Fitch Initiates Coverage of CNF Inc. at 'BBB'; Outlook Stable.

CHICAGO -- Fitch Ratings has initiated coverage of CNF Inc. (NYSE:CNF) with an issuer default rating (IDR) of 'BBB'. In addition, Fitch has assigned a rating of 'BBB' to CNF's unsecured debt obligations, as well as its $400 million unsecured revolving credit facility. The senior unsecured rating applies to approximately $595 million in outstanding debt obligations. The Rating Outlook for CNF is Stable.

The ratings reflect CNF's solid operating performance, strong liquidity, and manageable debt load, offset to a degree by the cyclical nature of the freight transportation industry. With the December 2004 sale of its Menlo Worldwide Forwarding (MWF) operation to UPS Inc., CNF removed a significant source of volatility in its consolidated financial performance, allowing management to focus on the company's two remaining core units, Con-Way Transportation Services (CTS) and Menlo Worldwide Logistics (MWL).

Subsequent to the MWF sale, approximately 70% of CNF's consolidated revenue and 90% of its consolidated operating income are attributable to CTS, with the remainder driven by MWL and its unconsolidated Vector SCM joint venture with General Motors. Margins are expected to show continued strength, particularly at CTS' regional less-than-truckload (LTL) units, as the company takes advantage of heavy freight transportation demand to grow yields and loads. On the logistics side, MWL has an opportunity to strengthen its results as it leverages its market vertical strategy to increase revenue and lower the cost of integrating new business. Margin improvement is expected to drive continued increases in free cash flow over the next couple of years, although the growth could be limited somewhat by heavy capital spending.

CNF has a strong liquidity position, with operating cash flow and proceeds from the MWF sale contributing to year-end 2005 cash and equivalents balance of $717 million. Liquidity is enhanced by access to a $400 million unsecured revolving credit facility that matures in 2010. With its relatively large cash and equivalents balance, CNF ended the year with negative net debt of $120 million. Over the course of 2005, CNF took advantage of its cash position to reduce leverage, repaying $113 million in debt maturities with cash on-hand. Looking ahead, cash obligations tied to debt maturities in 2006 through 2009 are light, ranging from $15 million in 2006 to $23 million in both 2008 and 2009, with no heavy maturities until 2010, when $200 million in principal payments are due on the company's 8 7/8% notes. CNF is also approximately half-way through a $300 million share repurchase program that it began in January 2005. It is expected that the remaining $150 million in share repurchases will occur about equally across the quarters in 2006.

Since 2003, CTS' regional LTL units, along with their competitors, have been enjoying a period of heavy freight transportation demand. Robust manufacturing activity, heavy demand for imported goods, capacity tightness in the truckload sector, and shifts toward just-in-time inventory management have driven increased volumes into the regional LTL network. This has provided the regional LTL carriers with the ability to keep base rates relatively strong, while adjusting their fuel surcharges upward as the cost of fuel has increased.

With a full-year operating ratio (OR) of 88.1%, CTS' regional carriers are among the most-profitable carriers in the LTL sector, due in large part to the labor flexibility provided by their non-union workforces. CTS' rank-and-file employees not only drive trucks but also work the docks, producing a level of labor productivity that is difficult for unionized carriers to replicate. This labor flexibility also has contributed to CTS' relatively high operational service levels, which in turn, have given the carrier the ability to charge a premium for its transportation services, further contributing to its relatively strong OR.

Compared to CTS, MWL has struggled somewhat to increase its gross margins over the past year. The very forces that have contributed to the LTL sector's improved financial performance have increased MWL's purchased transportation costs, which tend to run in excess of 70% of the unit's gross revenue. Excluding these costs, however, margins on net revenue have seen some improvement, due in large part to MWL's market vertical approach to serving customers in the information technology, automotive, consumer, and industrial sectors. Since mid-2004, MWL has been building on its expertise in these sectors by developing common systems and processes that accelerate the process of integrating new, middle-tier customers. Going forward, the market vertical strategy is expected to enhance MWL's competitiveness vis-a-vis other third-party logistics providers, while driving continued improvement in net margins.

As a non-union company, CNF promotes a performance-based culture among its employees, tying compensation to the achievement of corporate goals. All employees, including senior management, participate in the same incentive compensation plan (ICP). Management believes that the performance-based culture is a competitive strength that keeps rank-and file employees focused on company performance. Although the ICP has occasionally produced volatility in the company's cash labor costs, on balance, the plan and CNF's corporate culture appear to be key ingredients in the company's operational and financial performance.

Following several key leadership changes in 2005, management has become focused on transforming CNF into an 'operating company' from a 'holding company,' emphasizing the need to break down walls that have historically existed between CTS and MWL and instead seeking synergies that can be created across the units. As part of this effort, the company moved CTS' logistics operation under the MWL umbrella. In addition, the respective sales forces of each unit have been charged with finding prospects for both CTS and MWL. MWL is also making greater use of CTS, particularly the truckload unit, as a transportation service provider, replacing some of the service historically outsourced to other carriers. Although the potential synergies between the CTS and MWL units are somewhat limited, this focus on finding ways to cross-utilize the two units' relative strengths could result in further improvements to revenues and margins going forward.

The LTL industry is capital intensive, with significant investments needed in tractors, trailers, facilities, and other equipment. On the other hand, the logistics industry tends to have little in the way of capital asset needs, as most facilities and equipment are either leased or customer-owned. Between 2001 and 2004, CNF's consolidated capital spending ranged between 2% and 4% of annual revenues. However, capital expenditures grew to $219 million, or 5.2% of full-year revenue, in 2005. In 2006, capital spending is projected to rise to $395 million, as CTS invests in land, buildings, and rolling stock to cover increased volumes and continues the build-up of the truckload operation. Although capital spending is, to an extent, discretionary, it will nonetheless put some pressure on free cash flow growth in 2006.

CNF maintains defined benefit (DB) pension plans for its employees. At year-end 2004 (the most recent information available), the largest of the plans, the CNF Retirement Plan, was 79% funded on a GAAP (generally accepted accounting principles) projected benefit obligation basis, with a benefit obligation of $863 million and total assets of $685 million. In 2005, CNF contributed a total of $127 million to its DB plans, and the company expects to contribute $75 million to the plans in 2006. Given the funded status of the plans, it is not expected that future cash contribution requirements will materially affect the company's credit profile.

The most significant concern going forward is the cyclical nature of the trucking industry, as industry fortunes have historically risen and fallen with the strength of the U.S. economy. Although demand for freight transportation continues to be strong, various economic indicators suggest that the pace of U.S. economic growth will slow somewhat over the next couple of years. Several factors could mitigate the potential negative effect of an economic slowdown on CNF's results, however. First, recent consolidation in the LTL trucking and logistics industries has reduced the fragmentation in both arenas, which could help support pricing in a weakened economy. Second, LTL carriers typically see the negative effect of a slowdown later in the cycle, as lowered shipping volumes initially shift from the truckload sector to the LTL sector. Third, as a portion of CNF's capital expenditures, pension contributions, and other cash expenses are discretionary, there are opportunities to pull back on spending, if necessary. Finally, by selling off its underperforming MWF unit, CNF has jettisoned a source of financial volatility that could have put an extra drag on its financial performance in the case of a slowed economy.

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