FedEx Corporation's (FDX) share price has been under pressure as it faces headwinds resulting from the current trade war.
I view FDX as a leader in the Air Delivery and Freight Services industry.
Its current attractive valuation presents long-term investors with a window of opportunity to invest in a high quality company which should benefit from the projected growth in e-commerce.
- FDX reported Q4 and FY2019 results following the close of business June 25th.
- Decisions made in Washington have had a significant detrimental impact on FDX which has led to FDX filing suit seeking to enjoin the U.S. Department of Commerce from enforcing prohibitions contained in the Export Administration Regulations.
- Despite new competition from Amazon.com and Uber Technologies I view FDX as one of the premier companies in the Air Delivery and Freight Services industry.
- There is no indication as to when current headwinds which have depressed FDX’s share price will subside but I view FDX as an industry leader which has fallen out of favor with the broad investment community and whose shares are now attractively valued.
When I analyze a company I take into consideration that macro events can have a negative impact on a company’s short-term investment performance. I also look at the extent to which the company being analyzed could be impacted by the entry of new competitors (eg. Amazon.com (AMZN) and Uber (UBER)).
Subsequent to my December 19th FedEx Corporation (NYSE: FDX) article, FDX has continued to experience significant challenges. The global trade environment continues to deteriorate and circumstances have become so dire that more than 300 companies are talking to government officials in Washington about how detrimental the trade war between the U.S. and China has been and will be to their business.
FDX has gone one step further than most other companies having resorted to filing suit in U.S. District Court in the District of Columbia on June 24th seeking to enjoin the U.S. Department of Commerce from enforcing prohibitions contained in the Export Administration Regulations (“EAR”) against FDX; here is the explanation from FDX’s CEO and Chairman regarding the lawsuit.
On June 25th, FDX released Q4 and FY2019 results in which it reported better-than-expected Q4 earnings amid stiff competition from rival UPS (UPS). In the conference call with analysts, FDX’s CFO stated that FY2020 performance is being negatively affected by continued weakness in global trade and industrial production, especially at FedEx Express.
In addition, the investment community was advised that macroeconomic weakness and trade uncertainty, a continued mix shift to lower-yielding services and the decision to not renew an AMZN contract will negatively impact operating income at FedEx Express. I do not view this decision as it relates to business conducted with AMZN as an entirely negative event. FDX made this decision as part of its plan to focus on serving the broader e-commerce market. I also note that FDX has indicated that existing contracts between AMZN and other FDX business units, or relating to international services, are not impacted.
Furthermore, AMZN is not FDX’s largest customer. The percentage of total FDX revenue attributable to AMZN represented less than 1.3% of total FDX revenue for the 12-month period ending December 31, 2018.
In making the strategic decision to exit the U.S. domestic contract with AMZN, FDX took the position that there is significant demand and opportunity for growth in e-commerce; growth from 50 million to 100 million packages a day in the U.S. is projected by 2026.
On the June 25th conference call with analysts, FDX’s Chairman and CEO indicated that in order to substantially grow its e-commerce business and improve profitability, FDX will need to become increasingly efficient in delivering residential packages and will need to drive down costs to serve this market. In this regard, FDX recently announced in-sourcing 2 million SmartPost packages and it also reached an agreement with Dollar General (DG) for over 8,000 pickup and delivery on-site locations with several additional initiatives pertaining to the growth of this area of FDX over FY2020.
In fact, once the DG rollout is complete the number of retail locations providing staffed FDX shipping will grow to over 27,000; this alliance brings FDX closer to the consumer than ever with FDX now within 5 miles of over 90% of the US population.
In addition, FDX has recently announced a number of innovative solutions for its FedEx Ground network such as:
- 7 day a week residential delivery;
- The rapid integration of FedEx SmartPost volume into standard ground operations;
- The enhancement of network capabilities around large package handling.
These changes directly address some of the key challenges inherent with e-commerce (ie. increasing consumer expectations and managing the cost for residential delivery). By bringing the SmartPost volume into the ground network FDX can improve density and efficiency in the Last Mile deliveries; FDX expects FedEx Ground to become the low cost Last Mile provider in the industry.
FDX expects to have a large package operation in nearly 40 Ground facilities prior to its peak season (late 2019) with the vast majority of these ground facilities being existing facilities; this approach minimizes CapEx and enables FDX to focus on placing large package handling in strategic locations which are close to ports and railroads.
In order to remain at the forefront of its industry FDX has been investing heavily in technology. The freight industry has historically been paper based and by updating its systems to incorporate the latest in technology, I envision FDX will be able to greatly benefit from near real time data since it will be easier to maximize the use of rail, improve delivery density and increase the efficiency of handling all packages.
The technological enhancements and state of the art tools are being implemented across all FDX operations. FedEx Freight, for example, is in the midst of adding technological advancements like advanced forklift computers, electronic shipping labels, and advanced driver assist systems.
