The Shipping Wars: FedEx Et. Al.

Introduction

FedEx is the quintessential American corporation; or rather, its founder, Frederick Smith, is the quintessential American businessman. A former U.S. Veteran, Frederick Smith founded FedEx after leaving the Marine Corps in 1969 (I should add, after receiving the coveted Silver Star, the third highest decoration for valor in the U.S. Military) with a $4 million inheritance. FedEx was, and some say will always be, an air delivery company: Frederick himself was a pilot. Legend has it that you can’t take a tour of the company’s Memphis HQ without walking through a halfway adorned with framed pictures of the company’s 639 airplanes. This will prove to be a very important point.

Before digging into the history of Federal Express, what exactly is ‘Express’ shipping? Express is essentially any expedited, quick delivery system, often within 2 days and is interchangeable with “time-definite” shipping, that is, the customer can set a specific time to receive a delivery (i.e. Tuesday before 12pm). Traditionally, only time sensitive mail was shipped through an Express network, but, as you can imagine, E-commerce and our increasingly interconnected world has led to increased demand for this type of shipping. In the beginning, Federal Express was just that, an Express delivery service; the company didn’t become FedEx Corporation until 1998 with the acquisition of Caliber System Inc., which completely revolutionized the company’s operations (FedEx Corp. even changed its name to FDX Corp. as a result). Caliber System essentially added two separate services to FedEx in addition to Express: ground, through Roadway Package System, and freight, through Viking Freight. Ground shipping, or “day-definite” delivery, is a more relaxed shipping (think a 5-7 business day delivery) process that is usually conducted through a network of trucks and drivers. Viking Freight operated in the less-than-truckload freight market (literally things that can fit in a truck trailer). Caliber came with some other businesses, including a logistics business, but those represented negligible portions of revenue and were an afterthought in the acquisition. FDX re-branded its businesses into three segments: FedEx Express (a redundant name but that’s neither here nor there), FedEx Ground and FedEx Freight. More recently, FedEx added another segment, FedEx Services with encompasses everything left over that didn’t fit neatly into the other three segments like FedEx print locations. Services only makes up $1.7bn of ~$70bn in revenue and less than 5% of operating income so we need not worry ourselves with this piece of the business.

Here are some quick statistics for the Express business (note ADV is average packages delivered per day and margins were adjusted by me; aircraft fleet includes owned and leased):

Express hasn’t been exactly a star student but remains a world leader in the Express business. The company has two domestic hubs- a “Superhub” in Memphis and one in Indianapolis- and two international hubs- Liege and Paris. The largest development in the Express business was the purchase of TNT Express, one of the largest Express networks in Europe, in 2016.

The crown jewel of the enterprise, however, is the Ground segment:

From virtually nothing, FedEx Ground challenged the thrown from UPS in the United States over the past 15 years, growing revenues from ~$5bn in 2007 to over $20bn today while maintaining the best margins in the industry. FedEx Ground now controls ~30% of the domestic small package market.

FedEx Freight does not make up a large portion of FDX’S business but is formidable in its own respect:

FedEx Freight is the largest Less-than-Truckload (LTL) Freight company in the United States. While Express and Ground serve Business-to-Business (B2B) and Business-to-Consumer (B2C) accounts, Freight services primarily the B2C market and often transports bulk goods/commodities.

Industry

Express

FDX operates in 3 interconnected, but distinct industries and really has a unique way of thinking about the relationship between its different business units. Firstly, we have the Express market. The three big players in this market are FedEx, UPS and DHL Express. Unlike the Ground and Freight segments, this is an international market with each company having its own “foothold”. FedEx is prominent in the United States market, DHL Express has the edge in Asian markets and UPS has a strong presence in the European market. The issue with Express is that it is expensive- we are a long way from the invention of global commerce, yet shipping by sea is still significantly cheaper than airborne shipping. Intuitively, as E-commerce grows, so should the Express market; while this relationship does exist over the long-run, there is a significant lag and oftentimes the day-definite business benefits disproportionately from the rise of shipping. To give an example, here is a graph of the implied market size of the U.S. domestic Express business based on Air Traffic Data:

