severity of the impact will be less than in the third quarter and is anticipated to further decline each quarter going forward. In Supply Chain, revenue is forecast to decline through midyear 2020, reflecting previously announced lost business and then return to target growth levels in the second half of 2020 as new business sold ramps up. Segment earnings in Q4 are expected to be negatively impacted by the recently ended labor strike at a large Ryder customer and by the impact of residual value estimate changes on vehicles used in this segment. These items are anticipated to be partially offset by improved operating performance. In Dedicated, revenue growth is expected to decelerate in the fourth quarter to mid-single-digit levels following a record sales year in 2018. The negative earnings impact from residual value estimate changes on vehicles used in this segment is expected to be largely offset by improving -- improved operating performance. On a full year basis, revenue growth should be above target, while earnings are expected to be within target. In Fleet Management, earnings from year-to-date lease fleet growth will be negatively impacted as we prepare for the sale of a large number of vehicles coming off-lease contracts. In Rental, we're anticipating weaker demand to continue particularly for tractors and expect to rightsize the fleet to better align with market conditions by early next year. Looking ahead to 2020, we expect lease fleet growth to moderate due to lower OEM production, the clearing of vehicles waiting to be outserviced and our enhanced focus on return on capital opportunities. Expected higher -- expected headwinds from used vehicle sales are largely reflected in the revised residual value estimates and related depreciation expense. Overall, our work to downsize the rental fleet and move off-leased vehicles through the out-service process will pressure fourth quarter earnings. However, we believe these actions along with the changes in residual value estimates we've made will better position us for 2020 and beyond. That concludes our prepared remarks. So operator, please open up the line for questions. [Operator Instructions]. Operator?

[Operator Instructions]. We'll take our first question from Ben Hartford with Baird.

Robert, kind of a thorough overview here. But I guess in the spirit of one question, as we think about Slide 13 and the key areas of ROC improvement, the experience within FMS and the lease portfolio issues in recent years, and then Item number five, accelerating growth in the higher return businesses. As you think about the next cycle, the next several years, how much of it is just accelerating growth in that business as opposed to making a conscious effort to reduce exposure within the FMS side and really shifting this business in a meaningful manner toward those higher-return segments? In other words, is it just growth on the SCS, DTS side that you see? Or do you intend to reduce the size of FMS business going forward?

Yes. That's a good question. Look, the returns that we are seeing in the lease portfolio as you saw over the recent years are good returns and within the targets of what we're looking for. So our goal is with this more -- with this new cost model, the cost model that we have, to continue to look for opportunities to sell business and grow that business. We think it's a good business to be. It's a good return business. Now having said that, part of this process going forward is we are looking to prune accounts potentially that may be underperforming within each of those model years, which at and of itself will slow growth down some. As I look at OEM production for next year, that's going to be less certainly than this year. So that's going to -- there's going to be fewer at best or we're going to see some slowing there. So I think what you're going to have is some natural slowing of growth in the ChoiceLease business. And then our goal is really to find ways to accelerate the growth in the other -- Supply Chain and Dedicated business by allocating -- things like allocating more salespeople to it, looking for additional opportunities to really enhance the growth levels we've seen there and improve the overall return to the company.

[Operator Instructions]. We will take our next question from Scott Group with Wolfe Research.

So can you say how much of a further decline in used truck pricing you've assumed today? I guess I'm trying to understand how much more of a used truck hit can we face before we need to think potentially about additional policy or accelerated depreciation adjustments. And then I guess with that, given -- I wonder what this means for losses on sales. So you're sort of doing $70 million of losses this year, give or take. What's a reasonable way to think about losses next year? Similar with this year? Worse? Smaller? Maybe with what you've done, maybe we're not having losses on sales issue. I don't know how to think about losses because I think that's separate from what you laid out in Slide 10.

