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3 Reasons Why This Shipping Stock Can Succeed

You could be forgiven for thinking that there was something odd about FedEx's (NYSE: FDX  ) latest results. The transportation company is usually seen as a play on global growth, but it simultaneously lowered its GDP forecasts and saw its stock price surge through an all-time high. What's going on? 

Fedex lowers GDP estimates

First, here's how FedEx has lowered its forecasts over the year to date:

Estimates for 2013 Start of the year Last Quarter Current Quarter
U.S. GDP growth 1.9% 2% 1.6%
Global GDP growth 2.5% 2.3% 2%

Source: Company presentations.

FedEx and its rival UPS (NYSE: UPS  ) are typically seen as cyclical plays. In other words, their share prices tend to follow the direction of the economy. This is why investors usually respect its views on the economy, and why its lowering of GDP estimates should be bad news. However, a number of elements have come together to give it some upside potential which isn't just about the economy.  

FedEx's structural challenge and its response
Our economy has changed since the financial crisis, and demand for FedEx's services has changed with it. Companies are now a lot more willing to use lower-cost delivery options, even if they ultimately receive their deliveries a day or two later. In response, FedEx's lower-cost ground segment is now its key earnings generator, while the contribution from its pricier express service has fallen.

Source: Company financial statements.

This shift wasn't great news for FedEx; it had invested in expanding its express capacity in anticipation of stronger demand. Ultimately, this led FedEx to spend the last few years losing margins in express while also restructuring the division.

Even as FedEx's customers have grown more frugal, its fuel costs have risen in line with oil prices. International trade has also been growing more slowly than global GDP, mainly because Western consumers' spending on exports from the Far East has slowed post-recession. All of this has led FedEx's express-shipping margins to decrease.

Source: Company accounts.

The company's response to these pressures is to increase its investment in ground shipping, and to work on efficiency gains in express, including retiring planes and modernizing the fleet. All of these things will help to increase its margins in future.

Productivity improvements, e-commerce and its rivals
FedEx aims to realize $1.6 billion in cost savings by 2016 -- which is a large part of the reason why analysts have EPS growing by 39% over the next two years, while revenues are only forecast to grow by 9%. During its recent conference call, management outlined that it was ahead on plans to cut costs, and reiterated its $1.6 billion savings target, despite seeing weaker-than-expected end demand thanks to a slower economy.

Moreover, FedEx's ground segment has strong secular growth prospects from burgeoning e-commerce demand. Speaking of its ground services during the conference call, the company declared that it would put as much money as it could into it. FexEx claimed that ground's margins would remain at 17% to 19%. Ground's volume growth was being "driven by e-commerce."

FedEx's aim must be to increase the amount of free cash it converts from its revenues, because compared to the 9%-plus that UPS has delivered in the last two years, FedEx's conversion looks small. Ultimately, free cash flow is what counts to an investor, because it fuels a company's dividends and buybacks.

Source: Company accounts.

The good news is that FedEx has the opportunity to increase cash flow, while UPS seems more reliant on global GDP growth. UPS lowered its full-year EPS guidance to $4.65 to $4.85 in July as a result of weaker global growth.

Although FedEx's other key rival, Deutsche Post (NASDAQOTH: DPSGY  ) , raised its guidance in June, this was solely due to a one-time item. In fact, Deutsche Post's half-year revenues were flat year-over-year. Increasing this growth will be difficult, because 63% of its revenues come from Europe.

Where next for FedEx?
FedEx should see margin expansion in the next few years as productivity improvements, and the shift in its earnings toward the ground segment, kick in. Indeed, analysts give FedEx a forward P/E ratio of 13.4 for May 2015 -- a discount to UPS's projected 16.7 for December 2014.

Moreover, UPS is slightly more exposed to the global economy then FedEx, and the latter seems to be executing its productivity plans well. FedEx should be converting revenues into cash flow much better in the coming years, and it looks to be a relatively decent value, provided the global economy holds up.

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Lee Samaha

Industrial sector focus. A firm believer in behavioural finance and an Austrian approach to the business cycle. Follow me on Twitter to receive quick and thorough analysis of your favorite stocks.

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