This comes from Citigroup on June 10th: Airfreight & Surface Transportation Is the Trend Your Friend? Air & Parcel Volume/Revenue Comparisons June 10, 2005 Scott Flower SUMMARY We recently completed an analysis of revenue and unit volume CAGRs and market share trends from 91-04 for the U.S. parcel and air express sector. Volume growth for the overnight air market declined from a CAGR of 8.6% between 91-95 to a CAGR of 2.5% since 96. Deferred air volumes have seen the fastest rate growth of all shipping, growing at a CAGR of 11% since 91. Ground parcel sector has grown more competitive since the mid-90s, due to FedExs entry into market. Ground volume CAGR a subdued 1.7% since 96. Since 1994, FDX lost 580 bps of overnight air vol. share to UPS, yet gained 710 bps and 770 bps of ground and deferred vol. share, respectively. UPS lost 740 bps of ground unit share, yet gained 950 bps of overnight air vol. share. Yields demonstrably firmer since 96 rather than early 90s, since then rev. growth has outpaced vol. gains by 160bps, 210bps, and 340bps for overnight, deferred and ground, respectively. Pricing remains firmest in ground. OVERVIEW Since the mid-1990s, several salient trends have developed within the U.S. parcel and air express sector that have altered the competitive landscape and changed the nature of the marketplace. Some of the more prominent of these trends include: 1) the gradual maturing of the overnight air express market, 2) the secular shift by shippers toward cheaper forms of shipping such as ground and deferred air services, 3) FedExs entry into the ground parcel delivery market, and 4) the increased emphasis by carriers on the bundling of services in an effort to provide shippers with the convenience of one-stop shopping while providing a point of competitive differentiation to avoid competition on pure price alone. As a result, carriers have responded by adjusting the way in which they do business in order to protect and/or gain market share and remain strategically competitive. Accordingly, we believe an analysis of the unit volume and revenue growth trends of the major U.S. parcel and air express carriers provides not only a historical review of these companies, but may also offer perspective on where these companies and the industry are heading, and what realistic top-line growth rates may be, thus providing investors with key insights into the competitive positioning and the investment merits of their equities. Our analysis of the U.S. parcel and air express sector addresses long-term unit volume and revenue compound annual growth rates (CAGRs) and the relative market share trends among the major carriers, which for purposes of our analysis include FedEX, UPS, and the United States Postal Service (USPS) (Airborne Freight, previously the third largest carrier in the U.S. small package delivery market, has not provided revenue and volume data since the companys acquisition by DHL/Deutsche Post in 2003). In particular, our analysis looks at the overnight air express, deferred air, and ground parcel delivery markets from both a carrier-specific and a collective industry perspective. We believe that such an analysis of intermediate and longer-term trends is important in that it provides investors with insight into the level of sustainable top-line growth that may be achieved by the various parcel carriers, as longer-term annual growth rates fluctuate less so than yearly comparisons. Also, taken over a longer period of time, this type of analysis lessens the noise that may influence data on a short-term basis. Lastly, we believe unit volume and revenue growth rates and market share trends are useful data points from which to evaluate pricing and capital spending expectations, therefore, providing a directional indication of the cash flow generation prospects for the various carriers, which, in turn, may ultimately play a key role in how the capital markets value their equities. Accordingly, we encourage investors to review our annual air express industry report titled Lift Happens, most recently published May 20, 2005, which analyzes capital spending and aircraft capacity addition trends. ADAPTING TO A CHANGING MARKETPLACE The U.S. parcel and air express sector is characterized as a high-fixed cost, hub-and-spoke network business subject to a large degree of operating leverage. The U.S. industry is dominated by two public players: FedEx, who pioneered the air express concept nearly 30 years