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FedEx: Misunderstood Amazon Threat, Cyclical Bottom, Confusing Downgrades And Upcoming Margin Expansion

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About: FedEx Corporation (FDX), Includes: AMZN, ODFL, UPS
by: GS Analytics
GS Analytics
Long/short equity, newsletter provider, mid-cap, small-cap
Summary

FedEx is witnessing peak pessimism with its P/E compressed due to Amazon fears and EPS depressed because of transitory factors.

Amazon would never like to lower prices for non-Amazon eCommerce players which are FedEx’s target market.

End markets are bottoming.

Sell-side is underestimating margin recovery.

The stock can see ~25% upside over the next six months and potentially double in medium to long term.

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Investment thesis

FedEx's (FDX) stock has been under pressure over the last couple of years thanks to the U.S.-China trade dispute (which has led to a slowdown in industrial - most profitable end market for FedEx), uncertainty over Brexit which has affected European economies, issues with TNT integration, upfront cost incurred in expanding six and seven days delivery, and exiting Amazon (AMZN) business.

While Wall Street is currently obsessed with Amazon threat and fears a pricing war, the reality is exactly opposite with pricing remaining strong and capacity tightening for non-Amazon customers. Amazon's real competitors are other retailers not FedEx. Any pricing war with FedEx will help lower cost for its competitors who rely on FedEx. Amazon has no reason to lower prices for non-Amazon e-tailers at its cost.

Things have started to improve on the macro front with phase I of the trade deal due to be signed this week. Odds of orderly Brexit have also improved with Boris Johnson's win. The company is focused on filling its spare capacity with high quality volume at a better margin. This coupled with cost savings from an 8% reduction in flight hours for express business, TNT integration benefits as well as easing comparisons will help the company generate significant operating margin expansion going forward. I believe the stock can see at least ~25% upside over the next six months with a potential to double over medium to long term.

Amazon Threat and FedEx Strategy

Of late, many sell-side analysts, investors, bloggers and professors are saying that Amazon can enter pricing war with FedEx and UPS (UPS) to gain the #1 spot and establish a monopoly in the Logistics space. The reality is exactly opposite. Both FedEx and UPS announced a healthy rate increase of 4.9% this year for their express and ground business. They even started levying $24 fees on packages weighing more than 50 pounds. Earlier this limit was 70 pounds. Amazon itself increased its prices by 3% in 2020. Does it look like a precursor to price war?

Think about it logically. Would Amazon like to increase or decrease prices for its retail competitors? Amazon's real competitors are other retailers not FedEx. Any pricing war with FedEx will help/lower cost for its competitors who rely on FedEx. Further, if Amazon goes too competitive in pricing for goods outside of its network (i.e. other than Amazon and vendors who sells through its platform) it will mean higher cost/lower service quality for its own network.

Amazon entered logistics industry to better serve its customers. Amazon logistics' aim is to provide the company a competitive advantage over other online retailers in terms of price/service quality to its customers as well as vendors. It will not help Amazon if its competitors start to get lower rates at its cost.

Also, any meaningful expansion outside of its own network might invite antitrust concerns. I don't think management is looking to spin off Amazon logistics as it will take away a key competitive advantage for the company. With both President Trump and (billionaire hating) Democrats vying for its blood, expanding outside its core vendors might not be a smart move. I also don't agree with the notion that it will take away the business from UPS. Ideally Amazon would like to keep ~80% of the volume on some of the most profitable routes and leave ~20% of the business to UPS.

FedEx's strategy in the current environment is to focus on non-Amazon eCommerce business which is around 56% of the total eCommerce business. This makes sense as this market is growing at a healthy rate and FedEx has much more pricing power in this market due to its fragmented nature.

FedEx has also postponed all non-essential capex (i.e., not essential for safety service, or replacement, or obsolescence). FedEx capex spend may look higher in its financial statement because it is replacing 159 A310 and MD-10 aircraft. Once that is complete by fiscal '22 year end, there will be a significant reduction in the corporation's ongoing capital expenditures on both an absolute basis and percent of revenues. UPS is following similar footsteps and has decreased its capex guidance for 2020 by $500 mn on last quarter's earnings call.

