Sunday, March 31, 2013

FedEx Offers Catch Up Potential

By now, you've probably had your fill of FedEx’s $FDX latest earnings reports. The company reduced guidance, which immediately gave grounds for the bears to come out and point to weakening growth. In reality, it was a mixed report that actually said more about FedEx and its relation to patterns in the global economy. Investors are often criticized for believing that "this time it's different" but in this case I'm going to stick my neck out and say that, with FedEx, it really is different this time.

FedEx Equity Research

What I’m talking about is that the global economy has changed in many ways since 2008. U.S. consumers have de-leveraged while European growth has been weak overall and varied across its regions. Allow me to briefly remark that this is because Europe is at least making some effort to deal with its debt burden while the U.S. seems to be content on making piecemeal changes while the markets reward it with low interest rates. Meanwhile, China continues to be an export-oriented economy and has seen export growth slow as a response to weaker consumer demand from other regions.

These issues matter a lot to FedEx. Indeed, it can be excused for structuring its business to deal with the kinds of economic conditions that were around in 2007, but could it have foreseen what was going to happen in 2008 and after? Furthermore, consider the nature of its business and the difficulties inherent in adjusting its fleet and distribution network to the new economic realities. The result is a business that has had to make ongoing adjustments over the last five years. And it’s not done yet.

FedEx’s ongoing challenges

I’ve discussed FedEx previously and readers who want to see how FedEx and UPS $UPS are both ultimately correlated with global GDP growth can read the article linked here. In addition to see the start of the trend away from express services readers can click here.

For now, I want to summarize the key issues in bullet-point form:

  • Consumers continue to shift to cheaper and slower delivery options and away from express. Express revenues were $100m lower than previously forecast by FedEx
  • Domestic express services were fine with the problem being in international express
  • Ground revenues continue to benefit burgeoning e-commerce deliveries and with the declines in express and low margins with freight, the ground segment contributed 79.2% of operating income in the quarter vs. 57% last year
  • Freight operating margins remain low at 4.4% for the first nine months, versus 17% for ground

The issues with international express are a function of how international trade’s correlation with global GDP has gone down for the reasons discussed earlier. Moreover, FedEx has had issues with network efficiency thanks to uneven trade flows throughout the world. Global trade was cited on the conference call as being lower than in 2008. In addition, a constrained Western consumer has slowed the growth of China’s exports. However, the imbalance in traffic to and from China remains in place. All of these factors lead to logistics problems in terms of fleet management.

These issues are exacerbated somewhat at FedEx, which chose to expand its express service only to walk into the global slowdown. Indeed, the problems have got worse over recent quarters. The company's response is to accelerate the plan to retire older planes and manage the network more efficiently by adjusting routes accordingly. Matters could not have been helped much by UPS’ January launch of a new express air service aimed at high-value international heavyweight shipments.

FedEx Competing With UPS

In fact it’s useful to compare the two because gross margins have diverged in recent years.




FDX Gross Profit Margin TTM data by YCharts

And while UPS share price is higher than it was in 2007, FedEx’s is noticeably lower. Like I said, this recovery was different.




FDX data by YCharts

Which Stock to Buy UPS or FedEx?

The problems at FedEx don’t seem to be going away any time soon, but the company is taking the right action for the long term. In addition, ground services now represent a large part of profits and the company is doing fine with long term growth assured from e-commerce growth. The lowering of EPS guidance is never a welcome sign, though. Neither is the threat of more impairment charges as the restructuring continues.

That said, I think value investors might prefer FedEx to UPS on the basis of a lower evaluation and the potential for it to catch up with its rival after restructuring and hopefully increasing margins.