FedEx Corporation (NYSE:FDX) Baird 2022 Global Industrial Conference November 8, 2022 2:00 PM ET
Company Participants
Mike Lenz – CFO
Conference Call Participants
Garrett Holland – Baird
Garrett Holland
All right. We’ll go ahead and get started. My name is Garrett Holland, senior analyst covering transportation and logistics at Baird. We’re thrilled to have FedEx participate in our industrials conference this year. Joining us from the Company, Mike Lenz, Chief Financial Officer. Management is going to review a few opening comments, and then we’ll get into some Q&A. So look forward to that.
But right now, I’ll turn it over to Mike. Thank you.
Mike Lenz
All right. Well, thanks, Garrett, and thank you, everybody, for joining us here this afternoon. We’ve certainly spent a great deal of time in the last several weeks, subsequent to our Q1 earnings release, meeting with investors and hearing your perspectives on that and sharing the things we’re doing to react to a changed environment for our business and the broader landscape that we operate in.
So if anything, it has absolutely redoubled our urgency and efforts to adapt to change and implement our strategies that we announced and rolled out at our Investor Day that a number of you, I believe, were able to join us for back in June, where we unveiled our Deliver Today, Innovate for Tomorrow strategy. And within that framework was financial targets that we outlined for our fiscal FY ’25, so 3-year plan, which was indicative of the evolution of FedEx from nearly 50 years of building and putting together the networks that sustain our competitive differentiation to an era of driving improved efficiencies and returns with better operating margins, lower capital efficiency, improved return on invested capital and increased returns to shareholders.
So while the environment has changed in that regard, and we’re going to have to go about getting out a little differently than we anticipated at that point in time, it absolutely remains the case that the predominant element of achieving those results was going to be implementing our structural cost initiatives. It’s just that much more imperative and expanded, those efforts, following the changes in the market that we experienced during the first quarter.
So to put some parameters around what are we doing relative to what we were thinking a few months back, for FY ’23, we have identified $2.2 billion to $2.7 billion of cumulative savings relative to the plans that we had for the business entering FY ’23. We’re well on our way to achieving $700 million here in the second quarter. But more broadly for the year, the main — the bulk of the savings will come from the Express division where we’ll be reducing flight frequencies.
We’ve already made great progress in that regard. We’ve eliminated roughly 8 or 9 international frequencies, about 23 domestic frequencies thus far that were — came into the schedule change we did in October. We’ve got another 8 or 9 domestic frequencies that will go in, in November. So we’re rigorously looking at that and evaluating our plans for post peak here as we come into the beginning of the calendar year after the holiday season.
So besides reducing the flight frequencies, we’ll be parking aircraft temporarily as we don’t need as much lift as we anticipated going into the year, and a big emphasis on optimizing the efficiency of our ground operations, too, within the Express business for lower volumes. At Ground, we — the last couple of years had explosive growth in demand and added capacity to grow with our customers.
At this point in time, it’s fair to say we’ve got a little more capacity than was anticipated given the demand we’re seeing. So we’re consolidating sorts in that regard. We eliminated about 7 or 8 intermediate sort points. We’ve consolidated about 500 loads into — to drive more efficiency within the line haul, and that’s all just within the second quarter.
So again, just a number of very specific actions that we’re implementing with speed and urgency to react to the changed circumstances. And then, of course, we’ve got to look at our overhead expenses and projects and initiatives. So we’re cutting back on the vendor headcount, deferred a number of projects, identified some initial office space location closures, and we announced the closure of roughly 150 of our FedEx office locations.
So again, it’s — we’re looking at everything across the board and moving with speed to implement these, and very confident of pushing the organization to hit the high end of that number there for the current fiscal year. But that’s reacting to what’s here and now.
