We noticed increased hedge fund chatter regarding FedEx (FDX) recently following large declines in its stock price. We think the price declines made it a promising investment opportunity for the next 12-24 months.
FedEx has around 5,000 operating facilities that link over 99% of the world's gross domestic product. It sorts over 15 million shipments per day. The company is priced like it is a low-growth stock with a forward P/E ratio of around 10x or 11x (if you believe management’s guidance), yet management has respectable long-term goals of increasing earnings per share 10-15% per annum. The company has had some below-plan performance in the past, and management has cut costs to correct that.
What elite funds think
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For the quarter ended December 2018, Mason Hawkins's Southeastern Asset Management increased its position by 4% to 2.64 million shares, good for 6.08% of its equity portfolio. “FedEx shares, a duopoly with UPS in the U.S. ground business, yet trades at a 13.9x price-to-earnings ratio (P/E), while UPS is at 18.0x. FedEx has lower labor costs and more growth potential as it takes share from UPS and integrates its recent purchase of TNT. FedEx has a dividend yield of less than 1% and a 1.2 beta, while UPS has a 2.9% dividend yield and a beta of 0.7,” said the fund’s September 2016 investor letter about the stock. The value fund believes FedEx’s margins are nowhere near peak and the company can “raise margins even without an economic or revenue tailwind.”
More recently Lakewood Capital, which doubled its FedEx position in Q4 and allocated 5% of its 13F portfolio to the stock, said the following about the stock in its 2018 annual letter:
“At 10x forward earnings, FedEx shares are trading at their lowest levels in nearly a decade. FedEx trades like a deeply cyclical business, and the stock has been punished due to concerns around the global economy. At the current valuation, FedEx is trading at right around the replacement cost for its network. While the company has seen recent weakness in international markets, two-thirds of FedEx’s revenues (and an even greater percentage of operating profits) are now generated in the U.S., where its ground business continues to see strong secular tailwinds from e-commerce. We see significant upside for what is one of only two major parcel carriers in the world, and at the company’s historical multiple of around 15x our estimate of fiscal 2020 earnings (fiscal year ended May), shares would be worth approximately 60% more than current levels.”
Artisan Partners was also buying FedEx shares recently. Here is what they said about the stock:
“In the December swoon, international shipper FedEx - our latest acquisition was under pressure as investors feared slowing global trade. Furthermore, FedEx indicated its integration of TNT Express was going to take longer and cost more than originally planned. We have long admired FedEx but only recently have we found the asking price of the business disconnected from our assessment of business value. FedEx operates a global network which enables the express shipment of goods to almost every corner of the globe, with time-definite delivery, in under seventy-two hours. It is the largest express air carrier in the world with industry leading speed and reliability performance. Additionally, FedEx operates a ground delivery business in the attractively structured US market. The logistics business is highly cyclical, which will lead to pressure on profits in an economic downturn. When we initiated our purchase, we assessed the market was pricing FedEx at a value which assumed a recession was around the corner. Taking a longer view, we think the majority of outcomes for FedEx in the years ahead lead to higher earnings and a better multiple as returns on capital improve once the TNT Express integration is complete and global trade fears subside.”
Why FedEx Stock Was Weak
FedEx used to be a great way to play the rise of ecommerce, which many expect to grow around double-digit percentage rates through 2025. The more people bought stuff online, the more things were shipped, with FedEx benefiting. The company’s revenues rose a lot because of it.
Lately, there has been concern that FedEx could be cannibalized by Amazon (AMZN). The rumor that Amazon might have left the delivery company XPO Logistics (XPO) also added to the speculation. Amazon was rumored to be XPO's largest customer previously, and XPO shares fell sharply after the company slashed its 2019 guidance. Overall, FedEx is down 26% in the last four quarters.
Amazon seems to be entering the delivery parcel business. According to the Wall Street Journal in February 2018, the company is "preparing to launch a delivery service for businesses," dubbing it "Shipping with Amazon." Amazon plans to start the service in Los Angeles and aims to bring it to other cities. It's initially going to be done with Amazon's third-party sellers, but it could eventually be offered to other businesses. The original plan was to offer delivery services cheaper than FedEx and UPS. Competition from Amazon is bad news, as it drives down margins.
Amazon is a strong competitor. The company used to be a bookseller. Due to Bezos’ determination, it became so much more. The former bookseller now sells everything, ranging from soda to televisions. Given how important speedy delivery is in the age of instant gratification, it would be logical for Amazon to want to "in-house" the delivery of parcels.
Amazon could save money if it did logistics on its own. It spent around $27.7 billion shipping globally in 2018 and $21.7 billion in shipping globally in 2017. According to some estimates, the company could save around $1-2 billion for 2019 if it had more control over its shipments.
For its in-house transportation fleet, Amazon has around 40 cargo planes (FedEx has around 675 aircraft), but plans on expanding that number to 50 over the next few years. Morgan Stanley believes that Amazon will eventually have around 100 planes at some point. The company has also recently established a position in the future of transportation with investments in self-driving tech (Aurora) and an electric truck start-up (Rivian).
