Growth would have been greater this quarter had management not discontinued relationships with customers with which it could not agree on pricing and capacity for peak season, but this discipline bodes well for future margin improvement.
By Keith Schoonmaker, CFA | 12-21-16 | 01:26 AM | Email Article

We're surprised when  FedEx  Ground fails to shine, and second-quarter Ground operating margin declined to 10.5% from 13.0%; conversely, we don't even raise an eyebrow at weak LTL Freight results, where operating margin dropped 100 basis points to 5.5%. Express delivered a flat but strong 9.4% EBIT margin, or 9.7% excluding TNT integration expenses. While some Ground compression in the past couple of years stems from accounting changes and inclusion of lower-margin acquisitions, this near convergence of Ground and Express margins would have been unthinkable three or four years ago, when Express was typically in the midsingle digits and Ground flirted with 20%. We'll incorporate actual performance into our valuation model, but expect to maintain our fair value estimate and narrow moat rating.

Keith Schoonmaker, CFA, is director of industrials equity research for Morningstar.

Demand and price were strong in most segments, but particularly in Ground, which increased average volume 5% and expanded yield 4%. Robust revenue makes margin compression all the more unexpected. Costs increased in purchased transportation, rent, depreciation, building insurance, property tax, and staffing ahead of opening four major hubs and 19 automated stations. The firm made 69 relocations and executed 185 facilities-related projects this year. Management believes margins will improve during the second half of the year, and in coming years as Ground facilities leverage volume. Growth would have been greater had management not discontinued relationships with customers with which it could not agree on pricing and capacity for peak season. This discipline bodes well for future margin improvement, in our view.

TNT integration continues, and the firm will give a more thorough update in March. Management maintains its estimate of $500 million total capital expenditure needed to invest in TNT, and post-2020, $750 million of annual synergies. Management maintained fiscal 2017 EPS guidance of $11.85-$12.35 excluding TNT integration costs and mark-to-market pension adjustments.

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Keith Schoonmaker, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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