Although I have tremendous respect for the business that FedEx (NYSE:FDX) has built, the same cannot be said of my opinion of most analysts' models and valuations for this company. FedEx has long struggled to deliver good free cash flow (FCF) generation, and although I think the company's new efficiency plans will produce better results, there's a gulf between “better” and “good”.
That said, FedEx shares have underperformed the market for about three years running and now don't seem particularly expensive. While I would have some concern that sell-side analysts are still setting too high a bar for the company (sowing the seeds for future disappointment), there's at least a buy case to be made today.
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Closing The Year On Some Solid Notes
FedEx closed its fiscal year with a pretty good quarter. Continuing a pretty long-term theme, Ground and Express were both good, while Freight remains weak.
Overall revenue grew 4% this quarter, with Express up 3%, Ground up 12%, and Freight down 1%. Express results saw better volumes (up 2% in the U.S., up 11% in International, but down 2% in International Priority), but revenue per package wasn't particularly strong. Likewise in Ground – revenue was up a strong 10% (with 25% growth in SmartPost), but revenue per package was up just 2%.
Operating results were more a question of perspective. GAAP-based operating income fell 41% as the company absorbed significant costs tied to its “business realignment program” and the early retirement of aircraft and engines. If you look at the adjusted number, though, income grew 11% and margins expanded by 60bp. I think it's something of a “heads I win, tails you lose” proposition to celebrate the future margin benefits of cost improvement programs while ignoring the upfront costs, but that's how Wall Street works. In any case, I would point out that both employee costs and fuel costs were quite favorable for the company this quarter.
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Freight Still Not Carrying Its Weight
It's difficult to say that FedEx isn't competitive in the less-than-truckload (LTL) trucking space. After all, alongside YRC Worldwide (Nasdaq:YRCW), this is the largest carrier in the country. That said, revenue in Freight fell 1% this quarter on a 3% decline in shipments, and adjusted operating income was flat. Relative to Old Dominion (Nasdaq:ODFL), FedEx continues to underperform in trucking, and I continue to find that surprising given the company's overall quality and capabilities.
What Will Be The Cost Of Growth?
In terms of North America, FedEx already has a great business. The company has 30% of the market for ground-delivered packages (against 60% for UPS (NYSE:UPS)) and about 50% share of the express market, and international rivals like Deutsche Post's (OTC:DPSGY) DHL and TNT Express (OTC:TNTEY) really aren't even rivals, as they no longer compete in the market.
But it's a big world out there. FedEx holds its own with UPS in Asia and most emerging markets, but the company's overall share is quite a bit lower and arguably not terribly economical. I have to ask, then, if that means that the company will continue to invest in planes, logistics centers, and employees in order to build the business in Asia (and, perhaps, Europe and Latin America), or whether they will let DHL continue to rule the roost (and/or let home-grown shipping rivals in China gain share). All of that costs money in the short-term – money for capital equipment and money in the form of lower margins due to less-than-fully absorbed overhead.
The Bottom Line
Even though UTi Worldwide (Nasdaq:UTIW) recently highlighted iffy air cargo demand, near-term demand isn't my concern with FedEx. My concern is, and has long been, that the company doesn't produce the sort of free cash flow and economic profits that sell-side analysts seem to think it does. Now, admittedly, the last two years have been looking up and I like the direction FedEx is going. But I think it's hard to assume that the future is going to be dramatically different than the past for a company that will need to continue spending money if it wishes to continue growing.
I'm looking for FedEx to grow revenue at a long-term rate of about 6% (against a trailing 10-year growth rate of 6.7%). I'm also looking for free cash flow to grow about 10% a year as the company moves from a historical free cash flow margin of less than 2% to an eventual margin of 4.5%. Even with that more-than-doubling of margins, though, the suggested fair value is about $103 – more than the current price, but below the average Wall Street target of $115. As such, I am more bullish on this stock than I have been in a long time from a value perspective, but I am still a bit nervous about the company's ability to hit those targets and/or live up to robust Wall Street expectations.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.