Fedex Corp (FDX) — Q2 2019 Earnings Call Transcript

Good afternoon, and welcome to FedEx Corporation's Second Quarter Earnings Conference Call. The second quarter Form 10-Q, earnings release, and stat book are on our website at fedex.com. This call is being streamed from our website where the replay will be available for about one year. Questions are welcome through our e-mail address, which is ir@fedex.com. When you send your question, please include your full name and contact information. Many of the questions we received in advance have been addressed in the remarks today or in the 10-Q. I want to remind all listeners that FedEx Corporation desires to take advantage of the safe harbor provisions of the Private Securities Litigation Reform Act. Certain statements in this conference call, such as projections regarding future performance, may be considered forward-looking statements within the meaning of the act. Such forward-looking statements are subject to risks, uncertainties, and other factors, which could cause actual results to differ materially from those expressed or implied by such forward-looking statements. For additional information on these factors, please refer to our press releases and filings with the SEC. Please refer to the Investor Relations portion of our website at fedex.com for a reconciliation of the non-GAAP financial measures discussed on this call to the most directly comparable GAAP measures. Joining us on the call today are Fred Smith, Chairman; Dave Bronczek, President and Chief Operating Officer; Alan Graf, Executive VP and CFO; Mark Allen, Executive VP, General Counsel and Secretary; Rob Carter, Executive VP, FedEx Information Services and CIO; and Raj Subramaniam, Executive VP, Chief Marketing and Communications Officer FedEx Corporation. And now Fred Smith will share his views on the quarter.

Thank you, Mickey. Season's greetings to all. Welcome to our call. FedEx is in the midst of another record-setting holiday season; long-term investments in capacity and advanced automation are paying off in speed advantage and outstanding service during peak and year-round. We salute our 450,000-plus team members around the world for outstanding service and we greatly appreciate their dedication to our Purple Promise, which simply states, 'I will make every FedEx experience outstanding.' At FedEx Ground, I think it's particularly notable that 96% of packages moved through an automated facility, translating to increased efficiency and speed. During this holiday season, service is at record levels. Just yesterday, 67% of FedEx Ground packages were delivered one full day earlier than scheduled despite it being one of the busiest days in the history of our company. What's more? Yesterday was the busiest shipping day ever at FedEx Office. This fall, we opened two major ground hubs, with Allentown, Pennsylvania being the largest in the FedEx Ground network. Both Express and Ground hub operations in North Carolina have been recently expanded as well. FedEx second quarter adjusted earnings per share were up 27% year-over-year and we anticipate full year fiscal 2019 adjusted earnings per share will increase year-over-year despite difficult global economic conditions. As our volumes and revenues demonstrate, FedEx is experiencing strong growth in the U.S., where the economy remains solid. However, our international business, especially in Europe, weakened significantly since we last talked with you during our earnings call in September. In addition, China's economy has weakened due in part to trade disputes. As a result, we have lowered our fiscal 2019 earnings guidance and are accelerating actions to reduce costs given the uncertainty of global macroeconomic trends. We are highly confident that we will achieve the benefits expected with the acquisition of TNT Express, although we will not achieve our FedEx profit improvement goal in fiscal 2019. The voluntary employee buyout announced in our earnings release today is consistent with FedEx's People-Service-Profit philosophy and addresses three strategic issues. One, we are nearing the end of our IT modernization program, Project Renewal, which began in 2010 to transition FedEx Information Systems into the cloud. Legacy mainframe applications are now being rapidly retired. This is one of the largest such transitions in the history of business. Once concluded, Renewal will have vastly reduced the number of FedEx IT Systems while dramatically improving security, speed to value, reliability, flexibility, productivity, and providing new automation opportunities for our customers and many FedEx operations. The VBO will provide our team members with important career options as legacy systems and technologies are retired. Massive integration of TNT into FedEx will be approaching its end stages, so a second rationale for the VBO is that we will not need the same number of staff positions at the end of this multi-year integration journey. And third, we believe new productivity-enhancing tools, from accounting bots and legal system analytics to predictive AI, will allow us to operate our company with fewer staff positions going forward. Of course, we expect overall FedEx employment to increase over the next several years, again, assuming moderate economic growth. Nevertheless, the VBO will help improve our tooth-to-tail cost. U.S. VBO is targeted to achieve an annual savings of $225 million to $275 million per year, providing an approximately 18 to 24-month payback.

