Dawn recedes still further in FedEx’s ‘night’

For more than a year, FedEx Corp. (NYSE:FDX) executives have been kicking the financial can down the road, saying the problems plaguing the company are transitory in nature and a worsening picture will soon reverse itself.

On Dec. 17, the can kicked back. The Memphis-based giant posted fiscal 2020 second-quarter numbers that were, in the words of Deutsche Bank analyst Amit Mehrotra, “breathtakingly bad.” Nothing worked, especially the headline number of $2.51 in adjusted earnings per share, which included a 51-cent-a-share tax benefit, that was 28 cents a share below the $2.79 estimate on Barchart.

Alan B. Graf, Jr., FedEx’s longtime CFO, called the results “horrific,” a word CFOs rarely utter on quarterly analysts calls. In what has become an oft-quoted description over the past 24 hours, Graf said the company had “hit bottom.” Analysts who thought the bottom had been plumbed a few quarters ago are taking Graf’s forecast with a grain of salt. As Bascome Majors, the pithy analyst at Susquehanna Investment Group, put it in the headline of his Dec. 18 research note, “the night seems to go on incredibly long.”

Those waiting for the night to end will need patience. Capital spending will remain at $5.9 billion per annum, the company said. This is  beneficial in the long term as, among other things, it includes bringing on far more efficient freighter aircraft. However, it will restrain free cash flows at least through fiscal year 2022, Majors estimates. FedEx continues to work through its perpetually challenging integration of European carrier TNT Express, acquired in 2016 for $4.8 billion in cash. Full physical integration won’t occur until fiscal 2022; until then, FedEx will operate two networks in Europe. The integration, which has included the $300 million to $400 million expense of rebuilding TNT Express’ I.T. networks and customer base following the 2017 “NotPetya” cyber-terrorist attack on its operations, will have cost $1.7 billion by the time it’s complete.

Then there is e-commerce. FedEx is pouring billions of dollars into re-engineering its physical network to meet the growing demand for business-to-consumer (B2C) traffic. As it works toward improving service levels, it has been met by a lower-yielding mix of traffic, and by intensifying competition, most notably from Amazon.com Inc. (NASDAQ:AMZN), which is building out its own shipping network at lower delivery price points.

Flying low (Image: SONAR)

Amazon, and the myriad disruptions it has caused, isn’t going away. This has led Ravi Shanker, a Morgan Stanley & Co. analyst (NYSE:MS) and a bear on FedEx and rival UPS Inc. (NYSE:UPS) shares because of Amazon’s encroachment, to contend that FedEx’s challenges are structural rather than cyclical.  FedEx and Amazon ended their U.S. air and service relationships earlier this year, and Amazon threw another log on the fire Dec. 18 by blocking certain third-party sellers using its “Prime” product from using FedEx Ground for their deliveries.

FedEx executives did not pooh-pooh the results. Even the relentlessly upbeat Raj Subramaniam, the company’s president and chief operating officer, said he was “not pleased.” Chairman and CEO Frederick W. Smith acknowledged that the company underestimated the large cumulative startup costs of Sunday service, which starts at the turn of the year, handling online orders of heavier weighted, non-conveyable items, and taking on last-mile parcel deliveries that had been the province of the U.S. Postal Service (USPS). FedEx announced earlier this year that all of its former USPS business would be in-sourced by the end of 2020. 

Can-kicking is a hard habit to break, however. Because the Cyber Monday ordering extravaganza occured at the start of FedEx’s fiscal third quarter, the company didn’t reap the benefits of the additional business during the second quarter even though it absorbed significant costs in the period, Smith said. Shanker disputed Smith’s argument, saying that if Cyber Monday activity was going to contribute materially to FedEx’s fiscal third-quarter results, the company wouldn’t have announced Dec. 17 a further 15% cut to its already-lowered fiscal 2020 outlook. Thus, it strains credulity to believe the second-quarter results would have dramatically benefited by Cyber Monday falling earlier, Shanker said.

Smith also said the global economy is running on two tracks, with U.S. e-commerce demand remaining strong while domestic and international industrial production have shown virtually no growth for more than a year. FedEx’s business has long tilted toward the business-to-business deliveries that are linked with industrial activity, so demand weakness in that segment would certainly weigh. However, Shanker and other analysts noted that the company made essentially the same macro comments in its fiscal first quarter, when its results were nowhere nearly as weak.

In comments that will likely give economists and trade analysts pause given FedEx’s relevance to global commerce, Smith and other executives said the world needs to prepare for a very different trading environment than what has existed for the past 70 years during a long cycle of multilateralism.

It can be argued that FedEx is doing what any prudent business would do under the circumstances. It is upgrading its physical infrastructure in the U.S. and abroad. The company is reducing global miles flown by 6-8% in response to declining international airfreight demand as it awaits deliveries of more efficient and productive equipment. It is availing itself of the generous depreciation benefits, at least through 2022, that are embedded in the 2017 tax law. Sagging operating margins at FedEx Ground will rebound as the impact of hub modernization costs ebbs, and the network starts to build suitable B2C package density, company executives maintain.

The problem, as Wall Street and investors see it, is that this narrative has been on the table for five quarters, and the company has disappointed with each report. Two figures tell the story: A year ago at this time, the consensus earnings estimate for FY 2020 stood at $20 a share. Today it is around $11 a share.

The second? FedEx’s share price slid by more than 10% Dec. 18, closing down $16.37 a share to $146.86 a share. In mid-January 2018, shares traded near $275 a share.