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.
Specifics
- 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.
- 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.