Thank you, Fred, and good afternoon, everyone. Let me begin by giving you our thoughts on where we stand on the economic outlook. In the U.S., growth remains solid, driven by robust consumer spending and favorable conditions in the industrial sector. Internationally, the economic strength seen earlier this year has given way to a slowdown. The peak for global economic growth now appears to be behind us. Eurozone growth has slowed from 2.5% last year to under 2% in the second half of 2018, and economic growth in the U.K. has slowed sharply since July. The secular slowdown in China's economy has been exacerbated by trade tensions. Spillover effects from these tensions and the fading tech cycle have negatively impacted growth throughout Asia. Emerging Asia's growth slowed from 6% in 2017 to 5.6% in Q3. World trade slowed in Q3 to just 3.5% compared to 5.3% in Q3 2017. Leading indicators point to positive, but even slower trade growth in the near term. Now turning to FedEx performance. We have grown composite revenue, volume, and yields at each transportation segment. We have been working to holistically manage base yields and surcharges, including fuel. The domestic pricing environment is competitive, but rational. We recently announced our 2019 GRI of 4.9% for FedEx Ground and Express shipments and 5.9% for FedEx Freight. As per our announcement yesterday, we are expanding e-commerce delivery options for retailers with FedEx Extra Hours, a service that enables participating retailers to fulfill e-commerce orders into the evening and receive late pickups by FedEx Express with next-day local delivery and two-day shipping to any address in the continental United States. Retailers can extend evening order cutoff time by 5 to 8 hours, with some as late as midnight depending on their current order fulfillment process. FedEx Extra Hours recently launched with select customers, including AutoZone and Best Buy in multiple markets across the United States. As e-commerce continues to drive business, we continue to invest in our extensive retail network. In October alone, FedEx Onsite expanded to more than 1,200 Walgreens-owned Rite Aid locations, bringing the total FedEx hold locations to more than 12,000. And extending this saving grace, once again, for anyone who needs it, pickup will be available on Christmas Day at the vast majority of more than 8,900 Walgreens locations. Further, we are encouraging our customers who have not already done so to register for FedEx Delivery Manager. This will not only alert them of upcoming deliveries, but also allow them to redirect packages to thousands of secure and convenient hold locations during the holiday season. Enrollments have grown over 72% fiscal year to date, a clear indication that customers are enjoying the visibility and control of their shipments. Thanks to our outstanding team members and unparalleled network, we are experiencing yet another record peak season for FedEx. Once again, we have not applied a residential peak surcharge. FedEx delivers for millions of small- and medium-sized businesses every day, and we want to support these customers as e-commerce continues to grow and become a major part of their business. And that's just one of the many reasons we are doing very well in the small and medium customer segment. We are extremely proud of the excellent service levels that we achieved this peak season, especially given the increase in volumes. The last three Mondays were some of the busiest days in the history of FedEx, including Cyber Monday where our volume crossed 32 million packages, more than double our average daily volume. We were able to deliver all of that volume with record service levels. With that, I would like to take this opportunity to thank more than 450,000 team members around the world who are going above and beyond to deliver this home stretch of the holiday season. Let me now turn the call over to Dave for his remarks.

