Swot Analysis Federal Express

Equity Research

Transportation

IWANOWYCZ, KAYLO, LEE, SEKINE, & WELLS

CORNELL EQUITY RESEARCH

December 5, 1999

Federal Express (NYSE:FDX)

SELL

Target: $30 “It is not going to happen overnight!”

Date:

December 3, 1999

Current Price: 52 week Price Range:

$41 15/16 $32 – 61 7/8

Dividend Yield: Proforma LTD:

0.0% $3.8

Combined Market Cap: Pro-forma shares o/s: Shares Short at 9/08/99 Short Ratio Average Volume Fiscal Year End: Institutional ownership:

$12.2 298.6 8.88 5.42 2.0 May 31 65.25%

billion billion million million days million

Company Description FDX Corporation is a global transportation and logistics enterprise that offers customers a one-stop source for global shipping, logistics and supply chain solutions through its subsidiaries FDX, RPS and others.

Consensus Estimate

05/99A 05/00E 05/01E

EPS P/E

$2.10 20.0x

Growth Rate: 12-Month Price Target:

12% $30 (14 X FY00’ EPS)

$2.17 19.3x

$2.52 16.6x

Valuation

Investment Thesis The outlook of FDX is at best uncertain. We believe that there are threats on all fronts: • E-Mail is reducing the amount of overnight package activities • Unclear strategy to deploy FDX’s ground transportation division • Low single digit domestic growth • International growth promising, but needs a successful track record • Unclear visibility into FDX’s execution strategy and product pipeline • Current investments yielding lower than cost of capital

DCF Valuation: EBO Valuation: G-Model valuation: EVA Valuation:

$48 $22 $43 $42

FDX appears to be overvalued in comparison to the current stock market valuation. Comparables Analysis: With respect to P/E ratio, Price to Sales, and Price to Cash Flow, FDX is overvalued in comparison to industry averages.

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Investment Thesis • E-Mail is reducing the amount of overnight package activities Electronic mail has become a popular method of transmitting personal information. We believe that such transformation will begin to emerge in commercial document delivery. Increasingly, commercial documentations will be sent electronically. This evolutionary shift in information delivery can potentially reduce the demand for the company’s core overnight products.

•

Unclear strategy to deploy FDX’s ground transportation division

UPS is the Godzilla of Ground Transport with a current market share over 75%. In addition, UPS has the density of labor and networks to deliver ‘business-to-residential’ products. FDX will need to significantly build brand recognition as a viable ground transportation competitor and build the labor force in order to measure up to the Godzilla of Ground Transport. In the near term, we expect that FDX may not achieve market share improvements with this product. We foresee diminishing market share as UPS aggressively postures to maintain and improve its market share. Should there be significant improvements in this area, we may be inclined to review the existing recommendation.

•

Low single digit domestic growth

The domestic market is currently viewed as mature and we expect market growth of 3 to 4% annually. The market is composed primarily of Priority and Standard overnight packages. Historical year-over-year growth in FedEx domestic business has been, on average, 12%.

•

International growth promising, but need successful track record

We believe that both international sectors can now grow in tandem. As Asia continues to recover and the company deploys the new $200 million hub in Paris, we expect to see an enhancement of FedEx international revenues. In the near future, we expect FedEx’s international revenue growth to be between 15 and 20%. Although such expected growth figures are high, the related base volume is low.

•

Unclear visibility into FDX’s execution strategy and product pipeline

Although there are trademarked services and products in the pipeline, it is not clear that FDX has deployed a coherent business locomotive to deliver shareholder value.

•

Current investments yielding lower than cost of capital

FDX’s weighted cost of capital (WACC) is approximately 8.5%. Assuming a return on invested capital (ROIC) in the 6.5% range, the company is not earning its cost of capital and, hence, firm value is being destroyed. In other words, no economic value is added through operations unless FDX improves its profitability.

Investment Summary In light of our analysis and our bearish assessment of the company’s future revenue stream, we believe tha through increasing efforts and costs, FDX will continue to build momentum to maintain its current level of domestic air and freight business. As much as we are cognizant of FDX’s improving business in Asia and it is expanding network deployment in Europe, we would like to observe concrete product developments and execution strategies before adjusting our estimates. Any of the following may be signals for improvement: • Predictable revenue stream on all fronts with recurrent growth level above 12% • Visible synchronicity on all fronts: domestic and international • Adequate management guidance into the depth of its product development pipeline • Visible deployment of strategies through joint ventures and partnerships with ground transport companies • Acquisition or joint venture deployments with Internet-enabled electronic documentation companies or partners 2 IWANOWYCZ, KAYLO, LEE, SEKINE, & WELLS December 5, 1999

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Table of Contents I.

Industry Analysis Industry Characteristics History Industry Outlook Market share Analysis Competitive Forces Challenges

II.

4 4 5 6 6 7

FDX: A Company Profile Company Business and background Business Segments Management SWOT Analysis Brand Strength

II.

8 8 9 10 10

Stock Price Performance Overview Volume and Price Momentum Relative Performance Insider Trading Institutional Ownership Short Interest

III.

11 12 12 12 13 13

Financial Analysis ROE Decomposition Profitability Asset Efficiency Analysis Cash Flow Analysis Altman’s Z-score Liquidity and Solvency

IV.

14 14 14 15 15 16

Accounting Financial Position Review of Accounting Policies Beneish Test for Earnings Manipulation

V.

17 17 18

Valuation Cost of Capital and Cost of Equity Analysis Analysis of Expected Company Growth EBO Analysis & Sensitivities DCF and EVA Analysis Comparables Valuation StockVal G-Model

VI.

Exhibits

19 19 19 19 20 20 21

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Industry Analysis Industry Characteristics •

The airfreight industry concentrates on the highest value, most time-sensitive manufactured goods moving long distances. Historically, this has been documents, small packages, and cargo that require overnight delivery. As costs have fallen, this has opened the doors for an increase in lower value and heavier manufactured goods to be shipped by airfreight.

•

The air freight industry consists of carriers that are known as integrators, who logistically manage a network of air and ground transportation (e.g. trucks and airplanes) in order to deliver items door-to-door.

