Earlier this year, I wrote an article about FedEx (FDX). In the introduction, I said the following:
“Finished up research on UPS (UPS) and FDX this week. Honestly, I found the exercise more difficult than I would've assumed going in. I think they are both reasonable investments at current levels, but I do not have an overwhelming level of conviction on that.”
Since then, I’ve continued to learn more about the industry (and specifically about FedEx). But despite the time and effort I’ve committed to this task, I don’t think I’ve moved the ball much closer to the finish line. If anything, I’ve grown less interested in owning these companies.
In no specific order, here are the factors that have kept me uneasy on FedEx.
Capital expenditures
Over the past 10 years, FedEx has generated roughly $47 billion of net cash flow from operations. Unfortunately for shareholders, not much of that has made its way down to them in the form of free cash flow. The reason why is because FedEx also spent $43 billion on capital expenditures (capex) over that period – a full 90% of its net cash from operations.
FedEx has had some capital returns over that period (a dividend payout ratio of 10-15% on adjusted earnings per share and roughly $1.2 billion a year worth of repurchases), but that has been funded by incremental debt. It outspent the cash generated by the business over that period by a wide margin, with the leverage ratio climbing from 0.4x to 1.9x (long-term debt to adjusted Ebitda).
Overstated earnings
As I noted a second ago, FedEx spent $4.3 billion a year, on average, on capex over the past 10 years. On the other hand, depreciation and amortization expense was $2.6 billion per year. The result has been a sustained and significant gap between free cash flow and adjusted net income. With time, I’ve come to believe true earnings power for FedEx is closer to its annual free cash flow, not the adjusted EPS figure presented by management. (Based on what was said on the fourth quarter call, it appears to me that the pace of capex spend shows no signs of slowing down.) That means the stock is trading at a significantly higher multiple than it appears to at first glance.
Unattractive returns
In addition to spending a boatload of money on capex, FedEx has not generated attractive returns on its incremental investment. The $43 billion of capex that the company spent in the past decade has resulted in a roughly $2.5 billion increase in annual cash flows (a mid-single digit return). It also spent north of $6 billion on TNT Express (inclusive of the integration expenses), and that has not lived up to expectations either (in management’s defense, they were blindsided by the NotPetya cyber-attack that significantly affected the company’s operations).
That last point really captures what I’ve been unable to wrap my arms around. At a high level, my sense was that FedEx, UPS and the U.S. Postal Service (USPS) were an oligopoly. I also assumed that they had significant scale advantages that should serve as a moat against any would be competitors (see the DHL example that I outlined in my prior article). The combination of those factors should’ve led to some attractive returns on capital. But that’s not what I see when I look at the financials. Instead, I see businesses with decent, but far from great, economics.
Broadly speaking, the huge investments that have been made to support volume growth and to improve network efficiency feel in some ways like what Warren Buffett (Trades, Portfolio) talked about dealing with in Berkshire Hathaway’s textile operations decades ago (from the 1985 shareholder letter):
“The promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide.
Viewed individually, each company’s capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.”
I don’t want to suggest it’s that dire for FedEx and UPS – but I do think there are some parallels.
Conclusion
I’ll close with something Charlie Munger (Trades, Portfolio) said at USC Business School in 1994 (from his talk “A Lesson on Elementary Worldly Wisdom”) that captures my problem with FedEx:
“Over the years, we’ve tried to figure out why the competition in some markets gets sort of rational from the investor’s point of view so that the shareholders do well, and in other markets, there’s destructive competition that destroys shareholder wealth.
If it’s a pure commodity like airline seats, you can understand why no one makes any money. Yet, in other fields -- like cereals, for example -- almost all the big boys make out. If you’re some kind of a medium-grade cereal maker, you might make 15% on your capital. And if you’re really good, you might make 40%. But why are cereals so profitable -- despite the fact that it looks to me like they’re competing like crazy with promotions, coupons and everything else? I don’t fully understand it.
Obviously, there’s a brand identity factor in cereals that doesn’t exist in airlines. That must be the main factor that accounts for it. And maybe the cereal makers by and large have learned to be less crazy about fighting for market share. For example, if I were Kellogg and I decided that I had to have 60% of the market, I think I could take most of the profit out of cereals. I’d ruin Kellogg in the process. But I think I could do it.
In some businesses, the participants behave like a demented Kellogg. In other businesses, they don’t. Unfortunately, I do not have a perfect model for predicting how that’s going to happen.”
As always, I look forward to your thoughts.
Read more here:
An Update on National Beverage
The Value of Best-in-Class Management
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