Okay. Thank you, Raj, and good afternoon to everyone. We are very pleased with our peak service performance as Fred and Raj have already mentioned. I'd like to thank all of our team members all around the world, especially here in the middle of our peak season. My comments are focused on FedEx Express today, where trends worsened in the second quarter, primarily due to international revenue challenges driven, of course, by international economic weakness. While international revenue was still growing, it is not growing at the rate we expected because of the overall global economic uncertainty that Raj just mentioned. Some of the largest economies in Europe are experiencing weakness that is impacting our international business. Germany, for example, saw their GDP contract quarter-over-quarter in the third calendar quarter. Italy remains a drag on overall Eurozone growth. The unrest in France, and I was just there two weeks ago, continues to escalate and spread with yellow vest protests now inspiring similar actions in Belgium, the Netherlands, Germany, and of course, throughout all of France. Also, the uncertainty of the United Kingdom with their Brexit issue. Following TNT's recovery from the cyber attack, we have seen an accelerated shift of our product mix to more freight than parcel, putting pressure on our system, and of course, our costs. Continued tariff and trade concerns and uncertainty in Asia are impacting our business there as well. We continue to work with our customers as they reevaluate their supply chains. As you just heard from Raj, the U.S. economy remains solid, and we are seeing strong growth in Express deferred package volume. Our TNT integration activities continue and are in full swing throughout Europe, Asia, and Latin America. Following the cyber attack, we accelerated the integration of our sales force by one full year and to date, approximately 70% of our global sales force has been integrated with the remainder to be completed at the end of this fiscal year. This will provide us a single point of contact for our customers, something they very much are looking forward to. Further, we accelerated investments in our IT systems and infrastructure to strengthen and enhance and protect the systems we use to run our daily business. Our focus continues to be on keeping our customers at the very center of all of our efforts while at the same time we are integrating our two global network businesses. The stations and countries that we have been integrating to date are primarily in smaller markets and represent approximately 30% of our combined volumes. The completion of the integration in these markets is indeed important, but synergy benefits have been limited given the relative size of the volumes we've integrated. The remaining integration work is focused on our much larger, more complex direct serve markets. Said differently, the countries that deliver most of the benefits are weighted to the later stages of the integration due to the complexities of their business. Our businesses are heavily dependent on IT solutions for the integration. For example, these require harmonizations of our services and then corresponding redesign of our multiple customer platforms, including, of course, fedex.com and our customer automation tools. Our original integration planning contemplated the long lead time required to build these IT solutions and accordingly, the benefits of these efforts would occur towards the end of the integration. While changes in our revenue mix and softness in volume have impacted the timing of the realization of the financial benefits, we remain confident in the long-term value of the combination and synergies to be realized through a single pickup and delivery network, single air and road network, back-office efficiencies, and of course, mainly our revenue growth. And now, I'll turn it over to Alan Graf to give more details.

Thank you, Dave, and good afternoon, everyone. As Dave just outlined, since our last earnings release, Express experienced significant weakness in business conditions and a change in service mix, especially in Europe. For the second quarter, International Priority volumes were up 1%, while International Economy volumes increased 9%. International Priority freight pounds were flat and International Economy freight pounds surged 16%. In the U.S., overnight package volumes were up 3%, while deferred package volumes increased 15%. These volume trends accelerated during the quarter and Express operating profit was significantly below our business plan in the first half of fiscal year '19. To address the shifts in our business conditions, we are implementing and accelerating several cost-reduction initiatives, both in the U.S. and internationally. These initiatives include a voluntary employee buyout program, capacity reductions primarily in the international airline network, limited hiring in staff functions, and reductions in discretionary spending. In addition to these cost reductions, we will continue to improve our productivity through various programs, including expanding the use of our technology and capitalizing on efficiencies available through the scale of our network as we integrate operations in Europe and gain market share at FedEx Ground. We had positive results from both Ground and Freight. The Ground segment operating income surged 18% to $586 million on an 8% volume increase and a 6% yield increase. Despite the upfront costs associated with opening two major hubs and inflationary cost pressures, Ground's operating margin increased 40 basis points to 11.4%. Ground's profitability will increase as investments in our market-leading automation, coupled with large productivity initiatives, come online. We will provide more detail on our Ground strategic projects in the coming months. The Freight segment grew operating income 37% with shipments increasing 8% and yields up 6%. Operating margin was 7.7%, up 120 basis points. Cost-reduction initiatives combined with continued profit improvements at Ground and Freight are expected to increase the long-term growth in corporate earnings and margins, improve cash flows, and increase our competitiveness. Regarding our FY '19 outlook, we are projecting adjusted earnings of $15.50 to $16.60 per diluted share, down from $17.20 to $17.80. This lower guidance is due to a shift in business conditions and service mix at Express, primarily in Europe. We're no longer providing guidance for revenue growth and operating margin for FY '19. The voluntary buyout will be offered to eligible U.S. employees. The cost of this program is expected to total $450 million to $575 million and will be recognized primarily in fiscal year '19 with the remainder in fiscal year '20. This voluntary buyout will have estimated savings of $225 million to $275 million in FY '20. We are also reviewing similar international opportunities. We are forecasting an effective tax rate of 24% to 25% for FY '19 before year-end mark-to-market retirement plans, accounting adjustments. Our capital forecast remains at $5.6 billion and we are reevaluating our capital spending going forward. We repurchased nearly $1.3 billion of our shares during the first half of this fiscal year, which has reduced our year-over-year share count. As I mentioned, we are reviewing all aspects of our financial plans, including whether we will repurchase additional shares this year. As a reminder, we spent $11.6 billion, purchasing almost 76 million shares over the last 5.5 years, resulting in a nearly 18% reduction in outstanding shares. During the remainder of 2019, we will continue to execute our TNT Express integration plans and will be focused on integrating the largest and most complex countries, which include the largest workforces and facilities. We continue to expect the aggregate integration program expense, including restructuring charges at TNT Express through 2020 to be approximately $1.5 billion and expect to incur approximately $450 million of these costs during 2019. However, based on the timing of the completion of integration activities, including any international voluntary employee buyout program, we may incur additional integration costs after 2020. The timing and amount of integration expenses and capital investments in any future period may change as we continue to execute the integration of TNT. We expect to realize the benefits of the TNT acquisition that were anticipated when the company was acquired, although at a more moderate pace caused by reductions in base business levels due to increasing economic weakness during the second quarter and a change in service mix following the NotPetya cyber attack. As a result, we now expect the operating profit improvement goal of $1.2 billion to $1.5 billion for Express over fiscal year '17 will not be realized in FY '20. Before we begin to address your questions, I recognize there is great interest in when we expect to achieve the $1.2 billion to $1.5 billion Express profit improvement and how much of it we will achieve in FY '20. At this stage, I'm not in a position to give an updated forecast for the reasons that my colleagues and I have mentioned. We are intensely working on further actions and plans to enable progress towards these goals. My hope is that I can give a directional perspective when we report our Q3 results. Like the rapid changes we have experienced, I'm confident that we will see improved operating earnings, margins, and cash flow in FY '20 versus FY '19, assuming moderate U.S. domestic economic growth and no further weakening in international economic conditions.

