Flying Into a Headwind

Stretching all the way back to 1841 when Charles Mackay -- the Scottish poet and journalist -- first published Extraordinary Popular Delusions and the Madness of Crowds there is evidence that crowds move markets. Which is the first of three maxims necessary to win with a headwind:

1. Crowds move markets.

In a volatile environment one can anticipate the future of an industry more reliably than that of any one player. A cautionary note on this maxim comes into play when merging in a headwind. As Justin Lahart wrote in his May 2008 Wall Street Journal article Bernanke's Bubble Laboratory:

Only when skeptical investors act simultaneously -- a moment impossible to predict -- does the bubble pop.

One might think of this as the "tailwind theory" of bubbles. Headwind theory has a corollary:

Only when convinced investors act simultaneously – a moment impossible to predict – does recovery begin.

Both these theories are "bubbles within bubbles." Amazon sales have surged because shoppers are increasingly gravitating on line to save on gasoline. Air carriers, on the other hand, are hurting because the cost of fuel drives up their expenses.

BACK STORY
In my post on Air Express Carriers: Creating Intangible Value I documented the relationship between shareholder value and competitive strategies for the top five international companies. I found that if FedEx (NYSE: FDX) had owned TNT [AEX: TNT] during its 2007 fiscal year the combination would have dominated its peers in earnings productivity:

When management wrings the last drop of earnings out of each sales dollar they can do no better, unless they change their business model -- or merge, which amounts to the same thing. The degree to which they achieve this goal is measured by relative earnings productivity. This is the ratio of actual earnings to maximum earnings.

The peer group in that analysis was the Swiss carrier Kuhne+Nagel [SWX: KNIN]; United Parcel Service (NYSE: UPS); and DHL [XET: DPW].

In my post on Air Express Carriers: Law & Order in Markets I asked the following questions:

Will the extraordinarily high and low dual market performances of UPS and DPWN be reflected in their future stock prices? Equally important, will the average performances of FDX and TNT be strengthened if a merger were consummated? Only the future will provide definitive answers.

The purpose of this post is to anticipate the future market value of a merged FedEx+TNT in June 2009 assuming management of the new company sets as it primary goal to maximize earnings in the face of a down market for its services and shares. The process of anticipating FDXT’s market cap, rather than predicting it, becomes management's goal. The first steps in competitive stock valuation are to anticipate future revenue and market value in this industry.

EXPRESS CARRIERS’ REVENUE
A useful way to anticipate group revenue in a seasonal industry is by applying a constant rate of change to year-on quarters. Using -2.5% as the constant results in the following expected quarterly revenue for the five express air carriers. A 2.5% tumble in revenue may not be "statistically" significant. But it sure would be enough to spook investors.

Notice the expected revenue in this chart simply takes the seasonal pattern down a notch from $60 billion USD in December of 2007 to $59 billion in December of 2008.

EXPRESS CARRIERS’ MARKET VALUE
Anticipating future market value in a down market means you go with your gut feeling. Is the air express  industry going to tank? Likely not. Most of the firms have hedged fuel costs. They also employ more people and are not as heavily invested in aircraft, as are the passenger carriers. This means they can more easily reduce their operating expenses [OPEX]. Will the five-carrier market cap flatten out at its most recent value? Not likely, given the anticipated fall in revenue. This drop in revenues will spook investors. So sinking values probably are in order. This chart reflects my gut feeling that market value will not tank, but it will sink well below current levels.

The most recent value of the five express carriers on August 1, 2008 was $145 billion USD. I used a 2^nd degree polynomial to create the "What if" trend line in this chart. That puts the group's June 2009 market value at $92 billion.

SECOND & THIRD MAXIMS
The second maxim necessary to win with a headwind is:

2. Optimize operating expenses.

That means management must adjust spending continuously so that the marginal cost of the next revenue share point equals its marginal earnings. In this regard everything is on the table: OPEX includes all the out-of-pocket expenses reported in the merged company’s income statement.

The third maxim for winning with a headwind is:

3. Anticipate peer behavior. 

My own guess is the peer companies will post a combined cut of OPEX in the neighborhood of 12.5% over the next 12 months from $42.25 to $36.97 billion USD. WPWN may cut more since it was hurting before the downturn. UPS and KNIN probably will cut less, but an overall 12.5% cut is a defensible starting point. The network of information resources available to management of the merged company will provide far more insights on this issue and adjustments can be made from quarter to quarter.

The following chart shows what FDXT’s numbers might look like in the mid 2009 given my simple assumption about the headwind it will face. By the way this issue is complicated by the fact that three different currencies are involved – the USD, the Euro and the Swiss Franc. This analysis makes no allowance for changes in the underlying exchange rates.

If industry revenue drops 2.5% to $58.6 from $60.1 billion USD by March 2009, management will maximize earnings at 22.64% of group revenues -- down 3.6% from a 23.48% share in March 2008. The impact of the fall off in group revenues and market share results in a 6% decline in FDXT revenues to $13.3  from $14.1 billion. Optimizing expenses produces a decline of 16.6% in OPEX to $10.3 from $12.3 billion. The effect of all these factors is a whopping 65.7% increase in EBITDA from $1.8 to $3.0 billion. Earnings to revenues increase from 3.0% to 5.1% while the OPEX to revenue falls to 17.5% from 20.5%.

WINNING WITH A HEADWIND
On August 1, 2008 FDX closed at $77 with a market cap of $24 billion. If the company were to merge successfully with TNT and adopt a maximum earnings strategy in the face of the headwind defined above its share price in mid 2009 would be around $107 with a market cap of $33 billion. That’s an increase of 38% in the face of an anticipated 37% decline in the pre-merger value of all 5 air express carriers. You might call this winning with a headwind. What's the chance these numbers are real? Virtually zero. What's the value of the process? Virtually limitless.

Thanks for visiting. As always your comments are welcome.

~V

Comments

[LGH]

Fedx does not hedge fuel.

fedx has some kind of phobia as to establishing itself as a true multinational firm. It is indeed a multinational, but the company has clearly concentrated most of its resources on the U.S. domestic market. Furthermore, Fedx is trying to avoid unions, I don’t blame them, however, in this case, Fedx has no other option, if they buy TNT, they get stuck with a unionized workforce.

UPS can write the check and Fedx is reluctant to do so, however, what price is to be paid for complete control? Will Bakker and his team seek secure positions in the future company plans, (since they are the more experienced in international business than UPS and Fedx) or can they be easily bought out? Bakker has stated many times that TNT is not for sale and can grow on its own. I hope he has not been deceiving the shareholders all along.

I do not see UPS with co-CEOs, one for domestic U.S., Davis, and one for international, Bakker. So where does Bakker and his team fit in?