FedEx Corp. (FDX, Financial) is the world’s leading providers of express delivery services and is a major player in the small shipment and logistics markets.
The company is organized as a holding company, with business operations that operate independently under the FedEx brand, offering a wide range of express delivery services. FedEx’s operational network — ground and air services — contains more than 55,000 drop-off locations, over 650 aircraft and approximately 150,000 ground vehicles. The company also offers freight services for larger load items through its ground and freight network. Further, the company offers specialized logistics services, which includes the former Kinko’s copy and office centers, now operating under the FedEx/Office brand.
In addition to air and ground fleets, the company operates an enormous front-end network of over 725 World Service Centers, over 1,750 FedEx Office locations, nearly 6,300 authorized Ship Centers and more than 38,500 Drop Boxes. The company has about 300,000 employees and contractors, and serves over 375 airports in over 215 countries.
In 2017, express delivery services accounted for the bulk of company revenues (approximately 60%), with standard ground and freight services accounting for the remainder. Ground and freight services are becoming more important in the overall mix of services offered by the company.
The company estimates that over 98% of its customers use two or more of its services, which is aligned with the company’s goal of becoming a one-stop-shop logistical firm for both retail and business clients. And, clearly, as e-commerce grows, FedEx is going to become of increasingly greater strategic significance to small and large businesses alike. The company is also focusing on expanding its footprint in high-growth markets like Mexico, India and Eastern Europe.
Purchase considerations
FedEx is benefitting from several factors: relatively low fuel costs, international expansion and the growth of e-commerce. The company estimates that e-commerce shipments will continue to grow at high rates over the next 10 years. Further, growth in e-commerce services and a greater need for a complete, economical and time-sensitive logistics firm is the right place to be as American manufacturing activity and local sourcing increases.
We like the company’s partnership arrangements, such as those with the U.S. Postal Service. The SmartPost service uses the USPS for economical final last mile delivery to residences, an attractive route for smaller e-commerce shipments. The company is also a key wholesale provider for the USPS express and overnight small package delivery services. Such alliances between firms tend to be productive win-win arrangements for both carriers and customers as well.
With FedEx’s other business expansions, its ground segment is approaching a 30% market share, a position from which it can start to call the shots in the marketplace. Further, the company has been able to raise prices while also gaining market share. And we also like to see that overnight shipment volumes are holding their ground and that FedEx is not only dominating in the air delivery market. The continued resurgence in the economy and growth of real wages and online shopping activities and deliveries will certainly help volumes and pricing, and the continuing shift to e-commerce gives a boost to this recovery.
An expected decline in U.S. import and exports resulting from Trump trade policies will likely hurt volumes, but will hopefully be more than offset by growing domestic shipments.
Further, FedEx’s size and scale offer it major cost advantages. We also like the fact that it has raised the dividend every year since starting to pay dividends in 2002 and while payouts are increasing, they are still less than we think they could be.
That said, the company is always vulnerable to economic downturns and rising fuel prices, particularly if cost increases come faster than they can be recovered in rates and fuel surcharges. Also, while cash flows are strong, this company must occasionally purchase or lease aircraft, and this and other capital expenditures can put a big dent in cash flows. While the company has done a good job of carving out its “full service” niche, it is always vulnerable to competition in both domestic and overseas markets.
Estimating sales growth
When assessing the competitive strength and investment merit of a firm, we like to first assess what’s going on with sales. Ideally, we are looking to invest in companies whose sales are strong, consistent, and are generally growing faster than nominal GDP growth (that is, real GDP growth and inflation combined).
Based on historical sales data, you can see that FedEx's revenues have grown by about 5.6% over the last 10 years. This compares to average nominal GDP growth of 3.1% per year over the same period. FedEx's sales have grown by 8.1% per year over the last five years and 11.3% per year over the last three years. It is worth noting that FedEx's three-year revenue growth rate is ranked lower than 89% of the 753 companies in the Integrated Shipping & Logistics Industry.
Overall we think the company is on stable ground. We also believe that it retains modest pricing power. We feel comfortable recommending investing in this company for growth and expect impressive things from this company in the future.
The second thing we like to do when assessing sales is to look at consensus market estimates. As reported by Morningstar, the market is projecting 7.6% annual growth for this year, 6.1% annual growth for next year and 4.4% for the year after that. These growth estimates translate into $70.4 billion in sales for this year and $74.8 billion in sales for next year. The projected increase in sales is expected to be driven by an increase in product demand, stable pricing power and stable production capacity.
A third thing we like to do when assessing sales is to compute the firm's sustainable growth rate. The sustainable growth rate reflects the rate of growth in sales that a company can support given its existing earnings power, capital resources and dividend payout policy. In any given year, a firm's sustainable growth rate is calculated by multiplying its return on equity (ROE) by its retention rate. Rather than rely on data from only one year, however, we calculate sustainable growth by using the firm's three-year average ROE and three-year average retention rate. FedEx's ROE averaged 19.5% over the last three years while its retention rate averaged 86.1%, giving the firm a sustainable growth rate of 16.8% per year.
Let's recap briefly what the sales data is showing us. From what we can tell, it is not unreasonable to estimate that sales over the next five years could grow at a rate of somewhere between 5.6% and 16.8%.
We're going to select a rate of 5.0%. This represents a blended rate forecast reflecting consensus three-year rate projections scaled by a 10-year average incremental change for the last two years of the five-year forecast horizon. With $65 billion in sales generated last year, this means that we believe that sales will reach about $84 billion in five years. This estimate reflects our understanding of the firm's historical results, market demand, pricing trends, levels of competition and changing regulatory requirements.
