the Fedex 2Q11 (ended November 30th) results

the results

Yesterday I listened to the FDX 2Q11 earnings conference call, which was held before the market opened in New York last Thursday.

FDX reported earnings of $1.16 a share on revenues of $9.63 billion.  The revenues were up by 12% year on year, the eps less than half that.  Earnings per share also just barely hit the bottom of the range of $1.15 – $1.35 that FDX guided analysts to when it reported 1Q11 results on September 16th.

Despite the close call, FDX raised its guidance for the full fiscal year from a range of $4.80 – $5.25 a share to a new range of $5.00 – $5.30.

The company did caution that its third fiscal quarter is always vulnerable to bad weather, of which the midsection of the US has already had plenty so far this month.  So it’s not yet clear what the quarterly breakout of the earnings will be.

details

The International Priority (IP) business, notably deliveries from Asia to the US, continued to grow rapidly, with revenues expanding by 14% over a year ago.  Notably, the domestic parts of the FDX distribution chain grew at about the same rate, and benefitted from improved operating efficiencies.

So what went wrong?

1.  After what was reported as only three hours of deliberation, a jury in Indianapolis awarded now-defunct airline ATA $65.9 million in its suit against FDX that it wrongfully terminated a long-term contract with ATA to transport US troops.  A reserve for this judgment–FDX said nothing on the call about a possible appeal–clipped about $.15 from eps.  That’s also the main reason the IP business had flat year-on-year operating income.

2.  FDX overestimated the strength of the IP business during the second quarter.  It extrapolated the frantic rate of shipment growth of the spring and summer into the fall.  But that didn’t happen.  Revenues in the IP segment grew by 23% y-o-y in 1Q2011 after an almost 30% gain in 4Q10–but decelerated to 14% growth in 2Q11.  (True, comparisons are affected by the fact that FDX’s business really began to pick up from recession lows in the second quarter of last fiscal year.  But FDX guidance still anticipated better than what it got.)

3.  FDX is now projecting a better full year than it was three months ago.  I’ll get to this in a minute.  Because of this, it is also projecting bigger bonus payments to employees than it was.  Therefore, it made a higher provision for bonuses in 2Q, and presumably also had to make a catch-up accrual for 1Q.  FDX mentioned this as a factor but gave no further details.

why the slowdown in the international business?

In ordering from suppliers, a merchant faces two complementary inventory risks:

–he can order what he is confident he can sell plus some more, and risk the expense of holding excess inventory for longer than he wants or selling it at clearance prices, or

–he can order only what he knows for sure will sell–or maybe less, and risk losing business as customers come into the store and find the shelves bare.

FDX wasn’t 100% clear on the point, but it seems to believe that retailers got cold feet as they planned for the holiday selling season.  They collectively made the cautious decision that the risk of being out of stock was much more acceptable than the risk of having excess inventories.  So they slowed down the pace of their new orders from Asia.

They are now finding out, too late to do anything about it, that customers are in a much better spending mood than anticipated.  As a result, store inventories will be severely depleted by the end of December.  This means, in FDX’s view (I think they’re right) that there’ll be a mad rush to restock early in the new year.  That will be very good for FDX.

In addition, FDX clearly believes that world economic growth is beginning to gain momentum and will continue to do so for at least this year and next.

my thoughts

I haven’t done enough work on FDX to have an opinion about it as a stock.  Clearly, earnings are going to improve, both as the global economy expands and as the costs of resuming normal operations–restoring pay and benefit cuts for employees and reactivating planes mothballed in the desert during the recession–now being charges against income–fade from the financials over the next couple of quarters.  To me, the real question is how much of that good news is already reflected in today’s stock price.

Be that as it may, FDX is a large, sophisticated company.  Because of the business it’s in, it has unusually good insight into the workings of the world economy.  It sees, directly or indirectly, manufacturers’ production plans and retailers sales experience.  And it must already have a good feel for the tone of business for the next several months.  I happen to think the company’s view of world economic growth is correct.  But, unlike my guesses, theirs is based on a wealth of commercial data that few other entities have.  So I think FDX is evidence that it’s still right to be bullish.

