Contents
FDX does face formidable headwinds in the form of weakening global trade and industrial production, the termination of one of its contracts with Amazon (FDX now admits Amazon is a competitor), and a costly integration of TNT.
Despite these significant short-term headwinds, I am of the opinion FDX is taking the appropriate actions to mitigate the effects of macroeconomic uncertainty while continuing to make strategic investments to improve its capabilities and efficiency so as to drive long-term growth in earnings, margins, cash flow, and investor returns.
Summary
- FDX reported weak Q1 2020 results and lowered FY2020 guidance.
- FDX’s CEO expressed extreme pessimism about the global economy on the Q1 conference call with analysts.
- FDX’s investments made/is making are critical for it to compete against its key competitors which FDX now admits includes Amazon.
- The time to acquire shares in great companies is when they have fallen out of favor with the broad investment community.
Introduction
Readers unfamiliar with the magnitude of FedEx Corporation’s (FDX) services may wish to learn more by accessing FDX’s website (click here, here and here); FDX’s mission and goals can be found here.
On June 26 I wrote this FDX article in which I stated that investors should be grateful when good companies fall out of favor. At the time of that article, FDX was trading at $159.70 and I stated that I had just acquired additional shares for the FFJ Portfolio at ~$158/share. Subsequent to that article, FDX’s share price has been on a roller coaster ride!
Following the September 17 market close of ~$173.55, FDX released Q1 2020 results. The broad investment community did not react positively to FDX’s results and guidance and when I started composing this article on September 18 shares were trading at ~$149.70; shares closed at $150.99.
While it is entirely possible FDX’s share price could pullback further in the short-term, I am of the opinion the changes FDX is making to position itself for long-term success will make it a far more valuable company several years into the future.
Based on my analysis, I have taken the opportunity to acquire another 200 shares at $148.94 for one of the ‘Side Accounts’ within the FFJ Portfolio.
In this article I provide my take on why investors with a long-term investment time horizon would be wise to consider acquiring shares following the recent plunge in the share price.
Business Conditions
Interestingly, FedEx’s CEO Fred Smith has changed his tune as to whether Amazon is a competitive threat. In prior earnings calls he has stated that Amazon was not viewed as a competitor but on the September 17 Q1 2020 earnings call, however, he stated:
‘And the last thing I'm going to say is, we basically compete in an ecosphere that's got five entities in it. There's UPS, there's DHL, there's a US Postal Service, and now increasingly, there is Amazon. That's who we wake up to every day, trying to think about how we compete against and give the best services to our sales force.’
While the thought of FDX having Amazon as a new competitor is enough to send shivers down an investor’s spine I think we need to put things in perspective. FDX is not sitting idly waiting for Amazon to destroy its business. In fact, FDX’s CEO indicated on the Q1 earnings call that when FDX’s strategic management committee presented the FY2020 business plan to the Board of Directors in the Spring, the following 3 significant challenges to increasing earnings in FY2020 were identified:
- Beginning in the Fall of 2018, it had become clear that global trade disputes were adversely affecting manufacturing in Europe and Asia, thereby slowing international shipping demand.
- The TNT integration was facing its most important phase, leading to the integration of European ground operations by the end of FY2020.
- The need to add capabilities to enhance FDX’s services for the rapidly growing e-commerce market; FDX expects this to grow in the US from 50 million to 100 million packages per day by 2026.
This increase in shipments will be destined increasingly to residences and FDX is of the opinion 1 in 4 packages will be short distance deliveries. Although the backbone of FDX is the B2B business, FDX is of the opinion its ground and express line haul and short networks carry both B2B and B2C commerce with great efficiency.
In order to address future growth opportunities, FDX has recently launched or recently announced the following:
- FedEx extra hours and express service will provide nightly pick up with next business day delivery;
- Insourcing FedEx SmartPost packages for FedEx Ground delivery by peak 2020;
- The expansion of the FedEx Ground oversized package network to approximately 100 facilities by peak 2020;
- New return services and thousands of additional pickup and shipping points, including 8,000 general onsite locations in less dense areas;
- FedEx Freight Direct for heavy and hard to handle items.
FDX has indicated that it can handle millions of additional shipments generated by these new offerings without adding significant additional sortation capacity.
While a significant volume of Ground growth will be lower yielding short haul zone deliveries, margins should improve due to increasing density and minimal line haul cost. In fact, management is of the opinion its services and capabilities and cost will be industry leading in the short haul sector.
