FDX: Is Canada Always on Top or Just America’s Hat?

Takeaway: Today's move shows an strong grasp of old news. Valuing Ground & Express separately shows the restructuring call option in FDX shares.

FDX:  Is Canada Always on Top or Just America’s Hat?



The FDX downgrade this morning shows an excellent grasp of old news.  In mature, cyclical industries, if one is buying on good news and strong data, one is probably making a mistake from a longer-term perspective.  It is precisely the weak margins at FedEx Express that got us interested in the shares last November. 


We think FDX can improve its Express margin over the next few years, in much the way DHL recently did and to a level near what UPS has.  We also think that investors will price the expectation for continued margin improvement into FDX shares should the restructuring show progress.  We believe FDX’s market price currently reflects only the value of FedEx Ground.  Each FDX share provides a free call option on the success of the FedEx Express restructuring, in our view.  That is an option we want. If we are wrong, and we could be, the downside looks limited from current levels.




  • Product Trade Down:  The mix shift to lower cost products has been going on for quite some time.  It is good they finally noticed.  As we pointed out in our November 2012 Express & Courier Services deck, the cycle in high value transports relates to economy-wide inventory levels.  Slack inventories slow shipping, since no one pays to express goods that are already sitting in inventory.  Express services peaked in ~2005 amid the tightest inventories of the post-war period, and we believe it is at or near a trough now (hence the title of our deck “When Will Then Be Now? Soon”). 
  • Mix Shift Only Small Part of It:  The reality is that DHL and UPS are more profitable than FedEx in Express sevices with the current mix.  FedEx has company specific issues, which we believe are addressable.  DHL has already completed a successful restructuring from a much worse margin position than FedEx Express is in currently.  We do not see a structural reason that FDX cannot match competitors’ margins.
  • Mix Shift Makes Targets Harder?  Since the $1.7 billion in cost reductions are to be measured against this year’s run rate, mix shifts are in the base for the cost reductions.  Mix shifts probably lower the bar for gains, which everyone already knows, but do not make them harder to achieve.  If mix rebounds, however, it would actually make it easier to achieve the targets.
  • Mix Trend is Here to Stay?  If that is the case, then all packages eventually end up in the SmartPost channel.  That isn’t going to happen and faster delivery does add value.  Extrapolating the mix-shift trend is a facile approach that does not consider the origins of the shift.   Factors like fuel prices and ocean freight rates have actually been abating.  Inventories may well tighten from current levels in North America, where consumption-oriented economic activity appears to be improving.
  • International Express:   It is not news that FedEx Express needs to restructure its aircraft fleet.  It is a key component of the restructuring plan.  Removing excess capacity is a good thing.  There is nothing wrong with redeploying 777s if they are more profitably operated in a different channel.  If the late pick-up service offerings do not make money, they can be put aside until demand supports the product offering. 
  • Domestic Express:  This fixation on FDX’s two networks vs. UPS’ one network is odd to us.  FDX has a separate Ground network, in part so it can use independent contractors to dramatically reduce labor costs and take market share from unionized UPS for 12+ consecutive years.  FedEx Express is flying archaic aircraft and needs to rationalize capacity, facilities and labor.  That is not a 1 vs. 2 network issue, but it is the point of the restructuring and a component of our long thesis.  It is not as though UPS is delivering an overnight package from Boston to Seattle through its ground network and FedEx Express is barred from operating trucks. 
  • Risks in USPS Airlift Contract:  That UPS is bidding against FDX for the USPS air contract has been known for at least several quarters.  We even discussed it with the former head of the Postal Regulatory Commission last November here.  The contract was put out in July of last year, with the bid packages received around October.  UPS already has about 10% of the USPS airlift revenue (see USPS supplier table below).  The intertwining of the postal service and FDX/UPS is complex and there is a history of bad blood between the post office and UPS.  In government contracting, if a supplier is doing a good job, they are likely to keep most or all of a contract.  Otherwise, it can be more work and scrutiny for government employees.  That said, we do expect UPS to get a larger share of the contract and expect margins on the contract to come down.  We also expect an announcement pretty soon.  But the revenue at risk is likely less than 3% of FedEx Express’s total.  We do not think it is worth much attention relative to a prospective $1.7 billion margin expansion opportunity.  

