The recent results from FedEx Corporation were a net positive, and the company appears on track for significant growth in earnings in the next few years. Given that the stock has dipped a bit recently, and prospects appear to be improving, is now the time to buy FedEx stock? Let's look at the case for and against.
FedEx Corporation needs to improve margin in its e-commerce operations. Image source: Getty Images.
Four reasons to buy FedEx Corporation stock
First, according to analyst estimates, FedEx and its rival UPS are both set for good earnings growth in the coming years. As you can see below, both stocks look to be good values on a price-to-earnings basis.
|EPS and P/E Ratios|| |
UPS (NYSE: UPS) EPS
UPS P/E ratio
FedEx Corporation (NYSE: FDX) EPS
FedEx P/E ratio
Data source: Company presentations, Yahoo! Finance.
Second, FedEx's ongoing integration of TNT Express is expected to lead to an increase in operating income in the express segment of some $1.2 billion to $1.5 billion from fiscal 2017 to fiscal 2020. For reference, FedEx's fiscal year end in April and adjusted non-GAAP operating income for fiscal 2017 was $5.48 billion. Clearly, TNT Express is a game-changer for FedEx and enables the company to expand in Europe -- FedEx is now a company comparable to UPS and DHL in Europe.
Third, long-term growth from e-commerce ensures good volume growth for package delivery companies. As you can see below, UPS and FedEx have both been able to grow volumes in their segments most directly impacted by e-commerce. In fact, both companies have more than enough volume growth to support expansion activities, and the fact that Amazon.com (NASDAQ: AMZN) is expanding its own delivery options is not really a significant threat to FedEx or UPS.
Data source: Company presentations. Chart by author.
Fourth, e-commerce growth has brought about margin challenges at both companies in recent years, but FedEx appears to have begun to turn the corner regarding the issue. As you can see below, FedEx's most recent quarter marked the second in a row in which ground margin expanded.
Data source: Company presentations. 100 basis points are equal to 1%.
All told, the case for buying FedEx rests on strong earnings growth prospects at express from the TNT integration and a combination of margin expansion and e-commerce growth in ground and express.
Four reasons to avoid buying FedEx stock
There's little doubt that FedEx has exposure to political risk. Recent actions and rhetoric on trade agreements from President Trump, alongside ongoing protectionism from countries like China, have created a threatening environment for global trade. A full-blown trade war would obviously be bad news for international package delivery companies like FedEx and UPS.
Second, the recent results from UPS and FedEx both contained higher-than-expected costs in relation to managing peak delivery demand over the holiday period. In a nutshell, it's very difficult to predict how demand will peak during a few days trading in the year. UPS has had issues with carrying too much capacity on certain days in the past, while this year, both companies found their networks stretched by surges in demand.
UPS suffered an unexpected increase in operating costs of some $125 million, while FedEx's express also took a hit to operating income partly due to "increased peak-related costs." It's a salutary reminder that FedEx contains earnings risk during the peak delivery season.
Third, although ground margin has improved in the last two quarters (see above), FedEx has a long way to go before it gets back to the kind of margin enjoyed by ground in the past. For example, ground operating margin in 2014 was 17.4% compared to just 12% in the first three quarters of fiscal 2018. Moreover, it's not proving easy to increase e-commerce delivery margin as FedEx and UPS have taken significant pricing actions in order to do so, but they still haven't conclusively demonstrated that they can generate margin expansion.
Fourth, and arguably most importantly, the stress of supporting e-commerce delivery growth has led to increasing demands on capital expenditure. For example, UPS significantly ramped its mid-term expectations for capital spending on its most recent earnings call, and even though FedEx reduced its capital spending forecast for 2018 by $100 million to $5.8 billion, it still represents a relatively elevated amount of spending.
As you can see below, increased capital spending has significantly eaten into free-cash-flow (FCF) generation at both companies.
Is FedEx a buy?
As attractive as the company is, not least for the stellar management of Founder and CEO Fred Smith, I don't think the stock is worth buying right now. On the positive side, it's likely FedEx will see margin expansion in express and significant earnings growth in the future. Moreover, the margin decline and FCF deterioration can, of course, be understood in the context of near-term adjustments made to service e-commerce growth and the TNT integration.
On the negative side, there are no guarantees that margin pressure will abate in terms of e-commerce deliveries, and recent results with FedEx and UPS have highlighted the risk of that both companies face during servicing peak delivery demand during the holiday season.
I think cautious investors can wait a few quarters to see if margin expansion with e-commerce related deliveries is taking place before feeling fully confident in buying the stock.
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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Lee Samaha has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon. The Motley Fool recommends FedEx. The Motley Fool has a disclosure policy.