FedEx (NYSE:FDX) shares hit a two-year low last week thanks in part to the package delivery company lowering its May 2012 full-year earnings per share guidance from $6.35-$6.85 to $6.25-$6.75 on account of lower demand in the U.S. and Asia, as well as global economic uncertainty. Meanwhile, over at UPS (NYSE:UPS), it’s full steam ahead. It expects record earnings for its fiscal year, which ends Dec. 31. Ever the contrarian, I believe now is the time to sell UPS and buy FedEx. Here’s why.
The Graham Number
Economist Ben Graham used this simple equation to assess whether there was any upside to a stock at current prices. He would invest only in companies whose share price was less than 1.5 times book value and 15 times earnings. One or the other could be higher as long as the two ratios multiplied together equaled less than 22.5.
In recent years, this has been adapted to produce a fair value share price that tells us whether a stock has any upside. You multiply 22.5 by earnings per share and book value per share. You then take the product of the three numbers and calculate the square root, which is the fair value price of the stock.
In the case of UPS, by multiplying 22.5 by adjusted earnings per share for 2011 of $4.40 and book value per share of $8.40, then taking the square root, I get a fair value price of $28.84 — approximately 54% lower than its Sept. 26 closing price of $63.21. At least by the Graham Number, it’s significantly overvalued. Now on to FedEx; where I multiply 22.5 by EPS of $6.25 and book value per share of $47.86, then take the square root, which gives me a fair value of $82.04. That’s 17.6% higher than its Sept. 26 closing price of $69.75. By the Graham Number, it’s undervalued.
UPS has higher margins and returns on invested capital. In both cases, they’re about double. Perhaps that’s why FedEx’s enterprise value is just 4.8 times EBITDA compared to 8.4 times for UPS. However, FedEx has a net cash position of $650 million compared to net debt of $6.5 billion for UPS. Its growth has come, to a certain extent, through financial leverage, which isn’t necessarily a bad thing.
But referring back to Ben Graham, he liked companies with financial leverage ratios of two or less. FedEx’s is 1.8 while UPS’ sits at 4.3 — more than double Graham’s maximum. During the past five years, FedEx has used whatever free cash it has accumulated to pay down debt and provide shareholders with a small dividend while UPS has mostly ignored debt repayment, instead offering shareholders a much juicier dividend as well as share repurchases. It makes sense given the difference in operating margins. But that all could change if FedEx continues to successfully grow its ground segment.