Estimating earnings per Share
Now that we have generated our sales estimate, we’re going to estimate growth in earnings per share. The method applied below takes the sales growth projection — in this case, 5% per year — and subtracts the expenses and taxes. What we're left with are the earnings. Then we divide by the projected number of diluted shares outstanding to determine the earnings per share (see table below).
A projected growth rate of 5% will result in about $84 billion in sales five years out. Now we need to take a look at the company's pre-tax profit margin (what’s left over after expenses but before taxes are subtracted). In the figure below, we can see that FedEx produces some pretty stable margins — 6.7% in 2018, 7.6% in 2017, 5.4% in 2016 and 3.4% in 2015.
The average for the last five years has been 6.2% and the average for the last 10 years has been 6.1%. We believe that FedEx's margins will remain stable at 6.1%. At this rate, projected pre-tax profits on $84 billion in sales would be about $5 billion. This means expenses would amount to $78 billion.
The next step in our estimation process is to establish what tax rate will be paid on the company's profits. The most recent year’s rate was -5.0%. Normally we wouldn't play with that number too significantly because in general, it shouldn't change very much from year to year.
The only time we would make major changes to this number would be in instances where maybe the current rate differed significantly from that of the past or if we had some knowledge about what rate was likely going to persist in the future, perhaps because the company is going to get some preferential tax treatment on operations abroad or because of a broad change in state or federal tax policy.
For FedEx over the last 10 years, the company's tax rate has been as low as -5.0% and as high as 85.5%. Tax rates for most U.S. companies are around 20.8%. We're going to select a rate of 20%. This would result in a tax expense of $1 billion from pre-tax profits of $5 billion in five years. This would leave us with $4 billion in projected earnings five years from now.
Our next main consideration is a matter of determining the number of diluted shares that will be outstanding in five years. FedEx has decreased the number of shares outstanding over the last decade. There were 312 million shares outstanding in 2008, then the number of shares went to 317 million in 2013, and then fell to 279 million in 2016. Currently there is 272 million shares outstanding. This data suggests that the company has been redeeming about 4 million shares per year. We're going to rely on the company's historical share repurchase activities to guide our estimation process. As such, we project share repurchases of 5 million per year over the next five years.
With shares estimated at 247 million in five years, earnings per share are expected to fall at an annual compound rate of -0.2% over the period. This is lower than our projected five-year revenue growth rate. Based on this earnings per share growth forecast, we are expecting earnings per share of $16.62 five years out. Results of our forecasting procedure are summarized in the table below.
Forecasting a target price-earnings multiple
FedEx’s stock has traded with a relatively volatile price-earnings multiple over the last decade, averaging 37.8x over the last 10 years, 25.1x over the last five years, and 19.3x over the last three years. Currently the firm is trading at 13.7x trailing 12-month earnings per share and 21.5x expected future earnings.
For determining an estimated target price-earnings multiple, the first thing we like to do is eliminate any outliers from the historical data series. This includes abnormal price-earnings ratios that are not reflective of the normal operations of the firm, and this could be the result of abnormal growth or significant one-time non-recurring charges/gains.
The next thing we like to do is to run an optimization procedure that tells us what price-earnings multiple yielded the best forecasting accuracy over the evaluation period. If in our judgement this multiple continues to accurately portray the earnings and cash generating power of the company as well as the growth and risk characteristics of the firm, then we will use this multiple as our target multiple. If not, we will adjust the multiple upwards or downwards accordingly.
The figure below presents the historical price-earnings profile for FedEx. We will utilize a target price-earnings multiple of 17.5x which we believe reasonably characterizes the risk-return attributes of the company's stock. This multiple represents an expansion of 16.3% relative to the current multiple. It also represents a contraction of 9.1% relative to the five-year average price-earnings multiple.
Setting a target price and valuation range
Now we need to take a look at the price history of the company's stock. From the figure below, we can see that the spread between the high and low stock prices has increased over the last 10 years. We have a current price of $230.22, with a high in the past 10 years of $274.32 and a low of about $34.28. We want to keep this variability in mind when establishing our upper and lower valuation range. Specifically, given the firm's historical stock price behavior, we should expect the stock to fluctuate by at least $43.81 over the course of a year.
Given our selected target price-earnings multiple of 17.5x, to determine a price target five years out, we then multiply this by our earnings per share estimate. Earnings per share are estimated to reach $16.62 in five years giving us a target price of $291.57. This price is higher than the current price.
To properly judge to what extent the stock may be under- or over-valued, we need to determine a fair-value range within which we expect the stock to trade. To do this we rely on the trend-adjusted average annual trading range for the stock, which from the analysis above we know is $43.81. This means that, given our target price estimate, we expect the stock to trade naturally, and fairly, between $269.67 and $313.47. The result of this is that when the stock is trading below $269.67 it is in the Buy Zone and when the stock trades above $313.47 it is in the Sell Zone. Currently the stock is in the Buy Zone.
Return potential
So what return can we expect for holding FedEx's stock? Well, we now know we can expect stock price appreciation of 26.6%. We can also expect to earn dividend income of about $10.00 over the evaluation period. Added to our price estimate, this means we could earn a compound annual rate of return of 5.5% over the holding period, provided our estimates prove accurate.
All-in-all, we are happy with this company and believe that it offers sufficient return potential to qualify for investment. We recommend buying the stock at current valuation levels.
Disclosure: We currently do not hold any positions in this company’s stock.