ago and remains the largest provider of air express services today and, UPS, which maintains the largest ground parcel delivery network and market share. DHL, a unit of Deutsche Post (followed by London-based Smith Barney analyst Roger Elliott), is the third largest public player within the domestic market by virtue of its 2003 acquisition of Airborne Express. We estimate that these three carriers approximately account for upwards of 80% of the entire domestic parcel delivery market. The quasi-governmental USPS accounts for the vast majority of the remaining domestic market share. Accordingly, the U.S. parcel and air express sector represents a tight oligopoly, influenced primarily by two carriers, FedEx and UPS, and to a much lesser extent DHL. For purposes of our analysis, we define the domestic parcel and air express sector as being comprised of overnight air express, deferred air, and ground parcel delivery services. Figure 1 below displays the relative market share trends among FedEx, UPS, and the USPS since the mid-1990s (these percentages are slightly skewed by the absence of Airborne Expresss data; however, we believe them to be directionally and relatively accurate). Figure 1. Total Ground Parcel and Air Express Market Share (based on volume) 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 FedEx 14.9% 16.4% 16.8% 18.0% 19.0% 19.0% 19.0% 19.5% 20.3% 22.0% 22.1% UPS 62.0% 59.7% 58.9% 55.1% 52.6% 53.2% 53.6% 53.7% 54.3% 55.0% 55.9% USPS 23.2% 23.9% 24.3% 26.8% 28.4% 27.8% 27.4% 26.8% 25.4% 23.0% 22.0% Source: Company reports and Smith Barney As can be seen in Figure 1, FedEx has been the most successful of the three major domestic carriers in terms of consistently growing unit volume market share over the past decade. Several factors have led to this trend, most notably is the companys entry into the ground parcel delivery market in the mid-1990s via the acquisition of Caliber System. In short, FedExs entry into the ground parcel delivery market has bolstered overall unit volume growth despite a maturing of the companys core air express market and position in that market. UPS, on the other hand, saw its total volume market share gradually moderate during the mid-1990s and then drop off significantly in 1997 following the Teamsters strike. However, as shown in Figure 1 above, UPS has made great strides since the late-1990s in recovering lost unit market share. In fact, between 1998 and 2004, UPS market share increased 321 basis points, the largest increase among the three major domestic carriers. In addition, 2004 marked the first year since 1997 that UPS market share exceeded 55%, a milestone of sorts. We believe UPS been successful in not only recapturing lost market share through sound judgment with regards to product areas in which to compete, but the company has also been successful in improving returns through product mix and careful yield management. This belief is best illustrated in Figure 2 below, which provides a comparison of the revenue and unit volume growth rates at the FedEx, UPS, and the USPS over the past decade (1994-2004). Figure 2. Total Ground Parcel and Air Express Growth Rates Volume CAGRs Revenue CAGRs 91-95 91-00 91-04 96-00 96-04 00-04 91-95 91-00 91-04 96-00 96-04 00-04 FedEx 14.4% 10.4% 8.3% 7.6% 5.5% 3.5% 8.8% 8.9% 7.1% 9.2% 6.1% 3.2% UPS 0.9% 1.5% 1.2% 2.0% 1.3% 0.6% 6.7% 6.4% 5.3% 6.2% 4.6% 2.9% USPS 12.1% 9.3% 4.4% 7.5% 0.7% (5.7%) 11.7% 10.1% 6.5% 9.6% 4.0% (1.3%) Total 5.0% 4.6% 3.0% 4.4% 2.0% (0.4%) 7.9% 7.6% 6.0% 7.5% 4.9% 2.4% Source: Company reports and Smith Barney In looking at Figure 2, it is readily apparent that since the early-1990s, FedEx has experienced significantly higher rates of domestic unit volume growth than UPS and, since the late-1990s, the USPS. Again, it is FedExs entry into the ground parcel delivery market that helped drive above-average growth at the company. While important, however, we believe unit volume growth must be considered in the context of revenue growth rates as well. Specifically, we are interested in understanding incremental benefits of increased volumes. To this end, we note that UPS has seen revenue growth widely exceed unit volume growth during each period of our analysis. We contrast this to both FedEx and the USPS, which have seen revenue growth trail volume growth or only slightly exceed volume growth over the periods of our analysis. Consequently, UPS continues to maintain returns on invested capital (ROIC), adjusted