•

Since FDX also competes in the second day ground services through an acquisition of RPS, the company must also be analyzed in the ground integrated ground transportation segment. UPS is the dominant player in that segment.

•

Heavy air cargo shipments tend to average between 200 and 300 pounds, or less than a typical LTL motor carriage shipment. Air express package shipments tend to average three to five pounds. The items weighing less than two pounds tend to be documents.

•

The line between ground and air transportation is blurring. It is difficult to compare FDX to all competitors in the transportation sector due to the “door to door” nature of the business. FDX competes in the “airline” sector as well as the “transportation – air freight” sector. Due to industry trends moving towards cost cutting and the introduction of new, faster ground transportation services, FDX has competitors in the ground transportation sector.

Falling costs, increasing volume

Movement towards integration of ground and air transport

Even though certain analysts believe that a 7.4% improvement in profits can be achieved in 1999, it is not clear whether this pertains to the “door to door” sector of the air express industry. Since there will be downward pressure on the top line revenues of integrators to switch to ground transportation, this could conceivably only be in the air freight segment and not extend to the air / integrator segment.

History Largest venture capital endeavor in history (at that time)

Late 1960s 1969 – 1971 1973 1974 1978 1986 1987 1988

Fred Smith, a Vietnam veteran, presented FDX’s business concept in a Yale term paper. He received a “C”. Smith raised $40 million in investor funds, $8 million in family money & $90 million through financing Service started to over 22 US cities with overnight delivery UPS strike, competitor REA Express went bankrupt UPS went public UPS loses $300 million on Zapmail, satellite based network providing 2-hour document delivery FDX bought Island Courier Companies, Cansica, and three Japanese freight carriers FDX bought Tiger International for $880 million, doubling overseas revenues and becoming the #1 air cargo company 4 IWANOWYCZ, KAYLO, LEE, SEKINE, & WELLS December 5, 1999

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1991 1992 1993 1994 1995

1997

FDX introduced EXPRESS freighter, an international air-express cargo service FDX scrapped its loss-making European domestic pickup and delivery service FDX pilots ‘rock the boat’ by announcing their decision to unionize; touching off protracted negotiations. FDX became the first US express carrier with direct flights to China, and created Latin America and Caribbean divisions FDX introduced InterNetShip, a service allowing users to print their own shipping labels and communicate with recipients via email, and a software package called BusinessLink, which allows businesses to sell goods over the Internet FDX announced plans to create a hub at Charles de Gaulle Airport in Paris (its first hub in Europe) and another in Miami (to drive its expansion into Latin America).

Industry Outlook Downward top-line growth: • Domestic growth is slowing. The airfreight portion of the transportation sector which includes everything from lightweight packages to heavier manufactured goods, is entering a slower phase within a long-term secular boom. Results for the air freight portion of the transportation sector, including lightweight packages to heavier goods, is entering a slower short-term phase. •

Downward Pressure on the Air Express segment in favor of ground transport. New services, such as deferred delivery and existing services offered by ground transport, are encroaching into FDX’s piece of the pie. Also, within a 600 mile radius (the distance a truck can travel in a day), people are opting for ground transportation, since the ground transportation companies are now guaranteeing delivery in as little as one day and as much as four days. The pricing of ground transportation is much more competitive than that of air. Further compounding this pressure on air express companies is the trend of suppliers and distribution centers locating hubs within the 600-mile radius to the more populated retail centers.

Top-Line Growth: • Industry studies show “Long Term growth promising”. The long-term prognosis has promise, with domestic airfreight expected to grow by 5.7% annually through 2002. (Reference: MergeGlobal, Arlington, VA). However, we believe growth will be around 2-3% on the conservative side. We want to aggressively look to signals that may identify growth opportunities. •

New sources of Income. Outsourcing and inventory reduction efforts will create markets through which suppliers’ ship to third parties who will manage inventory and then ship to the destination, creating a new shipping leg for product delivery. We believe that this will benefit the ground transportation segment contrary to what the airfreight industry had touted.

Cost reduction: • Continued efficiency efforts. Investments in larger wide-body aircraft will lower the per unit costs (could be as much as 15% depending on current aircraft mix, thereby opening the door for new classes of larger, heavier package transport. Cost Increase Pressures: • Labor Issues. In the air freight industry, aircraft pilot wages represent 10% of total costs. The industry faces constant pressure to improve labor wages, benefits and working conditions, while the experiencing competition and profit margin pressure. The recent surge in the need for ground transportation is being strained by a shortage in truck drivers, driving up trucking salaries. The 5 IWANOWYCZ, KAYLO, LEE, SEKINE, & WELLS December 5, 1999

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constant threat of strikes is also a concern in the industry. UPS’ 15-day strike affected the company’s revenues and earnings significantly. •

Cost increases. All fleets must be upgraded to meet Stage Three noise standards, which will necessitate upgrades to existing aircraft (estimated at $100 million in 1999) and/or retirement of existing planes and purchase of newer quiet engine planes.

Market Share Analysis Defining the US Air Express market as Domestic Overnight and Domestic Deferred, the revenue for the total market is estimated to be approximately $34 billion. FDX derives 56% of their revenues from this market and UPS derives 29% of their revenues from this segment of the market. While we estimate that FDX controls about 28% of the domestic express airfreight market by volume, UPS only controls about 18%. Airborne maintains approximately 10%. Airfreight accounts for $25 billion, which represented approximately 5.6% of the US commercial freight transportation market in 1997. Of the $25 billion, $20 billion was from the movement of domestic freight and $5 billion was generated by US based air carriers through the movement of goods to or from the United States. The airfreight / air cargo industry consists of air carriers, forwarders, and passenger airlines that transport freight as a by-product. In addition to the $25 billion above, an additional $15 billion was generated by integrators and forwarders handling international cargo. Domestic Ground, consisting of non-express packages, is considered to be a $17 billion market. UPS controls about 75% of the market and RPS, which is a subsidiary of FDX, controls about 11% - 12%. UPS and RPS derive approximately 54% and 11%, respectively, of their revenues from this market.