 

 

Wells Fargo: US economic recovery ISN’T sub-par

a better than average recovery

A month or so ago, I wrote about the thesis of Jim Paulsen, the chief investment strategist for Wells Fargo, that the US is actually doing a bit better than average for economic recoveries over the past twenty-five years.  The perception that the economy is relatively weak comes, in his opinion, from comparing apples with oranges–from comparing this recovery with all post-WWII economic rebounds, not with those of the last quarter century.  This latter group, however, are the only ones that occurred with an economy like we have in the US today.

Anyway, I’m suddenly on the mailing list for Dr. Paulsen’s monthly commentary (Thanks, Wells Fargo!).

a new angle

In his December comment, Dr Paulsen expands on his idea of a “back-loaded” economic recovery.  I don’t necessarily intend to talk about Dr. Paulsen every month, but I think he is making some interesting points.   They argue that we will be seeing accelerating economic performance out of the US economy in the months ahead.

women entering the workforce

In a nutshell, Dr. Paulsen’s November observation is that the US economy of the 1950s through the mid-1980s had a faster potential rate of growth than we have today because in the earlier period  the large-scale entrance of women into the workforce acted as a significant tailwind that we no longer have.

the effect of inflation

In his December commentary, Paulsen makes the additional observation that the switch from the inflationary mindset of the Seventies and early Eighties to a disinflationary one of the Nineties and beyond also has a significant effect on the behavior of corporations.  As he puts it, in the earlier period, “sales always rose and prices could always be increased.”  Therefore, it made no sense to worry about staffing levels or the size of inventories.  Price increases would always ensure that companies could report a satisfactory, and rising, level of profits.

The world has changed dramatically since the Sixties and the Seventies.  The Fed’s thirty year long fight against inflation has stamped out in customers’ minds the idea that prices inevitably rise.  In the new environment, a company has got to concentrate on keeping costs low and increasing productivity.  Hiring increases and capacity additions come only as a lost resort.

my thoughts

In my view, Dr. Paulsen’s observation about inflation is basically correct.   In fact, the old inflation-prone world of the Seventies is so foreign to today’s experience that it’s hard for people who didn’t experience it to comprehend how or why the economy ran the way it did back then.

But there are also a lot of other things different about the Sixties and Seventies:

–the industrial firms in Europe and Japan were still rebuilding after WWII

–trade barriers were much higher than today

–therefore, there were far fewer true multinationals, who aimed at selling large amounts of stuff at moderate prices all around the world

–electronic products, where performance always gets better while prices decline, were a much smaller percentage of industrial production

–the rate of technological change was much slower (so fewer worries that bloated inventories might become obsolete)

–there was no Internet and no online commerce

–there was no supply chain management software, so managements had little of today’s ability to analyze and control operations.

Yes, the Fed’s actions in the Eighties destroyed expectations of inexorably rising prices.  But the world is much more complex now.  Change is faster and competition is much more intense.  So cost control and productivity increases are essential for firms to remain competitive.  And today’s managements have powerful tools that allow them to dramatically curtail operations–as they did in late 2008 and early 2009–confident that this is the profit-maximizing thing to do.

good news

Today’s coin has another side, however.  Cost cutting and squeezing more output from a given amount of capital equipment can only go so far.  At some point, firms have to add people and plant in order to continue to grow.

Jim Paulsen thinks, and I agree, that we’re now at that point in the current recovery.  Productivity growth has been slowing for a while.  And there’s substantial evidence that companies are beginning to hire at a faster rate.  If so expect profits for publicly listed companies to accelerate in the months ahead.

Should you “buy when there’s blood in the streets”? … or “not try to catch a falling knife”?

Wall Street has spawned millions of clichés.  They run from capturing the essence of stock investing, “Buy low; sell high” to not-so-useful chatter (for investors) from traders, like “Wait for a pullback,” to the inane natterings of cable TV show personalities.

