FedEx Corporation (NYSE:FDX) reported stellar first-quarter earnings last week. Earnings per share came in at $2.10, well ahead of the average analyst estimate of $1.96. This represented a strong 37% year-over-year gain.
On the company's conference call, FedEx executives emphasized that they see more good times ahead. While the pace of earnings growth will probably moderate in the next few quarters, FedEx still has plenty of room to grow revenue and boost its profit margin.
FedEx Ground will keep growing
[W]e've probably got another year of increased capital before we're over the hump here in terms of ... building out the capacity we view we need going forward in the network.
-- Henry Maier, President and CEO of FedEx Ground
FedEx Ground has been FedEx's main growth engine in recent years. The company expects that to continue, and so it is investing heavily to expand capacity there. These investments are constraining margins in the Ground segment -- yet its 18.4% Q1 operating margin made it far more profitable than FedEx's two other main operating segments.
This is a huge opportunity for FedEx. The Ground division's growth should help FedEx boost its companywide profit margin over time by driving a mix shift toward the most profitable part of its business.
More cost cuts ahead
Our goal is to have all three of our major transport sectors operating at double-digit margins, and we're confident that we can do so.
-- Fred Smith, FedEx Chairman and CEO
FedEx is in the midst of a multiyear cost-cutting program that targets $1.7 billion of profit improvement in the Express division. In Q1, the FedEx Express operating margin rose to 5.4% from 4.1% the year before. The first quarter of FedEx's fiscal year tends to be seasonally weaker for the Express division -- but even leaving that aside, it is still far from the long-term goal of earning a double-digit operating margin.
The top remaining profit improvement driver is aircraft replacement. FedEx will retire 40 outdated MD-10s and replace them with a similar number of new Boeing 767s in the next four years.
Each replacement is expected to boost operating profit by $10 million, thanks to lower fuel and maintenance costs. This fleet renewal program will lead to hundreds of millions of dollars in annual cost savings just a few years from now, helping return the Express division to double-digit margin territory.
Ready for the holiday season
There are just scores of things that are done at each of the FedEx operating companies to accommodate a smooth peak season. Contrary to some of the popular press, we actually had an outstanding peak season last year, with the exception of a couple of weather events.
-- Fred Smith
Last December, many consumers were affected by holiday season package delays. Package delivery services couldn't keep up with a deluge of last minute e-commerce orders for Christmas, causing some packages to arrive after the holiday. (UPS had the most widespread delays.)
At the time, FedEx's management emphasized that delays were few and far between, and that the main cause was weather. The company is sticking to that story. FedEx expects another record holiday season this year, and the management team believes that it will be ready. To meet peak season demand, FedEx will hire 50,000 seasonal workers this year: up 25% year over year.
If the weather is more cooperative, FedEx will almost certainly get packages to their destinations on time. The real question is whether FedEx is better prepared to manage any potential winter weather issues this year. Time will tell.
Not worried about the Post Office
[W]e have a tremendous portfolio of services [that] allow us to effectively serve the e-commerce market. I think we've demonstrated the ability to develop a strategy that really targets the right kind of growth within the e-commerce segment that contributes to the bottom line and supports our yield strategy.
-- Alan Graf, FedEx CFO
Some investors have been worried about the potential damage to FedEx from price cuts recently implemented by the USPS. The USPS recently reduced Priority Mail prices by up to 58% for certain high-volume shippers, allowing it to win business from UPS and FedEx.
FedEx's management team doesn't seem very worried, though. FedEx already offers discounts to higher-volume customers, and executives appear confident that the company has a good portfolio of services to meet the needs of e-commerce customers. This will allow it to continue competing effectively with the USPS.
Calling all dividend investors
I think we just need to continue to improve [the dividend] until we get up into a range where people who are interested in dividends and dividend yields would be more interested in our shares than they are today.
-- Alan Graf
FedEx does pay a dividend, but its annual yield is a paltry 0.5%. As a result, dividend investors typically aren't too interested in FedEx stock. The company has returned a lot of cash to investors in the last year, but the vast majority of that has come through share buybacks.
However, with the stock price having nearly doubled in the past two years, dividends are starting to look more attractive relative to buybacks. FedEx's current dividend is less than 10% of projected FY 2015 earnings, suggesting that the dividend could grow exponentially. However, the next increase isn't likely to arrive until next spring.
What it all means
FedEx is on a roll, and the management team sees a clear path to higher revenue and stronger margins going forward. If the global economy gains steam, that will also contribute to long-term profit growth.
This will put FedEx in a good position to develop a long-term capital allocation strategy. When it does so, FedEx will likely opt for a significantly higher dividend payout ratio. Dividend investors should therefore keep FedEx stock on their radar over the next few years.
Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool recommends FedEx and United Parcel Service. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.