Yes, Scott. On Slide 9, we showed you that we -- overall, we brought estimates down 18% across all the power vehicles. But obviously, that's much more heavily weighted towards Class 8. So Class 8 was a bigger number. And then for -- that's for policy depreciation. For accelerated, we went beyond that to a lower number. So if you look at Slide 9, you can see that below that X, you're now looking at pretty historically low levels. I don't want to get into the exact numbers only because of the market conditions and things like that. But I think what you're seeing is we've taken a pretty big bite at the apple here at bringing those residuals down to what we see -- what we expect, really, over the next 18 months or so. So as your -- the second part of your question around gains and losses, yes. The change we've made here we expect will incorporate these losses going forward. So we wouldn't expect to see a lot of losses or valuation adjustments in addition to what you're seeing here on accelerated and policy depreciation.

So just I'm clear, you're assuming -- for the accelerated piece for the next year is you're assuming some further drop in used truck pricing from current levels. Is that right?

Yes. Yes. And we are -- go ahead.

But you're not saying how much, meaning like is it 5% further from here? Is it 20%? Closer to one versus the other? Maybe you don't want to say the exact number for market purposes, but like I just want to get a sense like if you've done enough or not.

Scott, if you look at Slide 9, where we had -- we kind of showed what our policy depreciation is, residual value for policy depreciation is relative to history. You can see it's actually below where Q3 ended. So that gives you an idea of what we're expecting for going forward. And what we're using for accelerated is below that X. So we're anywhere in that range. We're at historically low levels for prices as a percent of original cost.

Our next question will come from David Ross with Stifel.

Just a question again on the depreciation piece. In the past, we've talked about not being able to accelerate more depreciation than trucks that are coming off of their lease contracts, the idea being that their cash flow is not impaired. And so there was, I guess, some accounting disconnects where you weren't able to change the depreciation policy on a truck that's going to be sold in 2024. It seems like that's changed. And so that's what this policy depreciation is that you are able to take a one-time reset to the whole fleet.

No, no, no. No, David. This is -- none of this is an impairment charge. These are changes in residual estimates that increased the depreciation. So accelerated depreciation number is -- basically, what we're doing is we're taking every vehicle that we think will be sold through late 2021, and we are depreciating it to a new lower residual value over the remaining life of that vehicle. So obviously, there's -- you're taking all of that adjustment in residual value over a year or a two year period. So a very short period of time. The policy is basically just saying for the rest of the vehicles that are going to come in after 2021 to be sold, we're now saying -- rather than waiting until over time we get there, we're saying, "Look, we believe that the market next year is going to continue to be down." We really look -- we really create -- we really look out at what we think those vehicles will sell for in the future. And we've made an adjustment to those residual values based on our -- on recent multiyear trends and our current outlook, and that's that adjustment. So again, it's an adjustment to residual value, which increases depreciation for the remaining life for those vehicles. So it is not an impairment of any of those vehicles.

And then the other just related question is on the timing. So what's the reason for a continued change in depreciation, both policy and accelerated through 2020 rather than having it all be reflected in 3Q here?

The units have to -- David, have to be amortized over the life of that remaining period for those contracts. So that -- this is -- when you kind of set the new residual for each one of those assets, the numbers that we're showing over the next couple of quarters for accelerated is to get those units coming off-lease at that time down to the new level that we expect those residuals to sell for.

The timing is based on the end of term or end of life for those vehicles. So we're moving -- we're depreciating those vehicles to the new residual value over the remaining life. And in some of those vehicles, the remaining life is two months, one month. Some of it is 18 months, and some of it is a little further. But that's really what is creating that -- the red bar, if you will, the red part of the bar on Slide 10, which is the accelerated depreciation.

Our next question will come from Todd Fowler with KeyBanc Capital Markets.

Thanks for the additional detail. I really just want to make sure that I'm understanding how you're planting the information on Slide 10. So if I just look at what you're expecting for the first quarter of 2020, the $80 million of policy impact and accelerated depreciation, is it right to think about that on an apples-to-apples basis for the first quarter of '19 that what you reported, basically, the $81 million of EBIT in 1Q '19 would be close to zero under this new -- with using the new residuals that you've got in place?

Let me make sure I understand what you're saying. Well, let me explain the $80 million first. The $80 million is for the fleet that we have today. That is the -- that is how much incremental depreciation we're going to have for those vehicles in the first quarter of 2020 versus where we are today, what we were depreciating, I would say, before that.

