|Shares Out. (in M):||262||P/E||11.4||10.0|
|Market Cap (in $M):||37,466||P/FCF||0||0|
|Net Debt (in $M):||16,372||EBIT||4,265||4,894|
Certain statements contained herein reflect the opinion of the author as of the date written. NO INVESTMENT DECISIONS SHOULD BE BASED IN ANY MANNER ON THE INFORMATION AND OPINIONS SET FORTH IN THIS REPORT. YOU SHOULD VERIFY ALL CLAIMS, DO YOUR OWN DUE DILIGENCE AND/OR SEEK ADVICE FROM YOUR OWN PROFESSIONAL ADVISOR(S) AND CONSIDER THE INVESTMENT OBJECTIVES AND RISKS AND YOUR OWN NEEDS AND GOALS BEFORE INVESTING IN ANY SECURITIES MENTIONED. Please see additional Important Disclaimers at the end of this analysis.
I believe FedEx Corporation (“FDX”) is an interesting risk/reward at the current price for predominantly one reason—FedEx Ground is a very good, well-positioned, high ROIC business with sustainable, above average growth. Increasing US e-commerce volumes and pricing that has been able to grow above inflation has predominantly driven FedEx Ground’s growth. This high quality business is being overshadowed by the poor performance of its capital intensive, low-no growth, low return on capital FedEx Express business and horrendous overall capital allocation.
What is worth noting is that FedEx Ground is a truly separate business from FedEx Express. It operates its own separate infrastructure with dedicated sort facilities to Ground volumes. Independent contractors, who label their trucks as FedEx Ground and only delivery packages for FedEx Ground, operate its delivery trucks. In my view, FDX could spin out the FedEx Ground business and re-brand it simply as “Ground”.
FedEx Ground began as RPS in 1985 as a subsidiary of Roadway Services. In 2000, FDX bought this business and re-branded it as FedEx Ground. It acquired Parcel Direct in late 2004, which it rebranded as FedEx SmartPost. This sub-segment specialized in the consolidation and delivery of high volumes of low-weight, less time-sensitive B2C packages, using USPS for the “last mile” of delivery to residences where FedEx Ground lacks delivery scale.
FDX’s ground business, which has been growing at 2-3x the rate of U.S. GDP, has structural competitive advantages over UPS due to its sustainably lower cost structure mainly due to its more efficient and flexible (non-union) workforce.
The ground delivery industry (ex-Amazon’s self-delivery business) is mostly a duopoly between FDX and UPS, with ~1/3 and ~2/3 of the remaining market, respectively. While FDX breaks out its profitability for this business, UPS lumps domestic Express and Ground together.
FedEx Ground has a ~13% operating margin and a ~16% pre-tax ROA based on FDX’s operating segment disclosure in its FY2019 10-K. FDX has a major variable cost advantage vs. UPS in that it outsources the pick-up and delivery of its packages to many different, independent entities with lower cost and more flexible non-unionized labor.
FedEx Ground’s hub facilities are more advanced than UPS’, operating with a higher level of automation and thus the cost to sort packages is lower.
FDX has many different independent contractors it uses for pick-up and delivery of packages. As a result, it keeps this cost “honest” by having many different companies to choose from for the multitude of regions it serves. However, UPS’ labor force does have power in that it is employed under a national master agreement and various supplemental agreements with local unions affiliated with the International Brotherhood of Teamsters (“Teamsters”). It is worth noting that UPS’ air and ground operations are integrated.
Recent Developments at FedEx Ground:
There are a few noteworthy developments within FedEx Ground over the past number of months. First, FDX announced in May 2019 that it would increase its delivery schedule from 6 days to 7 days per week starting in January 2020. Second, to leverage its increasing schedule, it would be taking delivery back of much of its SmartPost volumes that it had outsourced to USPS for last mile delivery. Third, it made the strategic decision in August 2019 to sever ties with Amazon, which only made up a few percent of its volumes. Lastly, it has continued to increase its points of distribution by collaborating with the likes of Walgreens where customers can pick up and drop off packages in order to enhance package security.
These moves in the short-term impact operating profit growth, but de-risk as it relates to being reliant on Amazon for growth and helps position FedEx Ground to be the long-term, preferred partner to businesses that compete against Amazon.
What FedEx Ground Has the Potential be Worth in 4-5 Years:
Based on ~$21 billion in revenue in FY2019, FedEx Ground generated ~$2.4 billion in operating income net of its estimated share of unallocated corporate overhead. Over the next five years, I believe FedEx Ground should be able to continue to grow its revenue at a high-single digit to low-double digit rate (compared to a 12% CAGR over the past 5 fiscal years through 5/31/19) and ultimately gain some operating leverage (likely beginning in FY2021/2022) resulting in expanding margins.
FedEx Ground has been in investment mode for many years, which has resulted in declining operating margins. Segment operating margins declined from 14.9% in FY2016 to 12.6% in the LTM (through 8/31/19). However, unlike over-investing capital in a declining domestic FedEx Express business, in my view, this has been the right move to allow it to continue to gain market share (ex-Amazon volumes) for years to come within a structurally growing market. The capital intensity of the business is declining with capital expenditures below that of D&A over the LTM.
Looking out 5 years, based on my estimates, I believe FedEx Ground could have revenue in the range of $31B-$37B and operating profit in the range of $3.2B-$5.0B. Applying a ~25% tax rate on ~$4.1B of pre-tax income results in ~$3.1B of after-tax income. Given the sustainable, above average growth characteristics and ROIC, I believe this business deserves to trade at an above market multiple. Applying a 20x earnings multiple plus ~$8B in free cash flow generation results in an EV of ~$70B in 4-5 years, which compares to FDX’s current EV of ~$54B.
What to do with the rest of FDX:
Founder and CEO, Fred Smith, owns 19.5M shares or 7.5% of FDX worth ~$2.8B. While he clearly has major skin in the game, he appears to be thinking with his heart regarding the business he founded, FedEx Express. In my view, Smith continues to make poor capital allocation decisions. The TNT acquisition has been a disaster and spending billions of dollars on new, more fuel-efficient planes in a declining domestic volume Express business is not money well spent.
The FedEx Express business needs to be right-sized. I think it should remove capacity by getting out of certain lanes that lack the requisite volume. It should get rid of low-unprofitable business by providing greater incentives to customers to move that volume into FedEx Ground or cede it to UPS.
The bottom line is that outside of FedEx Ground, the rest of its businesses collectively do not generate any free cash flow. Outside of FedEx Ground, on a cash basis, it has not generated a return above its cost of capital for many years.
I have no idea if Fred Smith will come around to finally making the right operational and capital allocation decisions. However, this could be a situation ripe for an activist to get involved.
As long as the FedEx Ground business continues to grow nicely, it provides good downside protection and a lot of potential upside should management do the right things (or be forced to) with the Express business.
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FedEx Ground continues to grow nicely over time. Management allocates capital better.