FedEx (FDX) has issues integrating and improving the results of TNT after the acquisition three years ago. It is facing external risks, which include slowing economic conditions around the world and the ongoing trade war. Yet, when compared to United Parcel Service (UPS), it is greatly undervalued, by as much as 47%. My estimation of its value indicates that the market is placing very little value on the company's Express segment, yet it delivers about 50% of FDX’s revenue. Patience will be needed to wait for the closing of the valuation gap, as results-based catalysts may be more than a year off.
FedEx is a leading provider of a broad portfolio of transportation, e-commerce and business services. FDX has 261 million shares outstanding and net debt of $15.3 billion at the end of FY2019 (ended May 31). At $160 per share, the EV for FDX is approximately $57 billion. Comparatively, UPS, FDX’s competitor, has 859 million shares outstanding and net debt of $16 billion at the end of 2Q2019. At $120 per share, the EV for UPS is $119 billion. These data are summarized in Table 1 together with revenue, EV/revenue and EV/EBITDA information.
Table 1: Comparison of selected valuation metrics for FDX and UPS.
(Source: 10-K and 10-Q reports)
FDX provides its customers with its services through companies competing collectively, operating independently and managed collaboratively under the FedEx brand. The company has four reporting segments (independently operating companies): Express, Ground, Freight and Services. The segment revenue and segment operating profits for FY2019 are shown in Figure 1. The figure shows that the Express segment (which includes Express and TNT) has more than half the revenue, but the Ground segment is far more profitable.
Figure 1: FDX FY2019 revenue and operating profit by segment. The operating profit for the Services segment is negligible in comparison with the other segments.
FDX shares peaked in January 2018 at around $270 per share and have recently declined to $160, down about 40%. UPS has seen its shares dropped 10% over the same period.
Recent events do not bolster investor confidence
In the FY2019 4Q CC, management disclosed several items that do not add to investor confidence. First, management characterized FY2020, ending May 31, 2020, to be a “transition year,” telegraphing that issues that it is working on will not bear fruits in FY2020. Second, it is targeting a mid-single digit percentage decrease in adjusted earnings per share. Third, the TNT integration is projected to cost $200 million more than management’s forecast just last quarter, and the integration will extend into FY2021. Fourth, there will be no dividend increase in FY2020, and share buybacks will be significantly dialed back. As a result of these setbacks, the shares have lingered in a trading range around $160 per share and a comparatively lower valuation as compared to UPS.
Operating results have declined for three years
Figure 2 shows the operating margin for FDX compared with UPS. The FY for UPS ends on December 31, while FDX’s FY ends on May 31. In Figure 2, the UPS data that correspond to the FDX FY are those for the year ending the prior December. For example, I used UPS’s 2018 data to compare with FDX’s FY2019 data. I have used this same approach for all data comparison in this article.
Figure 2: UPS is consistently more profitable than FDX.
(Source: 10-K reports)
Figure 2 shows that UPS has significantly higher operating profits compared to FDX. I will explore this issue later. The figure also shows that since FY2016, FDX’s operating margin has declined. The profit decline is caused by many factors, the two most prominent ones being the macro factors affecting trade lanes between the US and its trade partners and the drag on profitability due to the TNT integration and TNT's performance.
The operating profit by segment of FDX is shown in Figure 3. The company acquired TNT Express in May 2016 and TNT’s results are included in the Express segment. TNT’s results had no material contribution to the results of the Express segment in FY2016, but have impacted the results of Express significantly since. For example, in FY2017, Express reported a segment operating margin of 7.0%. On a standalone basis, Express would have reported a segment operating margin of 9.8% (slightly better than the 9.5% reported for FY2016) and TNT would have reported a segment operating margin of 1.1%. The results of Express continued to struggle since the TNT acquisition.
Figure 3: FDX segment operating margin.