for operating leases that substantially exceed those of FedEx. In fact, the spread between the lease-adjusted ROICs of the two companies has ranged between a low of 401 basis points in 1997 (the Teamster strike affected year) to a high of 1,045 basis points in 2000, with an average of slightly more than 700 basis points over the period of analysis. Accordingly, we believe the data presented in Figure 2 highlights the changing nature of the U.S. parcel and air express sector and, more specifically, each carriers shifting market focus. Simply, FedEx, as the dominate player within the air express market, has most recently been focusing on growing its presence within the lower-yielding, but higher return ground parcel delivery market. Alternatively, UPS, the leader in the ground parcel delivery market, has been aggressively targeting and growing share in the higher yielding air express market. Again, however, we note that UPS revenue growth has exceeded its volume growth in every period of our analysis; this relationship has been less consistent at FedEx. This consistent relationship at UPS is a testimony to the companys yield management and product mix strategies; it also is reflective of the fact that it has typically grown faster than the overall market in domestic air express, which tends to have a higher average unit yield. The converse is true for FDX, where it is growing faster in ground than the market, which tends to have a lower average yield. Despite a blurring in the services being offered by the various carriers, we believe distinct differences that cannot be easily altered in the short-term and in some cases the long-term remain. Furthermore, while FedEx and UPS have made strides to bolster core growth by entering new markets, we believe that each of incumbent carriers may likely become increasingly aggressive in defending market share going forward in their core markets, thus future share gains may be more difficult to achieve. Within this context, sustainable run-rate unit volume and revenue growth rates, in turn, have implications for both earnings and cash flow prospects that investors should come to expect from FedEx and UPS. It is these expectations that are ultimately integrated into the valuation of each carriers equity. 3 MATURING OF THE AIR EXPRESS MARKET Throughout the 1990s, the overnight air express market experienced rapid growth, almost doubling unit volumes during the decade. Between 1991 and 1995, overnight air express volumes grew at a CAGR of 8.6%, whereas the overall parcel and air express sector volumes grew at a CAGR of 5.0%. Clearly, overnight air express services represented a substantial growth engine for the broader sector, and specifically for FedEx during the early-1990s. However, following the economic downturn that began in March 2000, air express market growth, particularly that of overnight air express services, slowed considerably. As a result, overnight air express unit volume growth fell to an uninspiring CAGR of 2.5% between 1996 and 2004 and a much lesser negative CAGR of (1.4%) between 2000 and 2004, rates reflective of a maturing market. To this end, we believe that overnight air express unit volume growth will remain subdued for the foreseeable future due to shippers growing preference for lower cost forms of transport and the saturation of the domestic marketplace. Clearly the slowing is not simply cyclical, we think secular forces as well are at work in slowing the unit growth rates in this market segment. Figure 3. Overnight Air Express Growth Rates Volume CAGRs Revenue CAGRs 91-95 91-00 91-04 96-00 96-04 00-04 91-95 91-00 91-04 96-00 96-04 00-04 FedEx 11.6% 8.4% 5.0% 4.9% 1.2% (2.4%) 6.1% 6.8% 4.4% 6.8% 2.9% (0.9%) UPS 6.4% 8.9% 6.6% 10.2% 5.8% 1.6% N/A N/A N/A 11.0% 6.3% 1.8% USPS (0.6%) 2.3% (0.5%) 5.3% (0.8%) (6.5%) 1.6% 4.5% 1.9% 7.8% 1.8% (3.8%) Total Overnight 8.6% 7.9% 5.0% 6.5% 2.5% (1.4%) N/A N/A N/A 8.5% 4.1% (0.0%) Source: Company reports and Smith Barney While a slowing in the rate of unit volume growth within the overnight air express market was to be expected, particularly given the robust pace of growth witnessed during the early and mid-1990s, we wonder to what extent have shippers become comfortable with the less expensive services of deferred air and ground parcel delivery. As this as a background, we note that our past few surveys of higher-value good shippers (truck and airfreight) indicate that shippers increasingly prefer lower