Although the repositioning of FDX for strong future earnings was expected to have a significant negative impact to FDX’s results in the short-term, the Board of Directors endorsed the proposed changes as FY2019 came to a close.
In my opinion, FDX is a company in transition and significant short-term costs were to be expected. I am willing to give senior management and the Board of Directors the benefit of the doubt that by the end of FY2020 FDX will have been significantly repositioned for strong future earnings as volumes continue to transition away from the US Postal Service.
In the summer of 2019, business conditions became increasingly challenging and the challenges were increased to some degree by FDX’s decision not to renew its largest Amazon contract plus the deepening trade disputes. Although the Amazon contract represented only a small proportion of FDX’s revenues, the nature of the business was such that near-term profits were expected to be adversely affected since the last bit of volume has significant flow through to the bottom line.
On a positive note, FDX has closed additional business to replace this lost Amazon traffic. This new business is currently being onboarded and FDX is taking out significant costs which were unique to Amazon's requirements.
Furthermore, as the global macro economy continues to soften, FDX is taking steps to reduce capacity. It will be retiring 20 MD-10-10 aircraft over FY2020 and FY2021 which will eliminate that fleet type from FDX’s air operations.
FDX has indicated that it is highly likely to also retire the remaining 10 A310 aircraft this year which will lead to the elimination of any costs related to that fleet type.
FDX is also parking the equivalent capacity of 7 MD-11 aircraft in FY2020.
Although there are no assurances there will be no recession during FDX’s FY2020, management is confident that continuing to push forward with the initiatives announced in May and June will improve FDX’s long-term future competitive position and industry leadership.
Q1 FY2020 Results
FDX’s Earnings Release can be found here. The accompanying Earnings Presentation can be found here.
Results were negatively impacted by weakening global trade and industrial production thus resulting in less than expected demand for FDX’s most profitable Express package and Freight services.
Express yields were also negatively impacted due to the resulting mix shift, lower weight per package, and customer trade down to slower lower price services. Management has indicated that these conditions are especially challenging in Europe, where capacity and network reductions are limited due to the current stage of the TNT integration; FDX is currently operating duplicate road and air networks.
FedEx Ground operating costs were higher due primarily to the expansion of operations to 6 days/week, higher purchase transportation costs attributable to volume growth and higher self-insurance expenses. Each transportation segment also had 1 fewer operating day in Q1 versus Q1 2019; this alone is estimated to have lowered earnings by ~$100 million.
The loss of volume from Amazon also had a negative impact on results.
In addition, operating costs, including depreciation, increased as a result of the strategic investment programs. FDX is currently in the process of modernizing its FedEx Express aircraft and hubs and is also investing heavily in technology that will further optimize the networks and will enhance safety and capabilities.
On the modernization of FDX’s aircraft fleet front, FDX expects the capital investment to lower costs through enhanced reliability, reduced maintenance costs, and improved fuel efficiency.
Partially offsetting the negative factors reflected above were:
- the benefits from a ~$0.3B decrease in variable incentive compensation;
- FedEx Ground volume growth of 7%;
- increased revenue per shipment at FedEx Freight and FedEx Ground;
- cost reductions from business realignment activities, including the U.S. voluntary employee buyout initiated in 2018.
During Q1, FDX issued $2.1B of debt with proceeds used to redeem debt maturing in FY2020 as well as a $1B contribution to the company’s pension plans; additional contributions to the U.S. pension plans is not anticipated in FY2020.
Another positive note is that there are no material debt maturities prior to FY2022.
FY2020 Guidance
Management has lowered its adjusted EPS guidance for FY2020 to $11 - $13/share; I provide my opinion on FDX’s current valuation in a subsequent section of this article.
This downward revision reflects the lowered revenue outlook which is being driven by increasing trade tensions and the corresponding weakening in global economic conditions, especially industrial production that has occurred since FDX’s June 25 FY2019 earnings release.
Although increasing uncertainty around trade negotiations and government policies has made it extremely difficult to forecast demand and corresponding earnings, management’s forecast assumes moderate U.S. economic growth, current fuel price expectations and no further weakening in international economic conditions.
