In November, FedEx Corp. (FDX, Financial) CEO and founder Fred Smith and Chief Financial Officer Alan Graf sat down for an interview with Stanley Cates of Southeastern Asset Management (the firm has held shares of FedEx in portfolios since the early 1990s, and it’s currently a 6% weighting in their Partners Fund). As longtime readers know, I’ve been following FedEx closely over the past year, and I thought there were a number of interesting tidbits from the interview. I think it’s fair to group what was said into three buckets: the good, the bad and the ugly. My takeaways from the interview are discussed below.
The good
One thing I took comfort in was management’s frankness as it relates to the struggles they’ve faced to date in their business, including the integration of TNT Express. They explained how headwinds from trade issues, lackluster global economic growth and the NotPetya cyberattack have adversely impacted FedEx (that’s the reality of a fixed-cost network). As Graf admitted during the interview, “We knew [TNT] would be expensive, and it would take time. I missed it; It took more money and more time. NotPetya notwithstanding, that really wasn't the biggest issue; It was really hard. As I look back with perfect hindsight, we weren't aggressive enough.”
I also thought management did a good job of outlining the current competitive dynamics in the industry, along with a discussion of their vision for how they will win in the long run (notably in the U.S. e-commerce / business-to-consumer delivery business). I found this comment from Smith noteworthy:
“Those steps that I outlined are integral parts of doing that. I've covered a lot of ground here, but you have to understand the context in which we operate with the Postal Service, and UPS (UPS, Financial) and FedEx being the only upstream networks that have those sortation capabilities. Amazon (AMZN, Financial) doesn't have a single hub. The Postal Service virtually has no hubs anymore. It's a two-way race, if you will, between us and UPS as to who's going to dominate that business.”
The bad
One thing that has become clearer to me over time is that Smith is somewhat obsessed with how his company is portrayed in the financial media (for example, he remembered the author’s name from a Business Week story about Amazon’s threat to FedEx that was published more than three years ago). While this is somewhat understandable considering that FedEx is his baby, it has gone far enough. Again, I can’t knock him too hard because what happens with something like the long-term stability of the U.S. Postal Service does have an impact on the company. But it’s still strikes me as a waste of time and attention to focus on how the company is portrayed in the press. The best way to quiet the critics is to focus on running the business and to deliver on the expectations communicated to investors. Everything else is just noise.
The ugly
Early on in the interview, Graf made a somewhat perplexing statement:
“What's exciting to me mostly is the fact that we figured out how to sweat our assets. Seven days a week, we were doing that during peak for years, and I think it's just a natural extension for us to go ahead and do it. We're open 24/7, 365 days a year. For years, we know we have suffered from low ROIC. One of the great big moats around FedEx Corporation is just that.”
I’m pretty sure that’s the first time I’ve heard the “low ROIC as a moat” argument.
At the same time, Graf and Smith consistently discussed what makes FedEx unique and why, in their opinion, others cannot replicate what they’ve developed (huge capital expenditure outlays over the decades and huge economies of scale – “to duplicate what we’ve put in over the past 40 years just cannot be done”).
At one point, Smith said the following:
“There are only two networks in the United States that can pick up, sort, transport, if necessary, sort again, and then deliver to every address in North America, and that is FedEx and UPS, full stop.”
Later on, he added:
“Even if tomorrow you wanted to start building this network, it's not possible. The moat is too high.”
Well, that all sounds good, but what does it ultimately mean for investors if your high moat does not translate to a business with decent returns on invested capital? It seems to me that there’s a disconnect between irreplaceable networks that would cost tens of billions of dollars to replicate and an inability to generate decent ROIC. Simply put, something doesn’t add up (maybe it’s that much of the company's investment in things like fleet modernization is ultimately just maintenance capital expenditure). Maybe the answer is that I’m putting too much weight on recent results. Time will tell.
And that pretty much sums up the issues I’ve had, and continue to have, with FedEx. It seems that it operates in a duopoly that should benefit from economies of scale. As I’ve discussed in the past, the failed attempt by DHL to make a push in the U.S. parcel market in the early 2000s seems to support that conclusion. The problem is that when you look at the company’s recent financial results, you come to a very different conclusion. The vast majority of cash flow from operations generated over the past decade have been reinvested in the business. In addition, in return for the more than $40 billion of capital expenditures over the past 10 years, investors have seen a roughly $2.5 billion cumulative increase in annual cash flows (a mid-single-digit return).
And at the end of the day, it’s the numbers, not the narrative, that matters most.
Disclosure: None.
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