What is stock analysis? Well, there are some that think it has everything to do with the dividend. There are others that only look at charts. There are others that think analyst estimate misses (notice how this is equivalent to companies' earnings beats) are a way to gauge the trajectory of a stock. And yet there are others who are lost in medieval times. We as investors need to move beyond these individual frameworks and start taking a holistic view. Let's take a look at what we mean as it relates to our analysis with FedEx (FDX).
At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation and relative valuation versus industry peers is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors.
If a company is undervalued both on a DCF and on a relative valuation basis it scores high on our scale. FedEx posts a VBI score of 5 on our scale, reflecting our 'fairly valued' DCF assessment of the firm and its attractive relative valuation versus peers. We compare FedEx to peers CH Robinson (CHRW), United Parcel Service (UPS), and UTI Worldwide (UTIW). In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:
• FedEx scores fairly well on our business quality matrix. The firm has put up solid economic returns for shareholders during the past few years with relatively low volatility in its operating results. Return on invested capital (excluding goodwill) has averaged 12.2% during the past three years.
• FedEx provides customers and businesses worldwide with a broad portfolio of transportation, e-commerce and business services. The company operates under various segments including: FedEx Express, FedEx Ground, FedEx Freight, and FedEx Services
• FedEx's cash flow generation and financial leverage aren't much to speak of. The firm's free cash flow margin has averaged about 1.5% during the past three years, lower than the mid-single-digit range we'd expect for cash cows. However, the firm's cash flow should be sufficient to handle its low financial leverage.
• FedEx's long-term financial goals are as follows: 1) achieve 10% operating margin; 2) increase EPS 10%- 15% per year; 3) grow profitable revenue; 4) improve cash flows; 5) increase ROIC; 6) and increase the dividend. We like management's focus.
• E-commerce and global trade growth continue to drive increased demand for FedEx's services. FedEx Express is becoming more efficient, FedEx Ground is gaining share, and FedEx Freight margins are rebounding.
Most Recent Quarterly Results
FedEx reported slightly lower-than-expected bottom-line performance in its fiscal second-quarter results. Revenue advanced 3% during the quarter, while reported operating income leapt 15% thanks to roughly 80 basis points of operating-margin improvement. Adjusted for the effects of Hurricane Sandy, however, year-over-year performance wasn't that great. The firm's quarterly earnings per share mark of $1.57 compares to an adjusted measure of $1.50, or a 4.7% increase, which itself was augmented by its share-repurchase program. Free cash flow was negative during the six months ended November 30, 2013, consistent with the cash use during the prior-year period. The company experienced improved yield and cost management (and materially better operating margin performance) at FedEx Express (its largest operating segment), but overall, the fiscal second-quarter performance wasn't as strong as we would have liked. Share repurchases will continue to bolster the company's bottom-line performance in the quarters ahead.
Traditionally, FedEx hasn't generated impressive measures of 'return on assets' and 'return on equity', and performance in the six months ended November 30 was no different. During the period, return on assets came in at just over 5%, while return on equity stood at an even 10%. Our future forecasts for return on invested capital hover in the low-teens, and while this is greater than our estimate of the firm's weighted average cost of capital, indicating economic profit creation, the magnitude is not great. We think FedEx is a good business, not a great one, on the basis of these return measures.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital - ROIC -with its weighted average cost of capital - WACC. The gap or difference between ROIC and WACC is called the firm's economic profit spread. FedEx's 3-year historical return on invested capital (without goodwill) is 12.2%, which is above the estimate of its cost of capital of 10.5%. As such, we assign the firm a ValueCreation™ rating of GOOD. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. FedEx's free cash flow margin has averaged about 1.5% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At FedEx, cash flow from operations increased about 54% from levels registered two years ago, while capital expenditures expanded about 42% over the same time period.
The estimated fair value of $121 per share represents a price-to-earnings (P/E) ratio of about 18.9 times last year's earnings and an implied EV/EBITDA multiple of about 7.1 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 4.5% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 6.3%. Our model reflects a 5-year projected average operating margin of 10%, which is above FedEx's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3% for the next 15 years and 3% in perpetuity. For FedEx, we use a 10.5% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $121 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for FedEx. We think the firm is attractive below $91 per share (the green line), but quite expensive above $151 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate FedEx's fair value at this point in time to be about $121 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of FedEx's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $163 per share in Year 3 represents our existing fair value per share of $121 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements