FedEx Still Getting A Pass

By Stephen D. Simpson, CFA | June 20, 2012 AAA

Even after all these years, I find it interesting to see which stories analysts and investors are willing to believe in, even when the fundamentals don't always support that belief. I don't believe that anybody seriously questions that FedEx (NYSE:FDX) is a well-run business, or that it would be very (if not prohibitively) expensive to replicate the infrastructure that it and rival UPS (NYSE:UPS) have built.

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By the same token, the company has had a hard time producing a truly impressive return on invested capital, and the company's free cash flow generation capabilities have always been limited--maintaining that network of planes, trucks and so on takes a lot of capital. Looking at the company's fiscal fourth quarter earnings, it looks like investors are willing to give the company another pass--margins and volumes were not that exceptional (nor was guidance), but the performance wasn't as bad as the results of other transportation and logistics companies might have suggested.

Decent, but not Great, Fiscal Fourth Quarter Results
FedEx reported a slight top-line miss for its fiscal fourth quarter, as sales climbed about 4% from last year. Revenue growth was led by solid high single-digit results from Ground (up 9%) and Freight (up 7%), while Express rose 3%. Volumes were a little soft in spots, particularly in the international priority and ground businesses, though FedEx's SmartPost initiative seems to be going well (volume up 16% on a 7% increase in yield).

Pricing was pretty solid and FedEx did a good job of managing expenses. While reported operating income didn't look so great due to some charges tied to retiring planes, adjusted operating income rose nearly 12%. Express was a bit soft (even on an adjusted basis) at negative 3%, while ground and freight showed very solid improvements.

SEE: Zooming in on Net Operating Income

Getting Serious About Costs and Efficiencies?
I think it's encouraging to see that FedEx management is getting more serious about cutting costs and improving asset utilization. The company has announced a reasonably extensive program to retire some aircraft, and though the company will offset some of this with new Boeing (NYSE:BA) cargo planes (so it's not going to cut as much capacity as it may appear), they should see lower maintenance and fuel expenses.

Hopefully this is the just the beginning. Management apparently has engineers and other employees at work poring over the company's operations with an eye towards a more comprehensive restructuring plan for this fall. This will almost certainly involve firing workers, but it will hopefully also examine overall network utilization with an eye towards running a tighter ship.

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Guidance Seems Conservative
The guidance that FedEx laid out for the next fiscal year was not especially strong; a less-popular company would likely have seen a pretty negative reaction. That said, it does look conservative. It doesn't seem as though management is banking on a significant pick-up in the economy, nor any substantial near-term cost savings.

Likewise, while management just put through another less-than-truckload rate increase and fuel costs have been coming down, it doesn't seem like management has to hope for much good luck to meet these numbers.

Still a few notes of caution are in order. Neither Expeditors (Nasdaq: EXPD) nor UTi Worldwide (Nasdaq:UTIW) have given investors much reason to feel good about international trade activity. Likewise, investors may still find better transport plays either in well-run growth stories like Old Dominion (Nasdaq:ODFL), dividend plays like SeaCube (NYSE:BOX) or riskier turnarounds like SeaSpan (NYSE:SSW).

The Bottom Line
Investing sometimes requires you to hold simultaneous viewpoints that are at least partially contradictory, and FedEx is a good example. While this is a very good company (and "good companies" often do well), the company's low free cash flow margins and low returns on capital are impediments to long-term value creation--and the stock has lagged the S&P 500 over the last five years.

I hold some optimism for the company's restructuring efforts, but I will need to see more specific numbers before I'm inclined to lift any of my long-term assumptions. As a result, though I acknowledge FedEx is popular and could catch a tailwind on signs of an improving global economy, I just don't see the shares as undervalued on a fundamental basis.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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