This comes out to a 2.7% CAGR (slightly larger than general GDP growth) despite E-commerce taking a significantly larger portion of total retail sales. Yet during this period, investments in the Express business have increased substantially with FedEx and UPS both adding 40 planes to their respective fleets. While we don’t have air traffic data for international markets (the Federal Bureau that complies air traffic statistics does not have reliable data for international carriers), anecdotally a similar trend is occurring. Of the largest Express carriers, only DHL Express is an Express-only service, similar to FedEx in its early days. DHL used to compete heavily in the U.S. market, albeit unsuccessfully against all-American businesses like FDX and UPS. The company decided to take the loss in 2009 and exited the U.S. business, leaving FedEx and UPS to consolidate the domestic market as a virtual duopoly. However, while this benefited FedEx and UPS early on, it had deep ramifications in the international business- DHL subsequently killed it in the European and Asian markets, increasing Express revenues from ~$9.9bn in 2009 to ~$16.1bn by 2018 while increasing operating profit almost ten-fold from $235mm to a staggering ~$2bn during this same period.

For obvious reasons, Express shipping is utilized for high-value items (think electronics), so the market remains small relative to the whole global transportation market. Some interesting trends are taking place, however. For example, the evolution of just-in-time and dropship inventory management programs may force certain companies to lean more towards Express shipping rather than day-definite delivery. And of course, the elephant in the room is Amazon, but Bezos deserves his own section later.

Ground

Unlike the Express segment, FedEx Ground is primarily a domestic business that operates in the continental United States: it doesn’t own any airplanes. In the 1990’s and early 2000’s, the domestic Ground business was completely UPS, but as we’ve seen, FedEx ground made a significant inroad in the industry with no sign of slowing down. There are two key differences between FedEx Ground and UPS that are worth mentioning: (1) FDX’s use of independent contractors and (2) the independence of FedEx Express and FedEx Ground. UPS drivers are all employed by UPS and unionized; they are paid more and operate using centrally distributed schedules. FedEx Ground drivers, on the other hand, are not FedEx employees- independent contracts purchase “routes” and employ their own drivers to service any business flowing through those routes (as a result, FedEx Ground drivers are not unionized). Secondly, UPS runs an integrated system combining its time-definite and day-definite operations. For example, if there is a truck headed to NY with Express packages, and a Ground package has the same end destination, employees will load the Ground package into the truck; as a result, UPS trucks aren’t branded ‘Express’ and ‘Ground’ and contain a mix of packages. FedEx, on the other hand, will have two separate trucks, one Express and one Ground. There are no integrated systems between the two businesses, so conceivably both trucks will head to the same destination, even if the packages can all fit in one truck.

As a result, it is difficult to compare the relative market shares of UPS and FedEx. UPS divides its operations into domestic and international while FedEx divides its operations into Express, which includes domestic and international Express, and Ground, which is all domestic. Based on my estimates, the most comparable “UPS Ground” is about ~$35bn in revenue (vs. FedEx Ground revenue of ~$20bn). If we believe FedEx has a 30% market share, which is what management argues in investor presentations/earnings calls, the total U.S. market is ~$67bn, giving UPS a ~52% market share. But when people talk about the transportation industry, they don’t delineate based on how long the shipment takes to get delivered. That detracts from the central question: how does shipping volume look like in the United States and how will that change over time? Combining the domestic Express and Ground businesses will give us a better understanding of this question. Looking at it this way, FedEx domestic revenue is ~$34.2bn (~$13.7bn domestic Express revenue plus $20.5bn Ground revenue) while UPS’s domestic revenue is ~$43.6bn, resulting in a similar market share split.

Freight

The domestic freight forwarding industry can be divided into two sub-segments: unionized carriers and non-unionized carriers. Most union carriers have gone bankrupt: the only large existing unionized freight carrier is UPS Freight. The “new-wave” of truck companies, the non-unionized ones, include Old Dominion Freight Line (ODFL), XPO Logistics (XPO), FedEx Freight and other smaller carriers. Of these three, only Old Dominion is a pure-play freight company (XPO has a large ‘asset-light’ logistics business; its freight business generates ~$3.9bn in revenue). Moreover, the freight industry is less prone to automation since shipments are usually “mission-critical” to businesses and procurement officers want a human point person to ensure timely delivery.

As seems to be the theme here, the pure-play, ODFL, is the best performer in the industry. Over the past 10 years, it has increased revenues from $1.4bn to ~$4bn and operating income from $130mm to ~$850mm (over 1,000 bps margin improvement). Since freight companies typically deal with bulk, low-value goods and commodities, we don’t measure output by number of shipments. Rather, we use efficiency figures like revenue per hundredweight and output figures like total tons shipped. Comparing FDX with its best-in-class peer Old Dominion, FDX Freight generates $266 per shipment in revenue vs. $339 for ODFL. You can imagine the scalable fixed costs- depreciation of the truck, the driver’s compensation, fuel costs to an extent- that translate into the stark margin difference between the two companies (8% for FDX Freight and 20% for ODFL).

