FedEx: Deeper and Bolder Drive Needed – BMO Equity Research Explains

Speaker 1:

Welcome to Markets Plus. We're leading experts from across BMO discuss factors shaping the markets, economy, industry sectors, and much more. Visit bmocm.com/marketsplus for more episodes. The views expressed here, are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries.

Speaker 2:

Today, we have a special episode from BMO's IN Tune podcast that aired on July 30, 2023. BMO’s Fadi Chamoun, Transportation Analyst, and BMO’s John Stephenson, Special Projects Contributor, discuss their recent report on FedEx and its well-received cost reduction plan. Let’s take a listen.

Camilla Sutton:

What is the state of parcel delivery today? And how do FedEx and UPS stack up? That is where we're going on today's edition of BMO IN Tune Podcast. I'm Camilla Sutton, Managing Director and Head of Equity Research and Canada in the UK, and I am joined by two of our equity analysts, Fadi Chamoun, transportation analyst, and John Stephenson, Special Projects analyst. Today we will be getting their insights from their co-authored FDX UPS comparative analysis report released on July 19. Fadi and John welcome, and Fadi, why don't we kick it off with you. Why don’t you run us through what the catalysts were behind writing such a deep dive on the parcel industry with the focus on FedEx.

Fadi Chamoun:

Thanks, Camilla. So, we have published several deep dive reports on the parcel industry over the past five years and we generally outline the cautious long-term outlook for the industry in those reports. This latest report we published on July 19, actually approached it with a positive bias towards FedEx stock. You know, we think that FedEx’s earnings per share have bottomed at around $15 per share this cycle. Management has outlined a very sizeable cost reduction plan and we have seen in recent results, at least the last two quarters, some proof points around, you know, positive execution towards those cost reductions. And we also believe that we may be approaching the bottom of the freight cycle. So, it felt like the past may be supportive at this point to be more constructive in terms of our outlook for parcel and especially FedEx. But as we progressed in the analysis, three things I would say, became clear to us and were outlined in the report with a lot of details. One, we started to doubt that the company cost saving plan goes far enough. And more specifically, I think, we doubted that the margin improvement has sustainability power over the medium to longer term. Second point is that our view of the freight cycle has worsened. I think we are seeing a lot of excess supply in various modes, air, ocean, parcel, truckload. And ultimately we feel that the demand environment is going to be muted for a sustained period of time. So our freight cycle outlook is cautious. And lastly, valuation has increased, which I think made the risk reward on balance a lot more neutral. This is non-consensus view, by the way on FedEx, as most of our peers, and even buyside conviction, have generally been more constructive.

Camilla Sutton:

Thanks for that Fadi. So maybe putting the cycle and the valuation aside for now anyways, why don't we drill down into your first point? Why do you believe that FedEx turnaround plan does not go far enough?

Fadi Chamoun:

Yeah, I mean, there are many factors that were outlined in the report that underscore why we are lukewarm about the sustainability and the impact of this turnaround plan on FedEx. I think the most important point is we think the industry is becoming more fragmented, and more competitive. That is, the parcel last mile package delivery industry. We think that the pandemic has caused significant distortion in the parcel freight cycle because it caused a significant capacity squeeze and drove powerful gains in pricing. But underneath all that, the industry has become more fragmented. UPS and FedEx currently move less than 40% of the small package business versus 80% in 2010. Amazon is now bigger than FedEx and UPS and most regional carriers have also gained a significant amount of market share of small package today versus less than, you know, 1% in 2010. They're almost 9% of the package industry today, those are regional carriers. So the market is more fragmented generally. And we think that the strong pricing power that FedEx and UPS exerted during the pandemic, which helped them offset you know, inflationary pressure and density problem, is more unique to the pandemic dynamic than really the underlying overall pricing power that the industry have over the medium/longer term. Look, e-commerce packages are the most expensive packages to ship on the parcel integrated networks of FedEx and UPS. We estimate that these carriers have the highest cost to operate for local e-commerce deliveries, basically relative to Amazon and relative to those regional carriers, and e-commerce deliveries are becoming increasingly a bigger portion of packages, so 80% to 90% of the deliveries that FedEx and UPS will make are e-commerce residential deliveries. And ultimately, they are operating with higher costs than their peers into a market that is very inflationary. And because the market is fragmented their pricing power is limited. And I would say that, you know, retailers like WalMart, Target, you know, all retailers, I think, are moving there -- how they deliver their packages into a more local delivery, environmental Omni channels, local distribution centers near the population centers, basically to accomplish two things: to reduce the cost of transportation, and also to be able to meet that next day quick delivery that the customer wants. And I think that that really that dynamic isn’t favorable for the FedEx and UPS networks overall. So while FedEx is attempting to close the productivity gap relative to UPS, and that's a promising initiative and to deliver significant cost savings, it is not clear to assume that this strategy will lead to sustained improvement and margin for the ground segment over time because of these factors.

