We have been spending a lot of time seeking companies that have the following attributes: (1) extremely high barriers-to-entry, (2) good growth potential for the next 15+ years with little obsolescence risk, (3) a high quality management team, and (4) a good balance sheet. It was surprising to find that very few companies fit the criteria above at any price... and of those companies, we identified FedEx is by far the cheapest. We believe that FedEx will have normalized margins of 10%+, and that normalized earnings in CY2012 should be $8.00+ per share. Therefore, one is buying a business with a significant "moat" and good long-term growth potential for less than 10x normalized CY2012 earnings.
While most are certainly familiar with FedEx's planes, trucks, and delivery vans, one might not know that the company operates three discreet businesses: FedEx Express, FedEx Ground, and FedEx Freight (there is also FedEx Office, which is very small and somewhat of a "loss leader"). Below, we'll discuss the three companies and each unit's unique set of opportunities and challenges.
FedEx Express, which is the world's largest express transportation company, provides time-definite delivery in more than 200 countries. The company states that it connects markets that comprise 90 percent of the world's gross domestic product within one to three business days. This is an asset intensive business with significant investments in airplanes, hub and distribution facilities, line-haul trucks, and delivery vehicles. While fully integrated, the Express division should be thought of as two businesses -- Domestic and International -- with very different outlooks.
The Domestic Express operations are FedEx's legacy business. The company's business plan was first conceived by Fred Smith as an undergraduate at Yale, and the company began providing service in 1971. This is a duopoly business with UPS. DHL, which had about 10% domestic US market share but was losing billions of dollars, exited the domestic US air and ground business in 2009. We believe that DHL's exit from the business will lead to a rational competitive environment; indeed, if one listens to FedEx's and UPS's recent conference calls and investor presentations, it is clear that pricing is a key objective (UPS has repeatedly stated that "pricing improvement is the #1 priority").
Unfortunately, the Domestic Express business is not well positioned for several reasons. First, the Ground business (to be discussed in further detail below) has grown rapidly and, thus, has significantly improved delivery density and transit times; since this is a lower cost service, it has been cannibalizing the Domestic Express business. Second, some of the packages sent are "documents" (almost all documents are in the Express business, not the Ground business), whose shipments are in secular decline due to email/internet (and previously due to fax machines). Within Domestic Express, it is difficult to know exactly what percent of the shipments are documents versus physical goods. Based on various assumptions, we believe that 25%-30% of Domestic Express package revenues are "documents".
In FY10, domestic Express package revenue (excluding domestic airfreight) was $9.8 billion, or about 46% of the express division and 28% of FedEx's total revenue. Other than FedEx Office, this is the lowest margin business within FedEx, so domestic Express package revenue (again excluding domestic airfreight) probably represents less than 20% of overall profitability. Domestic airfreight, which is comprised of general airfreight and also a contract with the USPS (USPS has a monopoly on postal mail; it uses FedEx for its overnight service for mail and packages), is about 6% of revenue... most of this business also does not seem particularly well positioned. Thus, the entire Domestic Express segment is 34% of revenue and perhaps only 20% of overall profits in a normal year. It should be noted that the Domestic Express network will not lose critical density and suffer from deleveraging, it is actually quite the opposite. The International Express business (discussed below) is growing quickly and leverages the Domestic Express network... so overall traffic in the Express network within the US will continue to grow even if Domestic Express doesn't experience volume growth.
Fortunately, the International Express business has very good margins and very good growth potential. Whereas the Domestic business has competition from somewhat slower Ground operations, international parcel shippers have few options when sending a package from - for instance - Chengdu to Chicago (ocean freight might take three or four weeks versus one or two days by FedEx). Therefore, International Express has three or four times the yield and very good margins (although, unfortunately, FedEx doesn't provide segmented margins for Domestic Express and International Express). We believe that this business has long-term secular tailwinds due to increased global sourcing and selling (as a side note, we highly recommend the book "A Splendid Exchange", which chronicles the history of trade), and from more high-tech and high-value-added goods (value per pound increasing is beneficial). The export parcel market is dominated by FedEx, UPS, and DHL, with FedEx having particular strength in Asian exports. It should be noted that DHL's competitive position has weakened significantly following its retrenchment from the US market (it still has "International" operations within the US, but it has scaled back significantly); a very knowledgeable acquaintance believes that DHL is "discombobulated" and won't be much of a factor in 7-10 years. In addition to its International Priority export business, FedEx also has "International Domestic" operations, which provides intra-country service within China, Canada, and several other countries.
