photo credit: atennies94

The following article is a reprint of my February 27, 2008 RealMoney column.

A long UPS/short FDX paired trade could work, but I’d wait for a pullback to $65 before UPS would tempt me as a long-only play.

My bullish November 2007 Landstar (LSTR - Annual Report) column represents my most successful pick for RealMoney to date. The stock is up 20%, compared to a 6% decline in the S&P 500. Landstar has also outperformed CH Robinson (CHRW - Annual Report) by 9% since I predicted as much in December, and YRC Worldwide (YRCW) has underperformed the S&P by 10% since I advised looking elsewhere.

Given that my transportation picks seem to be working out better than my others, I decided to push my luck with another long-short idea. This time, I think United Parcel Service (UPS) can continue its recent outperformance relative to FedEx (FDX - Annual Report).

Two years ago, I wrote briefly about the relationship on my blog, saying:

FDX has greater operating leverage and will continue to outperform as long as the economy continues to expand and trucking capacity remains tight…. Timing this switch is the difficult part.

Over those two years, the timing has clearly happened. UPS has outperformed FedEx by about 10% since then, and by 25% in the last 12 months.

Other than the operating leverage, I think the stocks are similar enough that a long-short trade would truly offset much of the risks. Clearly the macroeconomic and industry exposures are similar.

FedEx is expected to grow slightly faster (15% compared to 13% for UPS) over the next five years and has a lower P/E multiple. But UPS generates far more free cash flow. The free cash flow yield at UPS is 5.3%, compared to just 2% at FedEx. The cash flows can be used to buy back shares, pay dividends, or make acquisitions. All of these could boost the EPS growth rate for UPS. Because of the higher yield, I think there is much less downside for UPS.

UPS also tends to have slightly higher earnings quality, on average, than FedEx. I use the accrual ratio, which measures the difference between cash earnings and accounting earnings, as a proxy for earnings quality. This ratio is less volatile for UPS and tends to be closer to zero in most periods, both of which give me more confidence in the earnings reported by UPS (though earnings quality at FedEx is by no means poor.)

Source: Zacks Research Wizard, compiled by William Trent

The differences in performance, however, are only relative. Long-only investors have been disappointed by UPS over time, with the shares trading within 10% of the current price for the last two years, and within 20% for the last five. In fact, UPS is almost exactly in the middle of its long-term trading range.

I think the future performance will remain uninspiring. The 5.3% free cash flow yield is reasonable and offers some downside protection, but is not enough to juice returns. At roughly five times book value and 16 times earnings, I don’t see a huge opportunity for expanding valuation. The tight trading range has also means there is little advantage to a put-write strategy. Low stock volatility means the March $70 puts offer just over a 1% premium. That isn’t enough for taking the risk that the stock falls to the low end of its trading range – though I’d be much more favorably disposed toward UPS if the stock pulled back to $65 or so.

For the reasons outlined above, I think a paired trade going long UPS and short FedEx could continue to work over the next few months.

Disclosures: William Trent is long Landstar (LSTR - Annual Report)

Zacks Investment Research has provided Stock Market Beat with a complimentary trial subscription to Research Wizard.

Along with most of the rest of the trucking industry, the news on Friday from FedEx (FDX - Annual Report) and YRC Worldwide (YRCW) sent shares of Landstar (LSTR - Annual Report) down sharply, briefly causing it to breach the 52-week low. Landstar has long been one of my favorite names, and I took the opportunity to buy some shares because I think the current valuation will be tough to beat.

Don’t get me wrong – I’m not arguing that trucking revenues are about to ramp up across the board. As the chart below shows, the industry has been slowing since early 2006 and despite the little uptick in September the year/year change was a decline of 2.3%. Demand for trucking services is bad, and the slowing U.S. consumer suggests that it will probably get worse before it gets better.