At FedEx Express, initiatives are being implemented to lower the cost to serve the US market. In fact, a multi-year hub modernization program has been launched at two FedEx Express hubs which is expected to enable FedEx Express to handle more volume more efficiently.
Although the global trade picture presents considerable challenges, FDX continues to move forward with the integration of TNT; FDX is now beginning FY2020 with a global sales force that is 98% integrated.
In my opinion, the FDX of today is very different from the FDX of 10 years ago and what it will be 10 years in the future. I, therefore, caution investors to be very careful when extrapolating past assumptions and trends into the future.
FDX has noted that short haul package delivery will become increasingly important as retailers ship e-commerce orders from its stores. As a result, the average yields will need to be matched with changes which are not clearly visible when assessing FDX’s operations.
FDX also expects future developments will speed up e-commerce deliveries and postal reform thus resulting in discontinuities in the next several years.
Despite all the enhancements FDX is making to become more efficient and profitable in the long-term, I can appreciate how many investors will look at the global trade headwinds and the rapidly changing environment in which FDX competes and will wonder whether FDX will be a wise investment over the long-term. In my opinion, the changes FDX is making are critical and will benefit the company over the long-term.
I completely agree that FDX will most likely continue to face significant short-term headwinds which could result in less than stellar results over the coming quarters. I, however, continue to view it as a high quality company with a bright long-term outlook and have acquired additional shares for the FFJ Portfolio at ~$158/share.
Q4 and FY2019 Results
FDX’s Earnings Release can be found here.
Q4 operating income was negatively affected by:
- lower FedEx International Priority package and freight revenues at FedEx Express;
- higher costs at FedEx Ground;
- business realignment costs primarily associated with the U.S.-based voluntary employee buyout program.
Partially offsetting these factors were the benefits from:
- US volume growth;
- increased revenue per shipment at FedEx Freight and FedEx Ground;
- lower variable incentive compensation expenses;
- a favorable net impact of fuel at all transportation segments.
The higher FedEx Ground costs were primarily related to increased purchased transportation rates and the January launch of year-round, six-day-per-week operations.
Q4 FedEx Express operating income declined as weakness in global trade and industrial production drove a decline in international revenue. Offsetting some of this operating income decline was a $0.085B gain on the sale of a non-core business of TNT Express. Several immediate cost containment actions (significant reductions of variable incentive compensation, limiting hiring and discretionary spending, and completing the U.S. voluntary employee buyout program) has also helped offset some of this weakness.
FDX incurred realignment costs of $0.316B in Q4 (primarily severance for employees who accepted voluntary buyouts) which are expected to benefit FY2020 results by ~$0.24B.
In addition, there was a pre-tax noncash mark-to-market (MTM) retirement plan accounting adjustment of a net $3.9B loss due to a lower discount rate, changes in actuarial estimates and lower-than-expected asset returns. The 42 bps discount rate decrease contributed $1.8B of the net loss.
Management has indicated on several occasions that despite the current challenging environment the necessary investments are being made today to capture the significant future market opportunities. This includes:
- enhancing FedEx Ground capabilities, speed and efficiency;
- improving FedEx Express hub automation;
- modernizing FedEx Express air fleet;
- integrating TNT Express with significant benefits expected to be realized by summer 2021;
- reducing unit costs and increasing productivity.
FDX has indicated it is unable to provide a FY2020 EPS or effective tax rate (ETR) outlook on a GAAP basis; I indicated in my previous article that this is no different than every other quarterly earnings release provided by FDX so I do not view this as a cause for concern. It has, however, provided the following guidance in its June 25th Earnings Release:
- A low-single-digit percentage point increase in diluted EPS prior to the year-end mark-to-market (MTM) retirement plan accounting adjustment compared with FY2019’s $13.25 diluted EPS prior to the year-end MTM retirement plan accounting adjustment;
- A mid-single-digit percentage point decline in diluted EPS prior to the year-end MTM retirement plan accounting adjustment and excluding estimated TNT Express integration expenses compared with fiscal 2019’s adjusted earnings of $15.52/diluted share;
- A higher ETR in the range of 23-25% prior to the year-end MTM retirement plan accounting adjustment; and
- Capital spending of $5.9B;
- Total TNT Express integration program expenses through FY2021 are now estimated to be approximately $1.7B, of which $0.35B is expected to be incurred in FY2020.
The targets reflected above assume moderate U.S. economic growth, current fuel price expectations and no further weakening in international economic conditions. Should adverse changes in international trade policies and relations occur, FDX fully anticipates additional weakness in its business.
While FDX is not required to make a pension contribution in FY2020, it expects to make a $1B contribution.
Investors accustomed to large dividend increases and significant share repurchases over the last several years should now expect the stock buyback level to be significantly lower in FY2020. In addition, FDX has elected not to increase its $0.65/share quarterly dividend.
