Amazon Will Drop An A-Bomb On FedEx's Margins

| About: FedEx Corporation (FDX)

Summary

FedEx CEO is in a state of denial.

Amazon's aim is not to take over the entire FedEx business.

More likely, Amazon and others just want the most lucrative routes and FedEx's customers just want to lower their costs by destroying FedEx's margins.

Given these threats and other factors mentioned in the article, FedEx's valuation is stretched.

Investment thesis

FedEx's (NYSE:FDX) CEO is in a dangerous state of denial and is missing the point.

Amazon (NASDAQ:AMZN), Uber (Private:UBER), Lyft (Private:LYFT) and other customers and competitors may not be able to chip away much of FedEx's sales this year. But that's not the point at all. The point is that they will slowly but surely and with increasing speed and effect keep stealing FedEx's most-lucrative routes and segments and aim at lowering delivery prices in order to negotiate better fees with FedEx. This will hurt FedEx's sales only a bit but it will absolutely destroy FedEx's margins.

FedEx's CEO probably thinks Amazon wants to take over FedEx's entire business whereas in reality Amazon most likely just wants to destroy FedEx's margins to save money and take the most lucrative business (including its internal delivery business). Naturally, United Parcel Service (NYSE:UPS) will be impacted as well.

But new competition and margin pressure is not the only issue for FedEx. The current valuation of 15x forward non-GAAP adjusted earnings (that still ignores net debt) is a problem as well, especially in connection with the following factors:

FedEx operates in an oligopoly with UPS and USPS in the U.S. and with DHL internationally. After the pending TNT Express (OTCPK:TNTEF) acquisition, its external growth opportunities will be very limited due to further mergers having a slim chance of being approved by antitrust regulators. So, the top-line growth is most probably peaking and there are very few new organic growth opportunities at the high ROI that FedEx's current business generates.

Margins are most probably peaking as well. Profits have been rising much faster than top-line growth partly due to cost cutting. This margin expansion trend is clearly unsustainable. FedEx currently operates very close to the highest margins of the past decade and we are arguably, significantly closer to the top of the business cycle than to its bottom.

FedEx is a very capital-intensive business with high-fixed costs. It even touts this as their major advantage. I see it as a weakness if the industry starts changing. FedEx's CEO correctly argues that no customer accounts for more than 3% of its sales, and it will take time and money for competitors to make a major dent in sales. But what the CEO is missing to mention is that even a small drop in sales will have an outsized impact on operating profits, due to the high operating leverage that works both ways as well as because of the negative product margin mix when the company loses the most lucrative business first.

Given the cyclicality, strong operational leverage and at least some financial leverage - FedEx also is an excellent hedge of a long U.S. stock portfolio against a potential U.S. and global slowdown. In short, FedEx is a good short candidate in the long run, but may see some strength for one or two more quarters.

High margins attract new entrants and FedEx's customers such as Amazon (planes, drones, driverless trucks), Uber/Lyft (cars)

Even FedEx's CEO boasts of the high margins and advertises them to the entire world in case some competitor or customer missed the fact:

"If we were to isolate our e-commerce business one could argue that FedEx is one of the most profitable e-commerce companies in business today."

This boasting about high margins is bound to keep motivating Amazon and other FedEx customers to build small, flexible networks of their own to service their most lucrative deliveries and put pressure on FedEx to negotiate better rates.

Here is why I think FedEx's CEO is in a state of denial

History is littered with lessons of CEOs underestimating competitors and the industry's potential fast-paced change. FedEx's CEO sees his industry in the narrow definition of competitors, considering only the big three that control 95% of the U.S. shipments, failing to see new entrants and, most importantly, to see its own customers as its competitors. So, while I agree with FedEx's CEO that it would take time and money to seriously take on FedEx, I believe the negative effects on FedEx will be stronger than what the CEO and the markets expect, and they also will happen sooner.

I will debunk FedEx CEO's statement that it would take "way too much time and money" to take on FedEx. Time and money are totally irrelevant for some customers/competitors, such as Amazon. Here is why.

The "too much money" argument

First, money is not an issue. We live (whether I like it or not) in an era of ZIRP and NIRP, where strong companies are flush with cash and are able to borrow even more - at almost no cost or issue - new shares at high valuations. In this "funny money" era, a startup like Uber can grow from nothing to a $62B valuation in five years.

Moreover, it is not without interest that Amazon's Jeff Bezos participated in one of the earliest Uber funding rounds through his Bezos Expeditions. I see a clear connection there with the current Amazon's ventures into FedEx's territory via planes and drones.

As a side note, Uber's current valuation is 30% higher than FedEx's. When Uber's valuation grows to $100B and Uber takes over FedEx with its stock, I believe that will be a clear sign of the peak of this bubble cycle, similar to AOL's takeover by Time Warner 15 years ago, at the dot.com bubble peak.

The "too much time" argument

How much time would it take, really, to hurt FedEx? If you have the money and use a leasing business model instead of building or owning the infrastructure and the fleet, the time drastically contracts. Plus, markets are always forward-looking. Even if competitors start chipping away at FedEx's most lucrative business very slowly, the markets will discount some of the erosion forward and this could mean weakness for FedEx's stock as soon as the current earnings euphoria fizzles and as soon as the TNT revenues are reflected in the numbers in several quarters from now.

Amazon has always been focused on the long picture, so time does not matter for the company, as long as the investment makes sense in the very long run.

The A-bomb scenario that would be absolutely toxic to FedEx

Amazon is known for taking a long-term view and not caring about margins at all in the short run. When Amazon just masters to take care of a majority of its own deliveries, this would hurt FedEx only to the tune of roughly 3% of sales and a bit more in margins. This sounds benign. However, what if Amazon drops the A-bomb and runs their delivery network at zero margins or even at a loss, significantly undercutting FedEx's margins - either with the goal of attracting new clients at the beginning, or simply because their goal may not be to take over FedEx's business, but to depress their margins to save on delivery costs paid to them? Something akin to what Google is doing with its Fiber business. Pushing existing providers to innovate and offer better and cheaper services. A similar move could push down FedEx and UPS margins on a majority of their business, not just Amazon's ~3% business with FedEx.

Has Amazon ever not destroyed margins in a business it entered?

Think about it. Is there a business that Amazon entered where margins have not dropped? Amazon is a poster example of zero-cost capital, a zero-margin model. This is going to destroy FedEx's (and UPS') high-margin, high-ROI model. While FedEx owns most of its fleet, Amazon is renting, making it much more flexible to scale up and down as needed. This is in line with the low-margin, low-risk, high scalability approach of Amazon. Unlike FedEx's fat margins, Amazon operates practically close to breakeven, so they don't provide such a strong incentive by competitors to take Amazon's share.

My takeaway

I believe FedEx's CEO is downplaying the threats facing the company. Amazon and other competitors will chip away at FedEx's attractive high-margin business, naturally attacking the most lucrative routes and segments first and aiming to lower FedEx's margins and their own costs. The capital-intensive FedEx will slowly, but surely, underperform. I'm bearish on FedEx in the long run, though I see one or two more quarters of strong results which will likely drive the stock price higher. I'm also bullish on Amazon in the long run, but the price is stretched.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.