(Source: 10-K reports)
TNT Express was attacked in June 2017 by the NotPetya cyber attack. By early 2018, investors began to be concerned with the extent of the damage and the effect on results and integration. No one outside of FDX knows the full extent of the damage. Investor can surmise that the damage was very severe based on how FDX management characterized the impact during the FY2019 4Q CC: “had it not been that TNT had been a subsidiary of FedEx, the company would've been bankrupt. It would have just gone out of business.” Outside of the business disruption caused by the cyber attack, there are other issues that caused the continued decline of Express’ profitability: the additional cost in integrating TNT and the declining health of the EU and Chinese economies. Trade wars against many trading partners, particularly China, EU, Canada, Mexico, Japan and South Korea, have weighed on results as well.
FDX's operating margin is structurally lower than that of UPS
Figure 2 shows that FDX consistently has lower profitability than UPS. I have attempted to analyze and estimate the yield and cost of shipping a comparable package to understand the cause of FDX’s lower operating margin. The segmentation of the business is different for the two companies, making it difficult to conduct such an analysis. For those segments where a comparison can be made (with certain assumptions), yield data did not consistently point to an advantage for UPS.
One clue is the consistently lower asset turnover for FDX as shown in Figure 4. Given that FedEx Ground purchases most of its transportation as a service, the results shown in Figure 4 are even more surprising. My hypothesis for the lower asset turnover for FDX is the silo-like independently operated structure of its segments. Most of the assets in each segment are not shared. For example, Express has its own hubs and sorting centers, and they are not shared by Ground. Similarly, Express has its own vehicles, and they are not shared by Ground. In the case of UPS, assets are shared across the different reporting segments. With a silo structure, it is possible that the business processes are different across segments, resulting in different IT systems to support the different business processes within each silo. Hence, it is possible that the silo structure of FDX causes a lower asset turnover. A higher asset level leads to a higher cost to operate the asset, and hence, a higher cost to ship a package.
Figure 4: FedEx has lower asset turnover.
(Source: 10-K reports)
If that is the case, it may be very costly to change this structure and it will take a long time to implement a change to share assets, as legacy business processes have to be changed. Making such a change will very likely cause huge disruption to the operation of the business as well. As such, I expect this structural disadvantage to continue.
FCF has been dwindling
Figure 5 compares the cash flow ("CF") results of FDX and UPS. Figure 5 shows that both companies are quite competitive in their ability to convert EBITDA to CF from OPS. However, UPS is consistently converting a higher level of FCF from its CF from OPS. As FCF is CF from OPS less CapEx, it is clear that FDX is consistently investing a higher level of CapEx in its business. This is consistent with a lower level of asset turnover that I discussed earlier.
Figure 5: FDX’s FCF conversion is lower.
(Source: 10-K reports)
Figure 5 also shows that the FCF level has been meager for FDX in the last three years. The company has been borrowing to fund its dividend and share repurchase. Beefing up the pension plan has also been a call on CF in FY2019.
Figure 6 shows the comparison of net debt/EBITDA. By this measure, both companies have similar leverage. FedEx is rated BBB by Standard & Poor's and Baa2 by Moody's. The company’s credit rating is one notch above the minimum of the investment grade. It is likely that FDX desires to keep its investment grade rating. Hence, to conserve cash and minimize fixed charges, management announced that there will be no increase in the dividend and only limited share repurchase in FY2020.
Figure 6. Net debt/EBITDA ratio has grown for both companies.
(Source: 10-K reports)
As a side note, UPS has seen its credit rating downgraded recently from A1 to A2 by Moody’s. Hence, UPS may have to dial back its dividend increase and share repurchase as well.
FDX shares are undervalued by as much as 47% when compared to UPS shares
Since FDX consists of basically three independent companies, it is rather simple to estimate the value of each business if data for comparable peers are available. For Express and Ground, I use data from UPS. For Freight, I use other LTL and logistics companies such as XPO Logistics (XPO), Old Dominion Freight Line (ODFL) and Saia Inc. (SAIA) as peers.
FDX Ground is the crown jewel of the company. It consistently outgrows UPS’s Domestic Ground and is more profitable than UPS Domestic (Domestic Ground is over 70% of the revenue of the Domestic reporting segment). This is shown in Figure 7. FDX Ground also grows faster than UPS as a whole and is more profitable at the UPS overall operating margin level.
Figure 7: Comparison between FDX Ground and UPS Domestic.