What I think is important for this audience to understand and I think really has the leadership team excited is about the opportunity for us to structurally lower our costs and drive efficiencies in the business to weather all the different ups and downs that can come across in the external environment to be more resilient and more efficient. So focus on controlling what we can control as it relates to executing on the business because we adjust further to the macro environment, but we also want to make sure that we are structurally improving our efficiency.
So we identified $4 billion, which is an increase relative to where we were back in June. Express is the biggest piece of that. The air network, again, further opportunity there. More efficiency in terms of our sort locations, execution and ground delivery network, optimizing our clearance processes in that to become more efficient there as well as improve the customer experience.
And the element that we’ve talked about a great deal is the opportunity for us to improve our results in Europe as we’re now past the physical integration of TNT. And now we need to really leverage that platform we put in place to drive efficiencies and continue winning in the marketplace.
For Ground, it’s $1.1 billion of the total. Again, we’ve got the foundation in place in terms of the assets in that. So now it’s about becoming more efficient, sweating the assets, deploying our labor resources in that in the optimal manner, using it, the number of technology tools and development that we’ve got in-flight and will begin to come online here in the months and years ahead. And after a period of rapid growth, we are very much focused on continuing to lower our liability costs and the cost of risk that’s associated with that.
And then last, again, similar to what I said for the year, overhead and shared and allocated expenses. So procurement opportunities as we leverage the scope and scale of the enterprise, further consolidation in shared services — of shared services to process efficiency in that and back-office automation and modernization of our IT infrastructure and platform there.
So we’ve got a program in place to — we call the Drive program, which has specific what we call domains, 13 different domains we’ve identified thus far with executive sponsors and leadership. For each one of those, as a leadership team, we meet on it and status it weekly. So this is very much prominent focus of the entire leadership team and really signals our commitment and the urgency that we’re going at this.
Then the third plank besides the — we got the immediate term for the current year and what we’re focused on for the next couple of years and then what is the opportunity beyond that. We call it Network 2.0. So the initiatives I talked about, that part of the $4 billion set the stage for furthering the integration and alignment and leveraging our combined networks so that we can improve asset efficiency with pickup and delivery as well as line haul optimization between networks rather than singularly within networks. We’ve scaled that at this stage at another $2 billion of incremental opportunity that we will fully realize by FY ’27.
But we’re looking as we develop plans in that to see how do we realize that incrementally along the way here. But in the broader scheme of things, that allow us to operate and grow regardless of what the trajectory of the market is in a more efficient manner with less assets.
So we identified here 100 fewer stations than what we have today, which is roughly about a 10% reduction and then have a 10% fewer pickup and delivery routes. So that gives you a sense of what are the operational aspects and metrics around that to achieve that.
And then in conjunction with that, we’re using our assets more efficiently, and that lower our capital intensity as we go forward. And it has been a multiyear program to modernize the air fleet at Express. Express is the largest air cargo operator in the world.
And our CapEx spend on aircraft, we were about $2.4 billion the last few years. It will be more in the $1.5 billion to $1.7 billion here over the next couple of years and then line of sight to reduce that further after that.
We’ll complete the modernization of our major Express hubs in Memphis and Indianapolis largely by ’25, the last — but some latter part of next year beyond that and again, reducing the size of our capacity investment at ground as we’ve built out a comprehensive network there.
So that’s the overview of where we’re focused under our Deliver Today, Innovate for Tomorrow strategy with a relentless recognition by the management team that our first quarter results were not satisfactory, were disappointing to all of us. But we are relentlessly going after what we need to do to both react to the changed circumstances before us now and, equally important, implement the structural change to create long-term value and leverage the capabilities we’ve built over nearly 50 years.
Question-and-Answer Session
Q – Garrett Holland
That’s a great overview, Mike. Thanks. With that, we’ll get into Q&A. [Operator Instructions] Maybe to start, FedEx has a such a unique perspective on global demand. If you could take us kind of around the globe, what are you seeing in Asia? Obviously, trying to improve profitability for operation in Europe as demand deteriorates there. And then maybe close out here in the U.S. as we work through this peak season.
