On Wednesday morning, FedEx (FDX 0.43%) reported solid but not spectacular earnings growth for the first quarter of its 2016 fiscal year.
Global macroeconomic worries apparently didn't impact FedEx very much last quarter. In fact, the company's flagship FedEx Express segment posted very strong profit growth. But profit margins for FedEx's other two major business segments sagged in Q1, constraining overall profit growth.
A recap of the quarter
FedEx reported revenue of $12.28 billion for Q1, falling just a hair short of the analyst consensus of $12.30 billion, and up from $11.68 billion a year earlier. This revenue growth was primarily driven by the addition of $370 million in revenue from GENCO (a logistics subsidiary purchased last year), an accounting change for FedEx SmartPost revenue, and the impact of having an extra operating day in the first quarter this year.
Adjusted earnings per share rose 14% year over year, from $2.12 to $2.42. However, analysts had been expecting EPS of $2.46, on average.
Looking at FedEx's individual operating segments, FedEx Express dramatically outperformed the rest of the business. While Express revenue declined 4% year over year, to $6.59 billion, due to falling fuel surcharges and the strong dollar, operating income surged 45%, to $545 million, as base rates rose. The segment's operating margin reached 8.3%, approaching the company's double-digit margin goal.
At FedEx Ground, revenue surged 29% year over year, to $3.83 billion. However, much of this revenue growth came from the accounting change for SmartPost revenue -- which increases revenue and expenses by the same amount -- and the GENCO acquisition.
Furthermore, FedEx noted that it experienced higher-than-expected operating costs, partially due to carrying larger packages, as well as higher self-insurance reserves. The net result was that, in spite of FedEx Ground's rapid revenue growth, operating income declined to $537 million from $545 million a year earlier.
Finally, FedEx Freight's revenue was roughly flat compared to last year, at $1.60 billion, as average daily shipments unexpectedly declined 1%. Thus, FedEx didn't have revenue growth to offset normal inflation in salaries and benefits. This caused more than two percentage points of margin contraction, driving a 21% drop in segment operating income, to $132 million.
FedEx's management had warned investors in June that earnings growth would be slower in the first half of fiscal 2016 than in the latter part of the fiscal year. However, the company's outlook for the second half of fiscal 2016 is dimming, due to weakening freight demand and higher-than-expected operating costs and self-insurance reserves at FedEx Ground.
For the full year, FedEx now expects adjusted earnings per share of $10.40-$10.90, down from the initial guidance range of $10.60-$11.10. Still, while the guidance cut is disappointing for shareholders, it represents strong year-over-year EPS growth of 16%-22%.
Furthermore, FedEx has a good track record of keeping expenses under control. It is nearing the end of a dramatic cost-cutting program for FedEx Express, which has been responsible for that division's dramatically improved profitability. If necessary, the company should be able to achieve similar cost cuts at FedEx Freight to match its cost structure with demand.
At FedEx Ground, the current margin weakness is probably the result of a temporary imbalance between its revenue and its cost structure. The division is still growing at a strong rate, and has a long runway for growth, as e-commerce becomes more and more prominent. FedEx Ground should be able to gradually leverage its expenses to win back some of the recent margin decline.
Lastly, FedEx announced a slew of price increases on Tuesday afternoon. The Express, Ground, and Freight divisions will all increase rates by an average of 4.9% in January. FedEx Ground will also hike its surcharges for oversize packages in November. That should help address the negative impact to profitability from carrying larger packages.
These price increases, along with the company's ongoing cost-cutting program, will help bolster FedEx's margins later in fiscal 2016 and throughout fiscal 2017. As a result, long-term investors may want to put FedEx on their watch lists, in case the stock pulls back significantly following the earnings report. However, the shares were only down by about 2% as of 9 a.m.