Stefonlinton
The recent bankruptcy of Yellow Corporation (YELL) has raised a red flag across the North American freight industry. There are many causes for the company’s failure, some of which are macroeconomic, while others are specific to the enterprise. The company’s primary issue was its excess debt level and its difficulty in maintaining profit margins in the face of labor market strain. Importantly, like most freight companies, Yellow was performing very well from 2020-2021, with a considerable sales and gross margin bounce over that period; however, as economic strength waned ~2022 while operating and interest costs continued to grow, the company found itself without sufficient cash to meet its financial obligations.
Yellow’s high debt level and its management team’s failure to keep up with its competitors are two issues specific to the company. However, those issues and macroeconomic challenges ultimately led to the company’s failure. Most of those macroeconomic headwinds negatively impact other LTL carriers and broader transportation companies like FedEx (NYSE:FDX).
Thus far, FDX has not seen notable price action during the Yellow bankruptcy despite the company being the largest LTL carrier in the US, with significant investments in expanding its LTL operations. Of course, Yellow’s bankruptcy, if it results in a permanent business shutdown, benefits FedEx through potential labor pool increases and sales growth. That said, it is also a strong signal that systemic macroeconomic issues may be straining the transportation sector. I believe these headwinds may be large enough to justify a significant negative correction for FedEx.
Recession and Inflation Risk Factors
FedEx has performed very well since 2020, roughly doubling in value that year. The stock later lost all of its gains in early 2022 but has risen back near its all-time high since then. In my view, such erratic stock price behavior is a strong sign that investors face mixed signals regarding the company’s potential in light of macroeconomic circumstances. Historically, Fedex’s sales growth, its stock price, and its operating margin closely reflect changes to the Manufacturing PMI. See below:
The manufacturing PMI is a solid forward GDP indicator of business survey data regarding changes to new orders, inventory changes, labor, and other key factors facing manufacturing firms. The measure is highly relevant to FedEx because the company is a significant carrier of manufactured items, so changes to the PMI imply direct changes to FedEx’s sales. Today, the PMI is well below 50, indicating a negative trend in manufacturing business activity – the lowest measure since 2008, excluding the artificially generated crash in 2020 (from lockdowns).
As is historically common, FedEx is seeing a sharp decline in sales and negative action in its operating margin due to the slowing manufacturing economy. However, FDX’s value has risen close to its high level from 2021, breaking its historically strong relationship with its fundamentals. The company has also recently faced many negative EPS revisions and slight sales misses. Bullish sentiment surrounding the company generally focuses on its ongoing cost consolidation efforts and declines in fuel costs, which negatively impacted demand in 2022.
That said, I generally believe bullish FDX investors may have some irrational exuberance or may not be fully aware of the company’s headwinds. Indeed, it is not a “potential recession” that could harm FedEx but an immediate decline in manufacturing activity that has already hampered its sales and margins and is likely to continue over the coming year. Adverse changes in manufacturing activity continue to pose a headwind for the company, while its systemic labor shortage and fuel costs may continue to drive cost pressures higher.
Like most freight companies, FedEx is struggling with a significant shortage of skilled transportation workers. The pilot market has been dramatically strained in recent years, causing an ongoing increase in pilot costs. FedEx pilots recently rejected a temporary labor agreement that would have increased pay and pension benefits by 30%. Although no strike is currently planned, like UPS (UPS), FedEx may be stuck in a situation where it has little choice but to transfer profits to workers due to an inadequate labor pool in the face of rapidly rising demand. Air transportation prices are incredibly high today as the number of transportation employees is growing quickly, indicating that demand for air transportation is growing too quickly for companies to train workers. Air transportation costs are also strongly associated with jet fuel prices, which have fallen substantially since last year. See below:
On the one hand, the pilot (and general air transportation employee) shortage poses a significant negative cost pressure to air cargo and passenger companies. Pilot salaries are skyrocketing, with experienced aviators now earning up to $700K annually. The deal FedEx pilots recently rejected would have increased pilot pay to ~$434 per hour by 2027. I believe this extreme wage growth is creating a “pilot bubble” that will likely pop; however, it may take longer than FedEx hopes, depending on economic circumstances. One of the major causes of the pilot shortage is the shortage of military recruitment, negatively impacting the training of many new pilots and tremendous increases in private flight school costs. Some airlines are looking to alleviate the shortage by lobbying the government to accept H1-B visas for foreign pilots; however, it is doubtful such measures will occur anytime soon, meaning FedEx will need to compete with passenger airlines for workers until then.
A similar set of issues is facing FedEx’s ground and freight businesses. The trucker shortage is relatively significant but less extreme than the pilot shortage. The problem stems from a sharp increase in transportation demand (partly due to E-commerce growth), an aging truck-driving population, and a lack of new recruitment. Wages are rising as a result, but young people are still avoiding the career path due to future potential job automation concerns. This is a feasible issue as unions and technology companies are already sparring over autonomous trucks, which are now primarily operable but not yet deployed in the market. In my view, while there will be resistance to autonomous vehicles, the potential cost savings for customers may be sufficient for lawmakers to allow their deployment over the coming decade. Further, the trucking industry is also seeing a significant increase in foreign drivers.
