“Overall, we expect earnings growth for Q1 2014 to be solid but challenged as we expect headwinds year-over-year from fuel surcharge timing lag, one less operating day and continued pressure on international yields and Freight volumes. Also the benefits of the voluntary buyout program will ramp out throughout the year with the majority of those expense reductions occurring after the first quarter. Our businesses are cyclical in nature and seasonal fluctuations will affect volumes, revenues and earnings.” - Alan Graf, June 19 2013 FY4Q 2013 Earning Call
Last quarter, FDX changed its guidance practices and ceased providing quarterly guidance. We think consensus is a bit off for FY 1Q as a result. We again expect the market to focus heavily on the Express division adjusted margin. This will be only the second quarter in which we should “see” some benefit from Express restructuring and we would settle for a repeat of the YoY improvement shown last quarter. We continue to think that FDX will prove a rewarding long-term position, as FedEx Express focuses on profitability instead of market share. FedEx is also well positioned to benefit from signs of stronger economic growth.
Consensus May Be Too Pessimistic: We hate to make quarterly earnings forecasts, but it is difficult for us to get to the $1.50 consensus estimate for this quarter. Quarterly earnings can be volatile, but we get an adjusted EPS number north of $1.58. Forecasting may be more difficult in the absence of management guidance details. Current consensus for the quarter is below the full year earnings growth rate guidance of 7%-13%.
Positives in Quarter: FedEx gets the benefit of a lower pension expense in FY1Q without the headwind of the new USPS contract. The Express margin should also benefit from additional capacity actions, continued refleeting, and the first tranche of headcount reductions. There is little reason to expect Express to give up the benefit of shifting low yielding volume out of high cost channels, which helped the FY4Q Express margin. There are offsets, like a higher depreciation expense and one less operating day, but they net out favorably in our scenarios.
Economic Data: The operating environment should have been less challenging for FDX than FY4Q 2013. For instance, IATA FTKs grew in June in July amid improving economic indicators, although certain key regions still showed weakness. ISM new orders, industrial production in Europe and Chinese export data also point to improving conditions. Excess airfreight capacity appears likely to have kept pricing restrained, but likely less so sequentially.
Fuel Prices: FedEx highlighted the risk of higher fuel prices, but YoY average jet fuel prices for the quarter look fairly flat. The lag in fuel surcharge may have a relatively modest negative impact. We do not expect FedEx Express to trot out a Syria excuse, since jet fuel costs should not be a particularly meaningful headwind.
Express Margin: FedEx reported a 6.6% adjusted operating margin for its express division in FY4Q 2013, up 50 basis points from the FY4Q 2012 result. Sequentially, that was a significant improvement - FY3Q 2013 margins were down 130 basis points from the year ago quarter. Continuing those gains into FY1Q, which may be be too pessimistic, gives an adjusted express margin of 3.6%. An adjusted express margin exceeding 4% would likely be viewed as exceptionally good progress.
Capital Spending & Capacity: Growth capital spending for FY14 is to be directed at FedEx Ground, with FedEx Express spending targeted at lowering costs (not expanding capacity). Returns for both of those initiatives should be higher than the capacity additions to Express in recent years. We will look for more details around the Ground spending initiatives.
Trade Down: While there is a lot of focus on the trade down, much of FedEx Expresses recent improvements have come from ‘self-help’: adjusting capacity to meet the quantity and yield of volume. UPS said in its more recent earnings release that trade down was still a headwind. However, we will focus on FedEx’s adjustment to the mix shift, which should keep margins moving back toward those of competitors. As long as margins expand on the Express division’s huge revenue base in coming quarters, we do not expect trade down to be the share price driver.
About $8.00: We still expect FDX to generate FY2014 adjusted earnings just shy of $8.00. After all, current consensus barely secures management’s deferred compensation packages according to the recent proxy. Fortunately, if we are wrong, FedEx senior managers will probably be able to get by without it.