Mike Lenz
Okay. Well, first of all, look, the situation in Asia Pacific, where we have a proportionately larger exposure than any of our principal competitors, we had always recognized and understood within the context of that 3-year horizon that I outlined there that the current supply-demand circumstances weren’t going to persist, where you had unprecedented demand for priority services with constrained supply with — I think the stat is it’s 1/2 to 2/3 of transpacific freight capacity is typically on the underbelly of passenger carriers.
Well, that obviously hasn’t been there for a good couple of years now. So we recognize that was going to occur, but unquestionably, the commencement and the speed and the depth of that shift was beyond what we certainly had anticipated. So that’s why we’ve been taking down transpacific flights there.
You’ve seen in recent weeks and months, our customers are highlighting less demand for their products and goods. You’ve seen a shift from goods to services broadly. And with the inventory-to-sales ratio that just incredibly spiked up beyond any historical reference, it was very clear that demand had changed significantly.
You’ve subsequently seen ocean sailings being ad hoc canceled in that. So that’s definitely a reversion back that was anticipated, but it’s been much faster than we would have projected. We would have thought that would be more in our fiscal ’24 when we start to see that.
So I think our — that really accelerated in the last couple of weeks of our fiscal first quarter, so call it, August. And then we’re just projecting that through for the duration here, and that’s why we’re looking at the network there.
The good news for us is that as that passenger capacity comes back in, we will leverage that. As we — we basically embargoed our deferred traffic over the transpacific, we’ll use that belly capacity to efficiently service and move that deferred traffic going forward. So that’s Asia Pacific, which probably the China slowdown in that kind of — it’s consistent, I think, with a number you’ve probably seen around.
In Europe, a couple of aspects there. One, certainly, the conflict in Ukraine, the resulting energy crisis, which is subsiding a little bit. But that clearly had an impact on industrial production in Europe, broader European economy and purchasing power in that. So we’re definitely seeing a slowdown in the macro backdrop there.
But we had our own considerations as it relates to when we implemented the last aspects of the integration with our air network and consolidation principally into our Paris Charles de Gaulle hub back in March. Look, any of these big implementations, there’s a few teething pains along the way, not unanticipated.
We were working through those but then hit some obstacles that we had expected to clear through. It stalled us for a little bit here in the first quarter, and that undoubtedly had an impact on our customers. And so we — we’re making good progress on moving forward with that. We’re past the issues there, and service levels continue to improve there. So a little bit of a — the macro backdrop as well as some specific circumstances we had there.
In the U.S., you’re seeing, again, as anticipated, a bit of a reset from the e-commerce boom and the volume surges that accompany that, had projected that as well but certainly seeing less volume than we had — we projected to have lower volume in our fiscal first and second quarter already. It just came in lower than our initial projections were. So I think it’s — you’ve seen a number of e-commerce and retailers that talk about a less-than-projected demand for their goods in that.
And there’s also a degree of consumers looking to get back out, go into stores. Again, it’s certainly the case that e-commerce as a percent of retail sales are still well above where they were prior to the pandemic, and that’s going to be secular growth going forward for the parcel industry. It’s just going through this reset period here.
So again, the last 2 peaks, I would say, were unprecedented maybe in terms of the magnitude of the ramp-up in that. We’ll have a solid peak this year but a little more moderate perhaps than what we’ve experienced the last 2 years, which I think our operations team will certainly appreciate.
It was a great effort to really adapt to unprecedented circumstances. We talked about the labor environment that we were going through last year at this time. So good to have that behind us.
Garrett Holland
And to follow up on some of the expense overview that we just saw, help us understand kind of the transparency that you’re going to provide as you chase down those cost savings. I know you’re pushing hard towards the high end of that $2.2 billion to $2.7 billion range. Did these expense savings help put a floor under earnings power here in the second quarter, fiscal Q2?