Market truisms are often mutually contradictory.  But, excepting the ones from TV, they often outline possible approaches to important investment issues.   That’s certainly the case with the two I’ve cited in the title for this post, which talk about how to deal with sharp drops in the market in general, and how to play a possible upturn in the business cycle (and therefore in the market cycle as well) in particular.

the big middle

In the old days–meaning pre-Eighties, professional investors in the US customarily talked about working the “big middle.”   The idea was to avoid undue risk at potential cyclical turning points in the market.  A manager would do this by becoming more defensive as he saw three signs:  the economy beginning to expand at an unsustainably high rate, the market becoming fully valued and the Fed about to shift money policy from expansive to restrictive.

He might miss the actual market peak by months.  But he was prepared to profit from the subsequent downturn.  As he sensed the opposite signs, however–the economy flagging, the market cheap and the Fed about to reverse course–he would do nothing.  He would wait for the market to clearly turn upward again before becoming more aggressive.  Again, he might miss the absolute bottom by months, but he would avoid coming out of his defensive position too soon and he would gain performance for a year or more after he turned his portfolio more positive.

No one talks about this overall strategy anymore.  Why not?

–For one thing, as a result of deliberate policy decisions by the major governments of the world over at least the past quarter-century, individual country economies are much more closely linked in a global network than they were.  The closed economy model is a thing of the past.  Markets are affected, sometimes profoundly, by events that take place elsewhere and over which the local government has only limited control.

–The investment business is much more competitive today than it was then.  Underperforming for six months or a year may be enough to get a manager fired before the “big middle” strategy allows him to catch up.  His clients may say they’re ok with the risk mitigation his approach provides, but when the numbers fall behind the peer group, memories can be very short.  And it’s always the customer’s right to take his business elsewhere if e chooses.

–For thirty years, we’ve been seeing the creation of ever newer derivatives tools that allow the manager to change portfolio composition much more quickly than before.  In addition, volumes in the physical market have been steadily increasing as well, allowing managers whose contracts with customers bar the use of derivatives to act swiftly, too.  Maybe we’re now seeing the limits to this speed, even large market participants have the flexibility to alter their portfolio structure in a matter of a few weeks if they choose to.

To sum up, linkages with the rest of the globe mean more chances for sharp short-term market movements, which new tools and increased competition have professionals increasingly focused on.  Also, as the recent “Crash of 2:45” shows, the new tools themselves may be another source of temporary market instability.

the falling knife

Opinion is divided on how to approach sharp market declines.  “Don’t try to catch a falling knife” expresses one technique.  I’m not sure what the origin is.  I’ve only begun recently to hear it in the US, although it was already very common among British investors when I began to look carefully at foreign markets in the mid-Eighties.

The “falling knife” idea is a variation on the “big middle” theme.   The thought is that when investors are selling aggressively and stocks are dropping sharply, it’s better to wait until this energy has exhausted itself before going in to pick up the pieces.  See the bottom and watch the turn happening before entering the market.

blood in the streets

The “blood in the streets” approach is to some degree the opposite idea.  Buy when everyone else is selling, when the predominant emotion in the market is fear, and when stocks are cheap.  Don’t wait for the turn.  By the time you’ve convinced yourself that the worst is over, the best buying opportunity is long gone.

more professionals are embracing the “blood” idea…

…in my opinion, anyway, for two reasons.  The opportunity to profit from market disruptions, and by doing so to perform better than one’s peers, is too great to ignore.  Increasingly, the time period over which clients are judging professionals’ performance is shrinking.  Hedge funds, where returns may be scrutinized and evaluated on a month by month basis, are the limiting case.  But this performance pressure is also being felt by long-only managers.

What should individuals do?

The most important thing is to ask yourself two related questions:

–Are you willing to accept the extra risk of trying to trade a downdraft in the market?

–Is your financial situation strong enough that you can absorb possible losses if you turn out to be wrong?

