The year-over-year inflation rate first crept above 6% in October 2021 and has not come down since; yet, key demand drivers for FedEx Corporation (FDX) and United Parcel Service (UPS) continue to grow strongly, argues equity analyst Colin Scarola in CFRA Research's flagship newsletter, The Outlook.
We analyzed the latest growth readings for U.S. consumer goods spending, the manufacturing index, imports, and exports. We found that while the latest month-to-month (M/M) annualized inflation reading slowed to 4%, the key demand drivers for FedEx and UPS were all still growing well in excess of that rate.
In our view, this indicates real growth (after inflation) will continue in all of these key categories for the package firms over the next year. We expect robust U.S. employment gains will continue to drive this growth despite much higher consumer prices.
Strong pricing power is an obvious advantage during periods of high inflation, and FedEx and UPS demonstrate their ability to raise prices every year. Long before the pandemic and ensuing inflation surge, FedEx and UPS routinely passed material price hikes for their freight and package transportation and delivery services.
For both firms, average base shipping rates for air and ground service increased 4.9% in both 2018 and 2019. In our view, the firms historically have been able to pass on these substantial rate hikes by leveraging their pricing power as duopoly-like suppliers with a highly fragmented customer base of thousands of firms in need of their shipping and logistics services.
FedEx and UPS are certainly not immune to high inflation, especially in labor costs. But the lack of inventory in their businesses, combined with their strong pricing power and fuel surcharges, situates them better than many other types of businesses during periods of high inflation, in our view.
We see evidence of this in recent trends for FedEx and UPS operating margins vs. the S&P Composite 1500. In the most recent quarter, operating margins broadly fell across the economy, but FedEx and UPS both managed to substantially expand margins Y/Y.
We see an attractive margin of safety in equity valuations of FedEx and UPS, especially relative to the broader market. Given recent strong growth readouts on their key economic indicators, we expect healthy earnings growth and new EPS records will continue for FedEx and UPS over the next one to two years at least.
Yet, these stocks are currently trading as if steep earnings declines are just around the corner. The current forward P/E multiple for FedEx is 36% below its median forward P/E of the past 10 years, while UPS is trading 24% below its 10-year median.
Meanwhile, the S&P 500 trades at a forward P/E of 17x, which is about in line with its 10-year median, not offering a discount. At 17x, the S&P 500 is therefore much pricier than FedEx and UPS on both an absolute basis and relative to its historical median.
We see healthy growth ahead for FedEx and UPS, and given the steep discounts the shares trade at, we view these stocks as being priced with a wide margin of safety for an unexpected downturn in their businesses, setting them up for attractive returns whether a recession hits or not. United Parcel Service earns our 4-STARS, or "buy" rating. FedEx earns our 5-STARS, or "strong buy" rating.
We don't expect the remainder of 2022 and 2023 to see a material drop in consumer goods spending but rather healthy growth as strong employment gains continue for the U.S. economy. Nonetheless, a drop in consumer goods spending is an important risk for FedEx and UPS, as much of their revenue is generated by shipping on behalf of U.S. manufacturers of consumer products and retailers.
