On Tuesday, FedEx Corp. (NYSE:FDX) reported financial results for the first quarter of fiscal 2020 - and it was another difficult period for the company. Revenues were flat year over year at $17 billion.
The Ground segment had a reasonable quarter with a 7% increase in daily package volumes and an increase in yields (revenue per package), leading to a high single-digit increase in revenue. Top-line growth was offset by higher expenses (primarily due to the expanded operating schedule), with operating income falling 5% in the period (Ebit margins contracted 170 basis points to 12.4%).
As shown below, the Ground segment has reported respectable financial results over the past five to 10 years. This segment has been a bright spot for FedEx over this period:
On the other hand, the Express segment has struggled. Fiscal 2019 operating income was down more than 10% from where it was at three years earlier (from $2.5 billion to $2.1 billion). In the first quarter of fiscal 2020, segment revenues and income declined 3% and 27%.
But the results are even worse than those numbers indicate. That's because the segment now includes TNT Express, the European business FedEx acquired in 2016 for nearly $5 billion. After that deal closed, management projected segment operating income in fiscal 2020 would be $1.2 billion to $1.5 billion higher than in fiscal 2017. In reality, 2020 operating income will be hundreds of millions of dollars less than in 2017.
To put that in context, let's assume the gap between the original expectations and reality (what Express actually earns in 2020) will be around $1.5 billion. Assuming a 25% effective tax rate, that is $4 to $4.50 in diluted earnings per share for FedEx. If you added that to what management currently expects for fiscal 2020 non-GAAP diluted earnings ($11 to $13 per share), the company's earnings would be nearly 40% higher. Underperformance in this segment has been a material headwind to profitability at FedEx (as well as to operating margins, returns on invested capital, etc.).
Why has this happened? Well, there are a few things going on.
Let's start with TNT. Integrating the business has taken longer and cost more than expected. In management's defense, they were blindsided by the NotPetya cyberattack that significantly impacted TNT's operations (Wired called it "the Most Devastating Cyberattack in History").
The other consideration for Express is the broader macroeconomic environment. As noted during the conference call, the "vast majority" of the earnings shortfall management now expects relative to prior guidance relates to "macroeconomic conditions that we did not predict."
Chairman and CEO Fred Smith discussed the same topic in his 2019 shareholder letter:
"A very big challenge has been the slowdown in global trade that began in the fall of 2018. The negative effects of trade disputes adversely affected the Chinese economy and contributed to a sluggish performance in the Eurozone. Uncertainty over Brexit also weighed heavily on the European market. The spillover effects from trade tensions have affected manufacturing and reduced shipping throughout Asia, Europe, and North America."
While I'm not fond of companies that point to external factors to explain their struggles, I think there's some evidence to support its claim. As noted on the conference call, global trade volumes in the second quarter declined for the first time since 2009. And as management noted on the call, they expect that to hold for the remainder of the year, with global trade volumes contracting for the full year. This is a clear headwind to FedEx's business, with the impact growing as you move down the income statement (there's a lot of fixed costs in this business).
I'm honestly not sure what to think about this. How much of this reflects short-term, macro-driven issues as opposed to issues in the company's Express business? I don't know the answer - but I have a feeling that anybody who does may have the opportunity to make some money here.
As I've noted previously, I have my doubts about FedEx's business. It is capital intensive, reported and non-GAAP earnings are overstated (due to outsized capital investments relative to the depreciation expense recorded on the income statement) and I think the returns on incremental invested capital have not been particularly attractive over the past decade.
This sums it up nicely: from the start of fiscal 2016 through the first quarter of fiscal 2020, FedEx generated $21.5 billion in cash from operations, but the company reinvested all of it - and then some ($22.5 billion of capital expenditures). On top of that, it spent $4.8 billion on acquisitions (TNT Express), $2.1 billion on dividends and $5.7 billion on share repurchases (note that repurchases in the first quarter of fiscal 2020 were essentially zero). The net result has been that cash outflows exceeded inflows by nearly $14 billion over this period. Clearly that is not sustainable over the long run.
Mr. Market hasn't missed this the company's recent struggles. As shown by the current valuation (forward price-earnings multiple), the market is quite skeptical about its future prospects.
Time will tell whether this is a temporary miscalculation or a sign of more difficulties to come.
One final thought. Here's what management said about Amazon (NASDAQ:AMZN) a year ago:
"While there has been significant media interest in what Amazon is doing... this should not be confused as competition."
And here's what they said this week:
"We basically compete in an ecosphere with five entities. There's UPS (NYSE:UPS), there's DHL, there's the U.S. Postal Service, and now increasingly, there is Amazon."
Change is clearly afoot.
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This article first appeared on GuruFocus.