So what we are moving towards is actually a very rational logistics supply environment for non Amazon eCommerce players. This will be very positive from pricing perspective.

I believe FedEx's strategy will pay handsomely. Think about the kind of operating leverage a transportation company, whose existing network is getting filled with incremental volumes at higher pricing, can generate. FedEx is likely to witness the same over the course of next few years. I expect its operating margin to surpass its previous peak over the next couple of years. Wall Street is not modeling it and is in for a big surprise.

When it comes to transportation companies, investors, analysts as well as management often give too much emphasis on volumes rather than the quality/ pricing/yield it is getting on those volumes. While incremental volumes may help short term results because of more lane density, going too competitive on pricing is not the best strategy for long-term returns. It's difficult to renegotiate prices higher with a customer who has shifted to you just for price rather than quality of service. Also, you might have to let go a higher yield opportunity just because your lanes are filled with low quality volume. Service quality and employee morale also suffers leading to further attrition of good quality customers.

Take for example the case of LTL industry in the last decade. Back in 2009 when LTL industry was witnessing pricing war and most of the players were going too competitive on price to take share from YRC Worldwide (YRCW). Some players like Conway even went to the extent of cutting their employees salary temporarily to make sure they remain profitable while taking share from YRCW. Old Dominion Freight Line (ODFL) didn't participate in this pricing war and continued focusing on its service. A decade later, Old Dominion's operating margins have improved to more than 20% versus 5.65% in 2009 and its stock price is ~20x higher than its 2009 lows. Conway, on the other hand, saw a short term increase in its stock price in 2009 but soon found it struggling because of low quality volume. It spent next several years trying to turn around its business and raise prices to an acceptable level and then finally had to sell itself to XPO Logistics (XPO).

Last year, there was an article in Wall Street Journal calling for Fred Smith to reinvent FedEx. He has already done it by changing its focus on the customers who are paying it appropriately for its service and this will start showing in the numbers as 2020 progresses.

Cyclical Bottom and the curious case of confusing downgrades

In addition to severing ties with Amazon, one thing which greatly impacted FedEx over the last couple of years was slowdown in global trade which affected its industrial end market. The company's industrial or B2B business is much more profitable than consumer or B2C business (which includes ecommerce) due to greater lane density and stronger yields. Recent development surrounding the U.S.-China trade deal as well as improved probability of orderly Brexit post Boris Johnson win marks a turning point in global trade environment. With China taking steps to lower tariffs and open up its economy there is a chance that global trade reaches a new high in upcoming cycle.

Surprisingly, some sell-side analysts are still posting negative commentary on FedEx citing macro concerns, which I believe make little sense at the bottom of the cycle. For eg., Argus research analyst recently downgraded the company citing trade, tariff and overseas macro concerns. I believe this downgrade is unwarranted as the worst is already behind us and these factors will be a tailwind going forward. If anything the stock should be upgraded as the worst is likely behind us.

Similarly Oppenheimer analyst Scott Schneeberger downgraded the stock after its last quarter earnings with title of his report being "Although it may be the Nadir, we are moving to perform rating."

Who downgrades a transportation stock at the bottom of the cycle?

Further, speaking to Reuters, he commented,

"The bottom line, we think this could be a good stock as we head into 2020. In fact, we wouldn't be surprised if shares didn't close down all that much on Wednesday."

Who downgrades a stock in December and calls that it can be a good stock heading into the next year?

Clearly he lacks convictions and is hedging his bets. While sell-side has luxury to make confusing calls, institutional investors can't afford to be underweight a company of this size for long if it starts to recover.

Management has been pretty clear and straight forward that worst is behind us and things are likely to improve going forward. Below are some of the relevant excerpts from the company's recent earnings call.

"Global trade volumes contracted year-over-year again in calendar quarter three, and will show contraction for the full calendar year. We should see a return to positive growth for calendar year '20 assuming no re-escalation in trade tensions".

"…we are at the bottom, our adjusted operating profit decline year-over-year is horrific, and it's going to improve, it's going to improve in Q3, and it's going to improve substantially in Q4 versus the prior year's adjusted operating income, it won't be the message so bad we might, we might not be back to where we were last year, but we will be a lot closer obviously than how wildly we were in the second quarter.