Competitive Forces Competitive Landscape: • Main Competitors. Federal Express is the largest integrated airfreight carrier, with domestic revenues of $10.3 billion in 1997. UPS, which is the largest transportation. UPS, which is the largest transportation company in the US, derives some $6.3 billion from domestic air freight/express services. While the industry can be characterized by two major players. Other important competitors constituting the competitive fringe are: Airborne Express, DHL Worldwide, and Emery Worldwide. • On the International front. Freight forwarders dominate the international market. Even though some companies are integrators domestically, they are only forwarders internationally. • Forwarders. There are approximately 2000 competitors, which are classified as forwarders. They do not own or lease aircraft and many do not own ground transportation either. • Super-regional LTLs. Also, the local LTLs (less than truck load carriers) are banding together to form super regional partnerships that extend their ground delivery over larger areas with more efficient cargo utilization and better coordination. Rivalry Among Competitors: With trucking routes extending 600 miles in a day and improved information systems and logistics management, UPS service is extending its ability to provide shorter service. Additionally, truckers are forming super regional alliances extending their organized delivery effort. There is additional competition from UPS, who is guaranteeing ground transportation service that rivals FDX. In the international arena, since there is expected to be more growth than in the US, domestic competitors are also implementing global and multi-national strategies. UPS announced in November, 1999 that they plan to build a European network, obtain airline authority to operate in Asia and build its market presence in Latin America. UPS is already in 200 countries and territories. 6 IWANOWYCZ, KAYLO, LEE, SEKINE, & WELLS December 5, 1999

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Excitement over the UPS initial public offering caused the stock price to rise from its initial price of $50 to $70 ½ after the first week of trading. With employees (38% of the company) owning 90% of the multibillion company, the company has built-in incentives to employees. With 62% of the company left to watch from the sidelines, this may backfire in the area of labor negotiations

Challenges Bargaining Power of Buyers: Diversion of Cargo from air to ground There will be a continued “squeeze” on profit margins as buyers (companies and individual consumers) switch to ground transportation services for less time sensitive deliveries. Threat of Substitutes: • E-commerce Opportunities. The small package segment of Internet ordering/shipping is likely to be through UPS and The US Postal Service. Some industry observers think that there will not be an appreciable increase in business due to e-commerce, since it is just a “shifting” the form of transport, but really no new net demands were created. Type of Opportunity Business to Business Business to Consumer Total electronic commerce Total electronic commerce Total electronic commerce

Timeframe 1998 – 2003 1998 – 2003 1998 1998 1998

Expected Growth $43 B – 1.3 Trillion $ 8 – 108 Billion $ 13 Billion $ 5 Billion $ 7.8 Billion

Reference

BCG Consulting Market Corp Forrester Res.

We believe there is a perception that FDX is an expensive way to send low value items. Most of the growth in internet retailing has been in the form of low price items such as books, CDs, computer accessories and software. Consumers are opting for 2 to 3 day deliveries weighing the cost of the article as a benchmark against the price of the shipment. UPS has benefited the most from this since they are positioned as the leader in the ground transportation segment. •

Broad band. We strongly may pose a significant long-term threat to FDX’s core competency, which is the delivery of 5 pound or less documents. We think that this threat is propelled by the close to lightning delivery speed of the Internet. Email has already begun to drive toward the obsolescence of transferring some information physically through delivery services. However, there are still some documents that are more difficult to transmit (timeliness, speed, quality, priority of electronic mail, etc.). The mode of delivery is still relegated to physical delivery because technology hasn’t made its electronic transfer seamless and easy. However, in the future where broadband technology will be pervasive, this created the biggest threat to FDX’s existing business package service. Initially, broadband will be available between large metropolitan areas.

•

Security and Encryption Technology. Legal documents, such as real estate contracts, and business documents require signatory and notary functions to certify the legality of the instruments. These documents are still transmitted physically, however, as security and encryption functions are improved and gain confidence and are widely accepted, this will also serve as a threat to existing

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FDX: A Company Profile Company Business and Background FDX is the world’s largest express transportation company. Revenues in fiscal 1999 were $14 billion and the first quarter of fiscal 2000 was $3.6 billion. There are more than 148,000 employees worldwide, serving 210 countries and 366 airports worldwide, with 643 aircraft. The ground vehicle fleet numbers 43,500 worldwide. The distance driven totals approximately 2.7 million miles in the US alone. There are 34,000 drop boxes, 2400 FedEx shipping sites and 7600 authorized shipping centers. The average package volume amounts to approximately 3.1 million packages daily, weighing in at 25.6 million pounds annually. Average daily freight volume is about 7 million pounds per day. This level of business generates more than 500,000 daily calls and 63 million daily electronic transmissions

Business Segments FedEx Domestic Growth slowing

The domestic market is currently viewed as mature and we expect market growth at 3-4% on an annual basis. This market is composed primarily of the primary products: Priority and Standard overnight packages, which also includes US freight products. Historical year-over-year growth in FedEx domestic business has been in the teens. 1999 is expecting growth at a reduced rate of 6.8%. The reduced rate can be attributed to the shift from air to ground shipping preferences, the improvements in ground transportation, such as swifter and shorter delivery routes, and the more successful deployment of UPS ground products. (See Market Forces and Competitive Landscape sections above for an exposition on FDX’s core competency – the overnight delivery product)

FedEx International Opportunities for growth in the mid teens

FedEx has spent much effort and capital to build its network of partners and operations in both Europe and Asia. FedEx launched EuroOne in the late 80s and AsiaOne in the mid- 90s. Although, FedEx has always operated much more profitably in its domestic operations than its international operations, when FedEx enters a new region of the world, it often takes several years before it builds critical mass. The success of EuroOne has been overshadowed by the launch of AsiaOne and also the most recent crisis in Asia. However, we believe that both international sectors can now grow in tandem, as Asia has begun its reversal of fortunes and the company has initiated the deployment of a new $200M hub in Paris, which will greatly enhance FedEx international revenues. We expect FedEx’s international revenue to grow at mid to high teens in the near future. Even though the expected growth figures are high, the existing base volume is low.