Okay. So maybe another way to ask it, Robert, then for the 2020 -- or Scott, if you want to jump in. The $250 million that you're showing in Slide 10, that's $250 million or about $3.50 of higher depreciation that you'd be expecting in 2020 compared to where you'd be in 2019?

Yes. That's correct. Understood, but it's all -- these estimates are based on the portfolio as of the third quarter. So it does not have additional assets that will be coming on in regards to subsequent quarters, in the fourth quarter and the first quarter. But that -- as of the third quarter, that is correct.

Okay. Understood. Yes. And Scott, that's why I wanted to ask a question about kind of first quarter. Kind of so if we're thinking about how you'd lead this out, what you're basically showing is as of today, here's the higher depreciation and understanding that there's going to be other moving parts growth within certain parts of the businesses and pieces like that. But basically, what you're saying right now is into 2020 on a full year basis, there's $250 million or about $3.50 of additional depreciation coming.

Correct. Yes.

Our next question will come from Matt Brooklier with Buckingham Research.

So wanted to talk about commercial rental and your conviction level in terms of being able to rightsize that. It's obviously a tougher used truck market, but if you could just walk us through maybe the timing around reducing the fleet? When do you think you get to your targeted level? What are some of the challenges that you face in the market, used truck market that seems incrementally more challenging here?

Yes. Remember, Matt, there's two things we do. We do move some vehicles to the used truck market, and we also redeploy some vehicles into leases and other applications. So I'll let John give you a little color on the actions that we're taking to get that rightsized by early next year.

Yes. So Matt, if you look going forward, I think Q4, we certainly are looking to sequentially reduce our commercial rental fleet primarily around the tractor vehicle class where we've seen the biggest decline in demand. And that's in line with what we're seeing from a freight perspective as well as from a ChoiceLease sales activity level. So we expect to really take a good swipe at the tractor class in Q4. That activity will continue into Q1. And you should see in the early part of 2020, we should be back to parity on some of the historical utilization levels. If you look at utilization this year versus last, just to remind you, Q3 was unusually high last year and we continue to add fleet through Q4. So Q4 utilization levels from a comparative point of view are also being impacted by the strong fourth quarter last year.

Moving next, we'll go to Stephanie Benjamin with SunTrust.

I wanted to go back, probably best to just reference probably Slide 9. But I wanted to think through -- I appreciate the extra color and also, I think, just the kind of more color on the impact going forward and what seems to be a more realistic approach. Can you kind of walk through what happens, given to your point that it is a cyclical business, if say, we start to see used truck pricing improve? I don't think anyone expects that to be anytime soon. But as we look to the end of 2020 or 2021, how would that impact the expectations that you've now adjusted for today? Just kind of high level, I just want to make sure I'm thinking about it correctly.

Sure. As I mentioned, we are forecasting a downturn that would last really through, call it, middle of 2021 so -- and a pretty significant downturn. So any improvement upon that would -- two things would happen. One is you would start to see gains. And the second thing is we would be able to slow down the accelerated depreciation. And if it weren't enough, we'd eliminate the accelerated depreciation. So obviously, used truck pricing going up, a lot of good things happen. What we've tried to do here is really lay out our view of what we think is going to happen over the next 18 to 24 months. If it comes in better, then we will -- we'll have opportunities to get some improvement from that. As a reminder, I do want to make sure we're clear is that our policy, so the stuff beyond 2021, we are expecting an uplift. It's where that -- if you see where that X is on Page 9, that's where we're expecting residual values to be out beyond 2021. So we expect it to go down from where it is now over the next couple of years or the next 1.5 years. And then over time, get back up to where that X is. Once it gets beyond that, then you've got gains. You'll have more gains and other good things that can happen.

Our next question will come from Justin Long with Stephens Inc.

So with all the adjustments to residuals, I was wondering if you could comment on where you anticipate book value to shake out once all of these adjustments are completed. And then, Robert, a lot of discussion around improving returns. At what point do you think you'll get back to earning a positive spread above your cost of capital?