cost modes of shipping and, in general, do not intend to shift freight placed in these channels back to premium air services in the near-term, at least in large doses. Furthermore, while we continue to believe that Just-in-Time (JIT) processes will remain the accepted standard in distribution management, we highlight the impact that increasingly sophisticated technologies are having on supply chain visibility, thus allowing shippers to more effectively utilize cheaper forms of transport. Accordingly, we believe the trend away from speed for speeds sake (i.e., overnight air express services) toward cheaper, timedefinite shipping alternatives will become progressively more evident over time. Simply put, deferred air and ground parcel delivery alternatives, which have become more reliable and consistent, represent a better value proposition for shippers. To some extent, less costly, but highly reliable shipping alternatives in ground and deferred air parcel are more cost effective in a world of secularly lower interest rates, where the value of inventory holding costs has been falling. Thus, very expensive overnight air transport creates less savings in other aspects of the supply chain, thus is less advantageous than perhaps it once was. Figure 4. Overnight Air Express Market Share (based on volume) 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 FedEx 62.6% 63.2% 63.1% 62.8% 61.1% 60.2% 59.3% 59.5% 58.3% 57.1% 56.8% UPS 27.1% 27.5% 28.4% 28.5% 30.4% 31.6% 32.6% 32.5% 34.2% 36.2% 36.6% USPS 10.3% 9.2% 8.5% 8.7% 8.5% 8.2% 8.1% 8.0% 7.5% 6.8% 6.5% Source: Company reports and Smith Barney 4 Consequently, we believe the maturing air express market and the trend toward cheaper forms of shipping presents a strategic challenge to air express carriers, particularly FedEx, over the long-term, given that domestic air express remains the companies single largest market segment. While we believe FedEx management is focused on undertaking the painful process of right-sizing the companys U.S. network to levels more aligned with long-term growth expectations for the air express market while lowering its cost base, we caution investors to not overestimate the pace of structural change in the companys infrastructure. Specifically, given the level of fixed costs and investment required to maintain an integrated air express network, the ability to reconfigure operations is an extremely challenging exercise that cannot be completed at the turn of a switch. Rather it will likely require ongoing focus and iterations over time. In the shorter run, it also presents a challenge to UPS, which has been supplementing its more modest ground unit growth with air express market share gains. In a less robustly growing air express market, the ability of UPS to grow its air units as quickly is challenged, thus putting more onus on it to sustain overall yields, defend ground market share, grow its international division, and improve the growth and profit performance of its supply chain services unit. Furthermore, we note that FedEx management must be prudent in its restructuring efforts in order to avoid deterioration of the companys service levels, which could potentially damage the FedExs premium brand image and the yields that accrue from this. Additionally, in spite of the internal focus FedEx must take in reorganizing its air express network, the company must remain keenly aware of the actions of its largest competitor, UPS, in our view. Specifically, during the last eight years (1996-2004), UPS has experienced stronger growth within its air express operations than FedEx has. While this is largely due to the relative size of the two companies networks and market share, UPS ability to leverage its integrated domestic network operations has resulted in a lower average cost across its range of products than at FedEx. Consequently, UPS has used its overall scale, integrated network operating efficiencies, and bundled pricing strategy to take directly and/or indirectly overnight air express market share from FedEx. Hence, should UPS continue to grow its share of the overnight air express market at the express of FedEx, among other competitors, it is likely that pricing may become an increasingly important competitive lever, as retaining market share will be a priority in an effort to cover the substantial expenses related to operating a high-fixed cost business. However, much of what strategic flexibility there is in pricing would