Thoughts on FDX’ F3Q:05 earnings report

· Upside report. FDX reported $1.03 EPS for F3Q:05 (Feb. quarter) vs. our estimate of $1.00, recently upwardly revised Consensus (First Call) of $0.98 and 45% better than $0.71 a year ago. Upside to our model was driven primarily by FedEx Ground with modest upside to Kinko’s based on our low expectations. LTL was modestly below our expectations and Express in-line.

· Strong operating metrics. Operating income was up 43% y-o-y on 21.1% revenue growth (including 12.8% growth prior to Kinko’s acquisition) and 110bp of y-o-y consolidated margin improvement (150bp improvement not including Kinko’s). This compared with our expectations for 38% operating income growth on revenue growth of 19% and 100bp margin improvement.

· Broad based strength. Volume and yield growth rates across virtually every product line were better than we expected (see Exhibit 1) driven by a strong economy, market share gains on the ground, continued rational but competitive pricing and a modest benefit from fuel.

Exhibit 1. FDX Volume and Yield Y-o-Y Growth

(1) Bear Stearns' estimates.
Source: Company reports, BSC estimates.

· Surprisingly strong Domestic Air Express rebound. Particularly impressive was the 5.5% increase in Domestic Air Express daily volume vs. our 1.4% projection and 1.3% y-o-y increase last quarter. This is FDX’s best Domestic Air Express volume performance in almost seven years. This also seems to validate our most recent shipper survey which indicated an increasing shift from ground to air as we get later in the economy. If FDX can continue to build volume in its fixed cost network we would expect it would begin to better leverage it into improved margins going forward.

· Capital expenditures creeping upwards with strong growth. Management increased cap.ex guidance modestly from $2.2B previously to $2.3B for F05. Still cap. ex remains at manageable levels at an estimated 7%-8% of F05 revenue.

· Management introduced a F4Q:05 EPS guidance range. In the release management introduced an EPS guidance range of $1.40-$1.50 the midpoint of which is modestly below $1.49 Consensus and our estimate of $1.48 prior to the release. On the call management noted tougher comparisons, rising fuel costs which its fuel surcharge lags by 4-6 weeks, and start-up costs related to new flights to China. Those flights should ramp-up fairly quickly.

· What does it mean for FDX stock? We believe there is more good news (express volume stimulation, ground market share gains and margin improvement, solid pricing) than bad news (no raising of guidance) in the report. The stock did not react particularly well into the quarter and we think this is a very strong report across product lines. There is the potential that the recent stimulation in domestic air express volumes if they remain strong could lead to FDX achieving its 10% Express margin earlier than expected. However we found the tone of the conference call a bit negative and defensive as investors and analysts expectations remain very high and management attempts to curtail these expectations.

· What about other transport stocks? FDX clearly is taking market share from UPS on the Ground, but that should not be surprising to anyone. It is possible given FDX’s big ramp-up in air express volumes this quarter that the ground market share is converting to some near term domestic air market share but we think less likely We expect to see UPS report strong overnight air volumes again in 1Q as we did in 4Q. Our sense remains that the cyclical move from ground to air express as customer seek to insure market share gains over pricing has likely began. FDX’s Freight, its LTL business, was strong but not like we have seen in recent quarters with more modest 130bp y-o-y operating ratio improvement to 92.8% compared to a 250bp improvement in a seasonally stronger F2Q:05 quarter on an 87.6% OR. Our sense is LTL stocks have likely seen peak margin improvement and that their maybe less upside this quarter for the group than some envision.