Why S&P Equity Research likes logistics stocks

Standard & Poor’s Equity Research Services (ERS) believes both the U.S. and the global economy are likely to show accelerating growth trends over the next year. Large globally diversified and vertically integrated transport and logistic companies like FedEx (FDX) and United Parcel Service (UPS) are usually among the first to see improving economic trends, since these companies operate in every facet of the U.S. and global economy.

For example, when inventory restocking begins, or when consumers buy computers or eBay items or books from Amazon.com, or when a manufacturer orders parts, or in many other situations through the global supply chain, FDX and UPS are among the companies that fulfill those orders. As such, they have a broad view into the global economic picture. And Jim Corridore, an S&P equity analyst, thinks they are starting to see improving trends.

In addition, due to the geographically diversified nature of these two particular companies, ERS thinks they are likely to continue to see growth in Asia and developing markets. Corridore thinks this geographical diversification could provide avenues of revenue growth even if the U.S. and Europe do not recover as fast as expected, providing a measure of protection against a longer recovery timetable. The two companies also have a pretty wide moat, according to ERS. In the United States, they are the only two companies that provide door-to-door air express and ground delivery. Globally, they compete with very few competitors, including DHL, which recently retreated from the U.S. market. Of course, they also compete with each other, with price competition cropping up from time to time as the companies attempt to take market share from each other.

Both these companies could show strong growth in revenues and earnings over the next year, says Corridore, who thinks the stocks are likely to benefit from the improved earnings he foresees, along with improving investor sentiment on the industrials sector as good economic news comes in.

Another reason he thinks the large scale logistics companies are likely to do well in the coming months is the benefits he sees of their owning their own fleet of planes and trucks at a time when trucking, ocean, and air cargo carriers are raising prices sharply. Though they do not own cargo ships, FedEx and UPS utilize their own fleets of planes and trucks. This practice, he says, should allow for sharp improvement in operating margins for both companies if volumes and pricing continue to improve as the U.S. and global economic growth forecasts get stronger.

FedEx reported its May quarter results on June 16, and experienced strong revenue growth in both international and domestic markets. For the quarter, revenues grew 20%, year over year, with Express revenues up 23%, Ground up 15%, and Freight up 30%, all in excess of what ERS had been projecting. These quarterly numbers represented an acceleration in revenue growth trends. The company said it expects continued growth in fiscal 2011 (ending May) on growth in industrial production and global trade.

The company is experiencing pressure in the areas of pension expense, maintenance costs and purchased transportation costs, but Corridore thinks all of these are short term issues, and he also expects these to be more than offset by strong revenue growth over the next year. For fiscal 2011, he forecasts revenue growth of 12% and per-share earnings growth of 42%, to $5.35 a share, on strong operating margin improvement.

Corridore expects UPS to see similar revenue trends when it reports its second-quarter profit results on July 22. For the first quarter, the company saw strong international revenue growth and a slower, measured recovery in the United States. For 2010, Corridore forecasts revenue growth of 10% and per-share earnings growth of 40%, to $3.24 a share.

In addition to a fundamental earnings recovery, Corridore expects investor interest in the industrials sector to continue to improve as it becomes clearer that the United States is in a clear sustained economic recovery. This investor interest could drive an expansion in FedEx’s and UPS’s P/E multiples, even as the companies experience a sharp growth in earnings.

Risks include the possibility the global and U.S. economies do not improve as rapidly as Corridore expects and the possibility of a pricing war between UPS and FDX in order to gain market share. Fuel prices also remain a risk as he does not think the companies would be able to recoup a sharp increase in fuel costs by rate increases and fuel surcharges. In addition, the stocks have become more volatile of late, as investors rotate from fear of global economic crises to enthusiasm over positive pieces of economic news.

Despite these risks, Corridore thinks the two brand names in package delivery are poised to show strong earnings growth as a worldwide economic recovery continues to materialize.

ERS advises purchase of the shares of FedEx and UPS. (See stock table.)

In contrast, investors looking for exposure to logistics companies, but who also want to benefit from holding a diversified security, may consider exchange-traded funds or mutual funds. S&P rankings on ETFs and mutual funds incorporate a rigorous analysis of each portfolio’s underlying holdings to assess valuation and risk, and are not based simply on past performance.
S&P has an “overweight” or “marketweight” rating on two ETFs that have one or more of the above-listed stocks within their top-ten holdings. (See ETF table.)

As for mutual funds, S&P has a four or five-star ranking on four equity mutual funds, all of which have a top-ten holding in at least one of the above recommended stocks. (See fund table.)

Note: The fund rankings in this article — from five star (best) to one star (worst) — are quantitatively derived from performance, holdings, risk, and expense analysis.
To get access to Standard & Poor’s Equity Research go to www.getmarketscope.com, or call 1-877-219-1247, or send an email to [email protected].

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