For stockholders, FedEx (FDX 3.82%) has been dead money for years. Since peaking around $270 per share in 2018, the global courier's stock has been more than cut in half. Investor concerns center around their ability to evolve in a world shifting toward digitally enabled consumption. This shift continues to manifest itself in strong e-commerce demand, a style of consumption relying largely on ground fulfillment. The issue?
FedEx's strength is in their express (or air) unit, which instead mainly supports business to business logistics. Desire to take a larger piece of ground deliveries prompted the Memphis-based company to shift capital allocation to projects serving e-commerce. To succeed, their competitive strategy aims to build out seven day and last mile delivery.
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An Ugly Third Quarter
The results have been mixed thus far. First, the bad: In FedEx's most recent quarter, CEO Frederick Smith reported a near 60% drop in profit year over year. Operating margins were cut in half from a recent decade low of of 5.4% to a new decade low of 2.4%.The courier did meet revenue and profit estimates, but did so largely thanks to low analyst expectations.
No matter how aggressively Smith invests, new capabilities will take time to ramp. Yes, e-commerce is rapidly growing, but increasing fulfillment to keep up takes time. For now, several express headwinds remain globally which FedEx's e-commerce unit is not ready to fully offset. Their harsh macro-reality was a world teetering on the edge of a manufacturing recession until the coronavirus rudely shoved our economy into that territory officially.
Massive capital projects and pandemic-induced slowing of business to business shipments are the main culprits for the 60% profit hit. FedEx, now more than ever, leans on an embattled express revenue stream to support e-commerce investments, a reliance growing more vulnerable. Immediate steps have been taken to try and halt FedEx's concerning trends.
Smart Decisions Made
This February, COO Raj Subramaniam announced the company will combine its express and ground fulfillments to increase efficiency. This allows dedication of more resources to supporting e-commerce growth while express continues its challenged operations. The move is expected to recover hundreds of millions in profit, significant for a company with a market cap sitting around $30 billion.
Perhaps the more public decision was FedEx moving away from servicing Amazon's deliveries. The Amazon logistics contract comprised 10% of FedEx's top line at decision time, so why the self-inflicting damage? Eventually, it is widely expected that Amazon will complete their courier investments in-house and remove third party shippers from the equation. Knowing this, FedEx is proactively handling the turbulence as seamlessly as possible.
Although Amazon was by far FedEx's largest customer, they were their lowest margin revenue source. Recent logistics contract wins with Dollar General, Walmart and Target depict FedEx's ability to replace Amazon with higher quality customers. A brand-new partnership with Microsoft gives Fred Smith's company access to cloud and AI technology to leverage in a fight against Amazon. This is what a more diversified future will look like. Smith's transformation will not happen overnight: removing a tenth of an order book takes time to replace. As a result, shorter term this has been a revenue head wind for FedEx. Longer term, I remain bullish.
A Subtle Positive
Not only does an Amazon-free future relieve margin pressure, but it also makes FedEx more approachable for retailers of all kinds. They now operate independently from Jeff Bezos's mega-cap inflicting existential doom on retail vendors all over the world. Independence makes them incrementally more appealing. As iconic brands like Nike pull their merchandise from Amazon due to unfair selling practices, Smith's team is a more natural courier decision.
FedEx's unique situation offers promise that moving past capital-intensive projects will leave a more fundamentally sound company. Subtle hints like operating cash flow approaching $6 billion in 2019 depict evidence of FedEx's profit potential when large investments are completed.
For now, FedEx remains challenged by a simultaneously compromised global express fulfillment environment, the Amazon void, and heavy ground investments still rolling out. It is these challenges which set the stage the compelling valuation opportunity that I continue to take advantage of.
Long term demand trends for e-commerce remain 3-4 times projected GDP growth.Fred Smith's company is poised to thrive in this environment, without Amazon.
