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We believe FDX offers a compelling short opportunity. After a furious 50% "green shoots" rally, stoked by management's comments in March that a bottom was near, FDX trades at 16.3x the consensus estimate of $3.31 for FY May 2010. For many reasons, we believe this estimate is totally unachievable barring a sharp and immediate V-shaped recovery.
FDX delivers packages and freight through its global express, ground, LTL and supply chain management services. The primary driver of FDX operating performance and share price performance is FedEx Express (64% of FDX earnings), which offers time-definite delivery services within one to three business days via the worlds largest global air network.
As an asset heavy player in the most high priced segment of the global transportation system (time definite air), FDX is susceptible to significant margin deleverage due to cyclical volume declines and secular shift away from premium air products toward increasingly efficient and significantly lower margin ground products. This margin deleverage has been masked over the past two quarters by gains from lagging fuel surcharges that are not disclosed and hence not fully appreciated by the market. Further, FDX has not updated the market on the status of its pension plan since 5/31/08 and will likely report a funding shortfall of $2bn - $3bn (10 - 20% of EV). Appropriately including fuel and pension impact, near term FDX earnings estimates are significantly overstated. Additionally, there is potentially adverse legislation pending in Congress that would greatly increase the likelihood of unionization of employees at FDX, further degrading underlying earnings power.
Pending catalysts include the 4Q09 earnings release, FY5/10 guidance and pension update on 6/17/09 (FDX fiscal year ends 5/31), ongoing volume data from other transportation modes (weekly rail car-loadings, etc.) and progress in Washington on the legislative front.
We get to $2.48 in FY5/10 EPS (versus $3.31 consensus) in our base case, with the largest differences being the expiration of fuel surcharges and underlying organic margins. Thus FDX is trading at 22x our forward estimate. Then we penalize FDX $4 / share for the present value of likely pension funding shortfall to be announced within a month. This yields a target price of $33 using a 15x fair multiple, roughly 40% below current prices.
However, the base case analysis gives FDX credit for realizing 80% of targeted fixed cost cuts ($600mm of $750mm target) in FY10. In our heart of hearts, we believe that only 50% of the targeted cuts will prove achievable ($375mm) in FY5/10. This could mean another ~$0.40 hit to FY5/10 earnings and a target price of $26, or 50% below current prices. Our base case also excludes the potential effect of adverse legislation described below.
The bull thesis on FDX is based upon exit of DHL from the US market (the positive effects of which have already been felt, making pending comps more difficult and masking how bad the last quarter truly was) and expectation for a cyclical turnaround (which we believe has gotten ahead of itself in both estimates and the share price).
FDX operates separate distribution networks for each its Express and Ground divisions. The costs of these networks are largely fixed as FDX is the owner-operator of its aircraft, trucks and distribution centers. To maintain service levels, the networks must be kept largely intact regardless of volume declines. The redundant nature of FDX's multiple networks exacerbates the issue. Roughly 60 - 70% of FDX costs are fixed. For comparison, UPS operates one integrated network to service its Express and Ground customers, which enables it to more effectively manage the network and protect margins in a downturn.
FDX is also most exposed to the highest priced products in the transportation system; time definite air. Pricing on these premium products is 4 - 5x pricing on deferred ground products resulting in significant margin degradation as customers shift downward. As deferred truck options have become more reliable, there has been an ongoing secular shift away from premium air products toward deferred truck products.
FDX has announced a $1Bn cost cutting initiative, $750mm which is related to fixed costs. We have given the company credit for 80% of their fixed cost targets in FY5/10 ($600mm) and 100% of variable cost reductions ($250mm), despite a company culture with no cost cutting history and likelihood that these costs will take time to come out of the system. Our one-for-one variable cost decline assumptions appear highly generous; a half full jet on the Shanghai - Memphis route does not use half the fuel of a full jet.