Thank you, Alan. We've got a mix of questions that came in prior to the call and then some that came in after the 10-Q was put up. So I'll go back and forth between the two to try to be fair here. So first question, which I'll take. Over the next 5 to 10 years, what are the biggest competitive threats to each division, Express, Ground, and Freight? This comes from Donald Broughton of Broughton Capital. Donald, we don't see any large or certainly no existential competitive threats to any of the three major divisions at FedEx. We do, however, see enormous competitive opportunities, and we have over many years taken market share and believe we have strategies in place that will allow us to expand the available or addressable market and, given the considerations that Alan just mentioned, to grow FedEx and to improve our profitability and margins and cash flows.

Thank you, Jack. I think in my opening remarks I talked about how excited we are about where Ground is now and where Ground is heading. We'll have more to say about that in the months ahead, but I would say there are two things, in particular, as we build scale at Ground and continue to sweat the assets that we have more efficiently, we're reducing costs at a very nice clip on a per package basis compared to what they otherwise would have been, which is going to make us much more competitive in the Ground network. I would also say, the use of technology has helped us to become much better in terms of improving our densities and with scale and technology, and a continued improvement in density will help drive Ground's operating margins up. I'm not going to give you a percentage; I just will tell you that we believe Ground has an opportunity to improve its margins over the next several years.

Okay. Yes, for sure. Earlier this month, as you know, we announced the nationwide launch of Walgreens Express, which is really a next-day prescription delivery service available at Walgreens locations. Regarding the question on investment, we are simply leveraging the fact that our current FedEx Onsite retail alliance with Walgreens allows our existing operational flows in and out of those stores, and prescription deliveries will be executed by the same station making the pickup, which our Extra Hour Service now makes possible. So this is one more example of how we are committed to increasing convenience, enhancing customer experience, and really expanding our service offering for customers. And let me add, we're doing all this in a very, very cost-effective manner.

Tom, I'll try to help you out here and turn this into a strategic question, because it was an anomaly in the first half. When you're in this business, you have a big fleet like ours, you have timing issues from time to time, and we had some timing issues in the first half. The second half, well, the comparisons will be almost flat year-over-year. But that's not the strategic question. The strategic question has to do with our continuing to replace our old aircraft with new, and we are continuing to do that. We're checking the pace, but having said that, it's been an integral part of how we're able to continue to hold our cost. The maintenance aspects of new planes versus used planes is absolutely unbelievable, not just from a cost standpoint, but from a reliability standpoint. Our ops division is doing a fantastic job. It's making a big difference in peak to have these new aircraft out here who have dispatch reliability through the roof. So from a strategic standpoint, the maintenance cost is going to go down over time relative to our revenues on our packages because of the newness factor.