The reason pure-play’s outperform integrated companies like UPS Freight and FedEx Freight is the interaction between different divisions. As we will see shortly, the majority of customers use multiple services (i.e. a business with an account at FedEx Express and FedEx Freight). Thus, money-losing rates may be charged in one segment to drive volume in another segment. Maybe industry participants would agree that FedEx Freight could probably increase margins to low double digits if it was spun off as an independent company, but it is important to consider the ripple effects this may have on FedEx’s other businesses. This is why, even if a spinoff makes financial sense, it would be difficult logistically (no pun intended) to separate these integrated companies.

The Elephant in the Room and USPS

Amazon is increasingly breaking into the shipping world, and this is cause for concern for incumbents. Recent events have also put this issue in the front page of newspapers. First, FedEx terminated its shipping contract with Amazon. Now, FedEx was never a large shipping partner for Amazon and Amazon represented only ~1% of the company’s revenues but was a symbolic event: FedEx realizes that Amazon is encroaching on the shipping business and it refuses to enable its own competition reach scale. UPS is a different story. 20% of Amazon packages are shipped by UPS, so it isn’t easy for them to terminate their contract. Overall, Amazon relies the most on USPS and UPS, but is increasingly becoming self-reliant (graph taken from WSJ):

Amazon also is entering into some sneaky deals. Amazon has entered into warrant contracts with Atlas Air (AAWW), Air Transport Services Group (ATSG) and StarTek (SRT) among others allowing it to purchase non-controlling stakes in these companies. Not coincidentally, these options allow Amazon to purchase various non-controlling stakes of these cargo carriers (from 19.9% of ATSG to 49.9% of AAWW), giving the company unbridled access to these fleets without having to consolidate these hard assets on its balance sheet. This is in addition to the 60 or so planes that Amazon already owns.


It is important to understand the relative sizes of these companies. Amazon is behemoth, but its logistics business still pales in comparison to FedEx and UPS. Both FedEx and UPS have 10 times the planes as Amazon, 8 times the trucks and a significant international presence. Moreover, Amazon only ships Amazon packages and there is merit in the argument that Amazon management proclaims in public: the larger investments in distribution reflect the growth of the company’s retail business, not as a foray into the logistics business. I don’t believe Amazon is entirely benign, but it also isn’t as aggressive as people argue. In addition, to reach a similar scale to FedEx and UPS, Amazon would most likely need a capital investment easily over $100bn. In the past 10 years alone, FedEx has spent ~$42bn in capex and UPS has spent ~$31bn while Amazon generates little cash after its investments in maintaining its software and retail business.

Amazon’s delivery operations are also unprofitable. In fact, last-mile delivery in general is a very unprofitable business and this makes up most of Amazon’s delivery (last-mile refers to the delivery from the local packaging/sorting center to a person’s residence). As we’ve mentioned, the name of the game in the logistics business is scale and last-mile delivery is inherently difficult to scale. Unless I ordered a truckload of things from Amazon, by the time the truck gets to my home it won’t be full. The issue for FedEx and UPS, however, is that people/investors are willing to subsidize a money-losing delivery business within Amazon but will punish the incumbents for running unprofitable roots. This sort of anti-competitive nature (if you want to characterize it as that), as long as it goes unchecked, may allow Amazon to reach the scale to eventually successfully compete against FedEx and UPS on a national scale.  

The USPS is also an afterthought of many people including investors in this space. However, it is incredibly vital for the success of FedEx and UPS. Think of a remote zip-code in Alaska that simply doesn’t have a high enough population to be profitable for a logistics company. For Amazon/FedEx/UPS/etc. the only way to profitably get packages to these remote areas is by using the USPS. In addition, as the infamously unprofitable last-mile delivery service is becoming more prominent due to E-commerce, more companies utilize the USPS (evidenced by USPS recently rolling out Sunday delivery services). Amazon itself shipped the majority of its packages through USPS just a few years ago (see graph above). The issue is that USPS is a dying business: the government sets rates, which are below break-even, and the company must serve these unprofitable roots. According to the Postmaster himself:

“In fiscal year 2018 the Postal Service recorded a net loss of $3.9 billion… While aggressive management actions have generated new revenue — principally in an expanding package business — and generated cost savings and productivity gains, the Postal Service’s business model is broken and will only produce widening losses in the coming years absent dramatic changes.”

