- By The Science of Hitting
"Finished up research on UPS and FDX this week. Honestly, I found the exercise more difficult than I would've assumed going in. Think they are both reasonable investments at current levels, but I do not have an overwhelming level of conviction on that."
The intrinsic value of FDX
Recent price action has led me to refocus my attention (UPS is down 25% and FedEx declined 40% over the past year). On headline valuation metrics, the stocks look cheap too; FedEx, for example, trades around 10x forward earnings on non-GAAP guidance. In this article, I'll walk through some of the positives and negatives that I see with FedEx (I will probably write an article about UPS later).
Let's start with the positives.
First, FedEx has significant scale. In fiscal 2018, the company moved more than 14 million packages a day and generated $65 billion in revenues. In addition, the business has been growing at a decent clip, with average daily volumes nearly doubling over the past decade (6.6% CAGR). FedEx has been helped by growth in its U.S. Ground business, where it has taken market share for 19 consecutive years (ground volumes have roughly quadrupled over the past 15 years, to 8.3 million packages a day).
This scale has resulted in efficiencies that enable FedEx (and UPS) to offer services that are difficult for competitors to match; as an example, analysts at Stifel, Nicholas estimated in 2013 that regional carriers account for less than 2% of the market. In addition, that position appears well cemented. Consider the example of DHL, which made a big push to compete in the U.S. parcel market in the early 2000s (following the $1 billion acquisition of Airborne Express in 2003). At the time, DHL argued they would bring "much-needed competition to a market that up until now has been dominated by a long-held duopoly." But things didn't go as planned. After five years and billions in losses, DHL capitulated and shuttered the business. At that time, DHL Express CEO John Mullen said the firm had struggled against the overwhelming brand recognition of UPS and FedEx. Another DHL executive put it more bluntly: "It is very difficult to build a network and compete profitably against well-entrenched companies, as we found out."
Another positive for FedEx is that its business is spread across a large base: No single customer accounts for more than 3% of FedEx's revenues. As we think about the future of the business and where risks lie (which I will discuss in a moment), lack of customer-specific risk is worth noting.
Finally, as I noted in the introduction, FedEx trades around 10x forward earnings (on non-GAAP earnings per share). Note that the forward price-earnings has been about 50% higher, on average, over the past five years (around 15x). If it turns out that the current fears are unfounded, the multiple could move much higher.
Alright, now to some of the negatives.
Let's start with where I just left off: valuation. Non-GAAP earnings add back integration charges related to TNT Express (which I will discuss in a moment). My problem is FedEx acquired TNT in 2016 and has taken on significant costs to integrate the business (the initial plan called for $700 million to $800 million in expenses; the most recent update called for ~$1.5 billion of cumulative integration expenses through next year). At some point I don't think these costs should be considered one-off, nor immaterial - especially since management stated on the last conference call that they may incur additional TNT integration costs beyond fiscal 2020. The same goes for costs related to certain legal matters, which FedEx management adds back to non-GAAP EPS (admittedly this has been smaller and less frequent).
But the bigger issue as it relates to valuation is cash flows. Over the past five years, depreciation and amortization has been $13.9 billion (cumulative). On the other hand, capital expenditures have been $23.5 billion. The gap between D&A and capex has been nearly $2 billion a year, on average, over the past five years. That's over a period where adjusted net income was roughly $3 billion a year. Said differently, FCF has been around $6 per share, putting the FCF multiple well north of 20x. This is a much different picture than net income. Personally, I have found differentiating between maintenance and growth capex to be difficult. That's a long way of saying that adjusted earnings per share may not be the right metric to use to value FedEx.
