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.
In the first quarter, FedEx grew its operating margin by 40 basis points year over year to 7%, all of the improvement and then some coming from the ground segment, which grew revenues 16% to $2.3 billion, operating income by 42% to $407 million and its operating margin by 330 basis points to 17.9%. If it continues to do this — and there’s no reason to think it won’t — the gap in margins will close fast. With the severe discount the market’s putting on FedEx shares, the winds of change between the two will be swift once investors realize UPS is no longer the undisputed profitability champion.
I always like to see the directors and executive officers with real skin in the game. However, when you get to the size of FedEx and UPS, whose combined market capitalization is more than $85 billion, it’s unreasonable to ask more than a token gesture. FedEx directors and officers own 7.6% of its outstanding stock. UPS directors and officers own 4.3% of theirs. On a percentage basis, FedEx does better, but on a dollar basis, UPS is the winner.
The thing that separates the two for me is Fred Smith, CEO of FedEx. He founded the company in 1971 and has been on the board ever since. Smith’s years of service to the company total 40 compared to 23 for D. Scott Davis, UPS’ CEO. Both are lengthy tours of duty, but in the end, Fred Smith’s legacy is the difference-maker. He is Mr. FedEx.
UPS’ current shareholder equity is $8.3 billion, and its return on equity is a lofty 49.9%. However, if you add back five years of share repurchases and dividends ($21.2 billion) plus a one-time recognition of the funded status of its defined benefit pension ($2.1 billion in 2006), its return on equity drops to 13.8%, not much better than FedEx’s ROE of 10%. If UPS never had made those share repurchases, it likely would be sitting with little or no debt today. It didn’t. For this reason — as well as the fact FedEx stock is a much better value — investors should sell UPS and buy FedEx.
As of this writing, Will Ashworth did not own a position in any of the stocks named here.