FEDEX ISSUES

The real growth issue for FedEx is keeping up with Amazon, e-commerce, and service demands. Falling behind opens opportunities for competitors.

Analysis: FedEx may have to compromise between growth and profitability

By Alessandro Pasetti

18/07/2017

“There are some questions about Amazon. I think I answered that in my rather long-winded thing (previously). Amazon is a fantastic company and it delivers things to all of us… We move things for Amazon and so forth, but there is far too much focus on that as opposed to the larger part of FedEx’s business.” So said FedEx chief executive Fred Smith in a conference call post-results, 20 June.
(The latest 8-K filing, released on 20 June, containing fourth-quarter and annual results can be found here, while the full 10-K for the year ended 31 May 2016 can be downloaded here.)
It’s always worth spending time assessing the unaudited annual results of FedEx around this time of the year – especially given the rising number of challenges the transport and logistics industry faces, as well as the changes that supply chains are undergoing, driven by the growth in e-commerce.
Just a nuisance?
Amazon is reportedly “now second in the world in a ranking of logistics companies by size”, with 160 million sq ft of warehouse space, trailing only Germany’s DP-DHL, according to Armstrong & Associates research.
“Did you notice that?” a London-based banker asked me recently. “Astonishing!”
“Yes. But does it matter?” I asked back.
“It depends on who is after whom, I guess,” he replied.
Ambition
The mix of private and third-party logistics space managed means a lot to Amazon, but it is less important for FedEx, which mainly remains a delivery business – and one of the best around.
As the Memphis-headquartered group says, FedEx Express – its chief income driver alongside ground operations – is the “world’s largest express transportation company, offering time-definite delivery to more than 220 countries and territories, connecting markets that comprise more than 90% of the world’s gross domestic product”.
By comparison, Amazon acts more like a third-party logistics (3PL) company, while FedEx – via FedEx Supply Chain, formerly GENCO – is relatively new to the 3PL game and has no serious ambitions elsewhere, while Amazon is growing inorganically, to my knowledge.
On this basis, it is easy to argue that FedEx is threatened by Amazon in almost every corner of the planet, but that’s virtually meaningless. The first table below indicates that FedEx operated only 12.6 million sq ft of sorting and handing facilities at the end of fiscal year 2016, while Amazon’s leased and owned square footage figures can be found in the second table.

FedEx sorting and handling facilities

Amazon Properties

Maybe these numbers are not strictly comparable, but they provide a good proxy for each company’s reach. Gauged this way, size is a nuisance rather than a problem for FedEx, given its different business model. Meanwhile, it is overly ambitious to wonder whether FedEx will ever have a chance to go after Amazon – some investors have argued that the reverse may apply – yet it is a good time to question the carrier’s performance and profitability, because its structurally more profitable ground operations have drawn lots of attention in recent quarters.
(As a reminder, FedEx says: “Ground serves customers in the North American small package market, focusing on business and residential delivery of packages weighing up to 150 pounds. Ground service is provided to 100% of the continental US population and overnight service of up to 400 miles to nearly 100%. Service is also provided to nearly 100% of the Canadian population.”)
Fred says
President and chief executive Fred Smith told analysts on 20 June that “modernising the FedEx aircraft fleet and expanding FedEx Ground capacity continue to be major strategic programmes, while the integrations of TNT, FedEx Supply Chain and FedEx CrossBorder are filling strategic gaps in our global portfolio”.
Those and other gaps must be filled one way or another, either by investing more to bulk up in the right places or by acquiring assets. FedEx seems to acknowledge, and has proved by its own corporate actions in the past few years, that the latter is the shortcut that allows it to make the profit and loss (P&L) statement look nicer.
Thanks to the TNT Express purchase and other minor deals, the group hit $60bn in revenue for the first time in fiscal 2017, while “adjusted earnings were a record at $12.30 per share”, Smith reminded his audience last month, defending the unique appeal of the business he founded in 1971.
As a reference, the stock now trades at all-time high of $218.3, and its growth trajectory has been truly impressive since it listed in April 1978. But there must also be vulnerabilities, right?
Trends
Chief financial officer Alan Graf noted that adjusted EPS rose 14% and “results benefited from higher base rates and increased package volume”.
“Also, Express continued to manage costs while integrating TNT. These factors were partially offset by higher network expansion costs at Ground while full-year 17 capital expenditures were $5.1bn, and several Ground network expansion projects were deferred into ’18 and beyond.”
That explains the change in capex budgeted for this year: “largely the under-spending of Ground in ’17 and the increase in Express in ’18 is why we’re up to $5.9bn”.
Henry Mayer, president and chief executive officer of FedEx Ground, also tried to reassure the analysts on the call, noting “we expect FY ’18 operating profit and cash flows to exceed FY ’17”.
FedEx is so good at what it does that it manages its business “as a portfolio (…) in the long-term best interest of the enterprise, not a particular operating company”, which now comprises: FedEx Express and TNT Express; FedEx Ground; and FedEx Freight.
The P&L shows that the express and ground units bring in the vast majority of revenue, which makes management feel good about prospects and growth rates for both…

FedEx P&L, source FedEx

…but trailing trends before the end of fiscal 2017 show why investors want to know more about how the ground unit is faring.

