FedEx’s Weak Results Spark Fears Of A Long And Feeble Recovery

FedEx (NYSE:FDX) stock fell around 7% Tuesday after the company reported Q3 earnings for the fiscal year ending May 2013. Reported EPS fell 28% y-o-y during the quarter despite revenue growth of around 4%. Continuing weakness in the FedEx Express segment due to shifting customer preferences for slower and lower yield offerings more than offset growth in Ground and Freight segments.((FedEx Corp. Reports Third Quarter Earnings, www.fedex.com))

FedEx International Express Demand Scenario Worse Than Expected

Revenue from the FedEx Express segment grew 2% primarily due to business acquisitions while organic growth in top-line was limited due to unfavorable volume mix. The segment’s operating income plummeted by two-thirds year-on-year to $118 million primarily due to a shift in demand towards lower yield offerings.

Within the Express division, the U.S. domestic operations did relatively better as both revenue per package and average daily package volume increased 1% y-o-y. However, an unfavorable volume mix in the international Express segment due to slowing global demand and GDP growth scenario impacted operating margins negatively. Tough comparisons due to the reversal of a $66 million reserve associated with a legal matter during the same period last year, higher pension and depreciation expenses and costs associated with the ongoing profitability improvement program further reduced earnings for the segment.

The shift in customer demand for slower deliveries is apparent from the fact that FedEx’s international deferred package volumes grew 12% while international priority volumes rose by just 2% y-o-y for the quarter. The fact that this trend has accelerated instead of slowing down as expected earlier is not a good sign. The company expects the trend to continue going forward and plans to take actions like reducing its Trans-Pacific capacity from April 1 and improving its cost structure to align lower yielding operations with lower cost networks by leveraging its FedEx trade network capabilities.

These measures may also involve temporarily or even permanently grounding some of its aircraft, which could potentially result in higher asset impairment charges in the future. Although the long-term market fundamentals are still intact and improvement in global GDP growth is expected to drive growth in international trade in the coming years, the persistence of this trend longer than expected will drive our current forecasts for the segment’s EBITDA margins and international priority shipment volumes lower.

Ground And Freight Continue To Rise

The FedEx Ground segment reported 11% y-o-y growth in revenues on higher volumes (up 10%) from both home delivery and commercial categories. Revenue per package grew marginally by 1% as higher rates and residential surcharges were partially offset by lower weight per package and fuel surcharge. Smartpost posted smart gains in volumes which rose 26% y-o-y due to rising e-commerce deliveries while the revenue per package was negatively impacted by rate hikes implemented by the USPS.

Operating margins for the Ground segment were down to 17% from 18.8% last year due to a one-time favorable self-insurance adjustment during the same period last year and charges associated with the business realignment program during this quarter. Higher network expansion cost and expenditure on purchased transportation further squeezed margins.

The Freight business saw an improvement in yield by 2% due to a better base yield from the economy offering as revenue grew marginally to $1.24 billion due to growth in average daily LTL shipment volumes. Operating margins improved from -0.1% last year to 0.3% during the quarter despite higher depreciation and amortization costs and investment in transportation facilities as the higher use of rail drove fuel costs 5% lower year-on-year.

Going forward, we expect to see continued top-line growth in the Ground segment backed by e-commerce growth. An improvement in market share (Fedex holds more than 30% share currently) driven by higher network coverage is expected to drive better operating margins as network expansion costs stable. Moreover, the use of natural gas based vehicles for transportation that FedEx is currently testing is further expected to enhance profitability. (See What’s Fueling FedEx’s Adoption Of natural Gas Powered Trucks?) We also expect to see the Freight business stabilize on a positive operating margin track with better volume-mix driven top-line growth.

We currently have a $122 price estimate for FedEx which will be revised downward due to the current weakness in the Express segment.

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