relate to cost structure and position. As such, FedEx, not being the low-cost air express producer, will be relatively more challenged in using price as a competitive measure. IS THE GROUND MARKET BECOMING TOO CONGESTED? The ground parcel delivery market, long dominated by UPS has undergone a considerable amount of change in recent years due in large part to FedExs entry into the market in the mid to late-1990s. FedEx, driven by the desire to fill a strategic gap within its business model and to mitigate the effects of UPS zone-based pricing and product bundling, which threatened the viability of its shorter-haul air moves, acquired Caliber System in October 1997, thus taking ownership of RPS, the second largest player in the domestic business-to business ground small-parcel segment. As a result of the acquisition, FedEx was able to offer shippers a complete service portfolio consisting of overnight air express, deferred air, and ground parcel delivery services. However, despite the initial success of its acquisition of RPS, FedEx Ground did not effectively compete with UPS in the residential ground market, as RPS was primarily a business-to-business service. As a result, UPS maintained a strategic advantage over FedEx within the rapidly growing, e-commerce driven residential ground market with the ability to provide unrestricted and integrated service to shippers. In response, FedEx launched its home delivery service in March 2000, and shortly thereafter expanded its coverage of the domestic market from 70% in February 2001 to 100% by September 2002. As a result of these efforts, as well as diversions surrounding the 2002 UPS Teamster contract negotiation, FedEx rapidly grew its share of the ground parcel delivery market from 8% in 2000 to nearly 13% in 2004. However, FedExs expanding share of the ground parcel delivery market has not solely come at the expense of UPS, as some would believe, but rather it has primarily come at the expense of the USPS as shown in Figure 5 below, particularly since 1998 which highlights the share shift from UPS following the 1997 Teamster work stoppage. FedEx Ground has been able to take share both directly and indirectly from both UPS and the USPS. Figure 5. Ground Parcel Market Share (based on volume) 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 FedEx 5.8% 6.6% 6.6% 7.2% 7.9% 8.0% 8.0% 8.6% 10.2% 12.5% 12.9% UPS 67.4% 65.2% 64.3% 60.2% 57.2% 57.8% 58.1% 58.2% 58.5% 59.1% 60.0% USPS 26.8% 28.2% 29.1% 32.6% 34.8% 34.3% 33.9% 33.2% 31.3% 28.5% 27.1% Source: Company reports and Smith Barney Thus, while we wish to take nothing away from FedEx Grounds measurable achievement, and the strong business model and management it has under unit CEO Dan Sullivan, we caution investors to not get overly excited by FedExs Grounds historical rate of growth, which moderated in 2004 as a result of challenging comparisons. Additionally, we highlight two developments that we believe contributed to the rapid growth exhibited by FedExs ground segment in recent years. First, on June 30, 2002, USPS instituted a rate increase for its Priority Mail service of 15% on average and over 40% for certain lengths of haul and weight classes. We believe a significant amount of the USPS lost traffic from price sensitive shippers found its way into the FedEx Ground network rather than the UPS network due to shippers apprehension over the July 2002 Teamster contract deadline. Second, we believe that FedEx Ground benefited from the diversion of traffic away from UPS during the months leading up to the July 2002 Teamster contract deadline. Remember also that the Teamster contract was structured as a six-year agreement, a year longer term than typical, thus pushing out again the time in which shippers will concern themselves with union negotiations at UPS. Thus, the volume benefits that accrued to FedEx as a result of these events should not be considered ongoing in any one year, but rather episodically recurring in their impact on FDX ground volumes. Figure 6. Ground Parcel Growth Rates Volume CAGRs Revenue CAGRs 91-95 91-00 91-04 96-00 96-04 00-04 91-95 91-00 91-04 96-00 96-04 00-04 FedEx Ground 14.9% 10.7% 11.2% 8.6% 10.4% 12.2% 17.1% 13.5% 14.5% 11.9% 14.3% 16.7% UPS (0.6%) 0.3% 0.4% 1.0% 0.8% 0.6% 3.1% 3.8% 3.7% 4.5% 4.0% 3.5% USPS Priority Mail 13.1% 9.7% 3.7% 6.9% (1.2%) (8.7%) 14.9% 11.9% 7.3% 9.9% 3.6% (2.2%) USPS Parcel Post 12.3% 9.9% 8.0% 10.9% 7.3% 3.8% 11.6% 9.6% 8.0% 10.5% 7.5% 4.6% Total