Investors have been bidding up shares of FedEx (NYSE:FDX)—the world’s second largest freight and logistics company—for the past few years. Shares have more than doubled since they troughed in 2011, and they now trade near an all-time high. While the company trades at a rather high valuation of 27 times trailing earnings, analysts expect the company’s 2015 earnings to spike to nearly $9/share, which makes the stock appear to be reasonably priced at $143/share. Furthermore the company recently announced that it would be raising its dividend by 33 percent. This is more of a symbolic gesture considering that new dividend is a mere $0.20/quarter, giving investors a yield of slightly more than 0.5 percent at the current stock price.
With investors and management confident in the company’s future, I am a bit concerned. Even if this concern is misplaced, the stock has relatively limited upside, whereas if I am right in my concerns, which I will get to in a moment, the stock has substantial downside risk.
My concern regarding FedEx is three-fold. The first relates to the recent World Bank announcement that it would be amending its forecast for global growth down to 2.8 percent from 3.2 percent. FedEx is a business that is highly sensitive to the global economy, as a great deal of global commerce utilizes shipping services such as those offered by FedEx and its primary competitor—UPS (NYSE:UPS). If the global economy slows, or even if it grows at a slower pace, then FedEx’s sales will be greatly impacted. This is a big deal because the company operates with relatively thin profit margins. Even a small decline in revenues can severely hit profits, and that can send shares plummeting.
This problem is exacerbated by the fact that FedEx takes a large earnings hit every quarter due to depreciation. The company owns a lot of trucks and planes that are constantly losing value, and this depreciation is relatively stable. Therefore the company has to make enough money to overcome this loss in order to earn a profit from a GAAP perspective, and net earnings are further leveraged to revenues.
Second, fuel prices have remained relatively high. The price of oil has traded consistently over $90/barrel now for over a year, and recently every dip below $100/barrel has been a buying opportunity. FedEx has a substantial fuel input expense as it operates energy intensive trucks and planes in order to ship goods. If fuel rates rise then FedEx has to raise its shipping rates.
This in turn puts pressure on its clients, and it puts further strain on the economy and further strain on FedEx’s business, and ultimately on its profits. Even if FexEx chooses not to raise its rates, it earns lower profit margins due to higher fuel input costs. Since the stock is pricing in a very positive outcome even a slight negative impact from fuel can push the stock substantially lower.
The third issue has to do with management’s fiscal responsibility. The company has been earning a lot of money over the past few years, and yet it has been returning very little to shareholders in the form of dividends. Even the recent dividend hike is very small compared to the stock price and to the company’s earning’s power. But my main concern has to do with the fact that in the quarter ended on February 28 the company borrowed money to buy back stock. Now this may make sense considering that it can borrow at a rate that is lower than its earnings yield (earnings yield is simply the inverse of a price to earnings ratio). But why is it making this decision now when the stock is trading at such a high level?
The share repurchases—which totaled $2.7 billion in the last quarter—took place with shares trading between about $130/share and $145/share. But just 3 years ago the stock traded down to less than $70/share. This hardly seems like a disciplined “buy low and sell high” approach, and it leads me to question the motivation behind the repurchase program.
Again, maybe these concerns are unfounded. But if I’m wrong, the stock is fairly valued, and it should generate modest single-digit returns. If I’m right, however, the stock can potentially drop 30 percent to 50 percent. It follows that I think the stock needs to be avoided at current levels.
Disclosure: Ben Kramer-Miller has no position in FedEx.