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Vera Yuan
Gordan Pape

FedEx: Benefits From Significant Economies of Scale

FedEx stock is a buy

August 08, 2016 | About:

This week we are adding FedEx (NYSE:FDX) to our recommended list. As discussed below it benefits from the favorable characteristics of this industry.

Background: FedEx invented the express overnight parcel delivery business back in 1973 and remains the industry leader. With $50 billion in annual revenue and $46 billion in assets, it now operates in almost every country in the world. It transports mostly small parcels and envelopes by air and ground, mostly on a next-day-delivery basis but also offers less urgent delivery and delivers larger packages and freight as well. FedEx has about 300,000 employees and contractors.

Structure: The company is divided into several main operating subsidiaries.

  • FedEx Express represents 52% of revenues and provides global (mostly air) transportation and information networks to deliver priority parcels, envelopes and freight to more than 220 countries and territories.
  • FedEx Ground, representing 33% of revenues, provides express parcel and envelope ground delivery throughout the U.S. and Canada.
  • FedEx Freight accounts for 12% of revenues and is a North American less-than-truck-load freight company.
  • FedEx Services accounts for 3% of revenue and includes centralized functions such as customer services to support the above three segments. The retail offices are a leading provider of document printing services with a global network of about 1,800 locations.

Stock performance: FedEx is up about 8% but was down 14% in 2015. It's up about 275% from the market lows of 2009.

Why we like it: FedEx benefits from the good economic characteristics that are enjoyed by other large established companies in this industry. Customers would likely find it inconvenient to switch providers after they become familiar with FedEx's systems for booking a pickup and for tracking packages and making payments. Also, clients are unlikely to shop around for every shipping need given the frequency and the relatively low costs compared to the value of the documents and packages being shipped.

As the dominant company in its niche, FedEx benefits from significant economies of scale. Any potential new competitor would face enormous costs to even begin to replicate FedEx's distribution networks. FedEx also operates in a relatively predictable business space. We can forecast with confidence that the business will grow with the economy over the long term. In particular it also benefits from the growth of ecommerce and increasing globalization.

Recent developments: The express segment was considerably more profitable in fiscal 2016 (which ended May 31) with an operating profit of 9.5% versus 5.8% in 2015 and 5.3% in 2014. The dividend was recently increased by 60%, but the yield remains low at 1% as the company retains most of its earnings. FedEx raised its rates in all of its divisions by 4.9% at the start of the calendar year.

At the end of May, FedEx completed the acquisition of TNT Express for $4.8 billion. TNT provides express delivery in most of the world outside of North America mainly on a business-to-business basis and mostly using ground transportation. This has increased the debt leverage on the balance sheet, but the debt is still not excessive.

Recent earnings growth: Adjusted earnings per share were up 21% in the fiscal year ended May 31 and up 24% in the fiscal fourth quarter. The package volume growth in the latest fiscal year was only 1%. Earnings have increased due to cost cutting measures, lower fuel prices net of surcharges and share buy-backs.

Valuation: (Based on Wednesday's $160.61 closing price). The price-to-book value (P/B) ratio is somewhat high at 3.13 but this is justified by the excellent return on equity of 20.9. The trailing adjusted earnings p/e is moderately attractive at 14.8. Based on management's projected earnings for the year ended May 2017, the P/E is attractive at 13.5.

The dividend yield is minimal at 1% as only 14% of adjusted earnings are paid out as a dividend. Adjusted earnings per share for the past five fiscal years increased by an average of 17%. But this was partly due to a large decline in earnings with the 2008-2009 recession. Sales per share were up a compounded average of 7.8% per year in the past five years.

I calculate an intrinsic value of $149 per share assuming a more conservative 5% annual growth, with a terminal p/e ratio of 14 in five years. If we assume a more optimistic 9% growth in earnings and a terminal p/e ratio of 16 based on a five-year holding period and using a required return of 6.5%, the intrinsic value would be $203. Overall, the value ratios would indicate a Buy rating.

Earnings outlook: Management is forecasting an 11% increase in earnings in the fiscal year that began on June 1 and is projecting profit growth to continue beyond that as the recent large acquisition becomes accretive to earnings in the following year. It seems relatively certain that FedEx will continue to grow over the years. I would expect more modest growth after 2017, perhaps in the 5% to 7% range.

Action now: Buy. The stock closed in New York on Friday at $162.91.

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