Eric Gillin

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FedEx Cost Cuts Take Spotlight

Eric Gillin

FedEx(FDX Quote) will release its second-quarter earnings report on Wednesday, but results will likely take a back seat to news on the company's cost-cutting efforts.

By and large, analysts know what to expect from FedEx, which has said earnings per share will come in between 80 cents and 90 cents for the second quarter. Analyst estimates are the high end of FedEx's range, with the average estimate at 90 cents, up from the 81-cent profit posted a year ago, according to Thomson First Call.

Revenue is also expected to grow from the year-ago quarter, with analysts forecasting $5.9 billion, on average, up 4.1% from last year's $5.667 billion, according to First Call. But analysts also say there could be more upside, as cost-conscious retailers use just-in-time inventory management to make operations more efficient.

"As more and more businesses move to just-in-time inventory, UPS (UPS Quote) and FedEx's services will be more and more in demand," said Jennifer Cooke Ritter, an analyst at Lehman Brothers, noting that inventories fell by $14 billion in the third quarter. "This most recent decline increases our confidence that many inventories were not well stocked at the end of the third quarter ... it could mean positive surprises for UPS and FedEx this quarter."

Indeed, in the previous quarter, FedEx topped Wall Street estimates by 4 cents a share on better-than-expected shipments. Once again, analysts will be focused on the company's bread-and-butter Express business, but even more so on its international Express business, which is a growing part of the business mix. Though small, accounting for just 19% of FedEx's revenue in 2003, the international business could see growth between 8% and 14% going forward, Goldman Sachs estimates.

"We estimate double-digit revenue growth on the international front, consistent with trends reported over the last four quarters, particularly given a modest improvement in the computer and semiconductor markets," said Joanna Shatney, analyst at Goldman Sachs, in a research note.

Meanwhile, FedEx's plan to cut costs and restructure in order to boost margins could draw the most attention from analysts. On June 24, the company announced a plan to achieve operating margins of 10% in the express business and launched a voluntary program to reduce jobs.

Because most of the job attrition will take place in the first and second quarters of 2004, Wednesday's earnings release will include charges and information about the cost savings from that plan. As with the previous quarter, when charges related to the staffing reductions were taken, investors will see two different EPS figures, one according to generally accepted accounting principles and the other pro-forma, which is comparable to analyst estimates.

Look for some charges related to the job-reduction program, which will cost more money in the near term as the company pays out severance and benefits, but will save more money in the long run. On Oct. 2, the company announced that the program was ahead of schedule and would result in higher pretax charges in fiscal 2004, raising annual cost savings in fiscal 2005 to between $200 million and $230 million.

"As it turns out, acceptance rates for the programs were higher than the company had anticipated, so it will have to do some hiring as a result. ... We hope to hear an update from management on the second-quarter earnings call as to the implementation of these programs, notably if service was disrupted due to this," said Ritter.

When it comes to those critical operating margins, FedEx has been making steady progress. In the last quarter, operating margins at the express unit came in at 3.7%, up from 3.2% a year earlier, but overall, FedEx still lags UPS by a healthy margin.

"If [FedEx comes] close to those double-digit margins, you're going to have significant profit growth over next three years and make today's $70 stock price look cheap," said David Campbell, analyst at Thompson Davis.

But even with FedEx trading down 18 cents, or 0.2%, at $73.98 ahead of its earnings release, some analysts don't think the shipment company looks cheap when valued at more than 22 times 2004 projected earnings.

In a research note from Dec. 5, Fulcrum Global Partners analyst Jeffrey Kauffman, who rates the stock a sell, called FedEx's new focus on margins "a shift in the life cycle of the company," but not one that requires a higher valuation.

"The company is embarking on a new strategy to improve margins and cash flows, and has taken a new approach toward returns on the business. Appropriate? Yes, in our view. However, is this a reason to believe that EPS growth is better going forward? At this point in time, our answer is no," said Kauffman.

With the analyst camp is divided on FedEx's outlook and valuation -- nine rate it a buy, 14 rate it hold and one rates it a sell -- analysts will be closely examining the company's guidance to see how the job losses will affect earnings. Current Wall Street estimates call for earnings of 68 cents a share in the next quarter, with $3.30 a share for fiscal 2004.

(Goldman Sachs said it expects to receive compensation from FedEx for banking-related services in the next three months. All of the analysts cited in this article said that no part of their compensation was, is or will be directly or indirectly related to their investment opinion.)