FDX: Process Positive on Purple
- The Cycle: The Express & Courier services industry cycle is driven primarily by economy-wide inventory levels, which are currently high relative to trend. However, excess airfreight capacity, declines in global trade and the relative pricing of containerized freight have also been headwinds for express volumes. Those headwinds have reversed recently or are likely to in coming quarters. In addition, FedEx Express has significant cost reduction opportunities that can drive share price upside independent of the cycle, in our view.
- Industry Structure: The Express & Courier services industry has an attractive industry structure. The industry is highly consolidated, with rational competitors, fragmented customers and few relevant suppliers.
- Valuation: We think that FDX provides the best cyclically adjusted valuation opportunity in the group, with upside to our base case in the 30-70% range (bear $85, base $120-$150, bull $180). Critically, our ~$85/share bear case model suggests little potential downside from current levels if our thesis fails. In addition to improved operating conditions, we believe FedEx Ground is likely to displace UPS as the dominant US parcel ground operation.
- Favorable Risk Balance: With key cyclical factors apparently turning FedEx's favor, several sizeable internal cost reduction opportunities available, and market share gain potential in both US ground and Europe express, a lot can go right at FedEx. While there are risks to our thesis (as always), we think that FDX represents an extremely attractive risk/reward balance at current levels.
Cost Reductions - Better Late than Never: The FedEx Express division is operating at a ~30 year low in margins. The company has just turned its attention to improving margins in that division, as opposed to adding capacity. The cost reduction opportunities, like swapping out 727s for more efficient aircraft, are unusually straight-forward. It is a valid criticism, in our view, that these cost reductions should have been implemented some time ago. Nonetheless, if margins return to historic or peer levels, the value of just the FedEx Express division could exceed the current market value of FDX, by our estimates.
FedEx Ground Winning: Investors we speak with frequently believe that UPS’s single network is superior to FedEx’s separate Ground and Express networks. While there may be advantages in the UPS model, the reality is that UPS is steadily losing market share to FedEx Ground, in large part because of higher labor costs. FedEx Ground has margins that we believe to be equal to or better than those of UPS’s ground operations, even though FedEx Ground has less than half UPS's scale. At some point, the market may reprice FDX to account for this soon-to-be dominant franchise. We also think that legal risks to the FedEx contractor model are lower under the current structure.
FDX Ground Advantage Reflected in Market Share Trend
Four External Headwinds: Inventories, Containership Rates, World Trade Volume and Airfreight Capacity are important drivers of FedEx Express’s business. The inventory to sales ratio is currently high relative to trend. That has historically been a (rare) signal to buy Airfreight Logistics, by our estimates. The price of containerized freight relative to airfreight reversed in the second quarter and airfreight capacity has begun to tighten in recent months. World trade usually grows, but contracted in 3Q.
1. Inventories: The secular decline in the inventory to sales ratio stopped in 2005 and the ratio has spiked higher this year. Both FDX & UPS shares are at or below their 2005 prices, despite significant business gains since then.
2. Container Shipping: The trend of cheaper ocean rates relative to air rates appears to be reversing as the relative price gap has been narrowing since Q1 of 2012.
3. World Trade: World export volumes have been down recently, but historically world trade has grown faster than world GDP.
4. Air Freight Capacity: Weak volume growth amid relatively normal capacity increases has resulted in slack capacity. A reversal of this trend should be positive for the group.
TNT Deal: At worst for FDX, the UPS/TNT deal would result in a more consolidated industry and distracted competition. However, we believe that FDX is a potential buyer for the European express assets that have been a regulatory sticking point in the transaction. A stronger European presence would improve Fedex Express’s global network, in our view.
Valuation & Strategy
Win-Win Positioning: From a strategy perspective, FDX should prove more resilient than the Industrials sector in a recession. However, if the economy snaps back, cyclically stretched areas like inventories and world trade should drive improved results at FedEx. While we may be a bit early in entering FDX, we like the win-win dynamic in an uncertain, stall speed economy.
F Jay Van Sciver, CFA
HEDGEYE RISK MANAGEMENT
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New York, NY 10012