Although FedEx has many competitive advantages, there is cause for concern. Amazon has deeper pockets than FedEx. Amazon has arguably greater tech mastery. The company has built-in demand for its transportation needs due to its customer base. It arguably can anticipate transportation demand better too, due to detailed purchasing history data.
Another reason why FedEx shares are down is due to international weakness. Due to the European economy undergoing some soft spots, FedEx’s earnings and guidance hasn’t met some bullish estimates.
FedEx Could Be an M&A Target for Amazon
Some investors think Amazon might buy FedEx. The company has shown that it is willing to buy to get into a sector. It bought Whole Foods for $13.7 billion to get into the physical store business.
To get into the delivery transportation business, Amazon would really have two big options, as FedEx is one of two main parcel carriers globally, with the other being UPS.
At around $50 billion in market cap and around $62 billion in enterprise value, FedEx is small enough for a company Amazon’s size to swallow and integrate without too many issues. At last count, Amazon had a market cap of around $800 billion. The other carrier, UPS, might be a little too big for Amazon given its market capitalization of almost $100 billion and enterprise value of around $113 billion.
It might also make financial sense for Amazon. Lakewood Capital Management estimates that FedEx is trading around "replacement cost for its network" at around current prices. So, for Amazon to do what FedEx is doing currently, it would have to spend around $62 billion. Given the importance of getting fast delivery and optimization to keep market share versus the likes of Walmart (WMT), a payment premium of $20-25 billion could be worth it for Amazon.
Amazon doesn't control much of the "last mile" delivery sector, which is important if the e-commerce company wants to make shipments faster and faster. FedEx is one of the big "last mile" delivery players, along with UPS.
Many believe the next big thing in e-commerce is same-day delivery or one-hour delivery. Offering same-day or one-hour delivery economically will depend on optimizing last mile costs and delivery time. So far, this service is very expensive, but the rewards of solving the problem economically would give the winner big rewards.
If Amazon buys FedEx, the latter's shareholders might make more money than before due to the premium commanded. FedEx currently has a forward price-to-earnings multiple of around 10x-11x. Given that FedEx has a historical multiple of around 15x, Amazon paying a forward multiple of around 14x-15x to buy FedEx seems plausible.
If Amazon Doesn’t Buy FedEx, it Still Trades at an Attractive Valuation
It is important to note that Amazon wasn't even FedEx's biggest customer in 2018, and the company accounted for under 1.3% of FedEx's sales for the year.
In terms of the effect of future competition, Morgan Stanley believes UPS and FedEx sales would be 2% higher if Amazon didn't do Amazon Air around this year. By 2025, that number could potentially amount to around 10%. There could be enough growth in e-commerce, which is expected by many to grow around double-digit percentage rates through 2025 that FedEx continues to benefit even if Amazon in-houses its own needs and competes.
The other headwind, international weakness, is arguably not that much of a concern given FedEx’s rather low forward valuation of 10x-11x. According to Bloomberg, “Trump is eager for a China trade agreement so as to spark a further equity rally”. FedEx lowered its adjusted earnings outlook for 2019 to $15.50-16.60 from the previous $17.20-17.80 due to some international weakness, among other things. We believe the trade disputes will be resolved sooner rather than later and the company will deliver a positive earnings surprise for 2019.
Lakewood Capital notes that FedEx "has been punished" due to concerns surrounding the global economy. The delivery of goods is a cyclical business. Although there is some weakness in the international segment, the fund notes that around two-thirds of FedEx's sales are generated in the United States, where the economy is strong.
FedEx is cutting costs such as limiting hiring and reducing discretionary spending. The company continues to integrate its TNT acquisition, which handled around 1 million packages shipped daily.
Risks to FedEx
There are some risks to the FedEx story. One risk is that the international economy continues to soften and FedEx earnings dive. Another is the U.S. economy weakening. Yet another risk is Amazon building a better logistical network over time and driving down margins for FedEx and UPS. FedEx management could also not execute very well. If Amazon buys another transportation giant, FedEx could lose a lot down the road.
The Amazon story is one to watch. Amazon has caused many retail stocks to underperform. It could potentially cause parcel delivery stocks to underperform too.
In June 2015, FedEx management projected “adjusted earnings to be $10.60 to $11.10 per diluted share before year-end mark-to-market pension accounting adjustments” for 2016. Shares traded at $170 at the time. Today, the company’s projections for 2019 are 50% higher, yet FedEx shares trade for $174.
We believe concerns about global economic softness and competition from Amazon depressed FedEx shares to temporarily low levels. FedEx will significantly outperform the S&P 500 Index over the next 12-24 months as the company beats its earnings guidance and completes the integration of TNT Express, which will boost FedEx’s earnings. We believe FedEx will continue to grow its earnings per share by double digits annually and deserves a P/E multiple of at least as high as the S&P 500 Index, which is expected to grow its earnings by 7% next year and has a multiple of 16.
We recommend a position in FedEx shares.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in FDX over 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.