Ground 3.3% 3.3% 2.2% 3.6% 1.7% (0.3%) 5.9% 5.9% 5.3% 6.3% 5.1% 3.8% Source: Company reports and Smith Barney While we anticipate FedEx will aggressively seek to continue the rapid growth of its ground business, we believe it will be difficult for unit volumes to grow at a double-digit pace for long. Furthermore, we believe the competitive landscape within the ground parcel delivery market will only intensify as: 1) FedEx increasingly relies on growing its share of the ground parcel delivery market in an effort to bolster the companys overall rate of unit volume growth amid a maturing air express market, 2) UPS becomes increasingly aggressive in its defense of ground market share via implementation of its Package Flow Technology (PFT) initiative, the tightening up of transit times within its network between key metropolitan regions combined with the greater bundling of its logistic services with package delivery offerings, and, finally, 3) as DHL more aggressively pursues a portion of the U.S. ground market through the integration of its acquisition of Airborne Express; although it may be a while before DHL become a factor within the U.S. ground market given its substantial money losing operations and its need to essentially build this operation from scratch given its very minor market share in this segment. Thus, over the long-term we will remain watchful as to the competitive dynamics within the ground parcel delivery market. Specifically, we wonder if a market that was served by two primarily players (UPS and the USPS) until the mid-1990s and is expected to experience only GDP-like rates of growth going forward will be able to support four carriers. With growth prospects for this sizeable market relatively modest, pricing, supported by cost structure, may become a pivotal means by which carriers grow or defend market share. As such, the potential for yield pressure potentially grows. To this end, we note that both FedEx and UPS continue to see the ground parcel pricing market as rational, although competitive, though perhaps somewhat more competitive than it has been. Yet corroborating their beliefs in a still overall rational yield environment, our past few surveys of airfreight shippers suggests that pricing discipline remains intact. In fact, shippers have expected rising yields over the past several quarters. SHIPPERS INCREASINGLY TURNING TO DEFERRED AIR SERVICES One of the overriding themes of our analysis of the domestic parcel and air express sector has been the resiliency and growth of the deferred air market. Specifically, between 1996 and 2004, deferred air unit volumes grew at a CAGR of 4.1%, widely exceeding the 2.5% CAGR of the overnight air express market and the 1.7% CAGR of the ground parcel market over the same period. Figure 7. Deferred Air Growth Rates Volume CAGRs Revenue CAGRs 91-95 91-00 91-04 96-00 96-04 00-04 91-95 91-00 91-04 96-00 96-04 00-04 FedEx 23.4% 16.0% 10.9% 12.8% 6.2% 0.0% 14.7% 14.1% 10.1% 15.5% 8.3% 1.7% UPS 33.8% 17.0% 11.4% 4.6% 2.2% (0.1%) N/A N/A N/A 7.1% 4.7% 2.3% Total Deferred 28.7% 16.5% 11.1% 8.4% 4.1% (0.0%) N/A N/A N/A 10.6% 6.2% 2.0% Source: Company reports and Smith Barney The success of deferred air, in our view, is that it offers an optimal blend of overnight air express and ground delivery services. Specifically, deferred air is faster than ground delivery, while at the same time being substantially cheaper from a yield perspective than overnight air express. We estimate deferred air shipping to be on average 30% below a carriers overnight air express offering. Accordingly, shippers who are cost sensitive, but need to meet tight deadlines have increasingly turned to deferred air services; a trend that we believe supports our thesis that shippers are increasingly deemphasizing speed sake in favor of cheaper but slower, time-definite transport services. While the economic downturn earlier in the decade certainly intensified this trend, we believe shippers growing emphasis on deferred air will remain intact over time as a secular trend. Figure 8. Deferred Air Market Share (based on volume) 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 FedEx 42.8% 44.1% 42.9% 46.8% 52.7% 51.4% 50.3% 49.8% 49.5% 49.6% 50.5% 7 UPS 57.2% 55.9% 57.1% 53.2% 47.3% 48.6% 49.7% 50.2% 50.5% 50.4% 49.5% Source: Company reports and Smith Barney In recent years FedEx and UPS have maintained nearly equal percentages of the deferred air market. We note, however, that UPS has