Source: American Trucking Associations

No, the main reason I like Landstar for the long haul (har!) is their business model. Rather than own their own trucks, they outsource the loads to owner operators who provide their own rigs. The business capacity owners (BCOs in Landstar terminology) get the lion’s share of the revenue for the load, which encourages them to haul as many as they can. This is a virtuous cycle that benefits both Landstar and their BCOs. More than 30,000 rigs are in the Landstar network, though some are much more active than others.

But the benefit isn’t just incentives to work harder. The revenue sharing process means that most of Landstar’s expenses are variable rather than fixed. When business is slowing for the trucking industry as a whole, Landstar’s expenses fall in proportion to any decline in revenues and the company is able to remain profitable.

For regular trucking companies like YRC, each unassigned truck is a drag on profitability. The truck certainly represents a depreciation expense and could also represent an economic expense if it is leased or purchased on credit. Every truck without a driver hurts the company.

At Landstar, an empty truck hurts the driver, who then has that much more incentive to haul some merchandise, earn some money and make the truck payment.

Industry Slowdown?

Although Landstar reported a 3% decline in total revenue during the first nine months of 2007, the decline was mostly due to a fall-off in one contract. The company provides disaster-relief services for FEMA and the milder hurricane season in 2006 led to lower revenue in early 2007 than was experienced post Katrina and Rita for 2005/2006.

According to Landstar’s latest 10Q, revenue would have been up 5% excluding FEMA business in both years. Contrast that with the decline in overall industry revenues, and I smell market share gains. The industry may be slowing down, but I don’t think Landstar is.

Cheap Growth

Over the last 12 months, Landstar generated $167 million in free cash flow. Nearly all of its operating cash goes to share repurchases and dividends since the company isn’t buying trucks. On a $2.1 billion enterprise value, that amounts to an 8% free cash flow yield – more than twice the yield on Treasury bonds and a healthy risk premium in today’s market.

What’s more, Landstar’s 5% apples-to-apples growth in a bad year suggests the longer-term growth rate could be significantly higher. With today’s price justified even without any growth, the prospect of an eventual return to double-digit growth rates gets my mouth watering.

Sure, the P/E of 17x is significantly higher than YRC’s 6x. But the lack of capital requirements, the absence of YRC’s $1.5 billion in debt and the variable cost nature more than justify the higher P/E in my opinion.

Disclosure: William Trent owns shares of Landstar (LSTR - Annual Report)

The $1.90 in earnings, excluding the gain, was below the average analyst forecast of $1.98 but above the $1.85 estimate that spooked the market on Monday. The net result is the stock rallied on the news, offering further support to the thesis that not all expectations are created equal.

FedEx blamed the shortfall on a slowing economy, a condition the company expects will reverse:

FedEx expects earnings to be $1.45 to $1.60 per diluted share in the first quarter of fiscal 2008 and $7.00 to $7.40 per diluted share for the full year, assuming an improvement in the U.S. economy beginning in the late summer or early fall. Earnings growth is expected to be below the company’s long-term 10% to 15% earnings growth target due to continued soft economic growth and to planned investments to expand the company’s networks and broaden its service offerings. Capital spending for fiscal 2008 is forecast to be approximately $3.5 billion, of which approximately 70% is targeted for growth.

The consensus estimate for next quarter was $1.66, with a full-year estimate of $7.39. Key to the forecast will be whether the economy does indeed improve in late summer or early fall. I think that is a tough call either way.

FedEx (FDX – Annual Report) on Wednesday. Estimates are for $1.98 on $9.14 billion in sales. Since this is already at the lower end of management’s guidance, falling short would likely be very disappointing.

But falling short is exactly what one highly regarded analyst now expects, according to this article:

FedEx Corp. is expected to release below-estimates quarterly results on Wednesday, according to media reports.According to Forbes, Bear Stearns analyst Edward Wolfe reduced his earnings estimates from $1.98 per share to $1.85 per share.

Wolfe said in a report to clients that the package business, both within the U.S. and abroad, has slowed down significantly during the first half of 2007

Wolfe’s comments sent the shares down today, but if he is right and the company does report $1.85 on Wednesday I expect they will be down quite a bit more.

