Last week, FedEx (NYSE:FDX) reported solid earnings growth for the first quarter of its 2016 fiscal year. However, investors were hoping for more, and the company also reduced its full-year earnings guidance.
After the earnings report was released, FedEx's top executives spent an hour talking to analysts and investors to provide more details about the company's results. Here are five important points the management team emphasized.
Maintaining flexibility to respond to demand
We adjusted our networks several quarters ago. So right now, we have a very flexible network that when the volumes go up, we can add cost. When the volumes go down, we take out cost, which is why we've done so well in our profit improvement program. -- FedEx Express CEO David Bronczek
All of FedEx's year-over-year profit improvement in Q1 came from the FedEx Express division. That was fairly remarkable because revenue in that segment declined 4% year over year. However, expenses declined by an even greater amount because of lower fuel prices and a variety of efforts to increase operating efficiency, such as updating FedEx's aircraft fleet.
Part of FedEx's recent success has stemmed from its efforts to more tightly manage capacity to match demand. For example, it has cut flights from Asia several times in recent years, instead sending lower-priority shipments in the bellies of passenger airline flights (a shipping method that is somewhat slower but cheaper). FedEx plans to continue this capacity discipline to keep growing its Express division margins.
New pilot contract won't hurt earnings
We think it's a win-win contract. It is in our outlook for not just this year but our strategic outlook [...] where we [...] are expecting to continue to grow our earnings, our cash flows, and our returns. -- FedEx CFO Alan Graf
FedEx reached a tentative contract agreement with its pilot union last month. The pilots haven't ratified it yet, but if they do, they will get raises averaging 10% in November, with steady annual raises for the next five years. The agreement also provides a signing bonus of $20,000-$35,000 (depending on seniority) to make up for missed raises in the past couple of years.
While this was a fairly generous contract offer -- and FedEx's pilots were already near the top of the industry in pay -- FedEx's management stated that it won't impact the company's projected profit growth trajectory. Other productivity-enhancing initiatives will more than offset the pilots' higher pay.
FedEx Ground capital spending is peaking
We have three major hub projects that will come online in FY'16, which is driving much of the peak in CapEx. [...] it is almost unprecedented that we will bring three major hubs online in the same year. -- FedEx Ground CEO Henry Maier
The FedEx Ground segment has been FedEx's main growth driver over the past decade, and the company has been investing heavily to meet rising demand, mainly from e-commerce. In June, FedEx Ground CEO Henry Maier noted that the segment's FY16 capital budget is $1.6 billion: up from $1.25 billion last year, and just $555 million in FY13. But he also stated that capital spending would fall 30%-35% next year.
Last week, Maier explained that FedEx Ground will open three new fully automated sorting hubs this year. That incremental capacity will support plenty of future growth while increased automation should steadily drive down handling costs. As capital spending moderates in the coming years -- and revenue continues growing -- free cash flow should surge higher.
Freight margins will rebound
Yes [...] we believe that a 10-plus percent freight margin is attainable on a full year basis. -- FedEx EVP of Market Development and Corporate Communications Mike Glenn
The FedEx Freight segment was one of the big disappointments last quarter; its revenue stagnated while its operating margin declined to 8.2% from 10.4% a year earlier. This caused a 21% decline in the segment's operating income.
FedEx's management admitted that slower-than-expected growth in industrial production has hurt the freight business. On the other hand, the biggest cause of the segment's margin decline was that the company had been planning for higher shipment volumes and was thus overstaffed. As FedEx pulls back on capacity, its operating efficiency and profit margin should rebound.
Working to spread out peak demand
I would say that many retailers are attempting to [smooth out holiday season demand]. That's why it's more difficult to actually forecast what the peak day is going to be. [...] We are still dealing with capacity constraints in our 7 to 10 day period during peak season. -- Mike Glenn
Package delivery companies like FedEx have often faced difficulty meeting demand during the peak holiday season in recent years. Last-minute online Christmas gift purchases -- sometimes combined with severe winter weather -- have made it difficult to get packages to their destinations on time in a cost-effective manner.
FedEx has been working with customers throughout the year to gauge demand. It is encouraging retailers to spread out their promotions throughout December rather than creating a rush during the week before Christmas. However, it could take a few years to get retailers -- and most importantly, consumers -- to change their habits. As a result, FedEx may need to impose caps on the number of packages accepted on the busiest days.
FedEx management's comments paint a picture of a company that made some short-term miscalculations about demand -- and is investing heavily for the future -- and still managed to grow its earnings last quarter. That makes the more than 20% sell-off in FedEx stock since June seem like an overreaction. As profit growth continues over the next few years, the stock should bounce back.