spent the years immediately following the 1997 Teamster strike recapturing lost volume from FedEx. From an earnings perspective, we view the growth in deferred air services as a positive, with the caveat that in order to be profitable, deferred air service must be managed correctly and freight moved in a manner that lowers the average transportation delivery cost of offering such services despite a lower yield. Specifically, we note the favorable cost profile of deferred air volumes from a carriers perspective, as a significant portion of these shipments are termed as air but are actually moved via the ground (being any where in the 15-25% range of total air shipments, we estimate), thus avoiding the need to use costly air transportation for the line-haul portion of these moves. As a result, we believe one of the key challenges or opportunities for the integrated parcel carriers over the next several years will be to appropriately manage their mix of business to accommodate and maximize the amount of deferred air traffic handled via the ground infrastructure, while supplementing the flow of overnight air express traffic through costly dedicated air networks historically centered around dedicated airline operations. VALUATION AND RISKS FedEx Corporation (FDX-$89.70; 2M) Valuation We maintain a $105 target price on shares of FDX, derived using a 20.0x multiple to our 2006 estimate. Over the past ten years, the stock has traded at a median 18.0x and 15.8x forward year 1 and forward year 2 estimates, respectively. We feel the use of the higher multiple is justified given the greater focus by management on improving returns on invested capital and free cash flow. At the same time, the company has addressed a key strategic gap in its service portfolio by aggressively expanding into the market for ground delivery services, and is now further penetrating the retail segment with the acquisition of Kinkos. That said, the companys balance sheet and returns are not as strong as its key U.S. competitor, UPS. Thus, we feel FedEx should trade at a discount to the mid-20x multiple that UPS shares have traded at since its IPO in 1999. Using EV/EBITDA as a secondary tool, we note that FedEx has traded at a median of 6.7x EBITDA over the past five years (ranging from 4.7x to 10.0x). Our $105 target price is derived using a relatively consistent 8.0-8.5x multiple to our fiscal 2005 EBITDA estimate. This slight premium to historical valuation is justified, in our view, by the increased focus on ROIC and free cash flow at the company. Near-term market volatility and short-term trading patterns may cause the Expected Total Return to become temporarily misaligned relative to the hurdle for this stocks fundamental rating, as defined under our current system. Risks We assign a Medium risk rating to shares of FedEx due to the following: 1) The companys market capitalization, placing FedEx among the largest capitalized companies in the U.S. 2) The greater market liquidity of the companys shares relative to other companies within the S&P 500. 3) The companys investment grade credit rating and ample interest coverage. 8 4) The companys improving levels of free cash flow and ROIC. And 5) The mature and stable nature of the companys operations, and the strength and depth of its management team. Risks to shares of FedEx achieving our target price include the following: Any slowing in the rate of economic growth could pressure margin expansion across the FedEx portfolio of companies. Additionally, the secular shift toward lower-yielding ground parcel services could limit margin expansion at the Express segment over time, in our view. Coupled with the broader maturity of the air express product in general, the fact remains that FedExs core domestic air operations remain under competitive and market pressures from a growth perspective, despite the most recent quarterly performance. Additionally, we remain attentive to flattening margins at the Ground segment as potentially dampening the prospects for share performance in the near term. At the Freight segment, any slowing in the manufacturing economy could limit the realization of operating leverage and margin improvement. Indeed, margins could begin to deteriorate due to the high fixed cost structure of LTL operations. While the Freight segment is a relatively small piece of the overall company, it has significantly contributed to the sharp earnings improvement turned in by FedEx in recent