Assuming the answer to both questions is “yes,”  these are my thoughts:

1.  Ask yourself what the primary trend in the market is.  Are stocks generally going up or generally doing down?  Are we in a bull market or a bear market?

In my opinion, you should only be interested in counter-trend movements.  Only think about buying, or about replacing defensive stocks with more aggressive ones, during a decline that happens in a bull market.  Conversely, only use a sharp upturn to become more defensive during a bear market.  Otherwise, do nothing.  During the past twenty years, the lows have typically been much lower, and the highs higher, than anyone would have predicted.  Welcome to a world with derivatives trading.

2.  Calculate probabilities as best you can.  The point is that you don’t need to find the absolute bottom in order to act.  For me, if I can satisfy myself that a stock might go down 10% but has an equal chance of going up 30%, I’m happy to buy.  Your own risk tolerances will determine what the appropriate ratio is for you.

3.  Separate market events from stock-specific ones.  In a temporary downturn, more economically sensitive stocks will typically decline more than defensive ones.  Similar stocks in the same industry should show roughly similar volume and percentage change patterns.   These patterns should also be similar to the stocks’ behavior during past declines.  An individual stock decline that is, say, twice what one should expect and that happens on much higher than expected volume can be a warning sign that sellers are acting on newly developed negative information that you may not be aware of.  In such a case, discretion is the better part of valor.  Choose a different stock to buy, or don’t transact at all.

4.  Don’t force yourself to do anything you don’t feel comfortable with.  I think it’s a characteristic of today’s market environment that if you miss an opportunity today, another one will likely occur in a month or two.

20th Century Business (Inventory) Cycle

This is a simplified version of how the business cycle progresses.  The detailed ins and outs aren’t necessarily that key for investors.  By far the most important thing  is to have a standard framework for trying to anticipate where new economic energy, hence earnings growth, will come from.

Preliminaries:

The most basic goal of US economic policy is maximum sustainable economic growth, meaning the highest number we can have without creating accelerating inflation.  The Federal Reserve is the primary agency charged with meeting this goal.  Its main tool is interest rate policy.  (Other countries have different basic goals.  For the EU or Japan, which suffered from hyper-inflation in the first half of the last century, the main thing is to have no inflation.  Economic growth comes second.)

The Fed seems to think that the maximum sustainable rate of growth for GDP in the US is about 2% per year now, and that inflation should be no more than about 2%.  This would mean that nominal growth should average about 4%.  These figures are lower than would have been the case twenty years ago, when the target numbers would have been 3% and 3%, meaning nominal growth of about 6%.

In this framework, the Fed has two roles.  It either provides interest rates that are low enough to stimulate growth when the economy is advancing at below its potential, or it raises rates to a level that slows growth when the economy is expanding rapidly enough to run the risk of accelerating inflation.

Starting out–the Road to Overheating

Let’s say that one day consumers decide, for one reason or another, to spend more in stores than they have been.  Stores realize that they don’t have enough sales help and that they’re starting to run out of merchandise.  So they hire more workers.  They call up factories and increase their orders.  If business is really good, they also ramp up their expansion plans, creating more demand for workers and materials in the construction industry.

Factories, in turn, have to hire more workers.  They, too, dust off their expansion plans, creating further ripples of expansion in the construction and machine tools industries.

At some point, the economy starts to run out of unemployed workers.  Companies that want to continue to expand can only do so by hiring workers away from other companies by offering higher salaries.  Wages, traditionally the main source of inflation in the US, start to accelerate.

Contractionary Phase–the Fed Raises Rates

The Fed’s role now changes from encouraging growth to protecting against inflation.  It raises interest rates.  The rise has two functions:  it has some economic effects by itself; it also serves a a signal that the Fed thinks the economy is growing too quickly and is going to do what it takes to slow things down.