USPS Annual Report

It is difficult to imagine a world without the USPS. It will certainly be a hit to many logistics companies as well as produce contagious affects for the growing internet economy. Only legislation and the political environment will determine the future of the USPS and whether it can continue to be a going-concern enterprise. The big takeaway here, though, is that Amazon is still extremely reliant on the USPS (and UPS to a lesser degree). Why? Because what they’re doing- last-mile delivery- is an unprofitable business that will be subsidized by shareholders only for so long.

How FedEx Sees its Business

Why did I explain the industry as three distinct segments? Well, this is how FedEx looks at its own business. The history of FedEx is extremely important when evaluating the state of the company right now. Naturally, these three segments are very interconnected: FedEx itself has this slide in every investor presentation:

Despite the inherent interconnectedness of its businesses, they are operated independently. Despite transformational changes within the company over the past few decades, one thing hasn’t changed since the company purchased Caliber Systems in 1998, and that is this line that’s been repeated in 10-K’s spanning the past 20 years:

“FedEx has developed a unique business strategy whereby our companies compete collectively, operate independently and manage collaboratively, which allows us to provide a broad portfolio of transportation, e-commerce and business services to our customers. Our companies compete collectively by standing as one brand worldwide and speaking with one voice; they operate independently by focusing on our independent networks to meet distinct customer needs; and they manage collaboratively by working together to sustain loyal relationships with our workforce, customers and investors.  

Our ‘compete collectively, operate independently, manage collaboratively‘ strategy allows us to manage our business as a portfolio, in the long-term best interest of the enterprise, not a particular operating company. As a result, we base decisions on capital investment, expansion of delivery, information technology and retail networks, and service additions or enhancements upon achieving the highest overall long-term return on capital for our business as a whole.”

FDX 2019 10-K

This sounds very reasonable: maximize value of FDX Corporation as a whole. But let’s push back a bit. Specifically, what drives the profitability of a logistics company like this? In other words, how can we maximize the value of a fixed asset base and what is the source of FedEx’s competitive advantage? Most people would answer scale. That is why last-mile delivery is so unprofitable that it must be subsidized by the United States government. The more packages you can fit per truck, the more efficient you are in delivering packages per minute and more business you have per route really drive profitability in this industry. It’s a highly fixed cost business, especially the Express segment: similar to commercial airlines, the profitability of Express will be determined by the average payload in each of the company’s 681 airplanes. But, according to this strategy, each company will operate independently, meaning Express won’t enjoy the benefit of an incremental $20bn of business from Ground, and Ground won’t benefit from the incremental $40bn business from Express.

To take an example, let’s assume I’m supposed to receive two deliveries: one PM Express delivery (i.e. after 12pm delivery) and one Ground delivery due for the same day. Well, I’m probably going to be visited by two trucks: one with an Express employee with my first package and another with an independent contractor delivering my Ground packages. Both trucks will have a lot of empty space. Anecdotally, I’ve heard numerous stories of people receiving packages within minutes of each other by two separate FedEx trucks. You can try it yourself: schedule an Express delivery and a Ground delivery to be delivered around the same time and get ready for two visitors. It’s a $30 experiment that reveals a lot about how FedEx runs its business. There is also no front-end integration between the businesses: businesses that utilize the services of Freight, Ground and Express (according to the slide above 79.5% of customers use all services as 98.6% use two or more services) will receive three separate invoices, deal with three different sales reps, and, of course, get their stuff delivered by three separate delivery men. Of course, separating freight makes sense given the differences between the types of products that are delivered through freight and the B2B focus, but Express and Ground are very similar businesses.

There is every reason to believe that FedEx would be more profitable if it combines its operations and eliminate this redundancy. Apart from the obvious, low-hanging fruit like back-office consolidation, it just makes logical sense that its cheaper to use less trucks/facilities/drivers to deliver the same amount of goods. Sure, but won’t FedEx drivers fail to deliver packages on time if the same truck contained both time-sensitive (Express) and non-time-sensitive (Ground) packages? Won’t this lead to a worsening of on-time percentage, an extremely important metric for a logistics company, especially for B2B accounts? I would be sympathetic to this argument, but UPS is doing it just fine: the on-time percentage of UPS is virtually identical to that of FedEx. I will concede that FedEx also has this slide in its investor presentation:

But this was an internal analysis with no outside backing. It also has no mention of on-time percentage, which is a far more important figure. Moreover, when you talk to businesses, most report similar qualities of service from FedEx and UPS, and other accounts say otherwise:

“USPS posted the best on-time delivery rate in peak season 2018 with 98.8% of Parcel Select deliveries made on time, followed closely by UPS at 98.3% on time and FedEx at 97.6%, according to data from ShipMatrix”

Supply Chain Dive, 2019

This argument falls under its own weight when presented with the facts.