My second concern is the company's lackluster results following $4.8 billion acquisition of TNT Express, a large European express delivery company. FedEx has publicly stated that it expected Express segment operating income (inclusive of TNT) to increase $1.2 billion and $1.5 billion from 2017 to 2020. But for a number of reasons, TNT has lagged expectations (including the 2017 NotPetya cyber attack that significantly affected the company's operations and cost the company hundreds of millions of dollars). On the most recent call, management admitted they will not achieve the profit target. Based on some of their additional commentary, it doesn't sound like we should expect the results to meaningfully improve in the coming quarters either (Express segment operating income was "significantly below the business plan" in the first half of fiscal 2019).
Finally, there's the lingering cloud of Amazon's presence in the delivery business. This has been the most difficult part of the story to get my arms around. Note that Amazon spent $26 billion on shipping costs over the trailing 12 months. It clearly has an incentive to do whatever it can to ensure that it is operating as efficiently as possible. Over the past few years, it has worked to cut out middlemen and to use last-mile services offered by the United States Postal Service (Goldman analysts estimate that USPS offers 70% lower rates on domestic shipments, on average, versus UPS and FedEx). The question is whether they'll stop here or if Amazon has larger ambitions. This quote from a former Amazon executive is what keeps UPS and FedEx shareholders up at night:
"I fully expect Amazon to build out a logistics supply chain that others can use. Over the next five years? I doubt it. Over 10 or 15 years? Oh yeah."
My understanding is that this has already happened in some countries. For example, Amazon CEO Jeff Bezos said the following in his 2013 shareholder letter: "We've created our own fast, last-mile delivery network in the U.K., where commercial carriers couldn't support our peak volumes." A few years later at the Recode conference, Bezos implied that the company now delivers 50% of its own volumes in the U.K. Clearly they are handling more than peak package volumes.
But I struggle to see how that would happen in the U.S. The cost to rebuild the FedEx and UPS networks would be astronomical. Goldman analysts did a deep dive last year and concluded that this feat would cost north of $100 billion (to give you a sense of what they would need to commit to, FedEx has 650 planes, 150,000 trucks, 400,000 employees and 4,800 operating facilities around the world). Also noteworthy is that FedEx spent $40 billion on capex over the past 10 years. This is an asset-intensive business. Is committing tens of billions of dollars to rebuild these networks Amazon's highest and best use of capital? The investment required to get to scale - in terms of time and money - would be significant. And success is far from assured (again, see DHL). If Amazon's goal is to simply replicate what UPS and FedEx have already built (as opposed to a radically new approach like they took with AWS), I don't think it makes a ton of sense.
This quote from a 2014 Wall Street Journal article sums up why I think that is the case: "Industry observers say it will be difficult for Amazon to match the efficiency of UPS or FedEx in more than a handful of U.S. markets, simply because it will be delivering fewer packages over a wider area."
Here's where I'm at on Amazon at this point: Can it selectively insource some work (like sortation) and lean more heavily on the USPS and regional carriers to pull volume from FedEx and UPS? Yes. But can Amazon take the step and become a logistics company serving residential customers and businesses? That's a more audacious feat - and as importantly, one that does not appear to further the goals of Amazon's e-commerce business. Time will tell if the "Shipping with Amazon" service expands beyond its current scope, but I'm still skeptical at this point.
I'll close on Amazon with this comment from Citi analyst Christian Weatherbee:
"The trigger we've consistently looked for from the company as a warning signal has been asset commitment. To date, the company hasn't made a meaningful push into the true transportation asset ownership we believe is necessary to be a competitor."
Where does that leave us? I like that FedEx's stock price has been crushed. And I think the company still has a competitive moat that is unlikely to be breached in the foreseeable future.
On the other hand, I have concerns about the level of capital expenditures and pension contributions, both of which limit their ability to pay dividends and repurchase shares (they've still done a fair amount of both, but help from incremental debt and a higher leverage ratio).
In addition, management's primary long-term financial target (10-15% annualized EPS growth) appears unrealistic. Something closer to what we've seen over the past decade (mid-single digit EPS CAGR) seems more reasonable to me. For now, I'm staying on the sidelines.
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This article first appeared on GuruFocus.
The intrinsic value of FDX