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FedEx Keeps on Truckin'

By Jim Corridore We at Standard & Poor's Equity Research Services think express-delivery company FedEx (FDX

; recent price, $81) will continue to benefit from strong international demand for its services, as well as improving U.S. demand -- trends that we expect to benefit the overall logistics industry. We don't think this potential is fully factored into the current stock price, and expect to see some expansion in key valuation measures for stocks in the overall logistics group over the next year.

We also expect FedEx's valuation to more closely align with its main rival United Parcel Service (UPS

; recent price, $72) due to our expectations that FedEx's returns on both assets and invested capital will more closely resemble UPS's performance on these metrics over time. The stock carries S&P's highest investment recommendation of 5 STARS, or buy.

FedEx operates the world's largest express-delivery company, and is the second-largest provider of small package ground transportation services in the U.S. In addition, the it operates a leading regional next-day and second-day interregional less-than-truckload (LTL) freight carrier, and recently acquired Kinko's, a provider of copying, printing, and other business services in the U.S.

COPY POWER. The company's FedEx Express unit (71% of fiscal 2004 revenues) invented the express-delivery business in 1973, and provides time-definite air-express services for packages, documents, and freight to 215 countries. FedEx Ground (16%) provides ground-based delivery of small packages throughout North America, serving 100% of the U.S. population with the ability to provide overnight service up to 400 miles to about 97% of the U.S. population. FedEx Freight (11%) provides LTL trucking freight services throughout the U.S.

FedEx Kinko's, acquired in February, 2004, operates 1,100 office and print centers in the U.S. and 117 additional locations in nine other countries that provide access to the full range of FedEx shipping capabilities in addition to the traditional Kinko's offerings. Kinko's was only included in the company's financial performance for a few months in FY 04, and is expected to provide about $2 billion in annual revenues.

FedEx's Express business has a fuel surcharge in place for all U.S. and most international shipments, which is subject to monthly adjustment based upon the spot price. We think this largely mitigates the impact of high oil prices, and that it eliminated the need to engage in major oil hedging transactions in order to lessen oil prices as a major business risk.

SAVINGS TO COME? With recent strong growth in its ground-delivery business and an increased percentage of revenues and profits expected to come from FedEx Kinko's, we think the company will improve returns on assets and invested capital. That's because we expect it to be able to generate an increased percentage of its revenues and profits from less capital-intensive business activities, as compared to the air-express business, which requires heavy capital outlays.

In addition, we believe the lower capital-intensive nature of its newer business segments should allow the company to continue to reduce its capital spending requirements over time. This could allow FedEx to generate more free cash flow. However, the company stated that due to the strong growth it was expecting in fiscal 2005 (ending May), it was increasing its expected capital expenditures for the year to $2.0 billion to $2.1 billion, up from $1.3 billion spent in fiscal 2004.

We believe that improvement in returns on assets and invested capital, amid continuing growth in revenues and earnings, should allow the stock's valuation to more closely approximate that of UPS, its main rival in the U.S. UPS has historically traded at a valuation premium to FedEx based on price-to-earnings, p-e-to-growth, and price-to-sales metrics. Since we believe that FedEx can close this valuation gap somewhat, we think the stock price will materially outperform the overall market over the next 12 months.

CHINA EXPRESS. We expect FedEx's revenue prospects to be aided by growing demand for international express delivery services, particularly in China and the rest of Asia. It recently increased the number of flights and capacity of the flights into Asia and Europe and announced that it would increase the number of cities it serves in China from 220 to 320 over the next five years.

In addition, FedEx recently initiated a direct cargo flight from China to North America, which we think will be the first of many new direct flights between the two countries. Indeed, the U.S. and China recently signed a new aviation agreement allowing 111 new weekly U.S.-China flights for cargo companies. While these routes have yet to be divvied up by the U.S. Transportation Dept., we think FedEx will get its fair share, which should contribute to increased China growth. The company also launched express service to Iraq, giving it a presence in the rebuilding of that country.

We expect international-express revenues to grow about 20% in fiscal 2005, fueled by higher shipment volumes and increased prices. Overall, express revenues are expected to grow about 14% to 16%, as we see U.S. domestic express business growing in the 4% to 6% range, largely on increased U.S. manufacturing activity. We see ground revenues rising about 10% to 12% and freight revenues up about 17%. Also, the addition of the Kinko's business should contribute $2 billion in incremental revenues. These projections lead us to forecast overall revenue growth of about 20% in fiscal 2005.