Perhaps a cultural mismatch? This seems like a more plausible explanation. Most FDX’s C-suite comes from Express. FedEx’s roots are in its Federal Express business in the late 1900’s. Fred Smith himself was a pilot while he served in the military. FedEx never fails to boast about how it has the most planes in the industry. The Ground segment, despite being the most profitable and fast-growing segment of the business, is an afterthought within the company. Is this worth sacrificing 400-500 bps of operating margin every year (equivalent to ~$3bn in operating income- we will get to this calculation later)? Probably not, but there’s another reason that may trump the financial incentive to integrate.

The Union Issue

Given that FedEx Ground is probably the biggest success story in the modern logistics industry (some would argue the title belongs to XPO, but I have my qualms), it pays to understand what about its business model led to such success. This biggest difference between FedEx Ground and UPS would be the workforce: independent contractors are paid less than UPS drivers ($40,000 for a FedEx driver vs. $70,000 for a UPS driver). If these drivers were considered employees, however, chances are they will unionize, argue for higher salaries and benefits, hurting FedEx’s advantage. Now, while there is no set standard for companies to determine whether people working for the firm are employees or IC’s, the IRS has laid out the following guidelines:

“The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work, not what will be done and how it will be done. To better determine how to properly classify a worker, consider these three categories – Behavioral Control, Financial Control and Relationship of the Parties. Behavioral Control: A worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised. Financial Control: Does the business have a right to direct or control the financial and business aspects of the worker’s job? Relationship: The type of relationship depends upon how the worker and business perceive their interaction with one another.”

IRS Guidelines

Specifically, the “degree of control” matters:

“Degree of Instruction means that the more detailed the instructions, the more control the business exercises over the worker. More detailed instructions indicate that the worker is an employee.  Less detailed instructions reflect less control, indicating that the worker is more likely an independent contractor”

IRS Guidelines

Over the past several years, pockets of Ground drivers across the country have been pursuing litigation against FedEx arguing this very reason: FedEx exerts significant control over their work, and they should therefore be classified as employees. FedEx has prevailed in these litigations thus far. However, if the Ground and Express networks were combined, suddenly drivers who previously had some leeway in determining their work schedule for Ground shipments must now handle Express shipments that need to be delivered by a certain time. If there’s an 8am delivery in that truck, then the driver needs to get up in the morning even if every other package is a Ground package that can be delivered at any point in the day. Given this, a stronger legal argument can be made that FedEx will be exerting “significant influence” and a much higher “degree of control” over the IC’s work schedules, and FedEx might have to yield and classify IC’s as employees.

A similar situation exists for Express workers. Due to the nature of time-sensitive shipments, work stoppages and strikes can yield havoc for Express businesses. This was a big deal in the early 1900’s in the case of railroads, leading the government to enact the Railway Labor Act of 1926 (RLA). This law essentially laid out a set process for employees to work out grievances with the parent company; in other words, it make it more difficult for employees to stop the operations of an Express business, go on strike or otherwise disrupt the daily package flow of an Express carrier. The key here is that this classification only applied to employees of railroads and other “Express carriers”:

“The term ‘‘carrier’’ includes any railroad subject to the jurisdiction of the Surface Transportation Board, any express company that would have been subject to subtitle IV of title 49, United States Code, as of December 31, 1995, 1 and any company which is directly or indirectly owned or controlled by or under common control with any carrier by railroad… All disputes between a carrier or carriers and its or their employees shall be considered, and, if possible, decided, with all expedition, in conference between representatives designated and authorized so to confer, respectively, by the carrier or carriers and by the employees thereof interested in the dispute.”

National Railway Labor Act of 1926 Text

Currently, FedEx Express is designated as an Express carrier under the RLA. However, if the company were to merge its Ground and Express networks, it may lose this classification, giving employees free reign to strike or join a national union (as is with the case of UPS). As an aside, given this, you can probably imagine how much Frederick Smith hates unions.