Mike Lenz
Look, we absolutely will realize more of the structural cost savings in the second half of the year. That’s where you get more of the benefits start to roll in principally from — at Express, the flight reductions. When you park the aircraft, particularly the older airplanes that we’re parking, you’re deferring a maintenance event, which is a significant expense while at the same time, you have relatively low ownership costs on those. So it’s an operationally and financially flexible way to manage capacity there.
So as I said, we’re projecting a lower demand outlook for the foreseeable future here. I don’t have a perfect crystal ball to say what the overall macro environment will be. Don’t have a full year earnings outlook for FY ’23, so I don’t have any specific projection to give you there. But rest assured, as some of these specifics that I was highlighting illustrate, we are fully committed to continuing to take the actions we need for changed expectations of what the operating environment is.
Garrett Holland
That’s helpful. And what’s the right framework for investors to think about the permanent savings there, $2.2 billion, $2.7 billion, another $4 billion by ’25. What degree of those are permanent and can push beyond that $1 billion [to get it to everybody]?
Mike Lenz
Yes. So look, to frame that, that $2.2 billion to $2.7 billion is actions we took specifically, some of which were not something I want to be permanent. For example, we eliminated any assumption of accruals for our variable compensation plans, which is a broad-based plan. So that — I don’t put that in the permanent bucket, but the aspects like less flying, that’s — we will not fly as much.
We’re up to — I think we’re up to 16 flights over the Pacific was the plan. And so we — there’s no scenario where we envision coming back to that level of transpacific flying even if you were to see a shift in the — every downturn begets an upturn, but even in that fortunate circumstances, we wouldn’t go back to those level of flying. So that’s why I put that in that category there.
I think it’s important to keep in mind that, look, we were — just prior to the pandemic, we were in the midst of a significant shift in our international business as a result of changing trade policy and trade regimes with tariffs in that. And so we were in the midst of parking the equivalent of 7 wide-body aircraft in January of 2020.
Well, when the pandemic came along, we quickly had to reverse course on that, but now we’re fully focused on what we got to do to rightsize the air network at Express. And certainly, we’ll — we will retire our oldest 3-engine wide-bodies at the end of this calendar year. We call them the MD-10s. And then the 3-engine MD-11 is the next fleet that we’ll look to retire.
Garrett Holland
And when you think about Network 2.0, how does this change in the demand backdrop, cyclical as it may be? How does it impact the timing for that type of planning? And do you still feel good about the potential benefits from integrating these businesses?
Mike Lenz
Yes. No, that — it further emphasizes the importance and the relevance of that initiative and that opportunity, that is absolutely clear for FedEx. Look, everybody says, I couldn’t — let’s make it happen faster, right? Or why didn’t we do that before?
Well, for the — for decades, the independent networks served us wonderfully in terms of executing against the day-definite product and demand for Ground and Express. The time-definite was e-commerce has grown explosively. And it’s nearly 90% to 100%, depending on how you measure it, of the parcel market growth. It’s changed circumstances and the opportunity to optimize and harmonize the networks where you’ve got a preponderance of residential deliveries is significant. But there’s — we built these up over the years with independent systems, different type of assets and how we deployed our people. So we’ve got to really be thoughtful about having all the building blocks for that in place.
So for example, you can’t take an Express parcel and put it into a Ground sortation system and it reads it and sends it to the right play. You got to get all that. We’ve modeled it out from an operational insights platform that we’ve developed, but then you’ve got to operationalize that across the whole network.
So that’s just one example of sort of the system aspects of it. From an asset perspective, we will — you can’t take a container off of an Express airplane and just put it to a Ground a station or facility. You got to have the — and vice versa with straight trucks going into Express facilities.
So we will spend some CapEx there to get the facilities cost utilized as it were. But again, that’s within the lower capital intensity outline I gave you there. So that — we will certainly be looking to realize value from that along the way, but we’ve got to be thoughtful about sequencing it. And appreciate that it’s a network, and you can’t just singularly make one piece of it to work one way while the rest of it operates another way.
