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By Jeremy Glaser | 05-04-2011 04:17 PM

FedEx Ready to Deliver Shareholder Value

FedEx should be able to enhance margins from historical levels during the next two to three years, says Morningstar's Keith Schoonmaker.

Jeremy Glaser: From Morningstar, I'm Jeremy Glaser. The Wall Street Journal recently named six Morningstar Equity Analysts as the Best on the Street. I'm here today with Keith Schoonmaker, he was named the Top Industrial Transportation Analyst. We're going to take a look at what some of his picks where, where he sees the industry going next year, and also where some of his favorite picks are right now.

Keith, thanks for joining me.

Keith Schoonmaker: Thanks, Jeremy.

Glaser: So, let's take a look back first at some of the picks that got you this award. What were some of your most favorite stocks throughout 2010?

Schoonmaker: Sure. Well, I guess I'm blessed with having a list that's going to do well when there is an economic recovery. We've got a lot of high quality on this list with a lot of economic moats. In fact, all but about two of the names on the list were high-quality names that really benefited from the recovery in volume. And in fact those, what I would call, lower-quality names last year also did extremely well during the recovery. We have UPS and FedEx, both did extremely well last year with some additional volume, and railroads also did well. So, we're talking about names that have what we consider arguably the most powerful competitive advantage and tremendous barriers to entry.

We don't envision any new railroads being built anytime soon. Likewise, UPS and FedEx perhaps their moat was best evidenced by the withdrawal in 2009 of the worthy competitor DHL from the domestic express delivery service. Again, they have a very strong economic moat in that rational market.

Glaser: You mentioned that there were some lower-quality companies that also did well. Could you talk a little bit about those?

Schoonmaker: Sure. Lower quality sounds a little bit insulting, but I guess we had two names, UTi and Pacer. They both have more room for improvement than say, UPS and FedEx, two global titans that are already running quite well. In fact, we had Consider Buying ratings on both of these firms, Pacer and UTi throughout last year and investors who bought at those times would have benefited tremendously.

For example, Pacer traded below $3 and tripled over $9 last year. UTi rose from about $13 to about $21, not quite a double. We still have some optimism about Pacer's room to recover as it's still little bit of a turnaround story.

Glaser: Looking forward to 2011, what do you think some of the tailwinds and headwinds are for the industry?

Schoonmaker: I guess the headwinds are more likely to be slower demand and higher fuel prices. I don't know about you, Jeremy, but I think I fueled up this morning at about $4.70 per gallon for regular unleaded, and that certainly can have a drag on consumer demand in the long run just by consuming a significant portion of the consumers' wallet.

Now most of the names on our list are able to pass through higher fuel prices as fuel surcharges, but the way these mechanisms work is there's a bit of a lag. So, earnings can suffer in periods when fuel prices are rising. Then as fuel prices taper off, level off, or even decline, earnings can recover with a bit of a tailwind.

Also, fuel can be a net benefit for firms that have greater fuel economy like railroads or intermodal marketing companies. They can benefit from higher prices driving truck conversions over to the rails. Some of the tailwinds, I would say, would be just the outstanding leanness that these firms have winnowed down to as they went through 2009 and 2010 recovery, still maintaining extraordinary, if not record, profitability. For example, CSX and Union Pacific, both continue to set record operating ratios even as they add volume back to their networks.

Glaser: Thinking about your picks for 2011, what's on your radar screen?

Schoonmaker: Well, we have two 4-star stocks right now. One is Pacer and we consider that to have considerable uncertainty; that's a higher uncertainty prospect. And FedEx is our other 4-star stock at the moment. So most stocks in this sector we consider to be fairly valued at the moment, but these two have a little bit longer time perspective than the market does. And we think that our valuation has some drivers that will work out, let's say, two to three years for now.

Pacer is still a turnaround story. It needs to build its retail intermodal business to replace its legacy wholesale intermodal business. You can check out the name a little bit more on and see what I mean by this replacement business.

When we come to FedEx, it's really got in three of its four operating segments some improvements that are likely to take place over the next two to three years that are likely to enhance margins over what we've seen historically.

For example, 12% of its revenue comes from its freight segment, which has had loss-making operations for eight of the nine last quarters. We think it's going to turn around in the next one to two quarters based on greater health in that market space, the domestic less-than-truckload space, and also on some efficiencies that FedEx has designed by combining its national and regional less-than-truckload systems during the past one year.

Also, it is growing its international priority business; this is going to benefit its Express sector. And as Ground gets larger and larger at FedEx, it's going to enrich margins as well since its margins are double to triple what the Express segment has been able to produce historically.

Glaser: Keith, congratulations.

Schoonmaker: Thanks, Jeremy.

Glaser: Thanks for talking with me today.

Schoonmaker: My pleasure.

Glaser: For Morningstar, I'm Jeremy Glaser.


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