I'll take the first one. So if you look at the end of the third quarter, we ended about net $10.5 billion in regards to revenue-earning equipment. That included the charge that we took in the third quarter. So if you kind of look out in the fourth quarter, we're kind of looking at about another $100 million. And then over the period of time from 2020 to 2025, about another $500 million. So if you just look at the static book as of the third quarter, that would get you to somewhere between -- around $10 billion, $9.9 billion to $10 billion for the static book. Assuming that the market plays out as Robert just went through, that our assumptions and our kind of estimates are kind of what transpires, that's kind of where you would be. If things get a little bit better, then those numbers would be adjusted and our estimates would be updated accordingly. The same would be if things got worse than what we expected.

So I guess, Justin, to answer your question on ROC, when do we go positive and when do we get to our target, obviously, we've got a lot of work to do still on these ROC improvement initiatives. But assuming that the used truck market behaves the way we've outlined here, you're really looking at probably 2022 when we really have a lot of the depreciation behind us and the impact of these return on capital spread actions are really starting to take effect. I would expect us to start making very good progress, though, in 2021 as we get a lot of the accelerated depreciation behind us. But again, thinking about how do we get back to the targets that we set out and that we want to get to, it's probably more of a 2022. Again, I would shoot for positive spread in 2021 and then getting to the targets around 2022. And again, a lot -- I would tell you a lot of work needs to be done. And we've got a lot to do in terms of evaluating and executing on some of these initiatives.

Next, we'll go to Brian Ossenbeck with JPMorgan.

Maybe just for the longer term, Robert, can you just talk about the idea of essentially offloading or sharing some of the risks through the residuals? It sounds like you took a couple of big steps here to bring down the value to where you think is appropriate and maybe conservative. But what do you think about this future? Is this something that's really fleshed out at this point in time? Or is it something you're still exploring in the early stages of it?

Yes, Brian. It's something we're exploring. Clearly, working with our OEM partners over time and looking for ways to -- again, we're not looking to -- we're not going to offload the entire residual risk on anyone. But certainly being able to hedge some of that volatility, I think, is important for the model going forward. So we're looking at opportunities to work with the OEMs. Also working on the capital markets and what some of the other industries have done. And I'll let Scott give you a little more color around that.

Yes, Brian. So if you -- we're working with our bankers. But if you look at some of the other leasing markets, there are clearly different alternatives that can be used in financial products that can be used to kind of spread or share risks. So we're currently looking at those and evaluating the cost benefit of each one of those options. And I think we'll be able to share more probably as we get into next year once we kind of finalize some of those evaluations.

Okay. So it sounds like the current outlook doesn't include any assumption of these initiatives being put into place or any of these new structures to offset or mitigate some of the risk.

Correct.

Yes. These are a little longer term.

We'll take our next question from Kevin Sterling with Seaport Global Securities.

Robert, if I can kind of dig in the equipment that's prior to 2014, where obviously it seems like the biggest issue is if you got a -- when you go to sell that equipment, is that -- I guess I assume that mainly probably would have to go through the wholesale channel. Or would you have to sell that equipment overseas? It seems to me that's kind of the biggest issue, I would think, where kind of -- where values have declined the most.

Yes. No. There are retail -- Kevin, there's retail buyers for them. Some of it have to go wholesale. But clearly, there are retail buyers for this equipment. The challenge for us, I would tell you, first and foremost is really the original pricing that we had said as we moved into this new technology. Maintenance costs ended up coming in higher in those -- in the years that it was with us than we had originally priced. And now we happen to be in a down used truck market because it's not just these vehicles where we're seeing pricing decline. It's really across the broader market. So there are retail buyers. These vehicles still have life in them. And there are secondary buyers who will buy them and continue to run them, primarily probably lower-mileage type of operations as most of our used trucks do. But I got to tell you, the most important part, I think, I want everybody to know is really our confidence around the leases that we've signed since 2014. This isn't just a modeling exercise. We are actually experiencing better-than-expected maintenance performance on these. And even with the residuals that we have now forecasted which are significantly lower, we're still looking at, at or above our target returns on those. So we feel very confident about that portfolio of leases. We want to continue to refine it and improve it. So we're not done. I think every year, we want to find ways to improve the return on that lease portfolio. But we feel very confident about the leases that we've signed since 2014 and the returns that we're seeing.