FDX:  Is Canada Always on Top or Just America’s Hat? - usps


  • Fixed Cost Reallocation – WTF?   The complete loss of the USPS contract would obviously be a negative, but the full cost of that lost revenue would not be broadly reallocated to the rest of the Express division.  A quick perusal of the FY2002 10K for FedEx should ease any anxiety since 1) profit didn’t jump by a huge quantity as >$1 billion in costs were suddenly spread out over the USPS revenue and 2) the costs are identified as incremental salaries, fuel costs and other, mostly variable, factors.  Sure, there could be a charge associated with a partial or complete contract loss, but, in our view, the notion that there could be an ongoing $1.00 to $3.00/share loss associated with cost reallocation should not be presented and borders on moronic. 
  • Who Cares If They Cut $1.5 Billion Instead of $1.7 Billion?  Currently, FedEx Express’ value is not in the share price at all, in our view, as the FDX valuation can be explained by FedEx Ground alone.  If FedEx Express generated a couple of billion in operating income, shares of FDX would be revalued significantly, in our view.  Not that we value the company this way, but FDX currently trades at an EV/Sales of 0.64 while UPS trades at 1.53.  We believe the primary difference is that UPS’ Express revenue is vastly more profitable than FedEx’s.  That does not have to be so.
  • Why Would FedEx Lower Their Longer-term Guidance Targets?   FedEx has not reported a single quarter since the restructuring was expected to generate cost benefits. Further, restructuring is a multi-year affair. Forecasting a management reduction in targets based on something that has not started, especially from a position of inferior knowledge relative to company insiders and competitors, is, well, pretty aggressive.  The targets seem achievable to us, since DHL just did it and UPS already has it.  A discussion of competitors’ margins is notably excluded.
  • Where Do They Get These Multiples?  Why a 4.5 EV/EBITDA?  Who takes these valuations seriously?  The use of an aggregate, narrative fitting multiple is particularly tedious when a discourse on the disadvantages of FDX’s separate Ground and Express networks is followed by a failure to value them separately.
  • More Noise, Better Opportunity:  There is no new news on FedEx, but the shares are cheaper.  A single post-restructuring quarter has yet to be reported, but the street seems to have already decided the restructuring is a failure.  Will they change their minds if the restructuring is working by year-end, upgrading the shares at higher prices?  Haven't we seen that movie?
  • Our Take:  We think that FDX shares trade for what FedEx Ground is worth, leaving a free option on the upside produced by a successful FedEx Express restructuring imbedded in the shares.  The restructuring is a multi-year process, but one that is likely to succeed since management is focused on it, a competitor just did it and the industry structure supports it.  We think many have misread the Express cycle – loving FDX in 2005 at the peak and shunning it now (at a lower price) near a cycle trough in 2013.  In short, we think FDX is a straight-forward long, but apparently one that requires a strong stomach for both broker research reports and market volatility.



Today we shorted Carnival Cruise Lines (CCL) at $33.52 a share at 10:03 AM EDT in our Real-Time Alerts. Carnival bounced off an oversold low, but remains in a bearish TREND view per our Cruise Line specialist, Felix Wang.




McDonald’s is set to release March sales, along with 1Q13 earnings, tomorrow before the market open. Expectations are muted for March comparable sales but we believe the back half of the year is where there is most potential for a disconnect versus expectations. The stock has broken higher from $85 with no supporting increase in earnings estimates. The 1Q13 consensus estimate of $1.26 or 3% EPS growth looks aggressive but the company has many levers to manage the number. We will be hosting a call on April 25th to go through our bearish stance on MCD FY13 EPS versus expectations in more detail.


The company reported February sales on March 13th and, since then, MCD has outperformed the market by 340 bps. We continue to believe that the stock is ahead of the company’s fundamentals, with little upside to earnings for 2013 leaving the multiple embedded in the stock stretched.


Specific to the earnings release, we will be focused on the following:

  • Any update to 2013 guidance (sales, costs, reimaging, FX)
  • US comp in April
  • Commentary on competition in the QSR segment and MCD's value push


The charts below illustrate what we believe the investment community will perceive as good, bad and neutral results for the US, Europe, and APMEA March sales.


MCD SALES PREVIEW - mcd us comps


MCD SALES PREVIEW - mcd eu ocmps


MCD SALES PREVIEW - mcd apmea sss



Howard Penney

Managing Director


Rory Green

Senior Analyst



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2Q13 Macro Call: Our Process


Hedgeye held its 2Q13 Macro Call for institutional subscribers this week, which covered several themes we think will be big and noteworthy in the second quarter of 2013. We began the call with CEO Keith McCullough outlining his process. We use a combination of fundamental research combined with quantitative risk management.


