Overnight Overkill: FedEx's Net Prospects Remain Uncertain

The company is hoping to penetrate the residential shipping market, in which it has less experience than rival UPS.
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There is less to

FedEx's

Internet home-shipping strategy than meets the eye.

FDX

(FDX) - Get Report

, the holding company for the red, white and blue overnight delivery service FedEx, has seen its shares take off as investors bet that it's a safer way to capture a piece of the e-commerce boom than betting on dot-com companies.

Since December, FDX shares have jumped 24%, compared with a 13% gain in the

S&P 500

big-cap index. That was when

Barron's

ran a story dubbing the company the "cheapest Internet stock."

Bulls have championed FDX in recent months by arguing that owning shares gives investors a piece of the Net with none of the risks. The e-commerce boom has seen the rise of online sites such as bookseller

Amazon.com

(AMZN) - Get Report

and auctioneer

eBay

(EBAY) - Get Report

, whose customers are buying up a storm. And someone has to deliver all the books, CDs, computer games and so on that online stores are selling.

The reality is somewhat different.

The mantra of nearly every Internet firm that has floated stock in this bull market has been "lose money, grab market share." Memphis, Tenn.-based FDX may have to sacrifice current profits for possible future returns as it tries to penetrate the residential shipping market, in which it has less experience than rival

United Parcel Service

.

"It's up for discussion whether e-commerce will be incremental to the business-to-business market," admits Sally Davenport, an FDX spokeswoman. "The incremental business is really in the residential market. That's why we're investigating how we can serve that market more cost-effectively."

To be sure, FDX has a healthy $17 billion business that generated profit of $631 million, or $2.13 per share, for the most recent fiscal year ended in May, mainly by delivering packages from one business to another. Earnings are expected to grow 16% to $2.44 a share for the current year, according to analysts surveyed by

First Call

.

Delivering parcels and packages to the home is the booming growth area, but the market for residential shipping has historically been far less profitable than the company's main line of shipping packages to businesses.

Consulting firm

Forrester Research

expects consumer e-commerce sales to hit $108 billion in 2003, up from $4 billion in 1998. Even though the business e-commerce market is expected to be 10 times that, it's unclear whether orders placed by businesses via the Net will really expand FedEx's market. More likely, the bulk of FedEx's business e-commerce share will come from its existing customers. Instead of typing up a FedEx form, office managers will fill one out on the company's Web page.

One FDX division,

RPS

, began testing a home-delivery service in May that hires drivers on a contract basis and pays them based on the number of packages they deliver. This differs from FedEx and other divisions under the FDX umbrella, which pay company drivers a fixed salary. If the test proves successful, a more wide-reaching program could be rolled out in March, says Betsy Momich, the division's spokeswoman.

"Historically, it has been very difficult to be profitable delivering to residences," Momich says. She declined to elaborate on whether the test is currently profitable.

Jeffrey Kauffman, a

Merrill Lynch

analyst who rates FDX a buy, estimates that the average revenue per package for business shipments is about $15, or about three times the $5 revenue per package the company generates from residential shipments. Yet residential market costs are much higher. It's more efficient to deliver 100 packages to one office building than to 100 different homes. The latter makes for slim margins.

"What may not be a profitable market today could be a profitable market in a few years," Kauffman says. "It's an investment." His firm hasn't performed recent underwriting for the company.

FDX, along with other shipping companies, is also facing pressure in the form of rising fuel costs that could crimp earnings. This past Thursday, jet fuel closed at 60.5 cents per gallon, up from 44 cents a gallon a few months ago. Davenport, the FDX spokeswoman, says fuel accounts for just 5% of the company's total costs, and therefore any increase would have a minimal impact on earnings. But just two years ago, when FDX faced rising fuel costs and a softer business climate, earnings stumbled, a short-seller warns.

Meanwhile, FDX, which got its start shipping to businesses and says the bulk of its revenue still comes from this area, may find the residential market tough to crack. The company trailed both UPS and the

U.S. Postal Service

in packages shipped to residences this past Christmas, according to a survey by

Zona Research

. Since density is the key to profitability, grabbing market share is crucial.

"UPS is No. 1 in ground delivery, and it has the density in every neighborhood on every street," Davenport concedes.

With UPS filing to sell shares in an initial public offering later this year, the next Internet stock may indeed come in an unusual package: a brown truck.