The leap of faith at FedEx

FedEx Corp. has managed through multiple “show-me” moments in its half-century of operations. But none may be as important as what transpired Tuesday night.

FedEx’s (NYSE: FDX) fiscal 2023 second-quarter results, coming on the heels of a first quarter that included a pre-announcement of shockingly bad numbers, were important in trying to convince analysts, investors and the transportation community that the business either has been stabilized, albeit at what would be considered lower-than-expected levels, or that another step down in expectations would be necessary.

Clarity won’t be gained in three months. But one thing is clear: FedEx has moved quickly and with some heft to get ahead of a weaker across-the-board demand environment that is unlikely to improve in its fiscal second half. International air volumes are expected to be weak and yields will be pressured as budget-conscious shippers trade down to a less expensive but lower-margin nonpriority delivery option. 

In the U.S., e-commerce, which before the COVID-19 pandemic accounted for 16% of retail spending and which jumped to 22% during the outbreak, today accounts for 18% to 19% of retail activity and may go lower before it finds a suitable level. The slowdown will require a revenue reset for FedEx Ground, the company’s U.S. ground delivery unit and the transporter of virtually all domestic e-commerce.

The aggressive cost-reduction measures are a new leaf for a company that in the past has been criticized for sacrificing efficiency on the altar of revenue-chasing, and whose first-quarter results stemmed from not being able to cut expenses at its FedEx Express air and international unit fast enough to offset a sharp and sudden volume decline.

FedEx said Tuesday that it identified $1 billion in additional savings since mid-September when it pre-announced first-quarter results. It provided more detail on a program launched in the first quarter called DRIVE, whose core mission is to save $4 billion in annual costs by fiscal 2025 and to make those savings permanent. It also cut FY 2023 capital spending to $5.9 billion, a $400 million reduction from recent levels and $900 million below original projections.

According to Helane Becker, analyst at Cowen & Co., FedEx historically spends the rough equivalent of 10% of its annual revenue. This fiscal year’s capex looks to be closer to 6.2% of revenue, Becker said. The capex-to-revenue ratio reduction should be “viewed favorably by investors,” she wrote.

The cost cuts did help FedEx report earnings per share of $3.18, which beat consensus estimates by 36 cents. At FedEx Express, the company’s largest unit and where most of the cost cuts are being directed, profits rose sequentially by $164 million to $352 million. However, given that the unit’s first-quarter 2023 operating income plummeted to $186 million from $660 million, last quarter’s rebound, which equated to a 3.2% operating margin, was “nothing to get excited about,” said Amit Mehrotra, analyst at Deutsche Bank AG (NYSE: DB).

In fact, there was little in the second-quarter results to thrill folks. Total year-on-year revenue dropped by nearly $700 million to $2.28 billion. The second-quarter top line represented a $700 million miss from the low end of the company’s estimates. On an adjusted basis, profits declined $453 million to correspond with the revenue drop, not a positive scenario.

FedEx Express’ revenue fell 6% on a 12% decline in volumes, a disappointing outcome because it coincided with part of the peak holiday shipping season. FedEx Ground, the company’s U.S. ground delivery unit, posted a 24% gain in operating income due primarily to a 13% yield increase and to cost reduction efforts. Revenue rose just 2% and average daily package volume declined 9% to 9.4 million daily packages.

Even FedEx Freight, the company’s less-than-truckload unit and the company’s top performer of late, hit a pothole or two. Revenue rose 8% while operating income increased 32% due to yield-improvement steps. However, the unit’s profits fell sequentially to $440 million from $651 million. Company executives on Wednesday’s analyst call attributed the drop-off to a decline in average shipment weight. Not mentioned was a weakening industrial sector — an LTL carrier’s bread and butter — that forced the unit to furlough an undetermined number of drivers until early March.

Investors who’ve seen FedEx’s share price fall 33% over the past 12 months apparently felt that hurdling a low bar was better than being hit again by it. Shares on Wednesday rose $5.64 to close at $169.99 per share.

Analysts burned by the September pre-announcement and the withdrawal of earnings guidance for the rest of the year are trying to give the company the benefit of the doubt. It isn’t easy. Ravi Shanker, analyst at Morgan Stanley & Co., (NYSE: MS) applauded management’s quick cost-cutting actions and being as “open and transparent as possible” about them. However, Shanker said that the “real question investors will be asking is what these actions imply about the underlying revenue base.”

Shanker has a $130-a-share price target on FedEx, well below the targets of its peers. In his note, Shanker said he would review his target price following Tuesday’s results and the subsequent call.

The concern among analysts is that the full-year adjusted and diluted earnings per share estimates of $13 to $14 assumes about a $6.90 combined EPS over the next two quarters, which is currently below consensus of about $8 per share. Mehrotra of Deutsche Bank said the company’s full-year guidance implies that second-half EPS expectations need to decline by about 13%.

FedEx raised its calendar 2023 published, or noncontract, rates by 6.9%. Company executives expressed confidence in capturing the lion’s share of that increase. Yet uppermost on analysts’ minds is not revenue enhancement but cost discipline. As Becker of Cowen put it, FedEx “needs to improve their costs for the shares to trade higher.”

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Editor: Mark Solomon