Let’s look at what happens to a store.  Say that its policy is to have 10 weeks’ sales worth of merchandise on its shelves and that before the increase in customer buying it was selling 90 units a week.  So it had 900 units in stock, either in the store or somewhere else in its supply chain.  As customers raise their buying to 100 units a week, the store sees it only has 9 weeks worth of merchandise in stock.  But when it calls the factory, it most likely anticipates further increases in customer buying, so it raises its weekly order to 110 units and asks for an additional 200 units so that it will end up with 1100 units in stock.

After the Fed starts to raise rates, let’s say consumers cut their buying back to 80 units a week.  This would mean that the stores–partly because of their more aggressive attitude toward inventories, partly because of the customer pullback–now have 14 weeks of inventory in stock.  So the stores slow their expansion plans and cancel orders for  4 weeks worth of merchandise, as fast as they can.  After the stores phone their cancellations in, the factories are shocked to find themselves without any work for the next month.  They lay off workers and cancel their orders for new machine tools and buildings.  Because of this, the plant construction business may have no work for an even longer time.  They, too, reduce spending and lay off workers.

This process is called the inventory cycle because it revolves around the cyclical expansion and contraction of inventories of goods.  

In this example, a 20% change in consumer spending–which may result from a 10% decrease in income–creates inventories that are 40% more than stores want to carry, factory production that temporarily drops to zero and a capital goods industry that’s completely out of luck.  The numbers may be heroic but the distribution of pain is at least directionally correct.

 

Recovery and Expansion–the Fed Reverses Course

At some point, the economy slows below its trend rate of growth and the threat of inflation dissipates.  The Fed then switches roles in favor of promoting growth.  It begins to lower interest rates.  This move again has a dual character:  it stimulates growth and it signals that Fed policy has changed.  

In traditional financial theory, a lower interest rate makes some business capital spending projects viable that had made no economic sense at higher borrowing rates.  In one way of looking at recovery, these projects begin to be acted on.  If they haven’t already, layoffs stop.  Firms hire workers, who earn income and begin to spend more on goods.  This reinvigorates stores, which also hire more workers.  In other words, industry leads in recover, with the consumer following.  

In my experience, this is the path recovery takes in most places outside the US.  It isn’t the way it works here, though.  In the US inventory cycle, as soon as the Fed starts to lower rates consumers go back into the stores.  The consumer leads industry.  One explanation for this behavior is the “wealth effect,” the idea that the value of consumers’ houses or stock portfolios typically rise on the reversal of Fed policy and the accompanying feeling of greater prosperity leads to spending in advance of income growth.  The “wealth effect” explanation doesn’t have to be right.  It’s the behavior that counts.

Traditionally, a Four-Year Cycle…

This whole process used to take close to four years, with 2.5 years of expansion and 1.0-1.5 years of contraction in the economy and a similar pattern in the stock market, leading the economy by about six months.

…but Future Inventory Corrections May Have a Different Shape

This pattern may still hold true on the domestic side of emerging economies.  But in the US at least, we now have extensive supply chain software installed in the big companies in most industries.  The internet allows global dissemination of this information at low cost.  We have larger and more vertically integrated firms in many industries, so manufacturers can see far down the distribution chain.  As a result,  many of the uncertainties that compelled CEOs to react slowly to changing economic circumstances twenty or thirty years ago are now gone.  So the inventory cycle may look less like a sine wave and more like a sharp drop, long bounce along the bottom, sharp move up and gradual bounce upward.

The stock market has also changed, and can react to new economic information far more quickly than it used to be able to.  A huge market for derivatives is available now that was in its infancy thirty years ago.  Transaction volumes in the physical market are also very large multiples of what they were then.  And short-selling was less accepted as a mainstream institutional or individual investment strategy.    But in the old days, there were substantial barriers–apart from business considerations–that limited portfolio managers’ ability to quickly become more defensive or aggressive.

Looking back, I suppose that it shouldn’t be too surprising that the stock market cycle and the inventory cycle were closely related.  But we may find in the future that the traditional pattern of leads and lags between the economy and the stock market have been more a function of the instruments we have had at hand to express our economic conclusions than anything else, and so may no longer hold true.