The quantitative process involves using risk management signals and levels to determine entry and exit points for a stock or index. It involves a multi-duration model that includes: TRADE, TREND and TAIL. The fundamental research utilizes our world-class research team to find ideas that we can apply to our quantitative model.


We look at a combination of politics, monetary policy, economic health and other factors to see where certain companies and countries are at and how to trade them.

BRAZIL: Getting Smoked

Brazil's BOVESPA Index dropped -2.1% yesterday and is down -13.4% year-to-date. One of the worst performing markets on the planet, the country just experienced a 0.25% rate hike to 7.5% on central bank borrowing rates by Alexandre Tombini, the governor of the central bank of Brazil. It's the first rate hike since July 2011 and has given investors plenty to worry about. We like staying short commodities and short Brazil through the iShares MSCI Brazil Index ETF (EWZ).


BRAZIL: Getting Smoked - BOVESPA


In an effort to evaluate performance and as a follow up to our YouTube, we compare how the quarter measured up to previous management commentary and guidance




  • IN-LINE: PENN's quarter was more or less in line with our expectations once you strip out some of the one time corporate charges and underperformance in the Southern Plains segment


PENN 1Q 2013 REPORT CARD - pa1



  • SAME:  There has not been much change in spend per visit.  Any admission trends were impacted by cannibilization or weather-related.  Overall promotional activity across the regional markets have been rational.
    • "It certainly is more at the lower end with less trips, the retail consumers.  We are seeing some trip decline throughout all the segments of the business.  Some of that is due to cannibalization. But generally the big issue and the majority of our loss of business volumes have been at the retail end."
    • "March was clearly better than January and February, and we can talk about weather, we can talk about timing and tax returns, we can talk about the payroll tax. January and February clearly were not good months for our industry as a whole. And March, we saw a bit of recovery. Now, there couldn't have been pent-up demand from weather. Weather and timing of tax returns are two things that you would think would be just a timing issue and would come back in March. So I don't know that we're prepared to call March a consumer recovery, but it was certainly nice to see at the very least that some of the lost business from the first half of the quarter came back in March. From what I hear, we're not alone in saying that."


  • SAME:  PENN remains on schedule and on budget with the re-branding and facility upgrade of Hollywood Casino St. Louis, which is expected to be completed later in 2013.
    •  "The acquisition there of Harrah's St. Louis I talked about earlier, that closed in November. We've decided to invest about $60 million in that property (this year); some new slot machines, some new carpets, facelift."


  • SAME:  Ohio State Racing Commission has a view of the racing environment is 'obsolete' and demand is slowing; thus, Penn is at an impasse until the Ohio commission agree to a rational amount of seating. As of now, no change in proposed 2014 opening.
  • PREVIOUSLY:   "Racing Commission has decided that they think we need more seats for the racing section of those businesses. So the process is a little bit on hold at this point. We're not changing the opening date from 2014, while we seek a resolution there."


  • SAME:  March optimism is being extended into April.  Repeat visitation has been strong. PENN expects another build up in revenues in July/August time frame.  
    • "With Columbus, I'm not spending any time worrying about where Columbus is going to end up. It's going to be fine. It's showing sequential growth. It's showing increased visitation. It's showing improvements in the slot customer base. Clearly the fact that Scioto was out first in the market with very aggressive marketing upfront was not ideal. The reality is, over the long term – and I don't mean years, I mean a few more months, I think you'll see the Columbus property really come into its own in terms of getting an appropriate level of market share."


  • WORSE:  PENN raised corporate overhead guidance by $11MM due to higher development and stock liability expense (related to the higher share price). If we exclude development costs of $2.5 million and liability based stock compensation charges of $3.1 million, Q1 corp expense came in at $21.6MM. For Q2-Q4 2013, there will be $3.5-4MM development expenses and $5.5MM of stock liability charges.
  • PREVIOUSLY:  "I would expect corporate overhead to come back to a more normal level, probably on a normalized basis somewhere around $80 million would be our expectations."


  • SAME:  Q1 $62.7MM capex ($21.8MM maintenance capex, project capex: 1/2 wrap up costs at Columbus/Toledo, $6MM on tracks, rest on Hollywood St. Louis).  2013 capex will be $94.2MM maintenance capex and $277MM project capex.
  • PREVIOUSLY:  "Looking at 2013, we're expecting $275 million of project CapEx and roughly $97.9 million worth of maintenance CapEx for next year. Looking at the first quarter, I would break that down that we expect to spend roughly $49.4 million on project CapEx in the first quarter and $27.2 million of maintenance CapEx."

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