Yesterday, FedEx Corporation (NYSE:FDX) outperformed materially yesterday (+4%+ versus SPX +0.7%) on the conjecture that the company is a potential target. Bloomberg reported that Pershing Square is in the process of raising a $1B fund and will invest another $2B of its own capital in an activist position in an undisclosed target. CNBC reported that FedEx is a potential Pershing Square target. Earlier, we mentioned that JPMorgan has doubts that FedEx is Ackman’s mystery stock. Count another skeptic on the sell side, John Barnes of RBC Capital.
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There is nothing quite like waking up in the morning and finding out that a high profile activist shareholder may be interested in one of the names in your coverage universe. It’s an especially interesting event when you have an Underperform rating and a negative thesis on the stock. Imagine our surprise when following a letter to potential investors sent out by Pershing Square, FedEx Corporation (NYSE:FDX) was mentioned as one of the potential targets.
However, he is still bearish and explains in detail why he believes the rumors are false. Below is an excerpt from the report.
Based on criteria gleaned from the Pershing Square letter to potential investors, the target is a large-capitalization, investment-grade U.S. corporation that principally operates in one business, trades at a lower multiple than its competitor, is simple, predictable, and free-cashflow- generative, enjoys high barriers to entry, high customer switching costs and substantial pricing power. In our opinion, FedEx Corporation (NYSE:FDX) does meet the broader criteria (a large-cap, investment grade name with high barriers to entry that trades at a discount to its closest competitor).
However, we believe FedEx Corporation (NYSE:FDX) falls short on the more salient criteria, namely high customer switching costs and significant pricing power. In our view, FDX does not truly benefit from either of these advantages. We think the point regarding one principle line of business is debatable. While it’s true that the lion’s share of FedEx’s revenue and earnings are derived from package delivery, the company does so through several distinct networks, which we believe would be very difficult to integrate from both an operational and cost standpoint.
Pershing Square Would Get 9% Stake
As a final note, we highlight that a $3B investment would give Pershing Square a 9% stake in the company at current market prices. Chairman and CEO Fred Smith has a 6.2% stake in the company, so we believe Pershing Square would likely have to fight a proxy battle in order to get management to take a new course of action. We believe such a proxy battle would be risky at this point since FedEx Corporation (NYSE:FDX) is still in the early stages of an aggressive series of turnaround initiatives.
That’s all we know. Pershing Square sent a letter to potential investors and laid out the criteria for a future investment. Following the publication of the letter, a number of parties pushed the idea that FedEx Corporation (NYSE:FDX) is either “a” potential target or “the” potential target. That’s all we know about this event, nothing more. But, we now have to decide how this event influences our outlook for the name and our formal rating on the stock. After looking at this situation from every angle we can conceive, we are reiterating our Underperform rating on the stock for two reasons.
First, in our opinion, FedEx may or may not be the target as several others were identified as the day went on. As a result, this is a binary event and in the event that FedEx Corporation (NYSE:FDX) is not the target, we believe the stock will likely sell off aggressively. Further, we believe our fundamental analysis is still correct. FedEx is struggling with a bloated Express infrastructure and cost structure, an under-utilized aircraft fleet and dealing with the trade down from air service to ground service, further exacerbating the under utilization of the Express network.
Further, we believe that if an activist shareholder, whether it be Pershing Square or another one, is in fact interested in FedEx Corporation (NYSE:FDX), it is doing so because it believes it can seat a management team that can deliver better results quicker and more materially than management’s current cost reduction and network rationalization efforts.
If FedEx was performing well and trading at a multiple that is in-line or higher than its closest competitor, an activist shareholder probably wouldn’t be interested. Therefore, we believe that our fundamental analysis of the company remains sound, management has further work to do in order to improve the Express and consolidated corporate profitability and any activist shareholder interest in the company confirms our analysis (at least in our opinion).
We recognize that if we are wrong and FedEx is in fact the target, the stock is likely to move higher and potentially materially higher. However, we are willing to face this risk if it means that we continue to communicate our opinion on management’s cost reduction and network rationalization initiatives and their need to do more and do it quicker.
If Pershing Square does make an investment in FedEx Corporation (NYSE:FDX), we will adjust our rating at that time if necessary. Until then, we believe our fundamental analysis is correct and the current earnings outlook for FedEx doesn’t support the current stock price or valuation. As a result, we reiterate our Underperform rating on the shares of FedEx.