Lower operating results and FCF are the reasons for a valuation gap.
The COVID-19 pandemic is providing a tailwind.
FDX is addressing operational inefficiency and FCF concerns.
About a year ago, I wrote an article on FedEx (FDX) when its shares were trading at around $160, roughly the same level as today. The thesis of that article was that FDX is undervalued by as much as 47%, mostly because FDX was trading at lower multiples compared to its peers. The article further pointed out that there were no near-term catalysts to help close the valuation gap. There were other concerns that investors have regarding the efficiency and FCF of FDX as well. Serendipitously, the COVID-19 pandemic that is ravaging many different industries is providing a tailwind and has created catalysts for FDX. FDX is also addressing most of investors’ concerns. As a result, it is likely that the valuation gap will close within the next twelve to eighteen months as these catalysts continue to play out and improve the results of FDX. This article will provide a description of the tailwind and the improvements that FDX has made within the last year.
Lower operating results and FCF are the reasons for a valuation gap
As a reminder, in the previous article, I compared the valuation of FDX’s three different segments, Express, Ground and Freight, with their respective peers. The peers are UPS (UPS) for Express and Ground, and a host of LTL freight companies for Freight. The analysis valued FDX in the range of $240 to $300 per share. Another way to look at the valuation gap is that Ground and Freight combined are worth around $160 per share, meaning that investors are getting Express for free.
The investor concerns raised by the previous article were: while Ground continues to grow, Express’s results were spotty especially in Europe; the TNT integration is taking longer and costing more and there are still execution risks in the TNT integration; FDX’s margins are structurally lower than that of UPS due to the three segments do not share assets and IT because of their silo structure, resulting in higher cost and higher level of investment; FDX’s FCF has been dwindling with continued heavy investment in capex, resulting in FDX levering the balance sheet as it borrows to fund dividend payment and share buy-back. This article will provide an update on how FDX and the tailwind are addressing these concerns.
The COVID-19 pandemic is providing a tailwind
The revenue trend of FDX’s three segments is shown in Figure 1. The FY2020 revenues for Express were impacted by the pandemic, due to business closures in China in 3Q, followed by business closures in the US and EU in late 3Q and early 4Q. However, the revenues in Ground continued to grow, driven by B2C shipment due to significant increase in eCommerce. This trend accelerated in 4Q. B2B shipment declined in 4Q but the decline was more than offset by the increase in B2C shipment. While 4Q revenue result was mixed, FDX reported in its FY4Q2020 that the trend exiting 4Q was very encouraging.
For Express, total intercontinental volume exited May with a YoY growth. While Asia Pacific volume, led by China, slumped in 3Q, it rebounded strongly starting mid-March where daily volume grew over pre-pandemic level, driven by shipment of personnel protection equipment “PPE”. European outbound volume also grew in the transatlantic lane due to drastic shrinkage in cargo capacity on commercial passenger airlines as well as increase in eCommerce. Similarly, Asia volume continued to strengthen throughout 4Q against a backdrop of shrinking commercial passenger airline capacity. The increased demand resulted in an increase in 4Q flight hours of 2.6% YoY versus a planned decline of 7%. FDX was able to implement a temporary surcharge on all Express and TNT international parcel and air freight shipments in April. Management expects that this tailwind of capacity constrain will continue as it might take eighteen months for the commercial passenger air traffic to return to normal.
For Ground, eCommerce’s explosive growth continues to drive B2C volume growth, partly offset by a reduction in B2B volume. B2B volume, however, started to recover in April. B2C yield remains above market even among large customers as the explosive growth in eCommerce highlights the value of Ground’s capacity. In early June, FDX announced that it is implementing temporary surcharges for SmartPost, over-sized package, and residential delivery, especially for its largest customers who are seeing surging growth in B2C eCommerce volume.
The pandemic, which is driving these trends, has not shown any sign of relenting. It will probably take a vaccine before the pandemic can moderate. At best, based on currently available information, it will be 1Q2021 before any vaccine can be deployed. After initial deployment, it will take many months for the benefit of the vaccine to take hold. Even then, it will probably take months for commercial passenger air traffic to normalize. The convenience of shopping online and having their goods delivered to their door will have become a habit for the consumers that the eCommerce trend will likely continue. It is very likely as well that FDX will be able to charge a better yield for its capacity given a continued supply demand balance favoring FDX.
While Express has been hampered by a continued recession in the EU, the recent agreement for a 1.28 trillion Euro COVID-19 recovery fund and budget brightens the outlook for the European economy. Perhaps the pandemic has finally galvanized the EU leaders to act in a concerted effort to stimulate its economy. When Europe’s economy recovers, it will greatly benefit Express/TNT.
