FedEx (NYSE:FDX) stock has been beaten up in 2020 by the market's fear of the impact of COVID-19 on the economy. It is down by roughly 15% year to date as I write. But is that creating a buying opportunity, or is there more pain to come?
The case for FedEx
Let's face facts: FedEx is so integrated with the global economy that to buy its stock is to cast a vote of confidence in global growth. In other words, if you aren't confident that the COVID-19 pandemic will be contained and the global economy will avoid a protracted recession, then you should be avoiding FedEx.
There's certainly risk around the stock right now. For example, investors were reminded of the danger in FedEx's near-term prospects when management suspended its guidance recently due to "the significant uncertainty caused by the COVID-19 pandemic and the related deterioration in global economic conditions." But even given that, you could argue that FedEx has upside potential, provided you believe the economy will recover in due course.
And that would be a fair enough argument, but unfortunately it's a bit more complicated.
It's more than just the economy
There's another risk that investors in FedEx would be taking on.
The key uncertainty around FedEx -- and UPS, too -- over the last few years concerns the ability to maintain profit margins while expanding e-commerce deliveries. The need to expand networks in order to service burgeoning e-commerce growth has also meant a ramp-up in capital expenditures. That's something that's eaten into free cash flow (FCF) generation in recent years.
As you can see in the chart below, both companies have seen operating-margin pressure, while capital spending (as a share of revenue) has gone up and FCF has been declining. If you are valuing a company based on future earnings and FCF generation, then it's important to have an approximation for what those metrics could be.
If margins are inevitably on the slide, that will lower long-term profit expectations. Moreover, if servicing e-commerce delivery growth entails a never-ending increase in capital spending, then long-term FCF expectations should be lowered, too. And the uncertainty caused by the pandemic has made figuring out what's going to happen even more difficult.
The pandemic muddies the picture
One approach to the problem of uncertainty around long-term margins and FCF would be to wait until there's clear evidence of margin expansion and/or management starts explicitly dialing down expectations for capital spending. In this way, investors might feel confident in making long-term assumptions.
Unfortunately, the COVID-19 pandemic is going to make it very difficult to discern the underlying trends in the business, at least for a while. For example, FedEx's recent SEC filing noted that its global business-to-business (B2B) demand had been "negatively impacted by the COVID-19 pandemic" but demand for residential deliveries "has increased due to sharp increases in e-commerce."
Given that residential deliveries tend to be lower-margin than B2B deliveries, there is likely to be a negative impact on margins and operating results, according to FedEx.
In other words, the margin numbers you will see from FedEx won't be reflective of underlying trends in the business on an ongoing basis -- the COVID-19 pandemic won't always be around. Bottom line: It's going to be hard to judge how FedEx is doing on margin overall.
Is FedEx a buy?
If you buy FedEx right now, you are taking on two types of risk:
- That the global economy and global trade are walking into a protracted slowdown.
- That operating margin and FCF trends will be obscured for a while by the impact of the COVID-19 pandemic.
The first risk may be something investors are willing to take if they believe there will be a quick recovery in the economy. However, the second is an added complication that won't necessarily be there with other stocks.
The key point is that there's already a lot of uncertainty around the ability of FedEx and UPS to maintain margins and grow FCF and the COVID-19 pandemic is only going to make it harder for investors to see if the underlying trends are improving on those fronts.