FedEx: Countering Negative Narratives, Bears Lost in the Weeds
Below, we respond to some of the criticism that FDX has received from the traditional sell-side following FY3Q earnings. Broadly, we are suspicious of anyone who thinks it is useful to write a report detailing how their model differed from actual results. More specifically, we think the negative reports have gotten the timing and magnitude of the FDX opportunity wrong. We think they have gotten bogged down in quarterly detail and meaningless regressions. Below, we respond to these details and try to place them in the context of the broader FedEx value opportunity. If we have missed key points of the bear thesis, feel free to let us know.
Bears Missing the Broader Opportunity
Stepping back, the value opportunity in shares of FedEx is clear, at least to us. The market ascribes little value to any FDX business other than FedEx Ground, in our view. This is odd, for example, because the market does not appear to ignore the value in UPS’s express revenue or its competitively disadvantaged ground revenue. While there are probably better ways to show it, FDX currently trades at an EV/Sales of 0.67 while UPS trades at 1.56. In our view, the primary differences are the multi-decade low margin at FedEx Express and a persistent rich valuation given to shares of UPS since its IPO (and, no, not leases).
There is no structural reason that the FedEx Express division cannot match competitor’s margins over the next few years, in our view. Capital spending and management focus are now being directed toward that end, and faulting management for not doing it sooner is pointless. The FedEx Express division has ~$27 billion in revenue and produces little income relative to its potential. It flies expensive, outdated aircraft and maintains excess capacity, both of which are fixable. The division could also get a margin boost, we think, from better balancing its network through a TNT acquisition. Deutsche Post was able to improve its express margins from much, much worse levels in a few years. If Deutsche Post can do it, anyone can, right? Importantly, the express industry is highly consolidated and is, excepting an unlikely-to-reoccur >300% increase in fuel prices in the last decade, structured for very solid returns.
FedEx Ground enjoys a substantial competitive advantage from its non-unionized labor force, among other factors, which has allowed it to steadily take market share. There is little reason to expect that to stop, in our view, which is to say we expect FedEx Ground to eventually take UPS’s spot as the largest ground delivery service in the U.S. (Has a heavily unionized company facing non-union competition in the U.S. ever succeeded?) Given the e-commerce driven prospects for package volume growth, FedEx Ground is likely to remain a valuable franchise.
Too much data can be toxic to clear thinking. While we do not precisely subscribe to the cocktail napkin requirement, a great value opportunity can rapidly get lost amidst 20 basis points here and 15 basis points there. Business and economic results are noisy, so we look for very large value opportunities relative to the uncertainty in our estimates. FedEx Express margins are running at over 700 basis points behind UPS, by our estimates. That is quite large. Our bull case valuation for FDX tops out around $180/share, with a conservative base case valuation in the $130-$150 range. Most importantly, our bear case shows little downside from current levels – an asymmetry even bearish reports agree with. We think that is the signal amidst all of the noise.
Bearish Minutia: FedEx Ground
- Lack Gains from Scale/Margins Weaker: Those negative on FedEx have correctly pointed out that FY3Q2013 Ground margins were sequentially weaker. Somewhat correctly, they highlight the prior period lack of clarity on the change in self-insurance accruals (annoying, yes, but you can see the reduced current and non-current self-insurance accruals in the 10-Ks, and those reductions fall almost directly to the operating income line. By our estimates, the companywide impact was an added $30-$40 million in fiscal 2012. It was not allocated to Ground, though, and the company should do better than that, in our view.) They also highlight that increased scale has recently not driven higher margins. But, does any of this matter?
- Current High Teens Margins Are Great: In 2007, FedEx Ground had a 13.5% operating margin and 2012 was a peak at 18.4%. Reduced spending on the independent contractor realignment and greater scale likely drove the gains. In a few quarters, margins can bounce around, but the trend is generally favorable.
- Mix Will Lower Margins (but in a good way): SmartPost and other e-commerce related services have lower margins – at least for now. These are the fastest growing components of Ground. We do not expect margin expansion at Ground because of this mix shift. These low cost services are market expanding, much the way the drop in time definite service prices were in the 1970s. If an investor has an issue with FedEx Ground’s margins vs. market expansion, we would expect that they are heavily short ground services customer AMZN.
- Why is 20% Needed? The fixation on 20% margins seems odd. We find FDX to be undervalued without assuming 20% Ground margins.