RPS Gargantuan obstacles to catch up to UPS, the Godzilla of Ground Transport

FDX acquired RPS in January 1998. RPS is in the ground, non-express business-to-business delivery of parcels weighing less than 70 pounds. RPS’s share of the estimated $18 B total ground market is currently estimated at 11%. In July 1999, FDX began its deployment of RPS, thereby taking steps to address FDX’s poor share of the business-to-residential market. Although we believe there is opportunity in this market, we believe FDX has major hurdles ahead. UPS is the Godzilla of Ground Transport and has over 75% market share. In 8 IWANOWYCZ, KAYLO, LEE, SEKINE, & WELLS December 5, 1999

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addition, UPS has the density of labor and networks to deliver products businessto-residential. FDX will need to significantly build brand recognition as a viable ground transportation competitor, as well as build the labor force to measure up to the Godzilla of Ground Transport. In the near term, we estimate that FDX may not achieve market share improvements with this product and foresee some diminishing market share as UPS aggressively postures to maintain and improve its market share. Should there be significant improvements in this area, this may be a signal to review the existing recommendation. Viking and Roberts/FDX Logistics

We expect FDX to sell these two operating units. Thus we will exclude these two units from our discussion.

The growth trends mentioned above are shown graphically in the chart shown below. The categories are further defined below: • Previous – Fiscal Year Ending May 1998, Actuals • Current – Fiscal Year Ending May 1999, Actuals • F1 – Fiscal Year Ending May 2000 • F2 – Fiscal Year Ending May 2001

2 0 .0 % 1 8 .0 % 1 6 .0 % 1 4 .0 % 1 2 .0 % 1 0 .0 % 8 .0 % 6 .0 % 4 .0 % 2 .0 % 0 .0 % P r e v io u s

D o m e s tic

I n t e r n a t io n a l

R PS

1 7 .6 %

1 2 .3 %

1 9 .0 %

C u rre n t

6 .8 %

6 .1 %

1 1 .1 %

F1

4 .9 %

1 2 .4 %

1 0 .9 %

F2

4 .3 %

1 5 .4 %

9 .8 %

P r e v io u s

C u rre n t

F1

F2

(See Exhibit 4 for detailed projections)

Management The most recent CEO, Tom Weise, who was at Fred Smith’s (the founder) side from the beginning, recently announced retirement. This paves the road for the current COO, to take the realm. The new COO has significant international office leadership experience, as well as having had responsibility for sales. This is another visible signal that the company’s focus is on international expansion and is looking to leverage e-commerce to build, maintain and obtain new client relationships.

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SWOT Analysis: Strengths, Weaknesses, Opportunities and Threats Strengths • • • • •

Weaknesses

FedEx is secular brand Largest market share in airborne service Superb service: 99%-Plus on-time service level First in using the WWW: tracking products in transit One-stop shopping

Opportunities • • •

• • • •

• • • •

Significantly smaller ground market share than UPS (75%): 11% domestic through RPS B2E strategy did not live up to management’s prediction: consumers chose ground instead of air freight products High level of debt to service Unpredictability in FedEx’s operating model: Quality of Earnings concerns

Threats

Cross marketing existing FedEx and RPS products Increasing ground freight activities in the B2B business The strong network in Asia through AsiaOne: the nature of the geography in Asia may benefit FedEx core competency, air freight; for fiscal 2000, potential 100% growth opportunity Air freight to grow 2x-3x in the next twenty years: 3.52% - 5.64% annually Growth of global business economic and enterprise service First international mover advantage in China Global supply chain services

• • • •

•

• • •

UPS is gaining ground on the domestic air freight market share Increasing jet fuel prices: trend will continue Broadband and internet: email and onlinesecurity may lessen the need to courier overnight deliveries: electronic signatory Emerging potential threat: non-asset based online providers: Expeditors, Circle, Eagle, CH Robinson, Hub Group (online freight matching companies) Rising interest expense: although this can be somewhat mitigated by fixed debt expenses (operating cash requirements and stock repurchase plan) Domestic growth is projects to grow at very low single digit rate Growing Airborne and European contenders not too far behind UPS as an alternative investment choice for the investment community

Brand Strength Oldest and foremost air express brand, Federal Express, also known as FedEx or FDX When you think overnight delivery, you think “FDX”. The brand is synonymous with quick, reliable delivery. The brand is also well known by the public for being able to track your package via the internet from source to destination, adding another element of customer service and window into the business. RPS ground transportation brand not well known FDX will struggle to create a brand in RPS that can be compared to the overwhelming dominance that UPS has (75%) in the express ground delivery segment. People today think of FDX as a premium brand, that under the right set of circumstances, one would pay a higher cost for overnight door to door service. FDX is thought of as the costlier alternative, therefore, one does not New Supply Chain Logistics Products and Business Building Products These products have been introduced as a means to allow FDX customers to link their existing information systems to FDX’s formats and provide tools for FDX’s customers to communicate delivery to their customers. The product brand names are as follows: InterNetShip (track all orders via an FDX account, Shipping applications (Ship API, Track API, Direct Link), Express Bridge (tell your customers when they’ll have their order) 10 IWANOWYCZ, KAYLO, LEE, SEKINE, & WELLS December 5, 1999

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Even though there are trademarked services and products in the pipeline, it is not clear that there is a coherent business locomotive that delivers shareholder value.

