FedEx Can't Deliver: Capitalize on Expected Downside

Last week we mentioned that we'd like to take a look at a downside put spread in Fed Ex (FDX), an overnight transport firm that could be vulnerable to higher fuel costs. We mentioned it, but we didn't do it. To our chagrin, we saw Fed Ex actually come out Monday May 12th with an earnings warning due to - yes you guessed it - higher fuel costs. So rather than jump on that bandwagon and what we suspected would be elevated put option premiums, we decided to put that trade "on the radar screen" and wait for a better time to buy in. One week later, we think that time has come. Nothing better than a seasoned steak, an aged bottle of wine, or a put spread trade that you've waited for to develop.

So today, we're going to create a put spreads on Federal Express. The way the overall market looks, we may be fighting the tape a little, but as the market crosses 13,000 on the Dow Industrials Index to the upside, we think there are some significant headwinds to be looking at, especially higher fuel prices. At the same time, we think we need some downside protection to offset last week's covered calls we recommended on Delta Airlines (DAL) (which is still a great bargain, if you missed it last week) so this trade will do that very well.

Technical Analysis

The above chart shows Federal Express stock for the last six months. The stock has been holding up despite higher fuel prices, but has come off its highs. Given last week's warnings on earnings, the technical indicators are starting to deteriorate. The Relative Strength [RSI] and Moving Average Convergence / Divergence [MACD] stochastic lines are negative right now, and look like they could turn south pretty quick. We think the timing is right for a put spread on this name.

Fundamental Analysis

• Current Price: $92.44
• Shares Outstanding: 310.6 million
• Market Cap: $28.5 billion
• Forward Price / Earnings (avg. Est): 14.8x
• PEG Ratio (5 Year Expected): 1.4x Price / Book: 2.0x

FDX lowered its quarterly profit expectations last week, announcing that they expect to earn somewhere in the range of $1.45 to $1.60 per share this quarter (their fiscal fourth quarter), a reduction from the previously announced expectation of between $1.60 to $1.80 per share. The company firmly blamed higher fuel costs for this reduction in EPS. Full year fiscal estimates for FDX were also reduced by many brokerage houses last week to a level of $5.80 (average) from a level of $5.90 the previous week. The next earnings date for FDX is coming on June 18, 2008.

Despite higher revenues expected in the 2009 fiscal year (analysts are projecting about 8% Y-O-Y growth in top line sales), analysts are now moving down their targets for 2009 EPS as well. At present, the average of the 18 analysts who follow FDX have a $6.20 EPS for the 2009 fiscal year, which while showing an increase over 2008's fiscal year results, does show that the company will continue to struggle for profit growth in an environment of rising fuel costs. Ninety days ago, the 2009 FY EPS estimates were over $7.10 per share. This is the canary in the coal mine, in our opinion, and the reason for our bearish outlook on FDX. Margins are going to be compressed in this industry, even if Fed Ex tries to pass on the costs to consumers with fuel surcharges. Competitive pressures in thin-margin industries usually lead to price wars, which are never good for any business's bottom line. Although we are not predicting this outcome, we are predicting diminished levels of profit margins for FDX.

Federal Express' balance sheet has some strength to it, giving the company some flexibility to meet rising fuel costs. The firm currently holds $1.0 billion in cash and maintains only $2.0 billion in debt. Not bad for a firm of this size (over $28 billion in market cap). FDX also pays an annual dividend of $0.40 per share.

Investment Recommendation

We recommend that investors create a put spread in the October 2008 expiration. We would buy the October $90 put for $5.70, and sell the October $75 put for $1.60, for a net cost of $4.10. The maximum profitability of this trade is $15 per contract if FDX is trading below $75 at October's expiration. We would look to exit this trade if the spread could be unwound for anything greater than $12.50 between now and expiration. This "trigger" can be entered with your broker.

Investors will have just about five months (until expiration in October 2008) to realize these levels if purchase of the stock and sale of the call occurs on Monday, May 19, 2008.

Please note: Options trades all involve a high degree of risk and the potential to lose some or all of your investment. These recommendations are general in nature, and you should consult your own financial professional who is familiar with your situation as to the appropriateness of these trade ideas.

Disclosure: Analyst has no position in FDX stock or FDX options.