Camilla Sutton:

So Fadi, if ground faces all these structural challenges, what about Europe or international and their profitability? Can FedEx move the needle enough in these segments?

Fadi Chamoun:

Yeah, I mean, those are the two big areas that FedEx has opportunities to improve their air freight network, and ultimately, domestic Europe operation where we think, you know, they lose a lot of money today and those operations within Europe. Look, in the air cycle, there is a lot of capacity that is coming into the market. Load Factors are already at six years low, at least six years low. That's kind of the data we have; and capacity is still outgrowing demand. And we think demand is going to be generally very muted over the next couple of years. So we think it's going to be really difficult for FedEx to move the needle meaningfully enough in the air freight segment in the context of an oversupplied market and pressure on pricing. Now, domestic in Europe, you know, FedEx’s path towards profitability is predicated on winning share against well-established and well-managed competitors, like DHL and UPS. So conviction around the past to improve is really not very high for those two segments, at least not in the next 12 to 24 months, I think it's going to take a little bit of more demand momentum recovery in order for them to achieve some, you know, big enough improvement in those segments over the next few quarters.

Camilla Sutton:

So John, let's pull you into the conversation now. Can you walk us through FedEx’s cost savings plan and why you and Fadi don't think it goes far enough?

John Stephenson:

Yeah, well, there's several reasons, but primarily amongst them is the fact that UPS is such a larger enterprise in terms of the number of packages that moves through its US domestic package network. It moves roughly 65% more packages than do the combined FedEx Express and ground operations in the US. And what that leads to in turn, is a productivity gap that we estimate could be as much as 90% more productive in the case of UPS and FedEx when you look at the efficiency of the pickup and delivery operations. And because they have this greater volume of packages, UPS benefits from a strong network route and dropped density. And all the substantial volumes all move through the single integrated network, which allows them to have a much more productive pickup and delivery operation than FedEx. And FedEx, on the other hand, uses two networks a ground and express to service local markets in the US. And oftentimes you see ground and express trucks passing one another on the same street. FedEx Ground pickup and delivery drivers are contractors, which gives FedEx quite a bit of flexibility, but the Express drivers are company employees. And we think given the shift towards higher volumes of e-commerce packages, this is really hugely inefficient and needs to be addressed by the company. As the pandemic ensued, FedEx volumes and those at UPS surged, but costs at FedEx rose twice as fast as they did at UPS. And this has led to a cost per package of FedEx that now is above that of UPS and FedEx Ground you would think with its more flexible, contracted pickup and delivery network would have would have been able to handle this volume surge a little bit better than that of UPS. But what actually happened was that UPS had far greater operating leverage with their largely fixed-cost model. Their pickup and delivery drivers just move greater volumes of packages leading to greater efficiency and greater productivity. FedEx has said that e-commerce growth is going to account for 90% of the growth of the company going forward. Given that, we believe that the best solution would be for FedEx Ground contractor network to deliver or at least substantially deliver all of FedEx US volumes. The company has identified savings in the pickup and delivery operations of a total of $450 million, which we believe is way too conservative. If we look at taking 100% of all the US Express volumes and having Ground deliver it, that could result in our estimate of labor savings of about $3.8 billion. And that doesn't include savings from consolidating the real estate, as well as GNA savings that would come from operating a single pickup and delivery network in the US as opposed to two pickup and delivery networks. We believe the current plan is just too conservative and not bold enough. Given the rising level of competitive intensity we're seeing in the industry, the weaker macro outlook, coupled with a greater industry fragmentation, we believe that FedEx should be much more aggressive in integrating their networks. In fact, if the US Express volumes were all delivered by FedEx Ground, FedEx pickup and delivery productivity would be about 87% of UPS, a very significant increase.

Camilla Sutton:

Wow, that certainly is. Thanks for that, John. Maybe let's go back for a minute to fragmentation in the market. Amazon is such a large player and the Postal Service or USPS is more aggressively targeting the parcel market as well. How do you see the risk of Amazon who is directly competing with FedEx or UPS?