Stock Price Performance Performance/Analysts’ opinions Overview

Oct 98

Dec 98

Sept 99

Oct 99

Analyst Meeting (1ST called by FDX in 6 years)

Barrons article on e-commerce

Share Buyback

Disappointing Quarterly Earnings

Events and Impact on Performance The FDX stock has seen a dramatic rise and a fall since October 1998, when the company hosted a wellattended investor meeting. Expectations started to build on cash flow improvement and e-commerce potentials. Then an article appeared in Barron’s in December 1998 discussing that FDX is going to benefit from e-commerce and should command much higher valuation just as the Internet companies do. This report turned out to be rather premature, as the primary benefactor of the rapidly growing e-commerce is the standard ground shipping company UPS with its business-to-residential coverage. FDX, on the other hand, is focused on business-to-business market, which can be more lucrative in the future but has not yet greatly benefited from the e-commerce trend. The direct comparison against UPS, which became public last month, will be unfavorable to FDX and will likely keep its stock price under pressure until the market starts to impound higher revenue growth in Europe. Capital Contrast to the previous three years when a small amount of shares were issued, FDX has aggressively moved into a share buyback program, which was announced in September 1999. The board approved 15 million shares, or approximately 5% of outstanding shares, to be repurchased. It is estimated that the company has completed about 60% of the whole program during late September and early October at an average price of $40.56, leaving 6 million additional shares to be bought back. In addition, there is an expectation that the company is likely to apply the selling proceeds from two asset sales in February 2000 to implement additional stock buyback for 3% of the outstanding shares. These repurchases are typically 11 IWANOWYCZ, KAYLO, LEE, SEKINE, & WELLS December 5, 1999

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interpreted positively, as it sends a signal that the management believes the stock is undervalued. Some analysts argue, however, that the company may not be making the best capital allocation decision since the money may be better spent to pay down debt. According to the four ratios that James O’Shaughnessy advocates as useful measures for stock evaluation, FDX appears to fall into the category of stocks that are more likely to appreciate in the future. Profit margins and ROE, where FDX has shown improvement, are said to be of little use in stock analysis, as these factors are already impounded in the share price.

Volume and Price Momentum Earlier in the year, for about a six-month period, the geometric rise in FDX’s stock price was pure Internet hype, initiated by the Barron’s article and the subsequent avaricious appetite of the investment community to identify the next business-to-consumer Internet play. After doubling the stock price within the same period, the ludicrous rise was guillotined by an earnings warning. Further, reports surfaced that FDX would not stand to gain as much from business to consumer fueled the charred stock price with more oxygen. The stock currently trades within a narrow band between $36 to $46, leaving no clear prognostication of a directional momentum. Aside from noise traders, we believe the investment community is eagerly awaiting 2QF99 results to substantiate the next positioning. We believe there will be tremendous negative price momentum if FDX fails to meet expectations.

Relative Performance Chart – Performance Relative to the S&P500

Insider Trading According to Vickers Institutional Research, there was only 1 insider trade over the previous 6 months: a purchase of 1000 shares. Since there isn’t a lot of insider trading, one can not draw any conclusions about whether management is “bearish” or “bullish” on the stock.

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Institutional Ownership Institutional investors currently own 65.25% of the 194.819 million shares outstanding. This doesn’t appear to be an inordinate amount of institutional investment. Purchase activity for the last three months is delineated below: • • •

3 Month Net Purchased 3 Month Shares Purchased 3 Month Shares Sold

- 14.710 million shares 34.593 million shares 48.764 million shares

Short Interest The number of shares for which there exists a short interest increased from August through November as detailed in the following chart. The increase in short interest indicates the possibility that investors feel that the stock may be overvalued. Month

Shares

11/08/99 10/08/99 09/08/99 08/09/99

8.884 6.355 3.419 3.220

% Outstanding 2.976 2.129 1.145 1.078

% Float

Days

3.234 2.313 1.245 1.172

5.424 2.370 1.973 2.067

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Financial Analysis ROE Decomposition ROE Decomposition FDX has registered higher ROE for the past three years mainly through profit margin improvement. The double-digit ROE, however, has been supported by the financial leverage, which remains fairly high compared to its peers in the industry. ROE Decomposition Profit Margin Asset Turnover ROA Financial Leverage ROE

1999 4.11% 1.65 6.78% 2.16 14.64%

1998 3.60% 1.69 6.11% 2.21 13.48%

1997 1.71% 3.15 5.40% 2.08 11.20%

Overall Profitability FDX has improved its profitability on various measures over the past three years as the table indicates. This trend needs to be carefully observed, however, as lower fuel costs have contributed to the margin improvement. The largest expense item is salaries and employee benefits, which are likely to edge up, as the labor market remains tight. Profitability Analysis Gross Margin Operating Margin Profit Margin

1999 30.47% 6.93% 4.11%

1998 30.04% 6.82% 3.60%

1997 28.39% 5.14% 1.71%

Asset Efficiency Analysis Despite the improvement in profitability, FDX has so far not been able to increase its efficiency in asset utilization. In fact both A/R turnover and PP&E turnover have slightly deteriorated over the past three years. As it plans to enhance its infrastructure, especially in the international markets, these turnovers may continue to be sluggish. Asset Efficiency Analysis Inventory Turnover A/R Turnover PP&E Turnover Inventory Turn-Days A/R Turn-Days

1999 35.52 8.19 1.28 10.28 44.57

1998 31.54 8.31 1.33 11.57 43.94

1997 36.32 9.04 1.42 10.05 40.37

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Cash Flow Analysis Because FedEx merged with Caliber, a ground transport company, to form FDX in 1996, it is difficult to compare the cash flows for FDX before 1996. As a result, we are showing the information for the Cash Flow Analysis from 1996 to the present. The composite graph shown below is characteristic of a company in the more mature phase of the company lifecycle curve (introduction, growth, maturity, decline). The company generates sufficient cash flow from operations, such that it is not as dependent on the capital markets. Chart – Sources and Uses of Cash Flow 2,000,000 1,000,000 0 1996

1997

1998

1999

-1,000,000 -2,000,000 CFO

CFI

CFF

Cash Flow from Operations (CFO) FDX has consistently generated a positive cash flow from operations since forming the newly merged company, FDX. Despite its slight decline in cash flow from operations from 1996 to 1997, FDX was able to rebound in 1998 with a 45% increase in CFO. Even though trends in the industry reveal increased margin pressure, FDX’s margins improved by 7.8% during the fiscal year ending 1999. Cash Flow from Investing (CFI) Cash flow from investing has typically been between $1.45 and $1.47 billion. This number is primarily influenced by changes in investments in property, plant and equipment. Between 1997 and 1998, FDX cash flows from investing were between $1.76 and $1.88 billion. This represents a 23% increase in investment over 1996 levels of $1.35 billion. Cash Flow from Financing (CFF) Over the past year, the company has been generating a higher cash flow from operations and as a result, employing the excess cash to pay down debt. No new debt was issued in fiscal year ending 1999. Also in 1999, the company issued $50 million of new equity. Assuming that the stock was priced at an average of $50 per share, this stock issuance represents approximately one million shares: a relatively minor issuance. In 1998, the company issued new debt (less than in 1997), but also paid down twice that amount of debt that it borrowed. The company may have reduced its debt level in response to the fact that it is more highly leveraged than its peers. FDX may also be becoming more sensitive to investor concern over its high debt burden.