Our next question will come from Barry Haimes with Sage Asset Management.

Again, just to make sure I'm understanding this correctly. If we go back to Slide 10, in the bar chart on the lower half, where you've laid out the year-by-year impact. So in effect, if we took those numbers and did a present value, discounted those back to the present, that would be the impairment in terms of less cash you will ultimately receive for disposing of those trucks based on the new assumptions. Is that the right way to think of it?

I mean when you're talking about this, all this is doing is we're not discounting back that piece. We're setting the ultimate residual we expect to sell those vehicles and then depreciating to that new residual level. And what you...

I understand. So in effect, you're -- by those amounts, when you ultimately dispose of all those trucks, you will have less cash than under the old assumptions based on the net present value of those amounts, right? I mean you're spreading it out over time in terms of depreciation. But the ultimate cash recovery from the vehicle is the net present value sum total of those -- of that bar chart. Is that correct or not?

That's correct. So that's from an accounting perspective. But at the same point in time, as we showed on the kind of the model year perspective, what was assumed in regards to the return for that price residual, it also has to be taken into consideration as you look at the book kind of post some of those changes in their most recent model years.

Our next question will come from Scott Group of Wolfe Research.

So I want to go stick on Slide 10 and just go back to Todd's question from earlier because it sounded like you were saying $250 million of higher depreciation now in '20 versus '19. And is that right? Or are these the absolute...

No, no, no. These are the absolute numbers. These are the absolute numbers. If you looked at it, $39 million less. But if you look at the run rate by quarter, the $289 million in '20 is in the second half of 2019. So on a run rate basis, you're really at less than half as you get into 2020. So these are absolute numbers.

Okay. Depreciation is a tailwind now starting in 2020?

Correct.

Year-over-year?

Depreciation is a tailwind starting in 2020, every year going forward.

Okay. And then on Slide 12, when you showed in 2012 and '13 we're below target and now we're above target. I guess how do we get comfortable here? Because it feels like the used truck issues have been an issue for older trucks. You're not selling any 2015 trucks yet. So how do we know that you're actually earning above target on these trucks?

Well, remember, we have -- what we've done is we've lowered the residual assumptions in terms of this analysis. We've lowered the residual assumption to really relatively low levels, the levels that we've shown you on Slide 9. So what we're saying is that even at those lower residuals, we expect to be above our target returns, again, primarily driven by the fact that our maintenance experience has been significantly better and continues to be significantly better than what we priced. So we know for a fact where maintenance costs are coming in. And at the end, this residual, we've lowered the assumption and said even with those lowered assumptions, we're going to -- we're expecting to come in above our target level.

Okay. And then just last thing quickly. You talk about lower CapEx next year. Any way to put some numbers around that?

Yes. Look, if you look at next year, clearly, there's a few things going on. But as far as CapEx, we're expecting there's going to be fewer -- there's going to be less CapEx on leased vehicles just because there's fewer -- there's going to be lower OEM production. So I view that as just fewer at best provider. So that's going to drive some of it. We're going to expect to continue to redeploy equipment. We talked about rental additional units. So we'll be redeploying equipment certainly in the first half of next year. And then on our ongoing initiatives to improve ROC, whether it's pruning accounts or continuing to raise prices, that's going to continue -- that's going to put a little bit of headwind on it also. So I would expect less lease capital next year. So with that, improved free cash flow levels, certainly well beyond where we were this year.

We'll take another follow-up from Matt Brooklier with Buckingham Research.

Just a follow-on to the free cash CapEx question. I'm assuming that your spend on commercial rental trucks, that will be lower as well?

Yes.

And then this is relatively small in the grand scheme of things, but could you talk to the impact of SCS from the GM strike? And then what are your expectations for that impact during fourth quarter?

Yes. We had -- at an automotive customer, we had a strike that we dealt with, starting in tail end of -- through Q3 and it has gone into Q4. Good news is that strike is done, but it will impact -- we do expect it to impact Q4. And that can bring -- it's certainly a contributor to why we're expecting Supply Chain returns to be below our prior estimate for the fourth quarter. So without giving you exact -- it's a good portion of the decline. That and obviously the additional depreciation from the vehicles used in Supply Chain.