FDX doesn’t say this. You can imagine how much of a PR blunder this would be if announced. FedEx will give you one of the other reasons I’ve mentioned here, yet this is the only one that holds muster. By employing an almost fully non-union workforce (the pilots are unionized by Fred loves his pilots and they’re taken very good care of), FedEx has more flexibility not afforded to union carriers like UPS. Things like layoffs and replacing workers with drones can be done much more efficiently by FedEx relative to its more profitable counterpart. But is it worth it? The last time UPS has to endure a strike was 1997. Notwithstanding the independent contractors, Ground has 110,000 employees that have not unionized despite not having RLA classification. 46,000 freight employees have not unionized either. Yes, it pays its drivers more but, as we will see, having a less redundant shipping network more than pays for these higher benefits. On the other hand, perhaps the strategic advantages of such a deconsolidated system and the flexibility afforded to FedEx more than compensates for the tangible financial impact. Fred Smith turned this company from nothing to the second largest logistics company in the world by revenue: he is much smarter than me and he prefers this system. Maybe he’s right, but the numbers don’t lie.

Financial Implications

The costs of operating separate networks are significant. FedEx’s operating margin has always been 400-500bps lower than that of UPS. The reason is simple: despite having virtually the same revenue base as UPS, FedEx has a substantially larger capital base:

De-constructing this a bit, the majority of FedEx’s EBITDAR advantage comes from its utilization of independent contractors in its Ground segment (~50k independent contractors paid $30k less than UPS drivers equals 50k*30k=$1.5bn in savings. $1.5bn/$70bn = 2.1% margin differential explained by this, roughly). However, this is more than offset by the “cost of the company’s asset base”, which we can take to be depreciation plus rent expense. This comes out to $6.7bn/$70bn=9.6% of revenues for FedEx and $3.1bn/$72bn=4.3% for UPS. We also see this in essentially every operating and efficiency metric between the two companies (note: ATM is available-ton-miles which is essentially a measure of capacity for cargo airlines):

This has also resulted in FedEx trading at a lower multiple to UPS (7x EBITDA vs. UPS at 10x). This gap narrowed to 1 turn of EBITDA in 2017, but then FedEx bought TNT Express and everything went to shambles again. Over the past 10 years, FedEx’s operating margin has averaged ~7.5% while UPS’s operating margin has been ~12%. FedEx’s large capital base has also resulted in a paltry cash conversion performance: 15% of operating income converted to FCF over the past 5 years vs. 44% for UPS. While revenue growth over the past five years have been similar for both companies (~5.5% for FedEx and ~5.6% for UPS), capex was wildly different (8.7% of revenue for FedEx and 5.9% for UPS). To be fair, UPS did recently admit that they’ve underinvested in PPE for the past decade, and plan to ramp up spending over the next three years; however, this does not justify such a significant difference between the two companies. It also doesn’t explain why UPS was able to operate essentially an identical business in terms of both nature and scale with almost double its nearest competitor’s margins.

So, UPS seems like a prime example for the case for integration. How would this look like for FedEx? Operationally, perhaps the best workaround for the union situation would be the way FedEx assigns workers to certain deliveries. Express AM deliveries (time-sensitive morning deliveries) are the most time-sensitive, Express PM can be delivered in the afternoon and Ground deliveries are the least time-sensitive. Therefore, FedEx can assign current Express/Ground employees to Express AM deliveries while assigning Express PM/Ground deliveries to employees and independent contractors. This may preserve the RLA status for Express employees without exerting “significant control” over independent contractors. However, there is no way to know whether this will work and even if it is possible logistically. Though I will also say that given the demeanor of the company’s C-suite and Fred’s dual love for Express and aversion to integration, I am fairly confident an internal study on the feasibility of such an integration has not been conducted. How would this look financially? Well, the obvious exercise is to look at UPS’s margins as the upper bound of what is achievable for FedEx. UPS is an extremely well-run company but so was FedEx for 20 years. More realistically, however, FedEx would probably not do a full integration given its size, and it would be more reasonable to assume FedEx can achieve a percentage of the difference between the two companies’ profitability. This would take the form of driver reductions and facility closures/consolidations.

