Stay Invested in This Transport Despite Lower Guidance

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On Dec. 19, FedEx (NYSE: FDX) announced 2Q13 results along with 3Q13 EPS guidance. Shares of FedEx fell by 1.8% to $93.20 on the same day. 

Disappointing Results for 2Q13….

The company reported 2Q13 EPS of $1.39 well below consensus of $1.41, indicating that Super-storm Sandy reduced 2Q13 earnings by $0.11/share at the Express Division. Moderate growth in revenues (4.9% yoy) was offset by higher operating expenses, particularly by higher transportation costs and non-operating costs, resulting in an 11.9% yoy drop in net income. The bottom line was also negatively impacted by the shift in sales mix and continued weakness in the global economy.

In addition, the company guided to 3Q13 EPS in the range of $1.25 - $1.45 versus consensus of $1.45 at the time of release.

2Q13 Performance by Segments:

      Express:

  • Revenue: Express revenues, including Ground and SmartPost increased by 4.2% yoy to $6.8 billion. However, operating income dropped by 33% yoy falling to $230 million and operating margin falling to 3.4% from 5.2% last year.  
  • Volume: Overall, average daily packages increased by 9% while the average daily freight pounds decreased by 1.6%. Domestic volumes were down 2% yoy due to the fact that a large cell manufacturing company moved out of Express network into the Ground and SmartPost network. However, international export volumes were up nearly 6%.
  • Yield: Composite freight yield decreased by 540bps due to changes in product mix and weight changes.

      Ground:

  • Revenue: Total ground revenues increased by 10.9% to $2.6 billion. Operating income increased by 29.6% reaching $412 million while operating margin dropped from 17% last year to 15.9%.
  • Volume: Total package volume for Ground increased by 7.6% for SmartPost, it increased by 17.3%. The management believes that the company will continue to expand its Ground market share.
  • Yield: Yield for Ground increased by 220bps yoy and for SmartPost, yield increased by 170bps yoy. 

      Freight (LTL):

  • Revenue: Revenues increased by 3.9% to $1.3 billion with operating income increasing by a significant 90% and operating margins improving by 250bps.
  • Volume: Total shipments per day increased by 1.8% while composite weight per shipment increased by a modest 0.1%.
  • Yield: LTL yield increased by 250bps. The management expects the demand to be soft while LTL pricing environment to remain rational.

But Confirmed FY13 Guidance

However, the company reiterated FY13 guidance despite the impact of Hurricane Sandy. This should be viewed positively reflecting management’s confidence in putting up a better showing in 2H13.

If we calculate 4Q13 EPS with the help of 1Q13 and 2Q13 reported EPS and the average of the guidance range provided by the company for 3Q13 and FY13, it comes to $2.21 which is moderately above the consensus of $2.06.

Investment Thesis

The stock has some upside potential in 2H13 particularly in 4Q13 as the cost initiatives at Express will gain momentum in 3Q13, setting the stage for better operating margins in 4Q13.

Currently, the market is pricing in the following negative factors in the stock price.

  • Poor 2Q13 results that were below consensus and lower 3Q13 EPS guidance.
  • FedEx’s revised US Industrial Production growth downward from 3% to 2.4% for CY13.
  • Voluntary Buyout Plan initiated by the company management which is expected to cost $600 million spread over the period until spring of 2014.
  • Significant cost savings required in order to achieve the EPS target for FY14 (consensus approximately $7.65). But most of the cost savings of the $1.7 billion plan will be realized in FY15 with some portion to be realized in FY14. 

However by the end of 3Q13, clarity on the following factors can bring the stock on positive track:

  • Cost Saving Initiatives: The Company had planned $350 million cost savings for FY13 in addition to the $1.7 billion profitability improvement plan to be achieved by FY16. The company indicated that part of the $350 million cost savings was though offset by Sandy in 2Q13, but momentum is building and investors can expect to see its impact on the bottom line in 4Q13.

Looking at the success of the restructuring plan that FedEx had implemented at its Express division in FY04, I am hopeful that the company would be able to achieve the cost saving initiative targets this time. As a result of the program in FY04, approximately 3,600 employees left the company at its Express division and the company was able to realize about $240 million in annual savings that resulted in considerable operating margin expansion at the Express division. Implementation cost of the program was about $225 million, therefore the payback period of only one year. However, the investors need to be cautious this time as the volumes at Express increased from FY03 to FY05, but now the volumes have been deteriorating and are expected to contract in the coming years due to shift in business mix (trading down to lower priced services).  

  • Voluntary Buyout Plan: The company is also expected to provide more clarity on potential cost savings from this plan which is part of the $1.7 billion profitability improvement initiative for the next 3 years. 
  • Better Dividends in Future: At the investors and lenders meeting in October, Mr. Smith promised better dividends in future along with another $3.00 in earnings. Investors should react favorably to this.
  • EBIT per Employee: Despite the shift in business mix and challenging trends at Express division, FedEx has been able to maintain the total company EBIT per employee. It should further improve with the announced cost saving initiatives and headcount reduction at Express which would in turn positively affect the stock.
  • Headcount Reduction: Recession of 2008/09 induced a shift in global supply chain management with the companies realigning their businesses to cope up with problems like customers trading down to slower, cheaper and closer transportation models. This trend has adversely affected the profitability of FedEx at Express division. Instead of focusing more on the slower, cheaper mode of transportation, the company has waited for the demand to return at its Express divison. However, the competitors like United Parcel Service (NYSE: UPS) and Deutsche Post DHL have been taking appropriate measures like reducing the headcount to restore the profitability while FedEx has increased the headcount. Now FedEx has also announced the plan for headcount reduction at Express that should help in improving the operating margins and the overall profitability of the company, therefore be positive for the stock.   

Conclusion

I recommend investors to stay invested considering management’s reiteration of FY13 EPS guidance that implies a moderately above consensus EPS guidance for 4Q13. In addition, the management has promised to provide more clarity on the $1.7 billion profitability improvement program in 2H13. The ongoing $350 million cost savings plan will also improve operating margins in 4Q13 that should be positive for the stock. In addition, the magnitude of the cost saving programs is significant and it could offer major profit improvement in coming years.

 


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