• Best Buy (BBY) on Tuesday. The estimates of $0.51 on $7.84 billion in sales have come down during the quarter but the stock hasn’t.
• Circuit City (CC) on Wednesday. The estimates of a loss of $0.32 on $2.43 billion in sales have come down during the quarter along with the stock.
• FedEx (FDX - Annual Report) on Wednesday. Estimates are for $1.98 on $9.14 billion in sales. Since this is already at the lower end of management’s guidance, falling short would likely be very disappointing.

The Economic Calendar looks pretty light.

Overall producer prices rose 3.2 percent from March a year ago, the biggest climb since a 3.8 percent 12 month gain to August 2006.However, core producer prices rose 1.7 percent from the same period 12 months ago, down from a 1.8 percent year-over-year rise in February.

That’s all well and good, but also well reported. However, we like to dig a little deeper and see which industries are benefitting from pricing power, as it could help us identify interesting stock ideas. The PPI charts are from the Bureau of Labor Statistics and presented as the year/year percentage change in price.

Highlight: Anyone know a good pure play in the turbine business?

Fruit and vegetable canners have pricing power:

And it still isn’t showing up in Del Monte’s (DLM - Annual Report) stock price:

Corrugated box prices are getting weaker:

Which may be a signal that demand for them – say, from FedEx (FDX - Annual Report) – is weak:

Given what’s happening to chemical pricing:

We think Dow (DOW) should be more receptive to buyout talks.

All the buyers for industrial valves:

Should be good for Curtiss Wright (CW - Annual Report).

Scarily for DELL (DELL) and Hewlett Packard (HPQ - Annual Report), computer pricing may only get worse.

Finally, semiconductor prices have taken a turn for the worse.

That should be enough to chew on over the weekend.

Disclosure: William Trent has a long position in SMH.

For the fourth quarter of fiscal 2007, gross revenues increased 31 percent to $951.3 million from $728.2 million in the prior-year fourth quarter. Net revenues also increased 31 percent to $331.2 million for the fourth quarter of fiscal 2007 from $253.7 million in the prior-year fourth quarter. Continued organic growth across all geographic regions, as well as contributions from the company’s March 2006 acquisition of Market Industries, Ltd., contributed to the fiscal 2007 fourth quarter revenue growth. After adjusting for the impact of acquisitions made by the company since November 1, 2005, as well as currency fluctuations on the comparison of UTi’s results, gross and net revenues each grew organically by 14 percent in the fiscal 2007 fourth quarter, when compared with the corresponding period a year ago.Operating income in the fourth quarter of fiscal 2007 rose to $32.8 million versus $17.5 million in the fiscal 2006 fourth quarter. Net income for the fiscal 2007 fourth quarter was $23.6 million, or $0.24 per diluted share, compared with $9.7 million, or $0.10 per diluted share, in the fiscal 2006 fourth quarter.

Consensus estimates called for $0.26 per share on $935 million in revenue. Because the miss related to cost issues rather than top-line growth, investors appeared to treat the miss as company specific, according to this Reuters report:

In a research note R.W. Baird & Co. transportation analyst Jon Langenfeld described the quarter as “disappointing, adding “top-line growth was solid and ahead of our expectations, but elevated costs drove meaningful earnings miss.”

Bear Stearns analyst Edward Wolfe also noted that revenue was stronger than expected, but added “UTIW has not yet straightened out its cost structure.”

However, we wouldn’t be so quick to attribute the revenue gains, more than half of which came from acquisitions, to a strong transportation environment. Recent data have shown a slowdown in trucking, a disappointment from FedEx (FDX - Annual Report), and other signs that fewer goods are being moved about. Meanwhile, the shares of companies similar to UTi such as Large Cap Watch List (Track at Marketocracy) member Expeditors International (EXPD) and Small Cap Watch List (Track at Marketocracy) and Mid Cap Watch List (Track at Marketocracy) member Landstar Systems (LSTR - Annual Report) have held up well.