If you were to combine FedEx’s domestic Express and Ground businesses, you essentially have a U.S. delivery business with the following characteristics: about 90,000 drivers and 1,300 facilities handing ~12m daily packages. The comparable UPS domestic company has about 75,000 drivers and 1,000 facilities handling ~17.5m daily packages. On a per driver basis, therefore, FedEx handles about 133 packages and UPS handles 233 packages; on a per facility basis, FedEx handles 9,231 packages and UPS handles 17,500 packages. If we can close each of these gaps by 50%, this would imply eliminating 90k-12m/183=24,000 drivers and 1,300-12m/13,366=400 facilities. We know drivers cost $40k/driver/year for FedEx, so the savings from the 24k reduction would be on the order of $960m. We don’t know what the cost of a facility is but anywhere from $5m-10m/year would give us potential savings of $2-4bn. This corroborates nicely with our margin picture: taking the low end of ~$3bn in total savings is about 4.2%, which would bump FedEx’s margin from 7.5% to 11.7% vs. UPS margin of ~10% (remember FedEx has the inherent ~300bps EBITDAR advantage to UPS because of its independent contractor model). Of course, these estimates could be way off, and I have no way of knowing the unit economics on a per route/per driver/per facility basis nor the interaction between these variables. There is also the unionization risk which would all but wipe out the EBITDAR advantage FedEx currently has over UPS. The point of this exercise is really to show the magnitude of savings that FedEx is leaving on the table in order to run two separate businesses: it is on the order of billions of dollars.

TNT Express

Moving away from domestic operations, let us discuss the blunder that was TNT. By way of background, FedEx acquired TNT back in 2016. TNT was a large Express operator in continental Europe with a large ground network presence (unlike FedEx, every other logistics company integrates their ground and express networks). Europe was traditionally dominated by UPS and DHL; FedEx could never seem to penetrate the market organically. Therefore, the company decided to do what it did with Caliber in 1998: buy an established business, rebrand it as FedEx and win Europe. This was after a failed attempt by UPS to buy the company in 2012 to strengthen its position in Europe. UPS offered $6.4bn, which was rejected (it then offered $6.8bn which was again rejected). Interestingly, the goal was to integrate TNT’s Ground network into FedEx’s established Express network in the region (something the company is very stubborn to do with its own network in the U.S.!)

Everything went well. It was by no means a bad acquisition, but an uncontrollable event occurred at the most unfortunate time just as FedEx began the integration process: NotPetya. For those not familiar with this cyberattack, I encourage you to read this Wired article that explains it in depth. Here is an excerpt:

“The release of NotPetya was an act of cyberwar by almost any definition—one that was likely more explosive than even its creators intended. Within hours of its first appearance, the worm raced beyond Ukraine and out to countless machines around the world, from hospitals in Pennsylvania to a chocolate factory in Tasmania. It ­crippled multinational companies including Maersk, pharmaceutical giant Merck, FedEx’s European subsidiary TNT Express, French construction company Saint-Gobain, food producer Mondelēz, and manufacturer Reckitt Benckiser. In each case, it inflicted nine-figure costs. It even spread back to Russia, striking the state oil company Rosneft. The result was more than $10 billion in total damages, according to a White House assessment confirmed to WIRED by former Homeland Security adviser Tom Bossert.”

WIRED, 2018

FedEx took at $300m charge because of the attack. It later went up to $400m. All in all, total integration expenses, which were supposed to be $400-500m and substantially completed by fiscal year-end 2018, ballooned to an estimated $1.7bn and integration isn’t expected to be completed until year-end of FY2020. According to industry participants, the attack pretty much debilitated TNT’s entire European operations; others say that TNT would be no more had FedEx not been there to keep it afloat. Finally, the intangible costs of lost customer relationships and loss of goodwill are even higher: TNT’s operations were down for a full two weeks and thousands of deliveries stopped in their tracks. FedEx never gained the much-coveted foothold in Europe though the acquisition nor did it gain any boost in operating income from this $4.8bn (and counting) acquisition. FedEx is still trying to bring TNT back on its feet, but even former executives of TNT pre-acquisition believe there’s no coming back. FedEx has traditionally been a strong international operator, but Europe remains a soft spot for the company.

Valuation

Valuation of FedEx is a daunting task primarily because it depends heavily on who is running the show. Fred Smith has created enormous shareholder value and is respected in industry circles and by investors alike. Competition is also fierce- UPS is a wonderfully run company and Amazon is creeping into the fray. There is also the issue of capex. FedEx is currently spending between $5.5bn and $6bn on capex every year. Management will tell you that a good portion of this is for growth (for example, the company has been working on modernizing its Memphis hub for a few years now and the total toll will be over $1bn). Free cash flow, as a result, is essentially breakeven. We can take UPS as our poster child as well: it has spent an average of ~6% of revenue on capex every year, or ~$2.8bn on average for the past 10 years. But UPS will be the first to tell you that they’ve underinvested in its infrastructure over the past decade; capex for the past two years clocked in at $5.2bn and $6.3bn, right along the FedEx trajectory. But they’ll also tell you about half of this is for a modernization plan that began in 2017 that will cost $7bn in total over the next 2 years. Part of me thinks modernization is synonymous with maintenance in this industry.

