After a disappointing set of Q3 results from FedEx (NYSE:FDX) last week driven by overcapacity in the international freight industry and an unfavorable volume-mix in the express package delivery segment, we have adjusted our price estimate for the company. Key drivers impacted by the change in our outlook for the company are average daily international priority and economy shipment volumes, and FedEx Express EBITDA margins.
According to our analysis the company now relies on its ground operations for more than 80% of its $107 valuation. Here, we take a look at the key factors driving the change in our outlook for the company.
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Overcapacity In International Freight Industry Driving Lower Pounds
Sluggish global GDP growth driven by policy uncertainties in the U.S., China recording the slowest growth rate in a decade and Europe’s struggle with an economic nightmare is driving feeble consumer demand globally. High debt levels in the U.S. due to low lending rates over the past years is further holding back spending as consumers prioritize debt reduction over consumption. All of these factors are responsible for the slower growth in world trade seen in 2012, and are expected to continue to have their bearing on international trade during 2013 as well.
Slower than expected trade growth has negatively impacted the global freight industry as yields have plummeted due to tough competition. Moreover, continuing shift in freight traffic from air to the sea, driven by higher fuel prices is not helping the air-cargo industry at all. FedEx Express reported a sharp 13% decline in international priority freight revenues, while international air freight revenues fell by 17% year-on-year during the third quarter. For the first nine months of the fiscal year ending May 2013, these figures were down 7% and 6% respectively.
Overall, the air freight pounds are expected to grow at a modest 2-3% annual rate as the integration of world economies over time will increasingly drive movement of small shipments directly from the point of production to the consumer. However, heavier, less urgent and low value per pound shipments will increasingly shift towards the sea route as companies thrive to manage their total distribution costs efficiently, which would limit the growth in air freight segment.
Unfavorable Volume Mix In The Packaging Segment Pressurising Yields
FedEx Express registered growth in average daily package volume in both, priority (up 2% y-o-y) and economy (up 12% y-o-y) categories. However, revenue growth from the express package delivery segment was subdued due to lower composite yield (down 4% y-o-y). This can be attributed to accelerated shift in customer preference toward economic offerings. According to the management, load factors were very high on international express routes. However, they were serving the lower-yielding products mostly. This reduced the top line directly while the use of high-cost priority network for deferred package deliveries put severe pressure on margins. The management looks towards reducing the impact of this continuing trend by redirecting lower-yielding deferred packages through its low-cost deferred and FedEx Trade networks. (See FedEx’s Weak Results Spark Fears Of A Long And Feeble Recovery)
Due to the unexpected extension of this particular trend, our estimate of the CY2012 EBITDA margin for the express segment declined by around 2.5%. However, we forecast the segment’s EBITDA margins improve to around 17.5% by 2016 (down around 150 basis points from our earlier estimate) primarily due to the company’s extensive ongoing profitability improvement program that aims at improving the company’s profits by around $1.7 billion by FY2016, compared to the base of FY2013.