FDX operates in a highly capital-intensive industry where billions of dollars are spent on the acquisition of fleet and other transportation infrastructure. Typically, companies with high levels of debt fare poorly in economic downturns and with the air cargo delivery industry being somewhat cyclical in nature I pay close attention as to how the ratings agencies rate FDX’s debt.
FDX’s senior unsecured debt continues to be rated Baa2 by Moody’s (middle tier of the lower medium grade category).
S&P Global continues to assign a BBB long-term debt rating. This rating is also the middle tier within the lower medium grade category.
Free Cash Flow
Although I look at a company’s stock price relative to its earnings I know that earnings can be distorted by the manner in which various expenses are reported. I, therefore, look closely at the degree to which a company is generating Free Cash Flow as this is a metric that is less likely to be distorted.
When we look at the difference between FDX’s Operating Cash Flow and Capital Expenditures over the past few years to arrive at Free Cash Flow (FCF), we see that FCF has been negligible and even negative in FY2017 – FY2019; FDX purposely made Capital Expenditures in excess of its Operating Cash Flow as part of its overall strategic plan.
Although a company which fails to generate positive FCF generally gives me cause for concern, FDX’s CFO indicated on the June 25th earnings call that he expects improved FCF in FY2020.
He further indicated that FDX wants to spend upwards of $7B in CAPEX (but guidance calls for $5.9B) since management is of the opinion the projects on the table will have good strategic returns. Many great ideas, however, do not always make the cut but for now, the plan is to tackle initiatives that will drive down costs. And improve FCF over the coming years.
If we use FDX’s FY2019 diluted EPS of $2.03 and its current ~$159.70 share price we get a diluted PE of ~78.67. FY2019’s diluted EPS, however, has been distorted by $11.22 in a ‘mark-to-market retirement plan accounting adjustment’. *
Looking at FDX’s PE for 2010 - 2018 we see the following levels: 22.3, 15.18, 14.73, 27.81, 22.01, 37.81, 27.02, 22.98, and 8.79.
Clearly, comparing FDX’s FY2019 PE with that of recent years is not practical.
Since earnings were negatively impacted by an $11.22 item that did not require FDX to lay out any cash, I am adding back the $11.22 mark-to-market retirement plan accounting adjustment. In doing this I get $13.25 in adjusted diluted EPS. I have not added back $1.18 in TNT Express integration expenses, $0.91 in business realignment costs, and $0.16 related to the FedEx Ground legal matter because FDX had to lay out money for these line items.
Using $13.25 in adjusted earnings and the current ~$159.70 share price to gauge FDX’s valuation I get an adjusted PE of ~12.05. In my opinion, this is an attractive level.
*Note: On June 12, 2015 FDX announced a change in its accounting method for defined benefits pension and postretirement healthcare benefits. It moved to this method to recognize actuarial gains and losses related to postretirement and pension versus the previous method in which it used to amortize gains and losses over a period of years. By adopting this accounting method, we now get a clearer picture of the performance of FDX’s pension plans because we get an instant recognition of gains and losses in the income statement. This method aligns the income statement treatment with the treatment required to measure the related assets and liabilities in the balance sheet.
Dividend, Dividend Yield, Dividend Payout Ratio, and Diluted Shares Outstanding
If you are reluctant to invest in a company unless it has a lengthy track record of annual dividend increases then FDX is not the company for you. FDX only initiated a dividend in FY2003 and for the first several years in which it distributed a dividend, dividend increases were negligible.
Most recently, FDX has decided not to increase its $0.65 quarterly dividend; the July 8, 2019 dividend payment will mark the 5th consecutive quarterly dividend at this level and I envision the quarterly dividend remaining unchanged until business conditions improve.
FDX’s dividend yield is now ~1.63% on the basis of its current ~$159.70 share price; this level is superior to the sub1% historical yields.
In FY2014 the weighted average diluted common and common equivalent shares outstanding amounted to ~310 million shares. This level had been reduced to 265 million in FY2019. FDX has indicated it does not intend to repurchase shares to the same extent as in recent years.
Although FDX’s business will likely be negatively impacted by AMZN and UBER I am of the opinion that the expensive, but necessary, investments FDX is making to remain at the forefront of its industry will be beneficial over the long-term.
With low-single-digit EPS gain projected for FY2020, excluding a year-end retirement plan accounting adjustment, FDX might hold little appeal for many investors.
In my opinion, I envision FDX shares remaining under pressure in the short-term thus giving investors with a long-term investment time horizon an opportunity to acquire shares in a great company at an attractive valuation.
I have been purposely refrained from deploying new money in what I view, for the most part, to be a market in which stock prices have become detached from the fundamentals of the underlying businesses. In the case of FDX, however, I am of the opinion that the share price has retraced to an attractive level and have thus acquired additional shares for the ‘side accounts’ within the FFJ Portfolio.
I hope you enjoyed this post and I wish you much success on your journey to financial freedom.
Thanks for reading!
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Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.
Disclosure: I am long FDX.
I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.