The other thing is, is that I think if you think about all the positive things we've said and that we're seeing, as we get into 2021, we will start lapping Amazon. We will have a lot more of the sixth and seventh day on our belt and we're going to be delivering millions of packages on Sunday for the rest of this fiscal year rolling into 2021. We will finally start getting turning the corner in Europe, with the operational synergies that we will start seeing and those will grow during the year. I've got nothing in this current range for any sort of a trade deal, because we haven't gotten one yet then we have some upside there. If that happens more, we will even have more upside into 2021. So without giving you specifics, we're at the bottom and we're going to come up off the mat and we're going to improve through the rest of this year and into the next."

"We're here at the bottom but we can see a way out."

While I understand investors' disappointment with management, ignoring the recent positive development on macro front might not be a wise approach. Some of the leading indicators like China's industrial production have already started improving and there is a very strong case for cyclical recovery in industrial economy and global trade going forward.

Upcoming Margin Expansion

In addition to improving macros helping sales, the company's operating margins are also likely to improve significantly. The following is a list of some of the key points to remember while thinking about the margins:

  • The company's industrial or B2B business is much more profitable than consumer or B2C business (which includes eCommerce) due to greater lane density and stronger yields. So, a recovery in industrial business will be positive for the mix.
  • The company started offering seven days delivery from the last quarter and has to bear upfront cost for that. As it starts getting the volume benefit from this initiative, operating margin will improve. Further, since this is non-Amazon volume the pricing and yield will be better than what it used to get from Amazon.
  • Third, the company is reducing its flight hours by 8% from Q4 (ending May) onward which will reduce cost, improve utilization and help margins.
  • The company is on track to meet the May 31, 2020 target date for interoperability of the intra-European ground networks (TNT and FedEx network). This will lower costs as the related FedEx Express operations are optimized. Further, in fiscal year '21, the integration of the remaining pickup and delivery operations in Europe will be completed, and by the end of the first half of fiscal '22 the physical network integration of TNT into FedEx will be complete. So, there is a clear path for improved margins in the company's European business for the next couple of years.
  • Going into the back half of next calendar year (first half of Fiscal 2021), the company will start lapping lost Amazon volume which it is replacing with high margin volume from other players.
  • There are several other factors as well like the company in-sourcing SmartPost volume given to USPS (management believes it will cost less for FedEx to deliver these packages themselves than what they are paying to USPS for the last mile delivery), impact from short holiday season not repeating, healthy pricing environment (Express and Ground price increase of ~4.9%, FedEx Freight price increase of 5.9%) which will be a tailwind going into the next year.

So, there is a clear path for FedEx cost improvement for the next few years which coupled with operating leverage from recovering volume and higher pricing can push FedEx margin higher.

Investors and sell-side analysts are somehow not modeling much improvement in margins going forward. Their typical estimates are around 30bps to 50 bps improvement in margins in FY 2021 (FedEx's fiscal year runs from June to May). This is surprising because I believe an 8% reduction in flight hours itself can save several hundreds of millions for express segment whose total annual expenses are ~$35 bn. Out of $35 bn ~$13.5 bn is salary and employee benefit. I believe ~10% of this or $1.35 bn is for pilots who are paid based on flight hours. So, a 8% reduction in flight hours will save ~108 mn in pilot compensation. Fuel is approximately $3.3 bn annually for express. So, an 8% reduction will save over $264 mn. For maintenance and repairs, which is ~$1.9 bn I am assuming a 4% savings (because all of that is not plane related) which equates to ~$76 mn. So, the total savings from these three components is ~$450 mn. There will also be some saving from landing fees, but I am ignoring that for now. Even if we remain cautious and take just $350 mn in saving, it can add more than a dollar to EPS from flight hour reductions alone. (Calculation $350 mn multiplied by 0.75 (tax rate) divided by 262 mn share count = $1 increment in EPS).

Combine this with benefits from TNT integration (~$750 mn run-rate saving post completion in FY2022, they have not given FY2021 component but it will likely be meaningful), recovery in ground business margins (management has guided for low teens margins in Q4 (ending May) in ground segment), operating leverage from recovery (express segment will likely see ~35% incremental margins) and easing comps. I believe the company's margins can easily improve by more than 100 bps in FY 2021 and I am likely to prove conservative here.