FedEx should continue to face strains from growing employee wages, particularly in its air segment. However, a decline in the manufacturing economy could end this burden, primarily caused by an extreme increase in transportation demand over recent years (as people become more reliant on online shopping). Worker shortage burdens may be alleviated now that demand is falling. There could even become a labor glut if more of FedEx’s competitors cease operations. In the long run, the rapid advancement of autonomous and robotic technologies could significantly reduce FedEx’s costs and improve its profits; however, that is a speculative view, and it may likely take around a decade for that transition to occur.
While I expect labor costs to decline due to waning manufacturing demand, the same is not necessarily true for fuel prices. As detailed in “XLE: The Oil And Gas Shortage Is About To Return With Force,” I believe there is strong reason to believe fuel costs will rebound, even if the economy slows at a faster pace. Fuel costs have fallen dramatically since 2022, not due to improved production but to improved supply from the Strategic Petroleum Reserve. As that reserve is now largely drained, the fuel market is being pushed back into a shortage, particularly considering other economic and geopolitical circumstances impacting oil production. While FedEx can pass these costs onto customers, higher rates should negatively impact demand, potentially exacerbating company sales declines.
What is FedEx Worth Today?
The macroeconomic headwinds facing FedEx are similar to those that ultimately pushed Yellow into failure. They’re generally the same across FedEx’s air, express, and freight segments, signaled by rising cost pressures and waning demand. I expect labor cost pressures may eventually slow due to the ongoing manufacturing slowdown, but they may rebound for fuel costs considering numerous issues in the energy market. Further, following UPS’s recent union deal, FedEx may need to increase driver benefits (not union) to compete for workers, increasing its cost outlook for the coming year. FedEx is pursuing consolidation transformations that aim to improve profit margins, but its operating margins have slid consistently since ~2021, so it is unclear if this approach will work.
Looking forward, I expect FedEx’s sales to continue to contract by around 10% over the coming two years from its TTM level. Such a change is similar, though not as extreme, as the sales decline the company faced during the 2008 recession (~17% decline). Indeed, considering the massive increase in FedEx’s sales over the past three years, creating immense costs for manufacturers, an even more significant sales decline may be justified. Further, I expect FedEx’s operating margins to continue to slide to ~4.5 to 5% due to increased cost factors. Thus, I expect its operating income in the 2024-2026 period to be around ~$3.65B to ~$4.06B. That estimate is about 25% lower than its TTM operating income but slightly above its pre-COVID range.
After accounting for the company’s ~$495M in net interest costs and 25% tax rate, I expect its net income to be around $2.36B – $2.67B, or an EPS outlook of $9.4 to $10.6. While my outlook is much more bearish than the consensuses view, showing a $17.7 target, I believe the consensus view significantly underestimates the recession risk (which is already a reality for manufacturing and related companies today), underestimates labor and fuel cost pressures and overestimates FedEx’s ability to consolidate efficiently. Accordingly, my forward “P/E” outlook for FDX is 25.2X to 28.4X, around twice as high as the company’s typical “P/E” level of ~12-14X. My price target for FDX is around $150, or roughly 14X the $10.8 EPS estimate. FDX would need to decline by ~46% to reach that price; however, that is not an extreme outlook considering it was trading below $150 just nine months ago.
The Bottom Line
Overall, I am very bearish on FDX and believe it is a solid short opportunity. While the company’s risk profile is nowhere near Yellow’s, it is much higher than most investors think today. Like Yellow, the firm is already facing strains associated with a slowing economy and could see those pressures grow dramatically over the coming year or two. Further, like Yellow, UPS, and most in the transportation market, it is struggling with a chronic labor shortage that could take over a decade to end due to aging worker demographics. The company’s efforts to improve margins through consolidation may work, but I do not believe they will entirely offset these macroeconomic headwinds.
FDX has a low short interest of ~1%, no material borrowing costs, and historically low option implied volatility. FDX’s low implied volatility may mean its put options are undervalued today, making those a potentially attractive means of speculating against the stock with defined risk. FDX has also risen back near its all-time high, creating what I view as a strong “double top” technical setup, pointing toward a stop loss at around $300 in case FDX breaks higher. In my view, it is very doubtful that FDX will rise to new all-time highs considering its valuation and economic headwinds. That said, speculative bullish exuberance can easily cause overvalued stocks to become far more overvalued.
Further, I do not believe FDX is a long-term short opportunity. After the slowdown ends, the company’s outlook may be much stronger as the labor market pressures slow. Technological improvements in AI and robotics may also significantly alleviate the company’s costs in transportation and logistics; however, I believe that transition is still too far away to improve its immediate value. At any rate, the most significant risk in betting against FDX is probably its potential to benefit from AI advancements since that is a crucial area of investor exuberance today.