We'll take another follow-up from Ben Hartford with Baird.

On the commercial rental side, I know you mentioned that you expected some stabilization in the front half of the year, helped by a reduction in the fleet size. But what are you assuming from a demand perspective with regard to rental through next year?

Yes. We still have -- we haven't put the plan together. But I would expect on the tractor side, we're going to see continued softness as more vehicles have come into the market and the freight environment continues to be soft, certainly in the first half of the year, maybe picking up in the second half. On the truck side, I think you'll see -- certainly, with some of the e-commerce sensitivity, we would expect to continue to see some growth there. So this is really more story about rightsizing our tractor and Class 8 fleet as we get into 2020. But I would also remind you as we get into 2020, as you saw on Slide 10, you're going to have a declining impact from our -- from the depreciation change and the residual value change as we go through the year. That will be a tailwind next year. We will benefit from some of the lease fleet growth of this year. Certainly, as the vintage vehicles from '12 and '13 begin to exit the fleet, that should help us also. We do expect to really hit and exceed our maintenance cost initiatives. So we're looking for a continued success there next year that could help the story. We think we've captured all the UVS headwinds and the depreciation changes that we made. We're going to continue to leverage our zero-based budgeting process to minimize overhead costs. So that's a very important tool to have certainly in an environment as the one that we're in. And again, we're going to really sharpen the focus around some of the return on capital improvement opportunities that we have, including, I would say, pruning of lower-return accounts and assets in areas that really may not help the top line as much but will help the bottom line and will help the return on capital story.

Okay. Good. And then back to the pricing actions that you're taking. To what extent do you feel like you're just kind of catching back up to either market levels or recouping price that you perhaps sacrificed in recent years versus the industry as a whole being able to move price higher? Can you provide any perspective in terms of where you think your pricing actions puts you over the past couple of years relative to the market?

Well, if you consider the market to be the other leasing providers, I think we're all swimming in the same ocean and we work to do that. So I think we're all -- certainly, we're -- what we've done is we've taken the appropriate action we think we need to take based on our costs and based on our learnings in the market and learnings of the business. Ultimately, that will dictate the amount of growth we get. However, we -- I would tell you the most important part of the story is that versus ownership, the story doesn't really change because everything we have felt around maintenance cost and everything, we have felt around lower residuals and lower used truck market, any private owner of a truck is feeling. So the value prop versus ownership and the outsourcing story remains just as strong, if not stronger than it was a year or two ago, because as we talk to customers today, they're trying to sell their 2012s and 2013s and are seeing the prices that they're getting in the marketplace. This is a business that they may not want to be in anymore. And it really creates a great opportunity for us. So certainly, I see us remaining very competitive in the lease business and in the -- again, versus ownership from a total cost of ownership standpoint. So as I said, you'll see some drop-off in growth next year, I think, as OEM production comes down and as we do some things around pruning some accounts. But overall, the value prop for leasing versus ownership is as strong, if not stronger today than it was just a few years ago.

Our next follow-up will come from Justin Long with Stephens Inc.

I just wanted to put a bow around the residual change EPS. Or is it the residual impact to EPS? I think you've said this year in the full year guidance, it would have a negative impact of $3.95. As we look at your assumptions for 2020, where do we kind of shake out in terms of the EPS impact? It's a little bit tough because I guess we don't have the first half of '19 numbers for policy and accelerated depreciation. So I just wanted to see if you could provide some more clarity on what you think that year-over-year tailwind in 2020 will look like.

I mean I'll let these guys work through it, but it's -- certainly, the $250 million is the depreciation impact that we're expecting in 2020, so $250 million. That translates -- from an EPS standpoint, that will translate to about $3.58. We got to look at what's going to happen exactly with tax rate and all, but it's about $3.58 headwind, versus this year is almost $5.

Okay. That's helpful. So roughly $1.50 of a year-over-year tailwind?

Roughly. Yes, those are very rough numbers. As we refine the tax rate and all that for next year, we'll be able to give you better numbers.

Our next follow-up will come from Brian Ossenbeck with JPMorgan.