(Source: 10-K reports)
As shown in Figure 1 above, Ground represents less than 30% of FDX’s revenue, but it contributes almost 50% of the operating profit. With its consistently high growth rate, being highly profitable, and an outsourced transportation model, Ground deserves a high multiple. With reference to the multiples of UPS shown in Table 1, I use the UPS multiples as the minimum for Ground. I also assign multiples for Express that are significantly lower than those of UPS's to account for the integration issues at TNT and the lower margins at TNT.
For Freight, the comparable data are shown in Table 2 below. Figure 2 shows that FedEx Freight is the largest LTL and logistics company in the US, growing faster than its peers, and is comparably profitable.
Table 2: Comparable data used for Freight’s multiples.
(Source: Yahoo Finance and Seeking Alpha)
The above-mentioned data and assumptions provide the basis for my estimation for the high and low end of FDX’s EV and share price valuation. The results are shown in Table 3 below. The estimation put the value of FDX shares between $240 and $300, significantly above its price of $160 today. This means that FDX's shares could be undervalued by as much as 47%. It is worth noting that based on the estimation in Table 3, the combined Ground and Freight value accounts for almost all the current FDX EV of $57 billion. This means that current investors are getting Express almost for free.
Table 3: Estimation of EV and share price of FDX.
(Source: Author’s estimation based on data presented in various places in this article)
Closing the valuation gap will take time. The TNT integration is projected to extend into FY2021 and may cost more. Even after the completion of the integration, improving results in Express will take time. Management has not provided guidance regarding when CapEx will taper and when FCF will increase. Nonetheless, when investors can see inflection of these issues, the valuation gap may start to close. Outside of execution issues, investors are discounting FDX shares because of several external risks described below.
The economy of the EU has been declining. China’s economic growth is decelerating. While the US is still growing, there is growing concern that the US economy will slow as a result of the trade war and tariffs. FDX’s business is very sensitive to the global B2B business and could be impacted further.
FedEx may become a casualty in the trade war between the US and China. China investigated FedEx for mishandling Huawei shipments as well as shipping "controlled knives" to Hong Kong. Investors have raised concern that FedEx may be put on China’s "unreliable entity list," impacting its business in and out of that country.
Pension liability will continue to impact earnings and CF. In FY2019, FedEx has to borrow to fund over $3 billion of deficit in its pension plan. With interest rates declining and with the stock market stagnant, investors are concerned that the funding gap may cause further earnings and CF impact in FY2020 and beyond.
With Amazon (AMZN) building up its aircraft fleet and its local delivery network, it may get into package delivery and logistics services and compete with FDX. With AMZN’s approach of “your margin is my opportunity,” AMZN may become the ultimate disrupter of the package shipment and logistics business. This is probably one reason why FDX has not renewed its contract for domestic Express handling of AMZN’s shipments.
Continued compression of Ground yield due to lighter weight and shorter shipping distance of e-commerce packages is another risk. As e-commerce continues to grow, shippers are working to reduce their shipping cost. One approach to reduce shipping cost is to ship from their local stores and warehouses, thereby compressing shipping distance. B2C packages are generally less bulky and less heavy compared to B2B packages. However, the cost of delivering a package, especially in the last mile, does not decline because of lower weight. Hence, the growth in e-commerce has compressed Ground’s yield and will continue to do so. FDX has recognized this challenge and is working to reduce its cost in order to reduce the impact on its margin.
FDX shares are deeply undervalued as a result of execution issues as well as investors’ perceived risks that are beyond the company's control. Since improvement in results will likely be very gradual in FY2020 and inflection may not happen until FY2021, it is unlikely that catalysts will come from its results in the near term. Easing of some of the external risks may provide some support, but the timing of these catalysts is very difficult to predict.
Disclosure: I am/we are long AMZN. 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.
Additional disclosure: All investments have many risks and can lose principal in the short and long term. The information provided is for information purposes only and can be wrong. By reading this you agree, understand and accept that you take upon yourself all responsibility for all of your investment decisions and to do your own work and hold the author harmless.
I have no position in FDX and no plan to initiate a position within the next 72 hours.