Our initial review of the FDX 10-Q shows some interesting inclusions and exclusions. To the negative side, the Intercompany expense reshuffling away from FedEx Express is not clarified. There is also a disclosure that some salary increases had been delayed until FY2Q. On the favorable side, the detail provided around the fuel surcharge lag suggests a greater impact than we initially assumed. Further, the Express review dropped some of the negative language around the IP/IE trade down. On balance, the 10-Q was not as favorable for our outlook as the earnings release, but that is fairly normal and we remain positive on the long-term potential for shares of FDX.
Intercompany Cost Allocation
The segment income statements show a $42 million in the Intercompany expense line decline at FedEx Express, along with allocation increases at Ground and Freight. That represents a significant, potentially non-operating tailwind for the Express margin through expense reshuffling among segments. We were looking for the 10-Q to provide some clarity and, yes, we should have questioned this item on the earnings call. Instead, the 10-Q includes new cautionary language on intercompany cost allocation: “our allocation methodologies are refined as necessary to reflect changes in our businesses.” It is very difficult to determine either the reason for or the appropriateness of the cost reshuffling away from FedEx Express. The size of the change in the quarter is not that far off the total YoY margin improvement, so it is not an item to let slide.
(We have pinged the company for background, but the 10-Q was released after business hours and we will follow-up as needed.)
Salary Increase Delay
There was also a disclosure that FedEx Express benefited from “the deferral of annual salary increases from the first quarter of 2014 to the second quarter of 2014 for many of our employees.” This was not quantified in the 10-Q and we have asked for additional background. We suspect that it is not a sequential positive for FY 2Q 2014, but the magnitude is likely to be more modest than the change in intercompany cost allocation.
Express: Fuel Surcharge Lag Impact, Maintenance Holiday, Pension & Depreciation
The fuel surcharge lag appears somewhat larger than our initial expectations, leaving the underlying margin better, all else equal as presented. This likely more than offset the benefit of the lower pension expense ahead of the new USPS contract. (The USPS contract was filed along with the 10-Q for weekend reading.) The higher depreciation expense looks to have been more than offset by lower maintenance, in part due to the 'maintenance holiday' provided by new aircraft. Lower headcount also contributed. The maintenance holiday will likely persist for some time, while the headcount contribution should improve as the voluntary severance program progresses this fiscal year.
Trade Down Toned Down
The 10-Q language around the trade down turned less negative, echoing managements’ comments that International Economy can be good business. Language used in FY3Q 2013 such as “shifts in demand from our priority international services to our economy international services and lower rates resulted in declines in package yields…” has been replaced with more muted language, like the shifts “continue to impact this business”. We estimate that the accelerated IP to IE mix shift in the quarter was not nearly as negative for margins as it had been during FY13.
FedEx repurchased 2.8 million shares in the quarter at attractive prices, similar to 1Q FY13. It is noteworthy, in part because FDX received a downgrade today from an analyst that would turn more positive if the company used its excess cash to pay higher dividends or buy in shares. But FDX did buy in shares, so we fail to reconcile the analyst’s view of capital allocation with the downgrade. That said, we like how FedEx focuses on running the business instead of promoting its buy backs.
There are a number of other items, including an update on the Independent Contractor litigation generally showing progress. Please follow-up on any specific items of interest.
On Balance: We still expect FedEx to improve the Express segment margin, eventually matching competitors in this well-structured industry. As the Express margin grinds higher, we would look for the market to place a higher value on the segment. The margin expansion will need to have more substance than cost shuffling between segments and time periods. We see specific items, such as refleeting, headcount reductions, network alignment and facility consolidation, that should help drive sustainable profit improvement. We also still think FDX should by TNT. We will continue to look for progress on those items through fiscal 2014.
Jay Van Sciver, CFA
HEDGEYE RISK MANAGEMENT
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