FedEx Ground deteriorating margins

TNT Express was the largest acquisition in FedEx history, and it is fair to ask management whether the express unit is now the core of its M&A focus, or is it more likely to entertain acquisitions in other parts of the business?
Next
Lots of rumours have surrounded Ceva Logistics of late and, perhaps at a stretch, the 3PL – currently in talks with Chinese and European suitors, according to our sources – could help FedEx become a bit more efficient in terms of capital structure, as FedEx is relatively under-levered and could easily replace Ceva’s high-yielding debt with cheaper funding.
Incidentally, Ceva was formed by the merger of TNT’s then logistics division, and TNT Express is now owned by FedEx, so there is the possibility of some sort of reunion. “I’d still put a fortune on it not happening”, my editor commented when I hinted at such a tie-up.
Such a deal could make more sense for Amazon (Ceva ranks fifth in terms of square feet of warehouse space, according to Armstrong & Associates) – Ceva is likely to be worth between $2bn and $3bn (up to 0.6% of Amazon’s market cap), depending on how much value is ascribed to its highly illiquid equity.
In early 2015, FedEx acquired GENCO, “a leading North American third-party logistics provider”, for $1.4bn.
It said: “With a comprehensive portfolio of supply chain services, GENCO’s expertise will expand FedEx service offerings in the evolving retail and e-commerce markets. GENCO’s infrastructure and supply chain capabilities include reverse logistics, providing triage, test and repair, remarketing and product liquidation solutions. Additionally, GENCO’s breadth of expertise in targeted vertical markets – such as technology, healthcare and retail – aligns with our strategic priorities in these areas.” (emphasis in bold is mine)
(One of the most interesting reports of FedEx’s move in the 3PL arena can be found here.)
An obvious question is whether FedEx might want to make a move in contract logistics as well as to raise the bar in freight forwarding, but strategically there seem to be other priorities.
Growth vs profitability
Mr Smith reiterated that “continued investments, integration and innovations should improve margins, cash flows, returns and earnings per share over the next several years”, but there is reason to believe FedEx might have to compromise between growth and profitability, particularly in the ground division, which is the most profitable unit in its portfolio.
Revenue growth until the end of the last fiscal year is shown in the table below.

FedEx Ground vs other unit (Source: FedEx)

On the one hand, a takeover of Ceva or any other 3PL is highly unlikely, as it would partly dilute the group’s margins, among other things. On the other, total e-commerce activity now accounts for one in six discretionary dollars spent by consumers, according to research sighted by FedEx in its 10-K last year.
“If this trend continues, calendar year 2016 will be the seventh consecutive year that online sales grew near or above 15% year-over-year,” it said at the time. So, additional inorganic growth could be sought.
The group continues to invest in growth at FedEx Ground in order to take advantage of opportunities in domestic B2C activities, and this is one of the reasons why it snapped up GENCO, but will it be forced to grow inorganically in ground rather than devoting more time and resources to express?
Trends
“Ground operating margin in Q4 was 15%,” Mr Graft said, adding that “operating income increased due to higher yields and volume, partially offset by network expansion and staffing costs as well as increased self-insurance reserves. In addition, FedEx Supply Chain continues to negatively impact segment margins”.
Meanwhile, Henry Maier, president and chief executive officer of FedEx Ground, said: “We expect to have more than 90% of the network to have Ground and residential packages sorted in the same building by 2020. The key to this is technology and the integration of sortation tools and technology across the network.”
But the audience wasn’t pleased with the answer it got, I gather, because over the past decade or so, as Barclays analyst Brandon Oglenski pointed out, FedEx appeared to focus on achieving high volume growth, especially in the ground segment, yet more recently, pricing appears to have accelerated while volume growth has been slower.
On this matter, chief marketing and communications officer Rajesh Subramaniam said: “We also continue to experience growth in demand for large, heavy package delivery as a growing array of items are now being sold online. Furniture, mattresses, sports and exercise equipment are increasingly moving to the FedEx Ground network for residential delivery.

“This trend has accelerated over the past 12 months, and we have made adjustments to facilities and investments in sortation technology that enable outstanding service for these larger packages. We’re continuing to analyse pricing and surcharges for oversized packages to ensure that we have appropriate pricing for the service provided.”
Amazon?
The final answer during the Q&A failed to lighten the mood.
Mr Smith: “Henry said that Ground probably will improve but didn’t answer about Ground margins. And we’re probably never going to answer you about it. That’s why I keep saying this is a FedEx Corporation and not a FedEx Ground conference call. Henry told you that FedEx Ground is shooting for mid-teen margins.
“The bigger story is the enormous upstream network operated by FedEx. And there’s only one other one of a similar size and scope, and that is UPS.”