Altman’s Z-Score Although we do not believe that FDX is in danger of bankruptcy, we ran Altman’s bankruptcy predictor model for completeness sake. The model predicts bankruptcy when the Z score is less than 1.81. The range between 1.81 and 2.99 is considered a gray area. Altman’s Z-score model is as follows: 15 IWANOWYCZ, KAYLO, LEE, SEKINE, & WELLS December 5, 1999

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Z = 1.2(X1) + 1.4(X2) + 3.3(X3) + .60(X4) + .998(X5) Where

X1 = net working capital/total assets X2 = retained earnings/total assets X3 = EBIT/total assets X4 = shareholders’ equity/total liabilities X5 = sales/total assets

FDX 1999 Financials Net working capital = $116,302 Total assets = $10,648,211 Retained earnings = $3,615,797 EBIT = $1,163,086 Shareholders equity = $4,663,692 Total liabilities = $5,984,519 Sales = $16,773,470

FDX Z-Score 2.89 The score for Fedex falls into the gray area or the “zone of ignorance”. This may be something to watch more closely especially if Fedex does not meet its revenue target goals.

Liquidity & Solvency FDX does not have any apparent liquidity problem. While leverage ratios have come down over the past couple of years, coverage ratios have improved. The company clearly changed its financing policy after 1997, gradually moving from debt towards equity financing. This is in line with the increase in operating cash flow for the same period. The overall debt level, however, still remains much higher that of comparable companies and could potentially hurt the future profitability if interest rates continue to move higher movement.

16 IWANOWYCZ, KAYLO, LEE, SEKINE, & WELLS December 5, 1999

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Accounting Financial Position FDX Corporation maintains a healthy balance sheet. As of May 31, 1999, the company had $325 million in cash, $2.15 billion in net receivables, and long-term debt of $1.36 billion. In 1999, while total assets increased by 10%, long-term debt decreased by 2%. Debt to total capitalization has dropped from 33% in 1997 to 23% in 1999. Operating performance has also been strong: for the 1999 fiscal year, annual revenues increased 6%, margins improved from 6.4 to 6.9%, and net income rose 25%.

Review of Accounting Policies •

Fiscal Year: The Company operates on four, three-month quarters with a fiscal year ending May 31.

•

Revenue Recognition: Revenue is recorded based on the percentage of service completed for shipments in transit at the balance sheet date.

•

Consolidation: The consolidated financial statements include the accounts of FDX Corporation and its subsidiaries. All significant inter-company accounts and transactions have been eliminated.

•

Property and Equipment: While ordinary maintenance and repairs are expensed as incurred, expenditures for major additions, improvements, flight equipment modifications, and certain overhaul costs are capitalized. Depreciation and amortization of property and equipment is provided on a straight-line basis over the asset's service life or related lease term as follows: Flight equipment Package handling and ground support equipment and vehicles Computer and electronic equipment Other

5 to 20 years 5 to 30 years 3 to 10 years 2 to 30 years

Aircraft airframes and engines are assigned residual values ranging from 10% to 20% of asset cost. All other property and equipment have no material residual values. Vehicles are depreciated on a straightline basis over five to ten years. •

Deferred Gains: Gains on the sale and leaseback of aircraft and other property and equipment are deferred and amortized over the life of the lease as a reduction of rent expense.

•

Deferred Lease Obligations: Rent expense on certain of the Company's aircraft and facility leases is recorded on a straight-line basis over the lease term. Deferred lease obligations represent the cumulative difference between rent expense and rent payments.

•

Capitalized Interest: FDX capitalizes interest on funds used to finance the acquisition and modification of aircraft and construction of certain facilities up to the date the asset is placed in service.

•

Spare Parts, Supplies and Fuel: Spare parts are stated principally at weighted-average cost; supplies and fuel are stated principally at standard cost, which approximates actual cost on a first-in, first-out basis. Neither method values inventory in excess of current replacement cost.

17 IWANOWYCZ, KAYLO, LEE, SEKINE, & WELLS December 5, 1999

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The Beneish Model for Earnings Manipulation The Beneish model reveals that FDX is not likely to be an earnings manipulator. The M-score for the 1999 Five and Eight Variable models are –2.92 and –2.90, respectively. Since these numbers are less than –2.22, the model suggests that there is very little chance that earnings manipulation occurred. A detailed analysis of the components of the Beneish model follows: •

DSRI: Days Sales in Receivables Index. The Company allowed its net receivables balance to increase at twice the rate of sales growth. Although manipulators typically reveal high DSRI values, we feel that the increase is reasonable; especially in light of the fact that total assets increased by the same percentage.

•

GMI: Gross Margin Index. Gross margins increased from 6.4 to 6.9% during 1999. This results in a GMI of .919 that lends to the premise that FDX is not likely to be a manipulator.

•

AQI: Asset Quality Index. Since FDX did not yield a significant change in the level of soft assets, AQI had very little impact on the Beneish calculation.

•

SGI: Sales Growth Index. An SGI of approximately 1.115 and 1.057 in 1998 and 1999 respectively, indicates that the Company’s sales have continued to grow, but at a slower pace. A high SGI points towards moderate, controllable growth. Since the 1999 SGI is relatively moderate, the number does not indicate potential manipulation by FDX.

•

DEPI: Depreciation Index. FDX’s DEPI of 1.039 and 1.025 in 1998 and 1999 respectively, indicates that the rate at which depreciation is slowing is moderating. This is consistent with the Company’s strategy if continued investment. Additionally, the ratio is in line with the increase in the total level of assets employed.

•

SGAI: SG&A Index. Since SGA expense increased at a rate that exceeded the rate of sales increase, the SGAI of .991 indicates possible manipulation. However, since the difference is only slight, we do not see this as a red flag; especially in light of the other parameters listed above.