Other than the concern over the long-term outlook for Domestic Express, some investors have regulatory concerns about FedEx Express's classification in the Rail Labor Act (RLA). Since its inception, FedEx Express has been subject to the laws of the RLA (which also includes railroads and airlines) rather than the National Labor Relations Act (NLRA). The RLA, which is intended to protect businesses that operate critical networks, makes it more difficult for unions to organize and strike by requiring action only at a national level (so local work stoppages won't cripple networks). It is important to note that both FedEx Freight and FedEx Ground are non-union companies that operate under the NLRA, so Express's switch to the NLRA wouldn't automatically lead to unionization. Nonetheless, a switch to the NLRA would be a distraction to management and could increase the risk of FedEx. UPS, which was originally a ground-only business, operates an integrated air/ground network and is thus classified under the NLRA.
According to FedEx, FedEx's status within the RLA has been confirmed on many occasions by courts and federal agencies, including the Ninth Circuit Court of Appeals in 1991, which concluded that "Federal Express is exactly the kind of an expedited all-cargo service that Congress specified and the kind of integrated transportation system that was federally desired. Because it is an integrated system, it is a hybrid, an air carrier employing trucks. Those trucks do not destroy its status as an air carrier. They are an essential part of the all-cargo air service that Federal Express innovatively developed to meet the demands of an increasingly inter-linked nation." According to FedEx, every court or agency that has looked at the issue has ruled that FedEx Express belongs under the RLA.
In the current House FAA bill, an amendment was included which would switch FedEx to the NLRA. However, FedEx appears to have enough support in the Senate to prevent the "FedEx amendment" from becoming law. In a June 17, 2010 interview with Dow Jones, Senate Commerce Committee Chairman John Rockefeller stated "I know perfectly well if I put that [NLRA provision] in the bill... it's not going to pass."
FedEx Express's margins have been:
The company is confident that it should have a 10%+ margin in FedEx Express. A major consideration is the mix change due to the much faster growth of International Express, which has much higher margins than Domestic Express. Additionally, with the exit of DHL from the domestic US market, we believe that UPS and FedEx will exert more pricing power. Additionally, in the recent economic downturn, FedEx eliminated $1.5 billion in expenses (almost all from the Express segment), which it believes will not come back with volume.
FedEx Ground, which operates only in the US, runs a separate network from FedEx Express (both have different hubs and delivery vehicles). While FedEx Express is designed for speed, FedEx Ground is more of a lower-cost, "milk run" operation. Importantly, FedEx Ground delivery vehicles are operated by independent contractors (not employees); contractors are responsible for buying or leasing their vehicle, paying for fuel and other expenses, and are generally paid per package. We believe that FedEx Ground (which has 22-23% share) has significant cost advantages versus unionized UPS (which is market dominant) due to its contractor model. DHL, prior to its 2009 exit from the domestic US market, had a 2-3% ground market share and had the least pricing discipline. FedEx Ground should have good long-term growth prospects due to increased outsourcing of supply chains (companies using parcel deliveries instead of proprietary distribution networks), growth of e-commerce, cannibalization from domestic Express, and continued market share gains from UPS. Overall, the company anticipates double-digit revenue growth in FedEx Ground.
A major investor concern within FedEx Ground is contractor lawsuits, so we'll discuss this is some detail. It should be noted that there are two types of contractor arrangements: single-route and multi-route. A "single-route" contractor is generally a single individual/truck having a direct relationship with FedEx Ground; "multi-route" operators contract with FedEx Ground for more than one truck/route (and hire employees/sub-contractors to operate some of the delivery vans).
The first successful challenge to FedEx's contractor model was in California, which stated that single-route contractors are employees and were misclassified, but multi-route contractors are not employees. Additionally, the California judge said that single-route contractors who were incorporated were not employees.
FedEx is currently altering its contractor model. First, it is encouraging (through incentives) single route contractors to either become multi-route contractors or to sell themselves to a multi-route contractor. Currently, two-thirds of routes are part of multi-route organizations... this will eventually become 100%. In addition, FedEx is requiring contractors to incorporate. The company is also changing contract terms that incentivize certain behavior instead of requiring certain behavior; for instance, a contractor is not required to wear a FedEx uniform, but will receive a "marketing" bonus incentive if one chooses to do so.
In December 2007, the IRS told FDX that it was seeking $319 million (plus interest) for back taxes and penalties relating to classifying employees as contractors in 2002 (the IRS also said it was looking at a few subsequent years). FedEx says it has a 1994 letter of assurance relating to this issue and that the business model has not changed since then. In late 2008, the IRS stopped pursuing 2002 back taxes at FedEx, but then announced a $14 million required payment (in Sept. 2009) relating to the FedEx Home (part of FedEx Ground) operations (which supposedly have more control due to providing turn-by-turn directions, etc.).
