Description

FedEx (FDX) is not a business I expected that we could ever own given the ‘secular growth story/serial compounder’ label that seemed permanently attached to it. However, FDX definitely would be affected by an economic downturn and recent generalized recession fears combined with FDX's TNT acquisition which has been worse (or at least slower) than expected and Amazon believed to be building up an internal competitor to FDX (example of sentiment: https://www.cnbc.com/2018/11/08/amazon-will-soon-compete-directly-with-fedex-ups-rbcs-mark-mahaney.html) the stock has rerated down to an 11x fwd earnings multiple.That is simply too cheap for a business of this quality and we expect the stock to continue rerating back towards a more sensible multiple over time - 15x-17x being the 10yr avg, which seems like a perfectly reasonable starting place even though it probably reflects a greater than 10% assigned cost of equity capital (which seems overly harsh to us).

Meanwhile, we think revenue can continue to grow at an HSD Revenue CAGR and an HSD to teens type EPS CAGR given the plausibility operating leverage. Note that FDX has achieved a 5YA revenue CAGR of 8.9% and a 9.5% 5YA EBIT CAGR. 5YA EPS CAGR sits at 28.9% but that reflects some favorable non-operational one-times. USing the lower end of our estimates and mutliples as a base case (notably lower than consensus 2021 EPS, for what it’s worth) we see 50-60% upside.It’s not hard to see a double in a more bullish scenario.

Obviously, if you think that these operating results are plausible then the stock would probably be ‘GARP-y cheap’ even at a 17x multiple but that’s really not necessary to underwrite a very attractive return.

We struggle to see a ton of downside from here. Assuming the same (very low) forward EPS multiple as now and unprecedented sustained operating margin pressure, we still don’t see more than ~-15% fundamental downside. As it happens, that also gets us to roughly the level of the average share repurchase over the past 5yrs (and note that the business was pretty clearly growing in value the whole time).

Business Description

I imagine that most readers are at least vaguely familiar with FDX’s business. Founded by Fred Smith in Little Rock, Arkansas in 1971, FedEx’s business strategy and trajectory is the stuff of business school case studies and US corporate legend.

The business mix is as follows:

Express is the original express delivery business, primarily relying on air transportation. FDX is the global #1 player here.

Ground is the UPS competitor, providing small package delivery to US business and residential addresses. Historically, this has been a much higher margin business than Express and FedEx has grown it rapidly, taking share from UPS and USPS. In addition to the rapid share gains, it is also the segment most directly exposed to e-commerce.

Revenue mix over time:

This has been accompanied by impressive share gains in ground:

Express and Ground segment margins over time, note that on the company’s accounting, Ground has 400-800bps of better segment-level margins:

This margin gap is backed up by the gap between UPS (mainly Ground) and FDX over time. However, GAAP T12M EBIT margins have stayed within their historical averages which is contrary to the margin mix implied by the growth of Ground:

Which the company attributes to one-time adjustments and reinvesting for growth (which we find broadly plausible):

Ground should be a structurally higher-margin business due to better route densities. Given the much higher mix of Express, we would never expect FDX to converge on UPS’ margins but it gives a sense of just how much is seemingly reinvested into growth - which is a theme that Fred Smith & co touch on regularly on the conference calls. Bottom-line being that we think that underlying profitability is structurally understated right now which buttresses our argument for structurally declining margins being hard to justify.

In that respect, it’s worth mentioning that this is still a classic ‘owner-operator’ business since Smith still owns 8% of the company with a seemingly deep bench of talent and a strong corporate culture. We believe the evidence over time supports the idea that Smith & co. are generally disciplined on reinvesting in the business and controlling costs when margins decline.

Finally, while I doubt that this is unfamiliar to most investors, shipping has been a structurally growing business over time both in terms of volumes and pricing power:

Risks

Recession and/or Trade War - there is no question that FDX and its peers would be hurt temporarily by any downsturn and a large drop in global trade would hurt FDX's international busienss. We are not macro investors and don’t have very strong opinions here but would simply note that most of FDX’s delivery activity is between locations within the US (and TNT Express is currently unprofitable and not incorporated into our base upside case). Damage would be done but we believe that it’s priced in.

TNT Express Deal - without question it has been a disappointment so far both in terms of profitability and timeline. Maybe it was simply a mistake although we remain open-minded. We would only flag a couple of things: 1) what’s done is done and Smith & Co are unlikely to make the same mistakes again so it seems overly harsh to capitalize the mistake in the company’s multiple going forward. 2) Not that this makes a mistake good per se but the deal was done at $4.8bn vs the $6.8bn bid that UPS offered four years earlier. It’s an oligopoly and FDX demonstrably behaved like the more disciplined player

Finally, Amazon - we believe the Amazon threat is likely overblown: it’s still in pilot stage and will take many years to even begin to compete directly as there is a very limited network of pickup points and the capex bill would be eye-popping eve by Amazon’s standards. Not to say that they won’t try to grow the network in certain metro areas, but there are already plenty of metro specific small Ground delivery players (eg Lasership) so there is plenty of business to go around, plus working with franchisees has never (so far) been AMZN’s strong suit. We think this looks like another in a long line of mooted Amazon threats that ended up being more bark than bite (eg auto parts, cosmetics). Additionally, we also think this touches on AMZN’s growing anti-trust problem especially against the US Postal Service, which Pres Trump has been at least rhetorically sensitive about.

Catalyst

Continued growth and execution

Clarity around progress with TNT

Granularity of the scope of Amazon's delivery plans