Monday, May 15, 2006

FedEx [FDX] gets a BUY

Last week I did an analysis on UPS and found that it would be a great buy except for a huge nasty pension monster hiding in the metaphorical closet. Since we have done an analysis of the shipping industry so recently I decided to visit a related company and analyze FedEx [FDX].

FedEx virtually invented overnight express shipping and at the height of the internet bubble many people thought FedEx was the safe internet play because they were the obvious candidate to deliver all those boxes of books, tools, and pet food that everyone was going to be buying online. Then things went south for the company. Most people, it turns out, are willing to wait 2-5 days for their internet purchases and FedEx failed rapidly integrate a buyout of RPS trucking in 1998, leaving them with a poor ground delivery service. UPS took advantage of this service hole and today is the biggest home delivery service. As of 2000 FedEx had essentially lost this market and the stock took a dive.

Casting about for data we find some interesting tidbits on the current situation. A study by Colography Group in 2004 found UPS losing about 1% of the ground delivery market and FedEx gaining that 1% (from 15% to 16%) while building up its air freight market share from 28.9% to 29.8%. More recent numbers from other sources indicate that FedEx is seeing rising shipment volumes and starting to gain traction in the market. A study in 2005 found that FedEx was gaining the largest share of increases in the US ground shipment market and in 2005 FedEx finally reached the point of delivering as many ground shipments as air shipments.

Trailing 12 month free cash flow is $3.2 billion (about 68% of UPS’ $4.7 billion), but FedEx has a market capitalization of only $35 billion versus UPS at $65 billion so FedEx actually has the more attractive price to free cash flow multiple: a very nice 11 compared to almost 14 for UPS. In other words FedEx shares (currently trading at $115) are actually cheaper on a per cash flow basis than UPS shares at $81. FedEx also has more revenue per price and significantly less debt than UPS. FedEx shows an operating margin of only 8.9% versus 14.33% but FedEx has a much better cost structure. In the last 12 months FedEx produced 70% as much revenue as UPS using half as many employees. Another sign that the company is set up to take good advantage of any increase in sales is that a 9% revenue growth over the last year turned into a 35% earnings increase. FedEx appears to be a business with lower incremental costs so they can take good advantage of any future growth.

Speaking of future growth, what about that implied discount number I like to compute? My technique is to apply the analysts average growth rate for ten years, followed by 6% slow-growth at maturity afterward, figure out all the cash flow the enterprise produces, then apply a discount rate to each years income to figure out the current value of the stock as a cash-flow business. Ultimately when all is said and done and the market stops behaving randomly, the cash flow is the true value of the business. My very conservative investing style is that I like to see a discount rate of 15% or higher. FedEx scores a very nice 17%.

It’s worth noting that these two numbers: price to cash flow ratio of 11 and discount rate of 17% are both better than the numbers that originally led me to purchase LECO in mid 2005, and it is up 48% since then. Let’s see what else we can learn about the business.

Shipping and logistics articles have been calling for a threefold increase in shipping volumes over the next ten years, which works out to an 11.6% cumulative growth rate in the core market FDX serves. Recent actual shipping data, however, has pointed toward 6-7% growth per year for the near future (data from the World Trade Organization) and those are the numbers UPS, for example, has used in their annual report. If I rearrange the cash flow calculations to see what growth rate is needed for a 15% discount rate (my threshold for a good buy) the necessary earnings growth rate is only 11.9%. The more rosy market predictions get almost this much growth straight from the increase in shipped goods. If we look back at the FedEx cost structure we expect increases in revenue (shipping market increases) to turn into much larger numbers at the cash flow level because FedEx does not see costs rise at the same slope as revenue. It seems that even conservative market growth will vindicate FedEx at its current price.

FedEx does pay a dividend. The dividend is small right now (0.3%), but it has only been in existence for 3 years and the company has been increasing it each year. It is common for companies to start their dividends small so that they can get used to the drain on their cash flow without worrying about having to lower the dividend if they didn’t appreciate the impact. FedEx is only paying out about 5.7% of the cash it has available for a dividend, so expect that dividend to rise.

The company also has significant insider ownership, which is a good sign. And reasonable debt, which is an important thing to check these days.

At first I found some spooky balances in the pension categories (it was $717 million underfunded in 2002) but the company has been making large payments on a regular basis to clean up its pension sheet. Right now FedEx is in an admirable position with only 6% of participants drawing benefits and the discount rate they are using in pension calculations is within the range of reasonable. FedEx appears to be solid in the pension category, and I certainly don’t see anything like the gaping $30 billion hole that cause me to make UPS a SELL. The fact of the matter is that FedEx could even sustain some pension surprises and still be worth significantly more than its current market value.

FedEx is one of those nice stocks with solid financials, a reasonable price, and a good growth market.

I’m rating FedEx [FDX] as a BUY and, consistent with Finance Wonk policy, I will be buying some on the market within the next few days.
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