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Without belaboring the issue, and to cut to the chase, the longer-term issue around FedEx Corp. (FDX) is the cost structure supporting FedEx Express, and management's willingness and ability to reduce headcount and fixed costs to right size the unit and make it profitable again.

Last October, FDX announced a $1.6 billion "profit improvement" initiative (which is really nothing more than a cost reduction strategy), to improve margins at Express specifically and at FDX in general.

FDX is different than UPS (UPS) in that FDX has more operating leverage and a higher fixed cost base, thus FDX requires stronger volume and higher revenues to maximize returns and to run efficiently, while UPS can run more efficiently in slower economies and environments, which has been the case post 2008, and 2009.

FedEx Express is 61% of FDX's total revenues, but operating income for the segment has shrunk to 0%. FDX's total operating margin is just 4% as of the May '13 quarter, down from FDX's stated objective of 10%, when the company and the business model is operating at peak capacity.

FDX revenue distribution by segment
5/13 2/13 11/12 8/12 5/12
Express 61% 61% 62% 61% 62%
Freight 12% 11% 12% 13% 13%
Ground 24% 25% 23% 23% 22%
Services 4% 3% 4% 4% 4%
Other -1% -1% -1% -1% -1%
Total 100% 100% 100% 100% 100%

* source: internal spreadsheet and 10-Q's

FDX operating income by segment
5/13 2/13 11/12 8/12 5/12
Express 0% 1.08% 2.07% 1.92% 2.55%
Freight 4.1% 4.3% 3.7% 4.1% 4.5%
Ground 0.33% 0.04% 0.68% 0.83% 0.74%
Services 0% 0% 0% 0% 0%
Other 0% 0% 0% 0% 0%
Total 4.4% 5.4% 6.5% 6.9% 7.8%

* source: internal spreadsheet and 10-Q's

As the reader can readily see from the numbers, FDX's operating margin is being diminished as FDX's major segment, FedEx Express continues to operate with too high a fixed cost base.

Ground continues to do very well, as it gains share against UPS, but Ground is just 25% of revenues, up from 0% in 2000.

The last few quarters FDX has discussed on the conference calls that their Asian customers have opted for "lower-cost" freight options, which presumably means leaving Express for shipping and other forms of freight movement.

In Q4 '13, ended in May '13, FDX reported that revenues rose 4% and earnings per share (EPS) rose 7% as "the tradedown effect" continued in Express.

The bulk of the $1.6 - $1.7 billion profit improvement isn't expected to show up until the fiscal '14 year, which started on June 1.

FDX is scheduled to report Q1 '14 financial results on Wednesday morning, Sept 18th, with analyst consensus expecting $1.51 in EPS on $10.97 billion in revenues for expected year-over-year growth of 5% and 2% respectively.

Our favorite analyst on the stock, Justin Yagerman of Deutschebank, thinks that fuel cost could be a negative this quarter as the fuel surcharge operates with a two-month lag (thereby compressing margin), but that shipping activity showed modest improvement through the summer.

Valuation:

FDX is trading at $110 per share as this preview is being written With current analyst consensus of $6.97 and $8.68 for 2014 and 2015 consensus, FDX is trading at 16(x) and 13(x) forward estimates for expected growth of 12% in '14 and 24% in 2015.

At 7(x) cash-flow FDX is trading inline with its cash-flow valuation for the last 10 years.

Morningstar has an intrinsic value on FDX of $112, while our internal model values FDX closer to $130 per share, using an average of the last 16 quarters or 4 years.

While the outlook seems bleak for FDX given the operating margin and squeeze occurring at Express, here is the bright side of the outlook:

1.) Global economies are recovering which should help improve volumes and freight shipping activity;

2.) While the outlook for crude oil prices seems bullish, we think prices for crude oil and jet fuel could decline moderately in the next year for a number of reasons that need to be detailed in another article.

3.) The combination of lower fixed costs at Express and an improving global economy with better freight volumes would improve FDX's "earnings delta" or earnings leverage;

Technically FDX's high print was $120 in May '06, and the stock bottomed near $40 during the 2008 recession. We would add to FDX near $90 on any pullback, which price level seems to offer multiple layers of technical support.

Margin expansion back to the 10% operating margin range for FDX is Nirvana, and will allow the stock's PE ratio to expand. At present we aren't there yet, but the faster FDX cuts Express costs, and the faster global freight volumes improve, the easier it will be for FDX to break out to an all-time high.


(Click to enlarge)

Source: FedEx Earnings Preview: Longer-Term, The Issue Is Cost Structure