Does FedEx Face A Cyclical Or Structural Problem?

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As FedEx Corp. (NYSE: FDX) struggles through one of the worst days in its 41 years as a public company, the question arises: Has the company made its bed and is now lying in it, or has an otherwise sound long-term strategy been undermined, at least in the short run, by cyclical forces beyond its control?

There is no black-and-white answer, as would befit a $70 billion a year business operating in a complex, interconnected world that has changed dramatically in just the past 18 months. Even those who believe FedEx is spending prudently to capitalize on future trends – such as launching seven-day-a-week deliveries and building capabilities in short-haul ground service where most e-commerce will travel – admit it could have been more transparent in communicating the impact of a massive 2017 cyberattack on its TNT Express subsidiary, as well as the abrupt departures last winter of two top executives: David Bronczek, FedEx’s president, and David Cunningham, head of its largest unit, FedEx Express. 

Perhaps it could have also picked a better time to jettison, Inc. (NASDAQ: AMZN) as a U.S. air express and ground customer, though few disagreed with the rationale behind it, given Amazon’s margin-killing demands on FedEx’s business. Or it could have taken cost-mitigation actions earlier once it saw that global weakness would be prolonged. Frederick W. Smith, the company’s founder, chairman and CEO, said the company began its current fiscal year on June 1 hopeful a U.S.-China trade deal would soon be struck and global trade conditions would return to normal.

On the other hand, those who believe FedEx’s missteps are coming home to roost acknowledge that the macro climate, especially the global goods-producing category, is weak and getting weaker, and that the company can only do so much if its customers are shipping less, if at all. The July global Purchasing Managers Index published by bank J.P. Morgan Chase & Co. (NYSE: JPM) and research firm IHS Markit (NYSE: INFO) fell to its lowest level since October 2012. Monthly air cargo data from the International Air Transport Association (IATA) has been down on a year-over-year basis in every month from December to July (August’s numbers were not published as of this writing). There is even talk that IATA’s cargo data will end the year not just far below 2018 results, but negative in absolute terms. That would be the first time that has happened since 2009. 

FedEx has accomplished much in its remarkable 48-year history, but it has yet to overcome one of the most immutable laws of business: that transportation, of any type, is derived demand. Effectively, the cyclical forces have bled into, and adversely affected, the company’s structural firmament.

After operating its entire life in an environment favorable to globalization and the businesses supporting it, FedEx, like other companies, has been forced to adjust almost overnight to a new attitude of protectionism, which has effectively stifled international commerce. The macro weakness, the magnitude of which the company did not expect, had the effect of a $900 million writedown of operating profit from the end of June to the middle of September, CFO Alan B. Graf, Jr. confirmed on the analyst call following the earnings release. 

Graf attributed much of the decline to the international component of the FedEx Express air unit, with most of the weakness coming in Europe. There, the company is struggling with unfavorable economic trends and the problematic integration of its TNT Express unit, which it acquired in 2015. FedEx has vowed to finish the integration of the two physical networks by the end of May 2020, but the toughest part, integrating France, Germany and the U.K., lies ahead. In the meantime, FedEx continues to run separate operations in Europe – a costly and, by this time in the process, unplanned proposition.

Wall Street, which shoots first and asks questions later, began firing immediately after the market closed on Sept. 17, when FedEx posted fiscal 2020 first-quarter results that were about 11 cents per share below median estimates, and stunned everyone by lowering its full-year earnings per-share outlook to between $11 and $13, well below its forecast less than three months ago, and nowhere near analysts’ estimates which have been brought down several times over the past few quarters as the company has either missed expectations, guided lower, or both. The after-hours carnage extended with ferocity into the next day’s regular trading session. By the time the bloodletting ended, shares had fallen $22.39 to close at $150.91, a decline of 22.39% and the worst one-day drop in 11 years.

The analyst fallout was swift, but the tenor varied depending on the analyst. Ben Hartford of investment firm Baird & Co., who has been willing to cut FedEx some slack because of the macro headwinds, said most of the company’s challenges are cyclical in nature. Patient investors, Hartford said, should be rewarded once the cycle begins to turn and FedEx can effectively leverage its positioning. FedEx is investing billions of dollars into fleet and hub modernization to capitalize on the growth of e-commerce deliveries, and the changes wrought by a new distribution model to a company whose core has been business-to-business service.

Hartford added that transport industry fundamentals have yet to bottom, and that the recent rally in transport stocks has been “premature.” He reset his FedEx price target to $175 a share, and said shares would get interesting near $150 a share, levels which were broken during intra-day trading on Sept. 18.

Kevin Sterling, analyst at Seaport Global Securities, took both sides of the argument but sided with the bears, acknowledging that FedEx faces pressures outside its purview but that it hasn’t moved quickly to offset them. “At the end of the day, I believe they are a victim of the macro and cyclical forces, but are not nimble enough to combat these headwinds,” he said.

Far less forgiving was Amit Mehortra of Deutsche Bank. Mehrotra slashed his price target to $142 a share, a draconian $36 a share haircut from his prior target. He lambasted the company for failing to take responsibility for past actions that have led to this moment, namely botched big-ticket acquisitions such as office-solutions provider Kinko’s (which eventually became FedEx Office) and reverse logistics provider Genco, profligate capital spending such as a $900 million tab to modernize its air fleet amid low single-digit operating margins in the express unit, and the continued integration issues at TNT Express. By fiscal-year 2021, FedEx would have spent $1.7 billion on the integration.

Satish Jindel, who runs transport consultancy ShipMatrix and has worked with and followed FedEx for more than 35 years, was no less tolerant. “UPS and DHL operate in the same environment,” Jindel said in a phone interview. “Why aren’t they experiencing the same problems?” Jindel repeated his call for FedEx to merge its air and ground businesses, which run separately, saying it would drop $3 billion a year to the bottom line by slashing unnecessary air-related expenses and focusing entirely on lower-cost ground services. Smith, on the analyst call, rejected the idea, as he has done before. “We’re very convinced that the way that we are operating is the preferred way,” he said.

According to Jindel, the problem lies with the company’s failure to admit that the ground business – not the air operation that effectively built FedEx into what it is today – is now the tail that wags the dog. He also hinted that Smith has surrounded himself with people who, for whatever reason, are not telling him what he needs to hear about market realities. Unless the company moves to combine the two businesses, “I don’t see it recovering for years,” Jindel said.

Company executives defended the fleet modernization plan, saying that the planes coming online deliver unmatched operating efficiencies that will pay off over a multi-year period. In addition, in response to the weakening macro outlook, it is retiring 30 older aircraft and is parking capacity equal to the space aboard seven MD-11 freighters.

 An industry observer, who asked not to be identified, sided with the company’s position. “They are making long-lived plans for long-lived assets,” the observer said, referring to aircraft. Noting concerns that elevated capital expenditures to support low-margin businesses like Express will limit increases in free cash flow, the observer said that FedEx’s board and management need to balance near-term cash flow requirements with the imperatives of growing the business for decades to come. The observer also said there was a “basic inequity” whereby tech-enabled startups can freely spend billions of dollars and effectively get a pass, while companies like FedEx invest for future opportunities and get criticized for it.

FedEx has seen many economic cycles and industry challenges come and go. When the current cycle shifts direction, the company will benefit and all the hand-wringing will recede into the background, the observer said.

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