In years past, FedEx Corporation (NYSE:FDX) hasn't done well converting revenue and operating income into free cash flow, or FCF, especially compared to competitor United Parcel Service (NYSE:UPS). FedEx is the most expensive stock in the transportation sector, but its FCF generation is likely to improve in the years to come, making it a stock worth buying despite its current price tag.
Let's take a closer look.
3 factors to consider with FedEx Corporation's cash flow
FedEx currently trades at a high enterprise value-to-FCF multiple, with enterprise value, or EV, defined as market cap plus net debt. But increasing FCF might lead to a reduction in the EV/FCF multiple down the road:
UPS tends to trade at a premium (based on earnings multiples) to FedEx because the former has done a much better job of translating its earnings into FCF in recent years:
So there's a case to be made that UPS is the value pick of the two, particularly as the earnings multiple premium gap has recently closed. However, there are three factors to consider when looking at recent history:
- FedEx's profitability plan is intended to increase profits by $1.6 billion by 2016, and FCF generation should consequently follow.
- FedEx is currently in a phase of undertaking high capital expenditures to fuel future growth -- the investment is holding back FCF conversion for now.
- The comparison with UPS is somewhat misleading, because FedEx's business structure meant it had to make more adjustments to the trend toward lower costs and slower delivery options.
All three factors suggest future improvement. In fact, some analysts expect FedEx to improve its FCF generation enough to put FedEx and UPS on a comparable FCF yield by 2016.
FedEx's improving FCF
First, the results of the profitability improvement plan are evident in the analyst consensus for future earnings. Note the sharp increase in growth from 2014 to 2016. It stands to reason that if FedEx can increase its earnings dramatically, then its FCF generation should increase strongly, too -- even without any pickup in conversion rates.
Second, FedEx's future growth has been fueled by the extensive capital expenditures the company has made in growth initiatives -- and increased capital spending tends to reduce FCF. Management outlines its capital spending plans in its 10-K filing every year. Its plans for the past six years show that FedEx's capital expenditure requirements are being boosted by strong investments for growth.
Third, in addition to the growth investment, FedEx has had to invest substantially because its income base has shifted since the recession. Simply put, customers have been preferring slower and cheaper delivery options. You can see how this shift has played out in FedEx's operating-income statements.
However, the good news is that its ground operations have seen a notable profit increase in recent years, while express operating income margins have increased. For example, in the most recent third quarter, express operating income margin came in at 5.2%, versus 2.5% in the same period last year.
Where next for FedEx?
FedEx's FCF generation could clearly receive a boost in future years thanks to an increase in income. Furthermore, capital expenditures have been relatively high in recent years thanks to growth initiatives -- which are already paying off -- and the need to invest to restructure the business because of changes in end demand.
What this means for investors is that the current high EV/FCF valuation is something of a misnomer, and the stock is a lot more attractive than it looks on a superficial basis.
Lee Samaha 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.