Margin deleverage was evident in 3Q09 and would have been worse without fuel benefits (more below). Revenue was down 14% y-o-y, EBIT was down 72% y-o-y and margins fell from 6.7% to 2.2%. Forward Street earnings estimates do not reflect this reality. Although consensus revenue estimates are for 15% and 13% y-o-y revenue declines over the next two quarters, respectively, Street forecast operating margins more than double from 2.2% in 3Q09 to 3.4% in 4Q09 to 4.8% in 1Q10. Upside operating leverage will accompany first derivative top line improvement (not second derivative improvement) and cost cuts. Even giving FDX credit for 80% of targeted fixed cost cuts and 100% targeted variable cost cuts, our Base Case margin for FY5/10 is only 3.4%, well below the Street at 4.8%.
FDX, along with its express and small package competitors, passes along changes in fuel price to customers via fuel surcharges. This surcharge operates on a ~6 week time lag. In a declining fuel price environment, FDX earns excess fuel profits as surcharges are based on higher historical prices, but the company purchases fuel at the lower current spot price. Over the two quarters, FDX has enjoyed significant excess fuel profits as the prices of jet fuel and diesel fuel fell ~75% from their highs.
In 3Q09 FDX purchased 278mm gallons of jet fuel at $1.73 per gallon and 69mm gallons of diesel at an estimated $1.33 per gallon. Along with other miscellaneous fuel costs, total fuel expense was $636mm for the quarter. Considering fuel prices fell ~40% over the quarter, surcharge revenue was greater than fuel cost by the same percentage, resulting in excess profits of $200 - $300mm. FDX has not provided disclosure to the market on this profit, but conceded that they have earned "hundreds of millions of dollars" on fuel surcharge excess profits. This profit is equivalent to ~$0.50 - $0.60 in 3Q09 EPS and implies that FDX (which reported $0.31 of earnings in 3Q) was operating at a loss of $0.20 - $0.30 for the quarter ex fuel gains. This lack of profitability is consistent with margin deleverage we expected given a 14% revenue decline in the period and is not clear to the market given obfuscation by fuel profits.
For 4Q09, FDX will not benefit from excess surcharge profits. In fact, FDX will likely lose money on fuel, as both jet fuel and diesel bottomed in early March and are up 30 - 40% off their lows, respectively. Should this trend continue, FDX will likely experience a loss of $0.10 - $0.20 on fuel in the quarter.
Ignoring fuel cost dynamics, Street estimates assume a $0.42 cumulative improvement in earnings over the next two quarters. Normalizing for fuel impact, this implies an expected improvement of $1.12 over the same period. We find this level of earnings improvement over the next six months highly unlikely and believe analysts will be significantly disappointed.
FDX is responsible for a number of pension programs. The company only discloses pension plan status once a year in annual filings. As per the FDX 10-K from 5/31/08, the company had $11.6bn in projected pension obligations and $11.6bn in plan assets. At the filing date, plan assets were 77% allocated to equities. Since that point, U.S. and world equity indices are down approximately 40%, indicating what would appear to be a $3.6bn decline in pension assets.
On the 3Q09 earnings call, the company said the pension was "not as bad as Street estimates" and alluded that assets had been reallocated to mitigate losses. They gave no quantitative detail, nor did they indicate what sell side numbers they were making their comparison to. It is very difficult to believe that pension assets did not incur significant losses. We assumed a loss half as large as the likely amount as per filings ($1.8bn) in our NPV calculation to arrive at a $4 per share impact. This funding gap is largely excluded from enterprise value and earnings estimates by most analysts.
FDX enjoys a significant advantage vs. UPS in that it has largely avoided employee unionization due to a historical regulatory anomaly, which may soon be changed by Congress. FDX is currently subject to regulation under the Railway Labor Act while UPS is subject to regulation under the National Labor Relations Act. The key distinction between the two lies in the ease for employees to unionize.
Under the RLA, unionization cannot occur at the local level, but must be done firm-wide at once. Under the NLRA, employees can unionize at the local level. This inconsistent regulatory regime is a function of the fact that FDX started as an airline (which falls under the RLA), while UPS started as a trucking company (which falls under the NLRA). This is also why UPS is the largest Teamster employer worldwide, while FDX is almost completely non-union (pilots being the exception). Now that the business models of FDX and UPS have converged, there has been a push in Congress to level the playing field and re-classify FDX under the NLRA.
