FedEx Has Scope To Deliver Value – FedEx Corporation (NYSE:FDX)

Despite the potential for further reductions ahead, as well as the likely EPS pressure early in 4Q20, I think FedEx (FDX) could work as a potential supply chain recovery story. Shares have drawn down significantly over the year and now trade at ~11x FY21 EPS numbers. Given FedEx’s potential to consistently compound at above-average ROICs through the cycles, as well as investors’ pessimism on TNT, I see ample room for an upside surprise should the macro outlook stabilize/improve. With green shoots of a recovery emerging in Asia, coupled with the EPS benefit from successful cost actions and a successful TNT integration, I see ample room for an upside surprise.

3Q20 Puts and Takes

FDX’s fiscal 3Q results were considerably weak on an absolute basis, though the excessively low expectations heading into the quarter led to a handy beat. Management also withdrew its full fiscal year outlook, which, while understandable, has likely clouded investors’ ability to assess FDX’s trough earnings power. However, there were some bright spots – for instance, management did broadly outline plans to keep costs in check amidst the uncertainties. Measures include the retiring of older aircraft by FY22, hiring restrictions, as well as delivering SmartPost and day-dedicated Express packages through the Ground network. On a positive note, management reiterated that the TNT integration remains on track, with an anticipated close by fall 2021.

We continue to make significant progress on TNT integration around the world and are on track to deliver important milestones as we end the fiscal year. In Q4, we will complete the interoperability of the intra-European ground network. This will enable us to lower our cost to serve as the related FedEx operations continue to be optimized. We also remain fully on track for completion of the air network integration in fall 2021, which will bring to a close the physical network integration of TNT into FedEx.

A closer look at the 3Q20 results within a historical context offers a sense of how weak the results were – consolidated operating margins at 2.8% (excluding TNT-related integration expenses) was the worst quarterly profit margin over the last decade, with FY20 margins now likely set for ~3-4%. Total company profits were also down by >50% YoY despite revenue rising relative to the prior year.

3Q20A

Revenues

$17,487

YOY Growth

2.8%

EBITDA

$1,391

YOY Growth

-24.2%

Operating Income

$483

Operating Margin

2.8%

Earnings Per Share (NYSEARCA:EPS)

$1.42

YOY Growth

-53.2%

Source: Company Data

Looking ahead, revenues are underperforming December expectations (note this is prior to the outbreak), with the early Lunar New Year and other structural headwinds likely offsetting the benefit from the favorable timing of Cyber Monday, and strong results in FDX Freight.

Prior to the outbreak of the coronavirus, commercial volumes and revenues were somewhat underperforming our December expectations. The coronavirus pandemic magnified global economic weakness.

Meanwhile, the COVID-19 disruption appears to have been a mixed bag for FDX – though total cargo capacity to China dropped by 40%, FDX did maintain their service levels, helping to support higher load factors. Interestingly, China volumes have started to rebound in early March as most businesses return to work.

What we have seen is 90% to 95% of large manufacturers in China are now back to work in some capacity, closer to 65% to 70% of small businesses in Mainland China are coming back to work from a manufacturing perspective.

While European activity has been weighed down by the outbreak, there is a clear opportunity to gain share – with the 60% of Europe-USA freight volume on passenger planes no longer flying (vs. 30% for US-China), FDX is well-positioned to step in to take advantage. The net impact will still likely be adverse as the demand trough is likely ahead of us, but expectations are already very low, and thus, I see ample room for an upside surprise.

Express Likely to Benefit From a Supply Chain Recovery

The Express segment’s 3Q20 results were largely a write-off given the softer global backdrop, with EBIT declining ~55% YoY, and margins deteriorating by ~270bps YoY in Q3, with the company right-sizing capacity to offset the impact (capacity reduction target of 6%-8%). However, it is worth noting that a pickup in Asia has led to FDX flying more planes than expected.

We had committed to you, I think, 6% to 8% of flight hour reduction in Q4. I would say today, we’re not there because we’re flying more in Asia than we had expected to

With the green shoots of a recovery on the horizon, a further manufacturing recovery in Asia should drive a surge in international air freight demand as businesses urgently look to replenish goods. Coupled with the TNT integration, the Express segment looks to be setting up favorably heading into FY21. Interoperability of the European Ground segment is expected to be finished by the end of FY20, and the pickup and delivery (P&D) and line-haul integration are set for completion in FY21. With duplicative costs set to be removed from the network, I expect to see significant improvements in the Express business’ margin profile next year, with the improved earnings power likely to support a re-rating case.

Cost Overruns Weigh on Ground Performance

Ground results came in well below expectations in the quarter as cost overruns offset the steady top-line performance. Revenues of $5.9B were up 11% YoY, though operating profit of $355M declined by 39% YoY on increased operating expenses.

Source: Form 10-Q

Delving deeper into the segment breakout, ~190 bps of cost headwinds to Ground were attributable to the 6/7 Day delivery and the Amazon (AMZN) loss, along with a $115 mm incentive comp headwind and 180 bps headwind from insurance. Management does, however, expect these headwinds to abate as we move through the calendar year.

On a positive note, e-commerce continues to drive outsized volume growth, as ground volumes were up 10% YoY, with management guiding toward continued volume growth going forward.

Source: Form 10-Q

Also notable was the launch of the last-mile initiative, with Express volumes going through the Ground network for select Deferred packages. Thus far, this has been rolled out in Greensboro, NC, and will expand to Cincinnati, Phoenix, Minneapolis, New York, Salt Lake City in April. However, management has yet to offer additional color into the potential gains from the move, which makes it difficult to quantify the P&L impact at this juncture.

Attention Shifts to FDX’s Cost/Efficiency Drivers

I see the near-term FDX story as increasingly focused on its ability to drive cost savings – in particular, the planned reduction in FDX’s air network capacity will be key, along with the move to shift a portion of the Express B2C volume to the Ground network. Ground should also benefit from the insourcing of Smart Post package delivery from the U.S. Postal Service. Though I would not be too quick to call a trough, I do expect sequential improvement in Ground margin in 4Q20, as a result, though visibility into FY21 remains limited. Additionally, FDX has reiterated its capex guidance of $5.9B for FY20, though the company has the ability to flex down capex if necessary. Looking ahead, capex should trend meaningfully lower in FY23 as aircraft deliveries wind down.

I also see additional earnings upside should FDX execute on the initial synergies envisaged with the TNT integration (i.e., route optimization, interoperability, and labor efficiency).

Source: Roadshow Presentation

With the market largely de-rating the stock following the EBIT improvement target delay, I think considerable pessimism has already been priced into TNT synergy expectations. I would argue that integration benefits are, instead, likely to be back-ended given major EU countries (such as France and Germany) will be integrated at the end. At this point, I think if management is able to capture even a portion of the $750 Mn EBIT benefit, we could see the stock re-rate in FY21 as the market re-evaluates FDX’s pro-forma earnings power.

Low Valuation Boosts the Risk/Reward

With FDX trading at ~11x earnings on my base case FY21 EPS estimate of ~$10.50/share, I see the medium-term upside potential for FDX as significantly greater than the downside risk. The current multiple is significantly below where FDX has generally traded through prior cycles, with a continually improving ROIC as the Ground segment becomes a larger part of the business, as well as synergy and efficiency benefits likely to cushion EPS in the upcoming quarters. Thus, I would argue FDX deserves a much higher premium to the market than it currently receives.

ChartData by YCharts

While there is a clear valuation case to be made, the market may not re-rate the stock until we gain better visibility into the potential ripple effects of the coronavirus across Europe and the US. Patient, longer-term investors may, however, find the stock worth a nibble.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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