For the current fiscal year, the consensus is approximately 5.3% for operating margins and $69.2 bn revenues. For the next year, assuming 6.3% operating margins and $72 bn in revenues (consensus estimates), we have $4536 mn in operating profit. This is $868 mn more than current year's consensus operating profit of $3668 mn (=5.3%*69.2). Applying 25% tax rate to incremental profit and dividing by 262 mn share count, we have $2.48 in incremental EPS for the next year. Add this to the current year EPS of $10.80, we get $13.28 in EPS for FY2021. I expect the company's operating margins to completely recover by FY2022 as the company realizes benefit of TNT integration and continues to fill its infrastructure with higher quality volume. This would mean an all time high EPS and I believe the stock price will also recover completely.

Valuations and where can the stock go?

FedEx stock price is currently witnessing peak pessimism of late with its P/E compressed because of fears about Amazon threat and EPS depressed because of transitory factors. I believe both will change this year and the sentiment on the stock will take a U-turn.

FedEx is a core provider for non Amazon eCommerce which is 56% of the market. The company has a significant pricing power in this market and it is impossible to even think of this market without FedEx. UPS and USPS both have relatively higher cost structure in this market due to unionized and government workforce, respectively.

The company's end markets are poised to recover, and with significant cost savings from flight reductions, TNT integration and other factors discussed above, the company is poised to increase its operating margins significantly. The company has 10%+ long term operating margin goal. No one takes that seriously but I believe the next few years of margin recovery which starts this year can take the company there. With the company not expanding its infrastructure unless necessary, and taking additional revenues with better pricing on existing infrastructure; its operating leverage might surprise analysts and investors positively.

FedEx is not a stock where institutional investors can be relatively underweight without impacting their performance meaningfully. During the downturn it was ok, but as the recovery starts I believe they will quickly shrug irrational Amazon fears and focus on what is happening on the ground level instead. Insiders are already buying at these levels and I believe institutional investors to soon join.

So, where can the stock go?

In the short term (less than six months) I expect the stock price to move towards $200 as investors realize the bottom is in place. The company's earnings over the next two quarters and forward guidance will help them better appreciate the recovery cycle over the next year, and the actual cost saving and margin improvement potential for the company. The stock has traded over an average P/E of ~13.5 over in the recent past. However, a cyclical company recovering from bottom usually gets a higher multiple. So, I believe a 15x multiple will be more appropriate. Applying it to my EPS estimate of $13.28 for FY 2021(ending May), gives a target price of $200. My target may prove conservative if investors realize the reality of Amazon competition and shrug off some of the irrational fears faster. This may cause P/E multiple to expand faster and move towards high teens. Also, as mentioned above, my EPS might prove conservative.

In the medium term (12 to 18 months), I believe the company will regain its margins completely and the stock can see a new all time high. Longer term, the stock can potentially double as its margins continue to expand with it taking higher quality volume on existing infrastructure.

Catalysts

  • Upward revision in EPS estimate as analysts better realize cost savings opportunities and incremental leverage from higher quality volume.
  • Pricing remains strong and some of the Amazon overhang going away.
  • Takeover bid from Berkshire Hathaway (BRK.A, BRK.B), Walmart (WMT) or other players. The company provides a very essential service for non-Amazon ecommerce business and there are not many other cost effective players. This makes it a very attractive acquisition target for long term strategic players. I expect some developments over the next six months as the recovery is imminent and potential acquirers might like to benefit from the current low valuations.

Risk

The biggest risk to the company is policy related. If Trump trade war reignites and causes macros to worsen, the stock might be negatively impacted. In general FedEx is quite levered to global trade and anything which impacts global trade negatively will be bad for the company.

If TNT integration doesn't go as planned or European economy continues to worsen, that's another risk.

Also, the company's P/E multiple depends on investor perception of Amazon threat. If investors continue to overestimate Amazon threat it will negatively impact FedEx's P/E multiple. Ironically, UPS which has a much larger Amazon exposure (I believe 10% of UPS volumes are Amazon related) receives less negative coverage and trades at a better multiple!

Disclosure: I am/we are long FDX. 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.