•

TATA: Total Accruals to Total Assets. A TATA of –0.114 and –0.107 in 1998 and 1999 respectively, reveals that total accruals are relatively low. An earnings manipulator will typically have high total accruals.

•

LVGI: Leverage Index. FDX’s LVGI of 0.936 and 0.900 in 1998 and 1999 respectively, indicates that the company is decreasing its debt level. Since these levels are low compared to known manipulators, FDX does not appear to be influencing the numbers.

18 IWANOWYCZ, KAYLO, LEE, SEKINE, & WELLS December 5, 1999

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Valuation Cost of Capital / Cost of Equity Analysis FDX’s weighted cost of capital (WACC) is approximately 8.5% based on its cost of equity of 10.54% and cost of debt of 7.22%. While the EVA model indicates much more optimistic figures for its return on invested capital (ROIC), the market appears to apply a more moderate percentage. Assuming a reasonable estimate of 6.5%, the company is not earning its cost of capital and, hence, destroying value. In other words, there is no economic value added to the company’s operations unless FDX improves its profitability. This poses a serious concern as FDX continues to expand its international infrastructure. Although the company has generated a healthy operating cash flow, any business slowdown may lead to a cash shortage that may call for additional debt issuance. This would add to FDX’s already high debt levels, increasing the cost of debt, thereby, the overall cost of capital.

EBO Analysis The EBO valuation model revealed an implied price of $21.60, thus implying significant overvaluation in the current financial markets. In arriving at our valuation, we used FirstCall analyst consensus earnings forecasts of $2.17 and $2.52 for the fiscal years ended 2000 and 2001, respectively. As described above, we based our model on a growth rate of 8%. We used a discount rate of 10.548%, calculated based on the Air Courier SIC Code 1103. Based on historical data and industry analysis, we employed a Target ROE of 12%. Sensitivity analysis: In order for the EBO to arrive at a valuation that is consistent with the market price, one might consider one of the following scenarios: • • •

Decrease the discount rate to approximately 7.3%. A discount rate at that level would be unreasonable, since the company has a cost of capital that is higher than 8.5%. Increase the Target ROE to 20.2%. In the Air Courier industry, all ROE’s tend to converge towards 12% over time. Since the company does not maintain a sustainable competitive advantage, anything significantly higher would be completely unreasonable. Assume a long-term growth rate of 33%. Although such a rate may be attainable for certain companies in the technology sector, it is certainly not feasible for an Air Courier company.

Tables depicting various combinations of these variables are provided in exhibit 1.

EVA and DCF Analysis EVA Valuation The EVA model calculates an implied price of $42 per share. The model measures the excess after tax returns of invested capital over the weighted average cost of capital, discounted by the weighted average cost of capital. Going forward, the EVA model assumes the best case conditions. We felt the ROICs were fairly high in the model and even so, price the stock matched the current stock price. (Exhibit 2) DCF Valuation The DCF model came up with a price of $48 per share. We assumed a 8% growth rate for five years, then trailing off to 3% for the next five years. The present value of the cash flows were discounted by the cost of equity capital of 10.54% and we used a terminal value multiple of 16, the historic average high for FedEx. When we ran sensitivity on the growth rate, we found that the more FedEx grows in revenue, the 19 IWANOWYCZ, KAYLO, LEE, SEKINE, & WELLS December 5, 1999

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less money they make in free cash flow. This is consistent with our earlier findings that the return on equity is less than the cost of capital. (Exhibit 3)

Comparables Valuation In performing a comparative market multiples analysis to determine FDX’s valuation with respect to its peers, the company appears to be slightly overvalued.

Freight Integrators FDX UPS Airborne Freight Corporation CNF Transportation Pittston BAX Group

Ticker Symbol FDX UPS ABF CNF PZX

52 52 Price Hi Lo 41.938 61 7/8 32 66.625 76 15/16 61 24.5 42 9/16 19 1/2 30.562 45 7/8 28.38 10.062 11 5/8 6

High Median Low

Price Market Current Dividend Cap. Earnings Sales Book CashFlow ROA ROE Ratio Yield 12749 18.2 0.74 2.65 7.3 5.93% 14.88% 1.027 0 76885 34.9 2.83 11.3 22.77 10.56% 26.26% 1.460 0.45% 1206 10.7 0 0.39 4.37 9.58% 19.07% 1.308 0.65% 1712 9.6 0.32 1.97 5.4 5.33% 16.17% 0.918 1.31% 195 9.2 0.1 0.62 3.44 1.03% 2.32% 0.976 2.39% 76885 1712 195

34.9 10.7 9.2

2.83 11.3 0.32 1.97 0 0.39

22.77 10.56% 26.26% 5.4 5.93% 16.17% 3.44 1.03% 2.32%

1.460 1.027 0.918

2.39% 0.65% 0.00%

StockVal G-Model 88

FDX CORPORATION (FDX)

PRICE 41.9 DATE 12-03-1999 QR 4.0 NET 8.5%•

71

STOCKVAL®

57

EPS Lagged 1-Year

45

45

36

36

29

29

23

23

19

19

15

15

12

12

10

10

8

8

6

6

5 1989

5 1990

1991

THE G-MODEL IR 6.07 K 1.90 K' 1.00 NE 2.27 PE 18.5 WPE 18.8 WP 43 AP 2% Expected Return 1-Yr

1992

6.07 1.90 1.00 2.47• 17.0 18.8 46 11% 11%

1993

1994

First Call Data Mean Estimate Change High Low Total # Up # Down House Estimate PE Ratio