It is quite possible that today’s disappointment will not spread to these other names, and we continue to like the non-asset based transportation names as long-term investment plays. However, in the short term we wouldn’t be surprised to see the weakness spread to more of the transports.

Update: We missed the fact that the railroads also had a setback, but apparently that, too, is company-specific.

FedEx Corp. (NYSE: FDX – News) today reported earnings of $1.35 per diluted share for the third quarter ended February 28, compared to $1.38 per diluted share a year ago. Third quarter results were negatively impacted by a slowing economic environment, lower fuel surcharges and severe winter storms, with the storm impact estimated to be $0.06 per diluted share. Results for the quarter also include an $0.08 per diluted share benefit from a reduction in the company’s effective tax rate.

FedEx Corp. reported the following consolidated results for the third quarter:

• Revenue of $8.59 billion, up 7% from $8.00 billion the previous year
• Operating income of $641 million, down 10% from $713 million a year ago
• Operating margin of 7.5%, down from last year’s 8.9%
• Net income of $420 million, down 2% from $428 million a year ago

Total combined average daily package volume at FedEx Express and FedEx Ground grew 4% year over year for the quarter, led by ground and international express package growth.

“The U.S. economy grew at a lower rate than we expected in the third quarter, and we saw continued adjustments in the automotive and housing markets. I believe, however, this represents a healthy transition for the economy as it phases into a more sustainable growth rate,” said Frederick W. Smith, FedEx Corp. chairman, president and chief executive officer. “FedEx is in excellent position to take full advantage of global economic-growth trends and deliver overall outstanding financial results in the long run.”

Consensus estimates called for $1.33 in EPS and $8.7 billion in revenue. With a net $0.02 benefit from one-time items, the EPS number was right in line but sales were light. For next quarter the Street expected $9.3 billion in revenues with $2.03 in EPS, while for the full year they were hoping for $6.78 on $35.5. billion. The midpoint of the guidance range provided by the company is disappointing.

For the fourth quarter, earnings are expected to be $1.93 to $2.08 per diluted share, while earnings for the full year are expected to be $6.45 to $6.60 per diluted share. Excluding the net impact of the costs associated with the new pilot labor contract, the updated guidance for fiscal 2007 is $6.70 to $6.85 per diluted share, an increase of 12% to 15% year over year excluding the impact of last year’s non-cash lease accounting charge.

Given that the disappointment appears to be in line with our expectations (which were previously discussed) we have little to add here.

• Housing Starts (Tuesday).
• The FOMC Announcement (Wednesday)

Significant earnings reports include:

• Large Cap Watch List (Track at Marketocracy) member Oracle (ORCL - Annual Report) on Tuesday. Consensus = $0.23 on $4.3 billion revenue and next quarter = $0.34 on $5.53 billion. We think acquisitions will result in upside to estimates though organic growth may disappoint.
• Adobe (ADBE) on Tuesday. Consensus = $0.29 on $655 million in revenue and next quarter = $0.35 on $718 million. We think they are likely to beat but that investors will still be too worried about the product cycle for the stock to benefit.
• FedEx (FDX - Annual Report) on Wednesday. Consensus = $1.33 on $8.7 billion in revenue and next quarter = $2.03 on $9.3 billion. We think the risks lie to the downside due to consumer weakness and the read-through from box makers.

For example, fruit and vegetable canning continues to exhibit strong pricing power:

Yet the market downturn has led Del Monte to give back most of its recent gains.

Meanwhile, corrugated box pricing has rolled over.

When combined with a slowdown at the consumer level, we think this could be bad news for the transportation companies that will have fewer boxes to move around.

Just when we were ready to give up the ghost, the weaker industrial gas prices appears to have broken through to Air Products:

Industrial valve prices are telling us to be patient with Curtiss Wright:

Finally, we have to point out the semiconductors. A price increase is unheard of in this industry, yet supposedly there was one. This is definitely the first we’ve heard about it, but it is worth pointing out just in case.

It would certainly make the market appear less bullish than we had thought.