quarters. Lastly, we highlight that asset based transportation equities, including FedEx, have traditionally not performed well on a relative basis in the year immediately following an increase in the target Fed Funds rate. Our past analysis has shown that in the six months following an initial increase in the target fed funds rate, the multiple applied to FedEx shares has declined anywhere from a slight amount to as much as 30%. Were the rate of compression in the multiple greater than we currently anticipate, shares could come under pressure. Should the impact on the company from any of these risks be more than we anticipate, the stock may not achieve our target price. United Parcel Service (UPS-$72.36; 1L) Valuation We maintain a $90 target price on shares of UPS. This is derived using a rough 23.0-24.0x multiple to our 2006 estimate. This multiple range is unchanged. Given the relative consistency of the companys financial results, its increasing presence in Asia, and hedging activities to limit the negative impact of any significant appreciation in the U.S. dollar, we feel using 2006 estimates is appropriate. UPS has long shown a slow and steady approach, which results in a greater degree of consistency in results that at some other companies. We use earnings as our primary determinant of valuation. Since the companys IPO in November 1999, UPS has traded at median multiples of 26.0x and 22.9x forward year one (FY1) and forward year two estimates, respectively. We are using a multiple slightly below this level as we recognize that multiples may compress and interest rates increase. At the same time, given evident market share losses in the domestic marketplace in recent quarters, we feel a modestly lower multiple is appropriate despite improved volume trends more recently. Using EV/EBITDA as a secondary tool, we note that UPS has traded at a median of 12.3x trailing EBITDA since its IPO (but has ranged from under 10.0x to as high as 26.0x). Our $90 target price is derived using a relatively consistent multiple of roughly 13.0x our 2005 EBITDA estimate. Risks 9 We rate UPS Low Risk because of: a) the companys leading returns and free cash flow generating capability among asset-based transportation providers, b) its strong balance sheet and AAA credit rating, c) the strength and depth of the companys management team, and d) both the security and growth potential for the companys dividend. Risks to the stock achieving our valuation target include the following: Given the companys relative exposure to retail, which we estimate accounts for upwards of 40% of revenue, any weakening in the key consumer-driven retail segment could slow the pace of broader earnings growth. Additionally, we once again highlight the greater strategic focus on the part of several competitors to gain share from UPS within its core ground segment. To the extent such heightened competition slows UPS volume recovery, or leads to greater price competition in this product, operating results at UPS could be negatively impacted. We also note that currency fluctuations, especially any pronounced weakening in the Euro, could act to dampen progress at the international segment, which has recently been a strong earnings contributor. Yet, we do note on this specific point that the company has somewhat insulated itself in this regard by undertaking some currency hedging protection to mitigate significant declines in the Euro. Additionally, any slowing in demand for international package services could result in a rollback of the operating leverage that UPS experienced over the course of the past several years. Finally, and more broadly, we note that transportation stocks, especially those that are asset-based, have typically under-performed the broader market in a rising interest rate environment. That said, given UPS relative immaturity to the public equity markets (the company has been public for five years) and solid financial position, we believe that such an analysis should not be overemphasized, as we view the companys financial performance and investment characteristics as unusual and far superior to most transportation equities. Rather, we highlight it here to alert investors to what we view as the broader potential vulnerability of cyclical stocks into the later stages of an economic recovery. If the impact from any of these factors prove greater than we currently anticipate, the stock could have difficulty achieving our target price.