As long as we got you on the phone, Raj, why don't you answer Christian Wetherbee's question from Citi, way up in the Northeast. Is the international express yield deterioration driven by missed changes at TNT or are there other factors affecting yield?

Well, Chris, the international yields are negatively impacted by exchange rates, product mix, and to some extent, region mix; those are the key factors.

So here's a question from David Ross of Stifel, which I would normally give to Raj or Dave Bronczek, but I'm going to take it because the answer is pretty clear. For the Express changes regarding international network capacity reductions, where are these taking place? Does it involve a number of flights or facilities? Will they be permanent or temporary? So the answer to the question, David, is if I told you that we would have to come and kill you because it would be this is competitively sensitive. Obviously, we can't tell our competitors what we're going to do, but anything you've got to recognize our networks are so big and the size of our Asia and our Pacific and our Asia to Europe and Europe to Asia networks are so extensive, we can take capacity up and down. So all kidding aside, Dave wants to jump in here. So don't tell him.

No, I won't. I can tell you that our networks are large and flexible, allowing us to adjust capacity as needed. For example, some traffic not currently utilizing our Purple tails has been consolidated to eliminate costs and enhance efficiency. We have numerous such examples globally, and the flexibility of our fleet and network enables us to increase or decrease capacity as required.

So Allison Landry of Crédit Suisse. How much flexibility do you have to throttle back to a $5.6 billion CapEx budget, Alan?

We received numerous inquiries about capital expenditures and aircraft. Thank you for your question, Allison. I'll summarize my response by saying that we are evaluating everything. I want to emphasize the points I made in my overview. All that information is available in the press release, so you could find it later. We are still handling a significant amount and experiencing growth in terms of volume and packages. Our yields are affected by broader market conditions. We are committed to growing our company. I believe, as Fred and Dave mentioned, we have the capability to scale back if necessary, though we do not anticipate a major downturn. Concerning our planned acquisitions and capital expenditures, we have significant projects in progress at the Indianapolis and Memphis hubs, along with an aircraft order book we are reviewing. These are essential for our long-term strategy, as Fred pointed out, we are planning for the next 25 years. The technology associated with these expansions and the reliability of the new aircraft are crucial for us. It's a balancing act, and this year may present some challenges. We may need to slow down certain initiatives to assess the situation. Nevertheless, we must continue to advance the majority of our current programs.

So this is a question from Lee Klaskow of Bloomberg Intelligence. I'm going to give it to Dave Bronczek because he lived for many years overseas and in Europe and then in Canada. Is it culturally harder to have employees outside of the U.S. to volunteer for these buyout programs? You take it, Dave, and maybe Mark wants to add something to it as well.

No, Fred, it's not. And I've been offshore half of my career, quite frankly, and the people over there are the same as people here. They want opportunity, they want diversity, they want a chance to grow with the company. On the other hand, they want our people philosophy. And part of our people philosophy is, if you have a voluntary buyout, they can voluntarily move forward to do it. I think that it's going to be well received. Alan and Fred didn't mention it in their comments, but we are looking at a global part to the voluntary buyout. And, of course, part of it was originally planned in the TNT integration. This is beyond that; this is much more than that. This is, of course, Europe and it's all around the world. So I think that it is part of our culture, our company's culture, that our employees actually like very much.

So there is another question from Tom Wadewitz from UBS about the air network. I think we've answered that, that there is lots of flexibility in it. We don't want to give details about the percentage moved in the Purple tails and that moved in underbelly. Suffice it to say, our Purple tail network is scheduled, so it provides unmatched service. And obviously, with the lower yielding, less service-sensitive business, we have the option either to put it on our planes or put it on other carriers until we build up enough density to put another flight on the network. That's the way the system works, but it's not in our best interest to go into further detail about that because of competitive interest.

Well, Dan, as we've talked about before, we don't have any concerns. And so far, as you can see from our press release, our numbers do speak for themselves, as we are seeing significant volume growth across our U.S. domestic parcel business.