- Ground Value Proposition b/t FDX and UPS Converging? FedEx Ground is roughly half the size of UPS’s ground service and yet has equivalent margins. FedEx Ground moves packages faster – and has been getting even faster. To the extent that FedEx is bundling air and ground to increase channel density, the issue is the empty space/lack of channel density (i.e. excess air capacity, which is being addressed), not the value proposition offered by FedEx Ground.
- Ground Margin Gains Will Slow: Of course FedEx Ground margin gains will slow. Much of the margin improvement since 2006 related to the need to restructure its independent contractor model. As that spending dissipated, margins popped. See here for a summary and replay of our expert call on FedEx Ground’s independent contractor model. This is also covered in our Express & Courier Services black book. Presenting a regression on per piece cost vs. volume without factoring in the origin of prior margin gains (e.g. completing the spending to restructure the IC model, which doesn’t relate to volumes or scale) is problematic and misleading. Scale is far from the only or most important factor driving average cost per piece at FedEx Ground.
- Express Margins Weak: That FedEx Express margins are weak is the point of our FDX long thesis. If Express margins were not weak, the stock price would be much higher and we would be writing about lawnmower engines (BGG) instead of FedEx. That said, the margins were sequentially weaker last quarter. Does this matter?
- They Didn’t Tell Us To Expect Margin Improvement: FDX management said we should start to see the benefits in FY4Q 2013, which is this quarter, not last quarter. See here for how we were not “in” FDX for last quarter’s results.
- Tougher Environment for Restructuring? We look to buy structurally sound/competitively advantaged cyclical stocks when their industry is at or near a trough, as we think the Express industry is now. We look to sell when the industry is peaking (~2005 for the Express industry). The weak Express market is unlikely to add to either the restructuring burden or the investor performance burden. If one buys into strong cyclical markets, one will end up buying peaking cyclicals – like FDX in 2005 or CAT in the middle of last year, in our view.
- Lower Bar for Restructuring Guidance: The $1.6B in restructuring benefit for FedEx Express is to be measured from FY2013 levels. FY2013 could be lower by $50-$100 million relative to prior expectations. Does anyone think that $1.5 billion in Express cost reductions wouldn’t be huge for FDX’s share price?
- TNT Possible: It is possible that FDX is orienting the Express restructuring around a potential TNT acquisition, lowering margins near-term for a positive long-term transaction. Most analysts do not address the potential of a TNT transaction.
- Breaking Eggs: Last quarter, FedEx started the process of the Express restructuring, which is disruptive, but did not receive the cost reduction benefits.
- How Patient Are Investors? We would point out that UAL has been “integrating” United and Continental for several years now. Yet, first quarter adjusted, ex-fuel CASM is supposed to increase double digit. After billions in restructuring and integration-related charges, investors have not lost hope in UAL’s cost reductions, even though we think they should. Giving up on the FDX restructuring now is absurd, in our view. The FedEx Express restructuring has not produced results because it has not really started, as of FY3Q results.
- Guessing About Multiples: Will FedEx ‘deserve’ a lower multiple once margins are higher? Just asking the question sounds odd.
- Backfilling P/Es: Some have suggested that when FDX completes its restructuring, it should have a lower multiple. They then proceed to pick a P/E number out of a hat that supports their bearish conclusion, with a narrative rationale for the arbitrary target P/E. There is no reason to pick a P/E, since explicit discounted cash flow valuations can be generated that include return on capital, capital spending and market growth assumptions.
- Winners Win: We would wager that if FedEx can execute on its restructuring, it is likely to have a higher multiple because it will be seen as a good company with a management team that can execute. Of course, that’s another unsupportable narrative, but one that better matches our view...
- Argue Specifics: We have presented the assumptions behind our scenario-based discounted cash flow valuations. We think these valuations provide a “reasonable range” for FDX’s fair value in a framework that is consistent with how we look at the investment alternatives. This approach allows the reader to disagree with, say, the reasonable range for long-term revenue growth at FedEx Ground (maybe 2% to 5%, but not 12%), instead of saying that the PE should be at a 20% discount to its 10-year average, whatever that means.
- Downside Limited: Bears acknowledge that there is little valuation downside from current levels. They just choose not to believe in the upside from a restructuring that has yet to flow through to a single earnings report and has been successfully executed by a competitor (DHL) in recent years.