Just a couple of quick ones here, maybe on the last point on taxes. Is there any way to think about the normalized effective tax rate and cash tax rate, maybe excluding some of these write-downs that you're reflecting here?

You're talking about -- you're just talking about our kind of comparable tax rate?

Right. Right. If you wanted to look at operations ex the acceleration and the policy impact, what would you say is maybe a longer-term number to use both on the effective and on the cash tax side?

I think if you kind of look at the comparable effective tax rate, it probably would be in the -- if you pull off these items we were tracking before the estimate change, probably in the 25%, 26% range. So I think going forward, that would probably be a good proxy. And then the gap -- the tax rate would be really impacted just from other items that are kind of related to pension and some of the other things that are excluded from the comparable numbers. I think as a general range, probably you could use a 25%, 26%.

Okay. And then cash taxes a bit lower than that because of the depreciation shields as we've seen absolutely?

Correct. I mean -- correct. Our cash -- yes, cash taxes would be lower because of the accelerated depreciation benefits we get for buying the equipment.

Okay. One last one for you, Robert, if you can just confirm. It sounds like you went through a very sensitive process here with the update that you summarized on Slide 10. But I guess it was mentioned earlier, we're accustomed to the usual year-end update with the five year rolling average in that sort of mechanics. So would you expect that -- based on what you've done today in the analysis, do you see here -- do you think that you're -- you would be confident that we're not going to see any additional adjustments at the end of the year? I mean that was based on where rates are trending. But do you think there's enough cushion or enough of an impact reflected here that we won't see another adjustment either up or down in three months from now?

Well, Brian, I can tell you that we've gone through a very extensive process over the last few months to really at a very granular level within the fleet and also looking at all the macro market indicators that we have to try to really come up with our best estimate of what this number is. I feel very confident in that estimate right now. Obviously, I don't have a crystal ball so I can't tell you everything that's going to happen in the world of used trucks. But I feel very confident in the estimates that we have here and the numbers that we put in front of you.

Our next follow-up from David Ross with Stifel.

Just a question about the hit that SCS and DTS took as a result of the increase in depreciation. I guess our thought was that they were customers of FMS. And FMS customers don't see any change in their cost or expenses and that would all be an FMS issue. So what's the issue with DTS and SCS because they leased all the equipment from FMS?

Yes. DTS and SCS both -- they are customers of FMS, but they have an equipment contribution that is given -- that is provided to each segment to really reflect the profits that are brought to Ryder for the business that they have. So that does include -- it's almost really showing you what these operations would look like if they actually own the equipment. So since it's laid out that way, when we change depreciation for that equipment, it is impacting the margins of both supply chains they gave. It's important to note, though, that, that is eliminated through eliminations, the earnings elimination line for total company. So I just want to make sure that you're not -- those aren't incremental to the depreciation changes that we're reporting in FMS.

Okay. And then as far as the free cash flow next year, you talked a little bit about the decline in CapEx. How quickly do you think you could get back within your target leverage range?

From a leverage standpoint?

Yes.

Yes. Look, that's going to depend. As we get this depreciation -- the accelerated depreciation behind us here in the next two years and you start to -- we start to grow the equity line, that's going to be a big driver. Certainly, as we reduce CapEx, that will also be a driver. So probably not in 2020, maybe late 2020 as we get into 2021. But again, a lot of things still that we've got to review. But we certainly feel confident that we will be getting back in that range as we get past this accelerated depreciation period and we start really growing earnings and growing equity again.

And there are no additional questions at this time. I'd like to turn the call back over to Mr. Robert Sanchez for closing remarks.

Okay. Well, listen, thank you, everyone. And we were in a little late today. But given the topics and the changes that we've made, I wanted to make sure that we answered all your questions. We will be on the road here over the next few weeks. So certainly look forward to seeing many of you then. And again, thank you for your continued interest in Ryder. We're glad that we've got this out there. Clearly not glad about another used vehicle downturn, but I think what you're seeing now is really our view of the short term and long term, our updated view of the short-term and long-term used vehicle market. And we think this will put us in a position now to be able to grow earnings from here and really expand on the contractual growth that we've had over the last several years.

And ladies and gentlemen, it sounds like that does conclude today's conference. Thank you all for your participation.