FDX has many different independent contractors it uses for pick-up and delivery of packages. As a result, it keeps this cost “honest” by having many different companies to choose from for the multitude of regions it serves. However, UPS’ labor force does have power in that it is employed under a national master agreement and various supplemental agreements with local unions affiliated with the International Brotherhood of Teamsters (“Teamsters”). It is worth noting that UPS’ air and ground operations are integrated.

Recent Developments at FedEx Ground:

There are a few noteworthy developments within FedEx Ground over the past number of months. First, FDX announced in May 2019 that it would increase its delivery schedule from 6 days to 7 days per week starting in January 2020. Second, to leverage its increasing schedule, it would be taking delivery back of much of its SmartPost volumes that it had outsourced to USPS for last mile delivery. Third, it made the strategic decision in August 2019 to sever ties with Amazon, which only made up a few percent of its volumes. Lastly, it has continued to increase its points of distribution by collaborating with the likes of Walgreens where customers can pick up and drop off packages in order to enhance package security.

These moves in the short-term impact operating profit growth, but de-risk as it relates to being reliant on Amazon for growth and helps position FedEx Ground to be the long-term, preferred partner to businesses that compete against Amazon.

What FedEx Ground Has the Potential be Worth in 4-5 Years:

Based on ~$21 billion in revenue in FY2019, FedEx Ground generated ~$2.4 billion in operating income net of its estimated share of unallocated corporate overhead. Over the next five years, I believe FedEx Ground should be able to continue to grow its revenue at a high-single digit to low-double digit rate (compared to a 12% CAGR over the past 5 fiscal years through 5/31/19) and ultimately gain some operating leverage (likely beginning in FY2021/2022) resulting in expanding margins.

FedEx Ground has been in investment mode for many years, which has resulted in declining operating margins. Segment operating margins declined from 14.9% in FY2016 to 12.6% in the LTM (through 8/31/19). However, unlike over-investing capital in a declining domestic FedEx Express business, in my view, this has been the right move to allow it to continue to gain market share (ex-Amazon volumes) for years to come within a structurally growing market. The capital intensity of the business is declining with capital expenditures below that of D&A over the LTM.

Looking out 5 years, based on my estimates, I believe FedEx Ground could have revenue in the range of $31B-$37B and operating profit in the range of $3.2B-$5.0B. Applying a ~25% tax rate on ~$4.1B of pre-tax income results in ~$3.1B of after-tax income. Given the sustainable, above average growth characteristics and ROIC, I believe this business deserves to trade at an above market multiple. Applying a 20x earnings multiple plus ~$8B in free cash flow generation results in an EV of ~$70B in 4-5 years, which compares to FDX’s current EV of ~$54B.

What to do with the rest of FDX:

Founder and CEO, Fred Smith, owns 19.5M shares or 7.5% of FDX worth ~$2.8B. While he clearly has major skin in the game, he appears to be thinking with his heart regarding the business he founded, FedEx Express. In my view, Smith continues to make poor capital allocation decisions. The TNT acquisition has been a disaster and spending billions of dollars on new, more fuel-efficient planes in a declining domestic volume Express business is not money well spent.

The FedEx Express business needs to be right-sized. I think it should remove capacity by getting out of certain lanes that lack the requisite volume. It should get rid of low-unprofitable business by providing greater incentives to customers to move that volume into FedEx Ground or cede it to UPS.

The bottom line is that outside of FedEx Ground, the rest of its businesses collectively do not generate any free cash flow. Outside of FedEx Ground, on a cash basis, it has not generated a return above its cost of capital for many years.

Conclusion:

I have no idea if Fred Smith will come around to finally making the right operational and capital allocation decisions. However, this could be a situation ripe for an activist to get involved.

As long as the FedEx Ground business continues to grow nicely, it provides good downside protection and a lot of potential upside should management do the right things (or be forced to) with the Express business.

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