FDX is addressing operational efficiency and FCF concerns
The TNT integration has been a painful multiyear episode for FDX, but the end is in sight. While the finish line has been moved out a bit due to the pandemic, management reported that the integration should be completed by early 2022. Even before the completion of the integration, FDX should be able to realize improved revenue and profitability. While execution risks still exist, I believe that the risk profile has significantly decreased. The integration expense for FY2021 is expected to be around $170 million and it will be significantly lower in FY2022. It has been a long journey, and it will take another 18 months to complete, but investors can look forward to Express better positioned to compete for market share.
FDX has taken a step to address the inefficiency caused by its silo structure. FDX announced in the FY3Q2020CC that Express will be contracting with Ground for the transportation and delivery of select day-definite Express residential packages in the US. This was rolled out in March in one city, and is expected to be rolled out to other cities in the ensuing twelve months. I have argued in the previous article that while the silo structure is not efficient from an asset utilization stand point, integrating Express and Ground assets, network and IT is too disruptive to the business and is a very risky proposition. The approach that FDX has taken to use Ground’s assets for some Express’ transportation and delivery is a feasible solution to address the efficiency issue. FDX has not indicated the end goal of this transition, but I am hopeful that the end goal will lead to a much more efficient use of FDX’s assets and will result in a higher ROA, higher profitability and lower capex. The transition, however, will take years. It is something investors should continue to cheer FDX on.
FCF has been dwindling as a result of heavy capex investment in the last several years. This is shown in Figure 2. The heavy capex investment is driven, in large part, by the need to replace 159 very old and inefficient aircrafts.
The original plan was to complete the aircraft replacement by the end of FY2022. In the latest update, FDX has decided to push out the replacement completion to FY2025, but the bulk of the capex will be completed by FY2024. In doing so, FDX will reduce the capex requirement of FY2021 by $1 billion to about $4.9 billion. The cash flow from operations in FY2020 was $5.1 billion. With the improvement in yield, the continued growth in Ground, a small recovery of Express volume and no expected requirement to contribute to the pension fund, my model shows that the FY2021 cash flow from operations can be in a range of between $6.4 to $7 billion. If this does occur, FDX will have more than sufficient FCF to cover the dividend and even can buy back some shares or de-lever the balance sheet.
Risks and concerns
There are still some concerns and risks. For one, Ground’s margin deteriorated from 13% in FY2019 to 8.9% in FY2020. This margin reduction is driven in large part by the heavy investment in Sunday delivery. Investors are wondering as to when Ground will deliver improved results from this investment. Management did not provide a definitive forecast. The biggest leverage will come when the volume catches up with the increased capacity. Management is not willing to commit to such a schedule. However, I do believe that the continued growth in eCommerce will fill the added capacity. FDX announced the addition of Sunday delivery in January, 2020, and invested ahead of revenue. By adding Sunday, FDX added about 14% to its capacity, using very simple math. Since Ground’s volume grew about 11% in FY2020, it will take over a year to fill that additional capacity, everything else being equal. One thing that will help to fill that capacity is the continued integration of SmartPost packages into the standard Ground operation, which is expected to be completed in the next six months. Meanwhile, margin will start to improve with improved utilization and yield.
While the pandemic is providing a tailwind for FDX, the same pandemic could cause a protracted economic downturn. FDX’s volume growth is correlated strongly with GDP growth. Hence a protracted downturn will impact not only volume, but yield as well. Hopefully, the governments and central banks of major countries will continue to deploy the proper fiscal and monetary policies to help their countries to navigate a recession. However, the longer the pandemic lasts, the higher the risk of a recession.
The US has been retreating from globalization. This retreat started in January 2018 with the beginning of tariffs on imported solar panels and then were expanded to other goods. The tariffs hit our trade with the EU, China, and other trading partners. This retreat has hurt Express’ volume. The sentiment of the country appears to favor a retreat. If the retreat continues, it will continue to be a headwind.
FDX is undervalued by as much as 47% compared to its peers primarily because of lower multiples caused by investors’ concerns of poor results of Express, the risks and cost of the TNT integration, the negative FCF due to heavy investment in capex, and the heavy investment in Ground’s seven-day delivery. The pandemic has provided a tailwind for both Express and Ground, and management is making changes to address the cost, structural and FCF concerns. These are catalysts that will help to close the valuation gap as they play out in the next twelve to eighteen months.