In CY2009, FedEx Ground won a United States Court of Appeals decision which stated that these contractors are independent business owners, not employees, and are thus outside the jurisdiction of the National Labor Relations Board. A jury in the Superior Court of the State of Washington also affirmed in a verdict that FedEx Ground single work area contractors operating in the Washington are independent business owners and not employees.
A forty state Indiana-based case is looking at both single- and multi-route contractors. Completely abandoning the contractor model might cost FDX $600MM per year according to one labor representative's study (of course, FDX disputes this amount). Assuming an incremental $10,000 cost for each of the 20,000 or so pick-up/delivery drivers, eps would decline by $0.40. In addition, there would be one-time settlement payments for prior year misclassification (as well as capital costs to acquire trucks, etc.). We believe the lawsuits are not like black lung and punitive, but more about FICA taxes and parking tickets.
While there has been much recent attention on classification of employees as contractors, we think the eventually model of multi-route corporations serving as contractors will be deemed to be a legitimate practice. There may, however, be one-time costs associated with prior mis-classifications.
FedEx Ground operating margins have been:
We believe that 14%+ normalized operating margins are achievable for FedEx Ground.
FedEx Freight operates in the volatile less-than-truckload (LTL) sector (which is a $30-$35 billion market, of which FedEx has an approximate 15% share). FedEx Freight revolutionized the regional LTL business by running a scheduled network (competitors would generally run trucks when they were filled); customers trust the 99% on-time performance and can take inventory out of their supply chain, and thus are willing to pay for the premium service. Other competitors include YRC Worldwide, Con-way (also known for its premium service), UPS, and Arkansas Best. Most market participants would likely agree that the recent conditions led to the worst LTL environment in decades. YRC, which had the leading LTL market share of just under 30%, was on the verge of bankruptcy (and potential liquidation); this led others to price aggressively to steal share from YRC. YRC, which escaped a bankruptcy filing through completion of a debt-for-equity swap, still has significant financial issues (mainly stemming from billions of dollars of off-balance sheet multi-employer pension and other liabilities); if YRC were forced to exit the LTL business, FedEx could potentially add hundreds of millions of dollars from taking its proportional share of YRC's volume and additionally hundreds of millions more if the complete collapse of a major competitor led to more rational pricing.
FedEx Freight's operating margins have been:
This is FedEx's most cyclical business. The company's believes a 10% margin is obtainable for FedEx Freight in "normal" times. We assume an 8% margin, although the exit of a major competitor would lead us to a more aggressive assumption.
FedEx has the overall reputation of being a very well run company, and we strongly agree with this assessment. Fred Smith, who owns about $1.5 billion of shares, is an intelligent and highly effective leader who is focused on long-term value maximization.
As of May 31, 2010, FedEx was in a slight net cash position. However, FedEx has pension plans that were $670 million under-funded as of May 2009; this might have increased somewhat since then. Additionally, the company had $14.7 billion future minimum lease payments (not NPV) under operating leases as of May 2009. Most of the leases relate to facilities (for instance, FedEx recently entered into a 20-year, $352 million lease at Newark Airport with The Port Authority of NY & NJ); about a third of the leases relate to aircraft and related equipment.
Putting it all together...
- FedEx is among the highest barriers-to-entry businesses anywhere (the recent exit of DHL from the domestic US market illustrates the scale required to compete), and we believe the "moat" will only be wider/deeper 15-20 years from now. Further, FedEx is less likely to be "price regulated" compared to other high barriers-to-entry oligopoly network industries (such as credit card networks, railroads, etc.).
- The company is confident that each of the three operating companies will have a 10% margin or higher. We assume a slightly lower margin on FedEx Freight, but an overall corporate operating margin of just over 10%. On our CY2012 revenue assumption ($40+ billion), this would generate EPS of $8.00+.
- We expect revenue to grow 8%+ through cycles for many years led by growth at FedEx Ground and FedEx International Priority.
- The company expects EPS to grow 10-15% through cycles. FedEx is benefiting from a favorable mix shift away from the low margin Domestic Express business towards the much higher margin FedEx Ground and International Priority businesses. With the additional benefits of pricing above inflation and some operating leverage, revenue growth at the 8% level should produce operating income growth of 12%+.
- Strong balance sheet
- Exceptional management
- While RLA and contractor rules are potential setbacks, they are manageable.
We would like to end this analysis with a question. Can you think of any companies whose barriers-to-entry are equal-to-or-greater than FedEx's that also have better 15-20 year growth potential? MA/V are obvious candidates (but with more regulatory risk)... if you can think of any that are better positioned than FedEx in this regard (especially those with low p/e multiples), please enlighten us in the discussion thread...