So I'll just take this for me. From a short and long-term perspective, what is FedEx's strategy to counter competition from Amazon? David Campbell of Thompson Davis. You know, I'm not really sure how to answer this question. I mean, we look at Amazon as a wonderful company in service and they're a good customer of ours. We don't see them as a peer competitor at this point in time for many reasons. We think it is doubtful that that will be the case. So we have very strong strategies, well understood by the management team. The addressable markets that we deal with are growing. And as we've said over and over again, we've grown market share, particularly in the sectors we want to grow. There have been some sectors that we've chosen not to attack for a number of reasons, and that can change from time to time. So I don't know what I can say other than what I just said. I think the prospects of this company are going to be 'disrupted,' which just occurs over and over again, to quote a previous statement, is fantastical. So I'll leave it at that.

Earlier this month, we announced the nationwide launch of Walgreens Express, which is a next-day prescription delivery service available at Walgreens locations. Regarding the question on investment, we are leveraging our current FedEx Onsite retail alliance with Walgreens, which facilitates our existing operational flows in and out of those stores. Prescription deliveries will be executed by the same station making the pickup, which is now possible thanks to our Extra Hour Service. This is another example of our commitment to increasing convenience, enhancing customer experience, and expanding our service offerings for customers, all in a very cost-effective manner.

Our ISPs are exceptional and do an amazing job. We take pride in partnering with them. In some markets, higher labor costs are emerging due to increased competition for workers, which impacts service providers, including both linehaul and pickup and delivery, much like it affects other businesses. This is one of several factors we consider. Each ISP agreement is distinct and negotiated individually. As I mentioned earlier, we are facing some inflationary pressures at Ground, but due to their impressive productivity and technology, they are managing to overcome these challenges and improve margins.

Let me just answer the question by saying that we always look in terms of how we can handle the customer if we have extra capacity. In this case, when one of our competitors was having some difficulty, we did, and we moved it in our network because we knew we could provide outstanding service. So our FedEx freight team did a great job of handling that. In that case, we did take that part of the business. I do want to go back, Fred, if it's okay with you to a question earlier about China that Raj answered. It is true that our customers are talking to us daily about possibilities of weakness, softening in China just potentially for the future. And the good news for us, with our customers, is we have such a broad array of our portfolio between our ocean, between deferred shipping, our express shipping, so we've been talking to our customers. There is a concern out there that has been raised. We've been able to talk to our customers about any number of different possibilities, keeping the business inside FedEx that I wanted to make that extra point, Fred.

Excellent. Let me go back to the question from Donald Broughton of Broughton Capital. And I'll ask Raj to speak to this. With TNT solidifying your position in Europe, are there plans to expand this service offerings in Asia or is the next great opportunity somewhere else, Raj?

Well, Donald Broughton, Dave has talked a lot about Europe. But outside of Europe, TNT has fantastic ground networks in the Middle East, Asia, and Latin America. And when you combine those networks with FedEx's unmatched intercontinental air system, we now have a unique network that allows us to offer new value to our customers in a very, very cost-effective manner. And this allows us to now target multiple large international market segments, and we are very well positioned to expand these service offerings, including Asia as you point out. For instance, the largest air cargo lane in the world is Asia to Europe. With the capabilities that we just talked about, we are now extremely well positioned to win in this market segment that I just talked about.

Let me add to Raj's comments, I was down in Southeast Asia recently, Raj happened to be with me, and I think he will agree the Southeast Asian road network we have has just unmatched our position in Singapore. We have a wonderful regional hub there that's among the most productive in the FedEx system. We just began a flight from Singapore down to Sydney and they were doing extremely well. Our sales and marketing people have done a great job putting that capacity on. So we have, as I have said earlier, strategic plans where we think we can attack a larger express addressable market and can grow FedEx even in a low-growth environment now. As we've said repeatedly today, obviously, when you have a change that comes on you as fast as this did, it's hard to react to it.

I would like to think we will be able to deliver increased operational efficiencies throughout our global enterprise, and we will continue to stay focused on providing strong service for our customers, including those in innovative industries.

Thank you for your participation in FedEx Corporation's Second Quarter Earnings Conference Call. Feel free to call anyone on the Investor Relations team if you have any additional questions about FedEx. Thank you.