FedEx Idea Alert: Degrees of Freedom Skewed To Upside
TREND = 88.52
TAIL = 86.23
FDX A Top Long Idea: FedEx is our top transport idea and we believe it is one of the best investment opportunities in the Industrials sector. We have put together a Black Book on the Express & Courier Services industry here and written a note detailing how FDX fits into our investment process here. FDX has many more positive degrees of freedom than negative ones, in our view, and we review the key aspects of our thesis below.
Inventories: Inventory levels in the broader economy are a key driver of express volumes. Businesses generally do not pay to express an item that they already have on hand. Relative to trend, inventories have risen to a level that has historically signaled a good entry point for the Airfreight & Logistics sub-industry. If you buy cyclicals when times are bad and sell them when times are great, the chart below indicates that it is currently lean times for express carriers like FedEx. Note that this inventory signal is rare, breaching this level only half a dozen times in the past 30 years and remaining below it for about 86% of observations.
FedEx Ground Set to Dominate Industry: UPS is not the first company to stand at a competitive disadvantage because of uncompetitive union labor costs. FedEx Ground appears destined to dominate the US ground parcel industry as UPS’s iconic franchise loses share to a more nimble competitor, in our view. Similar dynamics have occurred in many other unionized industries in recent decades. FedEx Ground has ~18% operating margins and a clear revenue growth trajectory, positioning the unit to be a significant value driver for shareholders.
Express Cost Cuts: FedEx Express has ~$26 billion in revenue at a rough 4% operating margin run-rate in fiscal 1Q 2013. UPS and DHL have much higher margins (about 5 points) and there is no reason we see why FedEx cannot match or exceed competitors’ profitability. Management is targeting ~$1.6 billion in P&L improvement at FedEx Express. If management hits that target, which looks achievable to us in a normalized operating environment, the value of just the Express division could exceed the firm’s current market value, by our estimates. We would happily take FedEx Ground for free.
TNT Deal Divestitures: Since UPS’s future appears to be in express services, we expect the firm to pursue the TNT merger aggressively. Divestitures of European operations are almost certainly needed to obtain EU antitrust approval for the deal. FedEx would benefit from a stronger presence in Europe and is the only real buyer for the assets, in our view.
Other Factors: We also explore the impact of containerized freight rates vs. airfreight rates, airfreight capacity and global trade in our Express & Courier Services Black Book.
Valuation Scenarios Suggest Positive Risk/Reward: We may be a little early in terms of the inventory cycle, but the cost reductions, FedEx Ground growth and TNT divestitures more than assuage our anxieties. Our bear case FDX valuation is ~$85, suggesting limited downside from current levels if our thesis fails to play out. Our base case valuation range of $120-$150 suggests healthy reward potential and upside to ~$180 if our thesis really comes together.
Jay Van Sciver, CFA
HEDGEYE RISK MANAGEMENT
120 Wooster St.
New York, NY 10012