FedEx Gets No Wall Street Love For Stellar Results

FedEx Corp. FDX ground delivery unit, FedEx Ground, has become the tail that wags the corporate dog. So when the tail is perceived to be dragging, the dog's currency — namely its share price — takes a hit.

The day after the Memphis, Tennessee-based giant posted fiscal 2021 second-quarter results that smashed even the most optimistic Wall Street estimates, shares took a nosedive. Near the close of trading Dec. 18, FedEx shares declined $16 a share to $276.26 a share. Shares have more than tripled since the low-water mark at the end of March.

It didn't seem to matter that two of its three transport units, air and international operator FedEx Express and less-than-truckload unit (LTL) FedEx Freight, reported record or near-record results. FedEx Express generated an adjusted operating margin of 9.1%, up more than 500 basis points from 2020 levels. It also reported adjusted operating profit of $943 million, an all-time record for the fiscal second quarter. FedEx Freight, meanwhile, posted a 13% operating margin, its best fiscal second-quarter margin performance in 15 years.

Instead, analysts focused on the dragging tail: the disappointing margin results from FedEx Ground. Ground operating margins improved 110 basis points, while operating income improved 61% year-over-year. Yet a 7.5% margin rate — 10% for additional revenue and income gained in the quarter — did not sit well with analysts and investors who hoped margins would land in the mid-teens range. The unit is the subject of much investor scrutiny due to the increasing relevance of e-commerce fulfillment, and the massive investments being funneled into it to make business-to-consumer (B2C) deliveries more profitable.

Deutsche Bank's Amit Mehrotra noted some positives about FedEx Ground's results, such as a 7% increase in yields. However, Mehrotra took the company to task as much for its inability to strongly communicate a path forward on margins as on the results themselves. FedEx, he said, "should be in a position to give more clarity and confidence around Ground's margin trajectory."

With FedEx's U.S. parcel mix shifting permanently toward ground residential deliveries, the company "should be in a position to offer a mid/long-term framework on how to overcome margin pressures and show long-term improvement," Mehrotra said. Share price growth, he said, will depend on management's persuasive powers. Mehrotra has a "buy" rating on FedEx shares with a $318-a-share price target over the next 12 months.

Morgan Stanley's Ravi Shanker was more unsparing in his comments. Ground revenue growth was strong but only in line with the firm's estimates, Shanker said in a note. Margins, meanwhile, were 13% below Shanker's forecasts, and represented the unit's third-lowest margin ever.

Shanker said he was surprised by the subpar margin performance, and said it may trigger a broad investor rethink of the company's near-term prospects, especially as it now confronts ever-higher investor expectations. FedEx "continues to ride the momentum from current conditions, but the bar is now much higher as well, and the [revenue and earnings] beat was most likely not enough," he said.

Shanker's long-bearish views on FedEx and archrival UPS Inc. UPS ran into a brick wall during 2020 as both companies posted stellar share gains. Yet the analyst remains steadfast in his opinion that FedEx's best days are behind it, at least for now. "It is hard to determine how much longer the sun will continue to shine on FedEx, but it is clear that at some point, it will set," he wrote.

A source close to the company, who asked not to be identified, said Wall Street was expecting more than what analysts had built into their forecasting models given the  high profile attached to e-commerce throughout the pandemic and into the peak holiday shipping season. "More than anything, investors want a Ground business that can grow margins and revenues from the e-commerce secular opportunity. While both happened they expected more on margins," the source said. Based on the tenor of comments made on the post-earnings call with analysts, "management thinks they can do better as well," the source said.

Indeed, much of the dialogue focused on the outlook for Ground margins. The unit continued to invest heavily in labor and infrastructure to manage surging volumes. Yet the continued investments may compress margins for at least a quarter and maybe longer. New CFO Mike Lenz would not comment on whether the unit has troughed on margin levels, though he and other executives on the call said the performance should improve from here.

Cost spikes

Henry Maier, FedEx Ground's president and CEO, said the unit's cost volatility spiked in the quarter due to the pandemic and the approaching peak period. For example, facilities came online much later than usual due to permitting and construction delays as virtually all government offices were closed for months through the spring and summer, Maier said. The unit is hiring a record number of package-handlers, which will drive up costs because the workers need to be trained on equipment and systems across an expanded physical network. 

In addition, the unit pulled forward peak payments to its vast network of independent contractors to help them adjust to unprecedented volume increases. FedEx Ground uses contractors who oversee the unit's drivers, who are not FedEx employees. 

"All of these things are higher-than-normal operating expenses associated with peak preparation than we normally incur" during FedEx Ground's fiscal second quarter, Maier said.

The unit's ace in the hole may be its seven-day-a-week delivery operations that it operates without any outside alliances. The expanded operation is designed not only to offer a higher level of service but to provide network fluidity that should drive down costs over time. The year-round service now serves 95% of the U.S. population, according to company data. 

FedEx said it will ramp up its IT investments and will work with customers to forecast load-planning with more precision. In a significant effort to improve package density, FedEx has migrated into its network most last-mile parcel traffic, known as SmartPost, that it once tendered to the U.S. Postal Service. FedEx has not commented on whether all that business has switched over, as was the original plan.

According to Maier, the ability to "sweat the assets" over a seven-day workweek led to a 15% decline in FedEx Ground's average cost per stop in the quarter over the same period in FY 2020. The in-sourcing of SmartPost traffic has reduced fixed costs per package by 9% year-over-year, Maier said. 

On average, FedEx Ground is delivering 25% to 30% of its volumes a day early, Maier said. The typical package now spends about 2.4 days in transit through the network, Maier said, a faster journey than at the same time last fiscal year despite all the volume challenges it has faced during 2020.

FedEx's Ground's infrastructure future lies in small automated satellites and stations designed to support overnight last-mile deliveries, Maier said. The facilities can go up faster and cheaper because it only involves modifying existing structures, Maier said.

But the holy grail, Maier said, involves no physical infrastructure at all. It involves the ability to load origin packages directly into a vehicle for delivery to a neighborhood, thus bypassing destination facilities for re-sorting, he said. "We're always going to have brick and mortar in our business," he said. "But many of the transformational initiatives … are intended to give us better real-time information about what's coming so we can make decisions that reduce our input costs."