Surely FedEx isn’t a breakeven business: leading up to the TNT acquisition, the company was producing over $1bn in FCF. Since FedEx and UPS are virtually the same business organized in different ways, perhaps it seems reasonable to use an apples-to-apples multiple to value the two. On an EBITDAR basis, FedEx is trading at ~6x ($71bn EV/$12bn EBITDAR) and UPS is trading at 11.5x ($121bn EV/$10.5bn EBITDAR). Based on this, FedEx could potentially double. But isn’t UPS a better company? It has higher margins, cash conversion, strong market share in not just the U.S. but also in Europe. On the other hand, UPS is more reliant on Amazon and every indication tells us that Amazon is looking to take its business elsewhere, a huge revenue risk for UPS. Many would also make the argument that FedEx has the better CEO: up till 2017, FedEx generated much more shareholder value than UPS in the same industry.

And then there’s the integration issue. If FedEx integrates its domestic Express and Ground networks, I think it can add over $2bn to operating earnings and increase margins/asset utilization significantly. If it successfully integrates what’s left of TNT and thrive in the European market, this will also remove a huge roadblock that has been weighing in on the stock for over 2 years. Will integration ever happen? Under Frederick Smith, I doubt it. But the possibility isn’t 0%, and a new CEO may be willing to take the jump. Moreover, issues like TNT and missing earnings estimates 3 times in a row have also made FedEx cheap relative to its historical self. Whether this means anything or not is in the eye of the beholder.

Given this uncertainty, this is how I view the company. The company’s Ground business is a growing (~11-12% CAGR for the past 10 years) $20.5bn company with a 13% operating margin. In fact, the company has averaged about a 15% margin and there is nothing in the business that suggests anything has changed. At this rate, the company is producing ~$2.8bn in operating income. Minus corporate allocations based on revenue gives you ~$2.5bn in operating income contribution. This business itself is worth at least $30bn ($115/share) and would probably fetch a 15-20x multiple on a standalone basis. This makes up over 75% of the company’s market cap. The Freight segment is a fairly stable 7-8% margin business with $7.6bn in revenues. Taking away corporate allocations gives you about $400m in operating income. For being the largest freight operator in the United States, this company could reasonably be worth $4-5bn ($15-19/share). Thus, the Freight and Ground business taken together are probably worth more than $135 a share. The value of the Express business is anyone’s guess. The business is earning ~$1.7bn in operating income after corporate allocations but for the past five years has spent an average of $2.7bn/year in capex. It is, however, one of the largest Express shipping companies in the world with room for growth and margin improvement (DHL, the best pure-play Express comparable, has a margin of 12%). I think an easy argument can be made for Express to be worth at least $40/share (~$10bn) based on $40bn in revenue generating a 5% FCF yield trading at 5x and can probably be worth more if the company can figure out how to make Express cash flow positive.

Conclusion

The way I approached this valuation is not how management thinks about the business. Management is very pro-Express when in reality is has really just been a drag on cash for the past decade. The other possibility is that Fred Smith has a grand vision for Express that will materialize in the future in the form of the largest best-in-class Express shipping company in the world with stellar margins. Similar to the Ground business today in the United States. I don’t think that is the right way to look at the business though.

The star of the show here is really Ground. It has been the one constantly outperforming business within FedEx over the past several years. It is also the most valuable. I personally believe an integration of Ground and Express will eliminate redundancies and produce significant improvements in margins, but this is a remote possibility given the dispositions of the people calling the shots. I also don’t know how a spinoff would work in this situation given Ground’s branding, but it is possible (albeit unlikely). There have also been some interesting changes in senior management recently, and Fred is also nearing retirement: this may catalyze some change.

The key to producing value as the company stands today, however, would be better performance at Express. It is not a structurally unprofitable business but is languishing in the shadow of overcapacity and a global supply/demand imbalance. If management can turn the cash flow generation button on, I think the stock will see significant improvement. Even less, I believe investors will do well if FDX can simply breakeven on a FCF basis.

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