POST POSITIONS. We think the company has a significant opportunity to leverage the Kinko's acquisition into a significant increase in package volumes as it puts a full suite of FedEx shipping services at every Kinko's location. At the same time, we believe the deal provides some diversification away from the company's reliance on shipping services, as the customer base that uses Kinko's doesn't entirely overlap with FedEx's existing base.

FedEx has also seen significant operating leverage and strong package volumes from a contract with the U.S. Postal Service for air transportation of Priority, Express, and First-Class Mail. This agreement runs through 2008 and was recently amended to provide for greater shipment volumes than previously required, also allowing FedEx to more fully utilize its existing fleet of planes at attractive operating margins, in our opinion. A second contract with the USPS allows for placement of FedEx drop boxes at every post office in the U.S., with about 5,000 already in place.

We see overall corporate margins benefiting from a decline in salaries and benefits as a percentage of revenues, due to savings from a voluntary early retirement program enacted in fiscal 2004 under which the company expects to save about $230 million to $240 million in fiscal 2005. This should be partly offset by increased pension and medical benefits costs. We expect purchased transportation, maintenance, and depreciation costs to all decline as a percentage of revenues, primarily reflecting fixed cost leverage of the company's expenses over a larger revenue base.

EARNINGS WATCH. We see fiscal 2005 operating earnings per share of $4.55, which represents 29% growth over the $3.52 figure for fiscal 2004, which excludes special items. For fiscal 2006, we see revenues rising an additional 12% to 14% and EPS rising about 13%, to $5.15.

Based on S&P's Core Earnings methodology, we estimate S&P Core EPS of $3.77 in fiscal 2005 and $4.52 in fiscal 2006. Our S&P Core EPS estimates include stock-based compensation expense of about $28 million in both years and costs of about $210 million in fiscal 2005 and $164 million in fiscal 2006, which relates to our estimate of the difference between the company's actual pension costs and its use of pension accounting.

In our opinion, the divergence between FedEx's operating and S&P Core Earnings estimates is slightly higher than that of other transportation companies we cover. This mainly reflects the company's stated assumed pension return of 9.1% for fiscal 2005, which we believe it's likely to use for fiscal 2006 as well. FedEx's assumed pension return differs from S&P's assumed pension asset total return of 4% for fiscal 2005 and 5% for fiscal 2006. Given the long timeline for the use of the assets in question, we don't think the company's return assumptions or the divergence between our operating and S&P Core Earnings estimates is cause for concern.

PAPER JAM? Our 12-month target price of $106 values the stock at 23 times our fiscal 2005 EPS estimate of $4.55 and 21 times our fiscal 2006 forecast of $5.15. This is in the middle of the company's historical p-e multiple range over the past five years of 13.2 to 28.5, while still at a modest discount to UPS, which is currently trading at about 25 times our 2004 EPS estimate of $2.95. UPS is also trading at about 23 times 12-month forward earnings, a measure that more closely equates UPS, which operates on a December fiscal year end, with FedEx, which has a May year end. On a p-e-to-growth basis, our target price values FedEx at a multiple of 1.6, using our expected five-year EPS growth rate of 14%, which would be in line with that of UPS.

Our valuation and target price is also supported by our

discounted cash-flow model, which assumes a weighted cost of capital of 7.32% and assumes 12% free cash flow growth for the first five years and 3% growth in the years that follow, resulting in a $105 fair value for FedEx shares.

Risks to our recommendation and target price revolve around the integration of newly acquired Kinko's, which could turn out to be less accretive to earnings than expected, as well as the possibility that expected improvement in the U.S. and global economy turns out to be less robust than we're expecting. The global economy could be hurt by prolonged high oil prices, which are currently well above historical normal levels.

Other risks include the possibility of a price war with UPS or DHL in either the international or domestic arenas. DHL recently acquired the ground delivery business formerly operated by Airborne Express, and has indicated that it intends to substantially expand that business, which if successful, could potentially take market share away from FedEx. Analyst Corridore follows stocks of airlines and logistics companies for Standard & Poor's Equity Research Services

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