Last week, I wrote a “Quick Look” post about FedEx. This week, FedEx published Q3 results. In a nutshell, management is optimistic about the outlook. The company continues to recover well from the recession. Global reach and power of the FedEx’s network is unmatched. Fred Smith, founder of the company, mentioned on the conference call that FedEx is 60% bigger than the next largest competitor. As GDP of the emerging countries continue to grow at a faster rate than that of developing countries, FedEx is well positioned to take advantage of the growing commerce in these countries.

Here is my investment thesis for FDX.

The Business: What do they do?

I probably don’t need to write a lot to explain FedEx’s business. FedEx Corporation provides transportation, e-commerce, and business services in the United States and internationally. It operates in four segments: FedEx Express, FedEx Ground, FedEx Freight, and FedEx Services. On an average day, they handle 3.6 million shipments. Even with revenue of $38 billions and operations in 220 countries, FedEx is still in its growth stage. As I highlighted in the summary post, here are some of the reasons I like Fedex –

• High barrier to entry: This is a capital intensive industry. Last year FedEx spent $2.8 billion, all the free cashflow generated for the year, in capital expenditure. Combining this high capital requirements with the formidable network that FedEx has built around the globe makes FedEx the dominant leader of the express transportation industry.
• Global e-Commerce and ever improving standard of life: The global e-Commerce is still in early stages. As e-Commerce continues to grow, FedEx will benefit from this secular trend and need for moving the packages. Same theory applies to the ever improving standard of life and, therefore, more consumption.
• Founder driven culture and one of the most admired employers: Fred Smith, the legendary founder and Chairman of the company, built the concept from scratch and built a great culture. FedEx is consistently rated as one of the most admired employers.
• Global recovery and international expansion: Just like every other company, during the great recession of 2008, FedEx went through a painful few quarters. Now, with the recovery under way, the company executives are more optimistic about the growth prospects.

Financials: How is the financial health?

FedEx’s balance sheet looks healthy with $1.67 billion in debt and $1.36 billion in cash. Revenue in last four quarters was $38.27 billion with $9.29 billion in EBITDA and $2.16 billion in operating income. Net margin has been hovering around 3%-4%. So, this is a low margin – high volume business.Financials have been improving as the global economy has been emerging from the recession.

As the firm continues to expand its operation in emerging countries, almost all of free cash flow gets reinvested back in funding the growth of operations. Capital expenditure, in the first 3 quarters of 2011, has been $2.7 billion.

Valuation: What’s it worth?

Traditional valuation of FedEx is a tough exercise because, at present, most of the cashflow gets invested in growth of the business. So, in a discounted cashflow model, the value of the firm becomes highly dependent on the terminal value of the business. As terminal value is calculated after 5-10 years in future, it very sensitive to change in discount rate, growth rate or change in projected cashflow in the terminal years.

With that caveat, my valuation resulted in values in the range of $123-$143. For the lower end of the valuation, I used a growth rate of 5% that drops off to 3% by 10th year. As a long term investor with high confidence in the business, I think, current stock price of FedEx is undervaluing the long term prospects of the business.

Risks: What can go wrong and when to sell?

Geopolitical disruptions, e.g. war, natural disaster, terrorism etc, can impact FedEx business in short term. Similarly, change in macro environment, e.g., oil prices, impact the profitability of the firm. But, these risks tend to be short term in nature. I don’t believe, over any reasonable period of time,  global commerce is going to contract any time soon.

Fred Smith, the founder, has been a steady hand at the helm since the beginning. In coming years and decades, I will be watching keenly how the company transitions to new management at the top.

As the company continues to expand its reach and network around the world, I will be looking to efficiency gains and margin improvements in coming years. Any deterioration in margin will give me a pause.

Conclusion: What’s the bottom line?

Given it’s size, I don’t expect FedEx to grow ten fold in next few years. But, I think, over a long time frame, FexEx is going to beat the market handily. In the recent conference call, Fred Smith and team sounded very optimistic about the future outlook in near future. As mentioned in the valuation, investment in FedEx is a bet on the future of the company beyond 5 years. I am ready to make that bet and hold the stock for a long time.

(Note: Top picture courtesy erikleenaars)

(Disclosure: As of the publication of this post, I hold long position in FDX. Please read the full disclaimer below.)