John Stephenson:

Sure, Amazon is potentially an incredibly significant competitive threat to both UPS and FedEx. While the United States Postal Service is currently a larger carrier of packages than Amazon it really is a small package capacity taker, whereas Amazon can cherry pick its deliveries. So if Amazon has packages to deliver in rural areas that are not profitable, it can turn those packages over either to UPS or the United States Postal Service for delivery. It keeps only the most route-dense package volumes for itself. Amazon's cost per package to deliver is roughly 64% of UPS, and 53% of FedEx, but that's if the sources of shipping revenue are excluded. So unlike the others, Amazon gets shipping revenue from several sources. It gets some from Prime memberships, and it's fulfilled by Amazon service, which is a service for third party retailers on its site where it offers shipping and fulfillment services. If you put those costs against their cost for delivery, their unit cost for juggling packages is around 15% of FedEx and UPS. As well, Amazon is UPS’s single-largest customer -- that likely in our estimation gives it a significant influence over the relationship. Amazon has done an incredible job in the last decade going from zero packages delivered to being larger than both UPS and FedEx. If its significant capacity were also used to offer delivery services to third parties, we believe the level of competitive intensity of the industry would rise very dramatically.

Camilla Sutton:

Thanks, John, you sum that up really well. So Fadi, back to you -- help me understand this a bit more? What does this all mean for UPS?

Fadi Chamoun:

Yeah, I think the roadmap for sustained performance in the large domestic segment for UPS is basically very challenged. The new management team, led by Carol Tome, did a really phenomenal job during the pandemic in terms of shifting the revenue quality higher and leveraging the pandemic unprecedented demand to drive strong pricing, gain and even used a lot of the free cash flow to pay down debt, de-lever the balance sheet. So I applaud all those things that they have done. But we feel that there is less gas in the tank at this stage, a fragmented market, more price competition, more inflationary cost pressure on the cost per package -- the roadmap to really sustain this performance seems to us very, very challenged for UPS. And, you know, I think ultimately, the fact that we talked about an international market, whether it's Europe, or the air freight market, could also weigh on the other segment, for UPS where their margins are well above normal trends, because we're still seeing the benefit of the pandemic play into those numbers. So, we are even more lukewarm on the outlook for UPS and its earnings for the next couple of years than we are for actually FedEx, because in the case of FedEx, like we said, you know, there is a goal here to achieve $4-$6 billion of cost savings. What we're saying in this report is that that's not high enough, they should be able to do a lot better than that. So there is at least I think in the case of FedEx, an opportunity to deliver significant cost savings and ultimately, potentially position the company to be in a much stronger competitive position. But, you know, John and I went through some of these factors -- they don't seem to have a plan to go deep enough and ultimately, you know, we think granted, the risk reward is a little bit more balanced at this level.

Camilla Sutton:

So Fadi, why don't we look at closing up here. But before we do that, can you give us some of your thoughts about the freight cycle in general? Fadi Chamoun: Yeah, I mean, that's been probably in my 25-year career and sellside one of the most confusing freight cycles. I think the pandemic probably caused a lot of these, you know, distortion, but we track a lot of leading demand indicators. Some are proprietary demand indicators, like the RDI. And some are macro indicators like the PMIs that have a high degree of correlation with freight volume, on balance, who really don't see an inflection point in demand for freight transportation capacity on the horizon. If we drill a little deeper, we find that there is maybe a good case that b2c or consumer-type freight has bottomed. But the b2b or industrial manufacturing freight is still on a downward trend, arguably with the Fed inflation fight still raging and the typical one-year plus lag effect of rising interest rates on PMIs and some of these freight market, we believe that there is a strong case that demand remains muted for the foreseeable number of quarters, call it four or five, six, potentially more quarters. So I would add to this that at least in the two sub-segments of the freight market, air and ocean, we have significant capacity that might take through 2024/2025 to be absorbed, even in a scenario where the economy actually rebounds to trend levels in the coming quarter, which is obviously a very low probability scenario. But just to underscore there is a lot of capacity in those air and ocean markets to be absorbed. And I think that's going to take, you know, several years to kind of return to a more balanced supply demand and sales market. So some of these imbalances, you know, have negative read-through to the parts of the industry that we just talked about today.

Camilla Sutton:

Thank you for that Fadi. Your report certainly covered a lot of ground. It was a really interesting read. And I'm glad we were able to host the podcast today to run through some of the pieces so thank you both Fadi and John. We certainly covered a lot of ground. That was Fadi Chamoun, BMO Capital Markets Equity transportation analyst, and John Stephenson, Special Projects analyst. BMO Capital Markets is proud to be able to deliver thoughtful analysis of upcoming sector trends that will prove important to clients investment decisions.

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