Management has cautioned that further anti-trade measures and/or adverse changes in international trade policies and relations would likely drive additional weakness in FDX’s business. For now, however, management believes the current macro and business conditions are such that adjusted EPS will likely fall slightly above the midpoint of the $11 - $13 range.
In addition to the impact of macro uncertainty, FedEx Ground operating expenses are expected to be higher than previously forecast due to volume mix, lower than planned delivery density, higher wage rates and ongoing investments to enhance e-commerce capabilities, including expansion to seven day operations. The new forecast also reflects the loss of FedEx Ground business from Amazon that began in August.
FDX’s FY2020 effective tax rate prior to the year-end mark-to-market retirement plan accounting adjustment is now expected to increase 24% -26% due to lower than expected earnings in certain non-U.S. jurisdictions. In response to these issues, FDX is taking additional actions on a number of fronts to better align costs.
FDX continues to expect to incur ~$0.35B of TNT integration expenses in FY2020 and $1.7B in total through FY2021. In addition, management continues to expect FY2020 CAPEX of ~$5.9B and while FY2021 CAPEX planning is only in the early stages, a similar figure is expected for FY2021.
Credit Ratings
FDX’s senior unsecured debt continues to be rated Baa2 by Moody’s. This is the 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
Please refer to the comments made in my June 26 article.
Valuation
At the time of my June 26 article, FDX’s had just reported FY2019 diluted EPS of $2.03 and shares were trading at ~$159.70 giving us a diluted PE of ~78.67. FY2019’s diluted EPS, however, had been distorted by $11.22 in a ‘mark-to-market retirement plan accounting adjustment’.
When I compared FDX’s FY2019 PE with that of 2010 – 2018 (22.3, 15.18, 14.73, 27.81, 22.01, 37.81, 27.02, 22.98, and 8.79) it was clear that a proper comparison would not be possible on the basis of non-adjusted EPS.
Since earnings were negatively impacted by an $11.22 item that did not require FDX to lay out any cash I, therefore, added back the $11.22 mark-to-market retirement plan accounting adjustment. In doing this I arrived at $13.25 in adjusted diluted EPS. I did 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/would have to lay out money for these line items.
Using $13.25 in adjusted earnings and the ~$159.70 share price to gauge FDX’s valuation I arrived at an adjusted PE of ~12.05 which I deemed attractive.
We now see that FDX expects FY2020 adjusted diluted earnings to come in just slightly over the mid-point of the $11 - $13 guidance. Shares are now trading at ~$150.91 so using FY2020 adjusted diluted earnings of $12 I arrive at a forward adjusted diluted PE level of ~12.58 (~12.41 based on my recent purchase price of $148.94).
I view this valuation as attractive.
I pointed out in my June 26 article that 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.
You will also note from FDX’s dividend history that the quarterly dividend has remained frozen at $0.65 for the most recent 6 consecutive quarters. I fully expect the quarterly dividend to remain unchanged until business conditions improve.
At the time of my June 26 article, FDX’s dividend yield was ~1.63% on the basis of the then current ~$159.70 share price; this level was superior to the sub1% historical yields. We now see that the dividend yield on the basis of the current ~$150.91 share price is ~1.72%.
At the time of my June 26 article, the weighted average diluted common and common equivalent shares outstanding amounted to 265 million in FY2019. This has been reduced to 262 million for the 3 months ending August 31, 2019.
Final Thoughts
In my opinion, FDX is taking the appropriate actions to mitigate the effects of macroeconomic uncertainty while continuing to make strategic investments to improve its capabilities and efficiency so as to drive long-term growth in earnings, margins, cash flow, and investor returns.
I do not dispute FDX will very likely continue to face formidable headwinds in the short-term and fully expect investors focused on the short-term will not touch FDX with a ‘10 foot pole’.
In addition, I fully recognize FDX now faces a ‘new’ formidable competitor in the form of Amazon. Looking at having Amazon as a competitor from a positive perspective….FDX is forced to become increasingly more efficient.
I have long held the thought that the time to acquire shares in great companies is when they have been ‘kicked to the curb’. Judging from the ~13% drop in FDX’s share price on September 18 from the previous day’s close, FDX has been royally ‘kicked to the curb’.
I like the changes FDX is making and although these changes are costly and not everything goes smoothly (ie. TNT integration), senior management and FDX’s Board of Directors has my vote of confidence. I have, therefore, acquired another 200 shares at $148.94 for one of 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!
Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].
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.