1995

1996

1997

2000 2.17↑ -5% 2.30 1.87 12 2 7

2001 2.52↓ +16% 2.70 2.10 11 0 5

19.3

16.6

1998

1999

2002 NE

NE

2000 2001 2002 2003 2004 2005 2006 2007

2000

2001

Normalized Earnings FYE May

2002

2.18 2.37• 2.57 2.79 3.02 3.28 3.56 3.86

G-Model: Investors can do better elsewhere The G-Model is a close approximation to the EBO model in that stock price reflects a forecast of next year’s earnings. The Earnings per Share line is shifted back one year on the time scale. This aligns current price and next year’s earnings to their normal market relationship. For FDX, the G-Model is shown above. One change we made to the model was to change the slope of the EPS line from 10% to 8.5%. This line represents the earnings growth or the price growth of FDX. In all of our other valuations, we felt that even an 8.5% growth in earnings was the best case scenario. So we feel that this model is the best representation of FDX’s best one-year outlook. Looking at the data on the bottom panel on the left side of the graph are the G-Models theoretical values regarding future and current pricing. At the very bottom we see that the expected one-year return is 11%. The numbers following AP (Appreciation Potential) shows 2% and 11%. The 2% represents the amount by which FDX may be currently undervalued while the 11% is the expected one year return. Above the AP is the WP or Warranted Price. At the time this model was done, the price of FDX was $41.90 per share. The WP suggests a price of $43 per share while the one-year target price is $46 per share. This suggests that FDX is currently fairly priced. Above WP is PE (Price Earnings) and WPE (Warranted Price Earnings). 20 IWANOWYCZ, KAYLO, LEE, SEKINE, & WELLS December 5, 1999

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These ratios are also very close suggesting that the stock is fairly priced. The PE is the currently price to earnings ratio and the WPE is the price to earnings ratio based on the existing G-Model settings. The other values, IR, K and K1 represent the interest rate of the five-year Treasury bond, the equity market risk premium and the company specific risk premium respectively. What the G-Model for FDX suggests to us is that either FDX is fairly priced or just slightly undervalued. In either case, investors seeking above average market returns would do well looking elsewhere.

21 IWANOWYCZ, KAYLO, LEE, SEKINE, & WELLS December 5, 1999

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Exhibit 1 – EBO Model


  
 



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FDX FDX Corp.

 

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22 IWANOWYCZ, KAYLO, LEE, SEKINE, & WELLS December 5, 1999

 !  ! 1!! 1

%! :: 11 ! 

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Exhibit 2 – EVA Analysis WACC

8.50%

Earnings Before Interest and Taxes (EBIT) Taxes on EBIT: Add: Income taxes fromincome statement Add: Tax shield on interest expenses* Less: Tax on Interest Income* Less: Tax on non-operating income* Less: Taxes on EBIT: Add: Change in deferred income taxes Add: Goodwill Amortization Net Operating Profits After Taxes, NOPAT Add: Depreciation & Amortization (except goodwill) Less: Net Change in Working Capital Less: Net Other Adjustment Less: Net Capital Expenditures*** Free Cash Flows to the Firm(FCFF) Invested Capital = ICt-1 + It EVA PV of EVA ROIC

Forecast 2004 2005 1,503,390 1,593,593

2006 1,673,273

2007 1,723,471

1999 1,163,086

2000 1,105,036

2001 1,193,439

2002 1,288,914

2003 1,392,027

429731

423,627 36,864 0 0 460,491 0 0 644,545 1,141,267 10,591 0 953,525 821,696

457,390 39,686 0 0 497,076 0 0 696,363 1,232,568 20,434 0 1,173,875 734,623

493,857 42,737 0 0 536,593 0 0 752,321 1,331,174 22,069 0 1,267,784 793,642

533,244 46,034 0 0 579,278 0 0 812,749 1,437,668 23,834 0 684,604 1,541,979

575,786 49,599 0 0 625,385 0 0 878,005 1,552,681 25,741 0 1,423,976 980,969

610,237 52,479 0 0 662,716 0 0 930,877 1,645,842 20,850 0 1,153,420 1,402,448

640,664 55,018 0 0 695,682 0 0 977,590 1,728,134 18,418 0 1,018,854 1,668,452

659,818 56,603 0 0 716,421 0 0 1,007,049 1,779,978 11,603 0 641,878 2,133,546

2,493,911 487,349 449,169 35%

1,660,479 696,363 591,530 28%

1,946,630 752,321 588,998 45%

2,102,602 812,749 586,459 42%

1,586,443 878,005 583,913 42%

2,380,594 930,877 570,576 59%

2,151,861 977,590 552,266 41%

2,044,322 1,007,049 524,340 47%

105724 -19337 1762979

1,849,366

Initial investment Sum of EVA Firm Value Shares outstanding Price

$

1,849,366 10,686,689 12,536,055 297,987 42.07

23 IWANOWYCZ, KAYLO, LEE, SEKINE, & WELLS December 5, 1999

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Exhibit 3 – DCF Analysis

24 IWANOWYCZ, KAYLO, LEE, SEKINE, & WELLS December 5, 1999

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Balance Sheet Input to DCF Model

25 IWANOWYCZ, KAYLO, LEE, SEKINE, & WELLS December 5, 1999

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Exhibit 4 - Growth Forecast FDX Corp. - Growth Forecast Domestic growth to be sluggish

Revenues FedEx Domestic FedEx International FedEx Total Caliber Total Total Operating Expenses FedEx Salaries and employee benefits Rentals and landing fees Depreciation and amortization Maintenance and repairs Fuel Other Total Caliber Total Operating Income

F1998 9,521 3,590 13,111 2,595 15,706

F1999 F2000E F2001E 10,172 10,670 11,129 3,809 4,281 4,941 13,981 14,952 16,070 2,794 3,126 3,452 16,775 18,078 19,522

5,774 1,233 845 802 709 2,961 12,324 2,371 14,695 1,011

6,225 1,318 911 890 594 3,170 13,108 2,502 15,610 1,165

6,662 1,474 988 1,012 768 3,254 14,158 2,807 16,965 1,113

F1999 F2000E F2001E 6.8% 4.9% 4.3% 6.1% 12.4% 15.4% 6.6% 7.0% 7.5% 7.7% 11.9% 10.4% 8.0% 6.8% 7.8%

International is the only bright spot with double-digit growth

Revenue Growth Projected to be 8%

7,173 1,617 1,069 1,024 808 3,495 15,186 3,087 18,273 1,249

26 IWANOWYCZ, KAYLO, LEE, SEKINE, & WELLS December 5, 1999