Saturday, November 10, 2012

A Look At FedEx's Prospects

I wear a single handed watch. No second hand, no digital display and only five minute intervals between notches on the face. The German manufacturer wastes no time in pointing out that it seems to cause time to slow down for the wearer. They are right and it doesn’t trouble me at all if I am a little late for some things. What does this have to do with FedEx Corporation's (NYSE: FDX) latest set of results?

Well, actually, everything!

Life in the Slow Lane

The underlying story of FedEx's results is that with a global economy that is clearly moderating, its customers are electing to shift to slower delivery services (Ground) rather than FedEx Express. This is not a huge problem for FedEx per se, because the Ground segment actually has higher operating margins. However, it is a problem when the company is geared for stronger growth at Express.

Here is a chart of how FedEx generated income in the last quarter ($millions).

Indeed it has already taken a $134 million impairment charge this year and retired 24 planes in order to closer align with ongoing volumes in the US.  Furthermore its international Express operations have disappointed this year and it has taken measures to scale back network expansion. Further measures to reduce costs in Express have been promised.

Similarly, the slowdown in Asia caught FedEx by surprise and a lot will depend on certain technology companies' (Apple’s iPhone5, Windows 8 computers, etc) shipments in the future but it’s clear that these shipments won’t counteract weaker end markets.

FedEx Downgrades GDP and Earnings Forecasts

The company is such a reliable bellwether that its GDP forecasts are generally more accurate than the Federal Reserve’s. When FedEx speaks, the market listens.

Here is how they updated the market on GDP

  • 2012 US GDP growth forecast unchanged at 2.2%
  • 2013 US GDP growth forecast at 1.9% vs. 2.4% previously
  • 2012 Global GDP growth at 2.3%
  • 2013 Global GDP at 2.7% vs. 3% previously

So 2013 growth forecasts have been downgraded but the bad news is that FedEx appears to have downgraded its earnings forecasts relatively more than GDP. There are three reasons for this.

Firstly, declining US domestic package volumes will hurt margins and growth even if International Express expands volumes; it is lower margin anyway. Secondly, political considerations have encouraged weaker export growth as Governments undergo protectionist trade policies in the face of a slowdown. And thirdly, weaker consumption growth in the US and Europe caused China’s export growth to slow.

Guidance was reduced substantially:

  • 2013 EPS Guidance of $6.20-6.60 vs. $6.90-7.40

FedEx has issues with realigning its business to the new growth, but its rival UPS (NYSE: UPS) will not be immune either. Here is how UPS’ growth usually correlates with global growth.

Frankly, UPS and FedEx remain the kind of correlated plays on global growth that they have essentially always been.

Another Way to Profit?

Even if an economy is weak there are always opportunities or eddy currents within economies from which investors can profit. In this case I think we should look carefully at what FedEx is saying about Express vs. Ground and air vs. rail. The Express segment saw revenues rise 1% but Ground revenues went up 8%.

If customers are shifting to slower rail based delivery then we should follow them. FedEx isn’t predicting a 2008-2009 type recession, it is just saying that growth will weaken and one consequence is that customers will want to use cheaper delivery options.

I think the key takeaway here is to buy railroad stocks. Companies like CSX (NYSE: CSX) or Norfolk Southern (NYSE: NSC) and Union Pacific (NYSE: UNP) look set to be benefit from a slow but steadily growing US economy.  The railroad sector has had to deal with the headwind of a weakening coal car loads thanks to the replacement of coal by gas in terms of electricity generation.

Another long term factor in their favor is that rail cars have become much more fuel efficient. This means that their value proposition is even more attractive as the world learns to live with high energy costs.  As a consequence, these stocks have all continued to do well even as the economy slows. Since they are traditionally regarded as cyclical stocks, this is a sign that the market has woken up to the fact that rail’s prospects are not just GDP correlated.

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