The U.S. House of Representatives has already included a provision in the FAA Reauthorization Act of 2009 (a bill primarily focused on funding for the FAA) that moves regulatory authority for FDX from the RLA to the NLRA. The Senate is currently working on its own draft which should be brought to the floor to a vote in early fall. Given the critical FAA funding authorization included in the bill, for procedural reasons (i.e., to prevent it from getting held up in debate on the floor) the Senate version may not include the FDX provision. However, when the House and Senate conference to reconcile the bill and put it to a floor vote (with no debate at this stage) there is a strong likelihood the bill will pass with the FDX provision included.
Including the FDX provision in the final bill is an easy way for Democrats to deliver on pro-labor promises and make up for failing to deliver other pro-labor efforts such as Card Check legislation. FDX re-regulation has long been a major focus of both the Teamsters (who would benefit from adding significant new members) and UPS (who would benefit by weakening a competitor).
This issue is completely separate from the well publicized class-action lawsuits by FDX independent contractors aiming to be reclassified as FDX employees, which remains outstanding.
While it is difficult to estimate the exact financial impact of mass unionization, it would certainly result in higher labor costs, institutionalize cost creep via negotiated annual wage increases and reduce cost structure flexibility, which has become particularly relevant in the current economic slowdown. At the very least, this is an issue that will garner increasing focus from investors this fall. Regardless of whether the legislation is passed, FDX shares should react negatively as the issue gains traction in Washington.
Risk / Reward
At current prices, the risk / reward on FDX shares are highly skewed to the downside, making the short opportunity compelling. Our Base Case yields a share price of $33, or roughly 40% down from current prices, while our best attempt to justify a Bull case yields share prices around $60, or 11% up.
Our Base Case valuation for FDX is 15x FY5/10 EPS of $2.48 less $4 for the NPV of likely pending funding shortfalls. This valuation is based on operating estimates we view as the most likely outcome, and if anything, will be worse than we have modeled. Key FY5/10 assumptions include:
The Bull Case values FDX at 14x Street high FY5/10 EPS of $4.50 and ignores pension shortfall. This thesis is predicated on a sharp cyclical turnaround and improved domestic competitive dynamic given recent exit of DHL from the US market. Based on margin de-leverage, fuel headwinds, pension issues and legislative dynamic, we find this valuation very difficult to justify and it appears expectations of a cyclical rebound have gotten ahead of themselves both in Street estimates and the share price. Further, the benefits from DHL's exiting the marketplace have already been felt; both FDX and UPS management publicly acknowledge that the benefit from taking DHL market share has already taken place and the elimination of this tailwind will make volume comparisons more difficult in pending quarters.
The greater risk, as we have seen over the past few weeks, is that long only money managers rushed into FDX (up 50% from 52 week low) in an attempt to chase performance and leverage to a turn in the economic cycle. While this strategy may be appropriate at some point and at some price, current valuation seems exceptionally stretched and we see over-optimistic Street estimates in the next few quarters as the catalyst for significant downward pressure on the share price.
Our Base Case FY5/10 earnings are $2.48 vs. 3Q annualized $1.24, Street median $3.31, Street high $4.50 and peak '07 earnings of $6.67. Current valuation ($54) is 22x our Base Case EPS, 44x 3Q09 annualized, 16x Street consensus and 8x peak '07 earnings, which we do not expect to see again any time soon. Given wide variance of Street estimates ($2.25 - $4.50), it is clear the sell-side has limited conviction on the name and a 16x consensus multiple is not justified.
3Q09 Summary Overview
FDX reported $0.31 of earnings in 3Q09 vs. Street estimates of $0.46, our estimate of $0.35 and prior year of $1.26. Total revenue was down 14% and Express revenue was down 18%. Express operating margin de-levered to 0.9% from 6.9% sequentially and 8.9% from 3Q08. Earnings likely included $.050 - $0.60 of fuel surcharge profits, without which, the company would have operated at a loss. Management provided no guidance on the call, but indicated that they "do not expect further volume declines," despite operating a business with no long term contracts or visibility. They also indicated that the pension shortfall is "not as bad as the sell-side thinks" without providing any additional details.
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