Garrett Holland
And shifting to Express margins, that was a primary source of downside in fiscal Q1. You’re obviously taking capacity out this quarter, more post peak. How quickly does the margin trajectory recover once you take these more aggressive cost actions?
Mike Lenz
Well, look, that’s one of the learnings and focuses of our team here as we look about transforming and changing the business is how can we make that move faster? How can we affect these structural changes to near-term demand to get the cost out sooner?
Look, the — it’s a continuum across our portfolio. The LTL business, which is a great business for us, but the execution and the aspects and the timing of being able to pull out cost elements is a much shorter time horizon. Ground is a little longer than Express. We’ve got the complexities of crew schedules and maintaining the network connectivity for our priority service capabilities worldwide. That’s got a longer lead, but it’s incumbent upon us to figure out how to shorten that so we can mitigate the impact of circumstances like we had here and drive the — to consistently drive the 8% to 9% annual margin for the Express business that we’ve identified in our FY ’25 goals.
So that’s fully the focus of the team. And again, 4 of those 13 domains I talked about are focused on the Express company for that very purpose.
Garrett Holland
Turning to Ground operations. Interested in your thoughts on the service through this peak season. And how you view that service is core to stabilizing or taking market share in parcel. What are you seeing in service at Ground?
Mike Lenz
So what — look, I talked a lot about cost initiatives, cost takeout and that being the key front-and-center focus of the management team. But it remains the case that revenue quality and realizing the value for the capability and the network that we have remains an emphasis as well.
So we are going to be thoughtful about that in a competitive environment. And our service differentiation is a key aspect of realizing that. So we’ve got Sunday service. Even though we have cut back, we still have Sunday service to 80% of the population, which differentiates us from our competitor.
We recently implemented and rolled out picture proof of delivery, and our network is faster than the competition. So very confident that those are just 3 attributes front and center that sustain the differentiation of the network.
And service has been consistently improving over the last several weeks and is back to where it was pre-pandemic. So I know there’s been a degree of rhetoric out there that — about potential disruptions in that. But what our customers are experiencing is great service, and we expect that to continue through peak.
Garrett Holland
That’s great. We’re running up on time, but maybe one question to summarize. How should investors be thinking about normalized earnings or cash flow, free cash at FedEx? What gives you confidence that the fiscal ’25 targets are still achievable?
Mike Lenz
So look, the — well, as I said, it will — we will need to get at it in a different way. Look, we had not based the plan on robust volume and revenue growth over that time horizon, fully recognizing the transoceanic supply-demand considerations, that the e-commerce had accelerated and that would moderate that.
So we were always focused on that the core aspect of achieving the margin improvement initiatives was going to be cost and efficiency focus. So it’s just expanding and going deeper in that regard. So those are things we can control. So that is the primary emphasis, and so that’s front and center.
You combine that with lower capital intensity. Look, historically, we ran about 8%. Our FY ’25 projection is for 6.5%. And certainly, I can see a line of sight given how I outlined some key projects rolling off beyond that, that we can go below that. And we’ll continue to adjust as needed.
We lowered our — after first quarter, we lowered the current year fiscal CapEx expectations by $500 million for — to reduce some of our — curtail our capacity projects in that. So you combine all those elements and you can clearly see the path to that cash flow generation, hence, the accompanying ROIC improvement and the commitment to improving the dividend payout ratio on a 25% normalized earnings basis against that.
I’m not counting where you might say we land this year, but I think that it all ties together in a cohesive strategy that really emphasizes what I started out with, which is this is a clear inflection point for FedEx and we have a great opportunity ahead of us.
Garrett Holland
That’s great. Well, with that, we’re out of time. Special thanks to Mike and the FedEx team for being here at the conference.
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