FedEx Turnaround Gathers Steam


On Wednesday morning, FedEx reported first-quarter earnings per share that came in just ahead of the average analyst estimate at $1.53, up from $1.45 in the same quarter last year. The company also reaffirmed its full-year outlook for earnings growth of 7%-13%.

For the past year, FedEx has been executing a cost-cutting turnaround plan. The company's solid earnings improvement last quarter -- in the face of notable headwinds -- is a strong sign that this campaign is starting to work. FedEx investors can look forward to continued growth in the FedEx Ground business and marginal improvement in the FedEx Express business as the year progresses.

Growth in spite of headwinds
In its earnings release, FedEx noted that operating income growth was offset by a calendar shift that resulted in one fewer operating day compared to the first quarter of FY13. This calendar shift affected all of FedEx's operating units.

An even bigger setback for FedEx was what it calls the "fuel surcharge timing lag." FedEx imposes a fuel surcharge as part of its normal shipping charges. This surcharge is based on the market fuel price from six weeks earlier, and, as a result of this lag, FedEx experiences a profit loss whenever fuel prices rise: The fuel surcharge is based on older, lower fuel prices, while FedEx pays the current market price for fuel. Falling fuel prices create an advantage for FedEx, as the surcharge is based upon prices higher than what FedEx has to pay.

Sure enough, in May (the month before FedEx's first quarter began), U.S. Gulf Coast jet fuel averaged $2.725 per gallon, rising 10% to $3.003 per gallon on average in August. Jet fuel peaked at an average price of $3.096 per gallon in the week ending on August 30, the last week of FedEx's quarter.

Given that FedEx spends more than $1 billion per quarter on fuel, a timing lag that bumps fuel prices even 5% above FedEx's fuel surcharge has a significant impact on the company's profitability. Fortunately, fuel prices have started to drop this month and surging U.S. oil production could continue to drive prices down. If this occurs, last quarter's fuel headwind will turn into a tailwind.

Cost reductions continue
FedEx is also making good progress on its cost-cutting programs. The company announced that as of the end of August it had completed 45% of its head-count reduction program, which will ultimately result in the departure of 3,600 employees . FedEx also reduced flights between Asia and the U.S. in July in order to better match capacity to demand.

FedEx is also moving forward with its fleet renewal initiative, which will produce significant maintenance and fuel savings. During the quarter, FedEx retired the last 14 of its outdated Boeing 727s. These are being replaced by used Boeing 757s that FedEx is acquiring from United Continental Holdings .

The company also took delivery of its first Boeing 767 freighter this month. FedEx plans to add a total of 50 767s to its fleet by the end of the decade, almost singlehandedly keeping Boeing's 767 production line running. These airplanes will be at least 20% cheaper to operate than the fuel-guzzling MD-10s they replace.

Still bullish on FedEx
FedEx achieved modest profit growth last quarter as its FedEx Ground business continued to grow and cost reductions began to take hold in the Express business. However, the fuel surcharge timing lag represented a major setback during this period.

As the company continues to reduce its cost structure over the next two years, profit growth should really take off. In the near term, the fuel surcharge timing lag could become an advantage, providing an additional boost to earnings. Moreover, FedEx remains well-positioned to profit when the global economy finally returns to stronger growth. Therefore, I remain bullish on FedEx, even though the stock recently hit a multiyear high.

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Adam Levine-Weinberg is short shares of United Continental Holdings and is long January 2015 $100 calls on FedEx. The Motley Fool recommends FedEx. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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