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A week went by and nothing. But eventually, as they always will, the rumours reached me. And everyone knows you can’t disprove a rumour” –  Jay Asher

A US-based banker with close ties with FedEx this week told me it was just a matter of time before the press would be “all over” its client.

“Why?” I asked.

The possibility of a break-up of the express operator, he hinted.

FedEx is a mean, lean, fighting machine, and that showed all the way through its 3Q financial results on Wednesday, from the P&L to the balance sheet via the cash flow statements.

The market was not impressed, however.

Admittedly, sales at its core express unit aren’t growing much, but is that really important for FedEx shareholders?

Group profitability and cash balances are up, while its capital structure remains so strong that net leverage would not be problematic, even if you assumed a 50% drop in its adjusted operating cash flow in the next 12 months – all of which begs the question: how long will it take before an activist investor starts circling its valuable assets?

A base-case scenario, based on a sum-of-the-parts valuation, suggests that a break-up of FedEx could yield limited upside of just about 10%, excluding transaction costs and the possible loss of synergies between its three core units. But upside could be meaningful – and FedEx’s equity could be worth 30% more than its current value – if a bullish valuation is assigned to its ground division, whose growth rate and profitability are much higher than that of express.

(See our excel calculator for a FedEx break-up scenario.)

Drastic action is not strictly necessary, and it may be argued that express operators such as FedEx could benefit from diversification: they can more easily hide their problems when trading gets tough, and less cyclical assets provide a buffer. This is not an easy story to sell to investors, though.

In fact, FedEx has one little problem: after an impressive 61% rise in its stock price in the last two years – which compares with +25% for the S&P 500 – its shares now hover around all-time highs.

Just how bad is that?

Even though its forward valuation points to a slight discount to fair value based on its net worth, FedEx has found it more difficult to reward shareholders with rapidly rising returns since the end of November. It has come under pressure since it reported disappointing results for the second quarters.

Of course, immediate corporate action is perhaps more urgent at UPS and Deutsche Post-DHL. UPS, in particular, has underperformed its rival and DP by 40 percentage points since early 2013. But FedEx is the one that should lead the way – and its financials show why that is.

Group results

3Q group revenues came in at $11.7bn, up 4% year-on-year. Operating income stood at $962m, up 50% from $641m one year earlier; operating margin rose to 8.2%, up from 5.7%. Net income was $580m, up 53% from last year’s $378m.

Higher profitability makes a break-up of FedEx more enticing now than at any given time in the past seven years. FedEx projects diluted earnings-per-share between $8.80 and $8.95 in fiscal 2015; guidance is for moderate global economic growth, and capital spending is forecast at $4.2bn in 2015 – 16% above the last three-year average.

The shares were down 1.4% on Wednesday, when quarterly results came out, and were essentially flat on Thursday as analysts expected better full-year earnings per share. But such quality earnings, at some 30/40 cents lower than consensus estimates, was hardly a big miss, really.

The units

FedEx Express reported 3Q revenues of $6.6bn, which were flat year-on-year. Operating income was $384m, up 129% from $168m last year, with a 5.8% margin, up from 2.5% year-on-year. FedEx trades at 12x forward EV/Ebit (2015), for an implied enterprise value of about $51bn. Assuming the same multiple is placed on the core express unit, express is valued at $19bn, including net debt.

That may seem a rich valuation, and one that would be justified only by a steeper growth rate, yet express has a strong market share, entry barriers are high, and although it operates in a very competitive market, the unit would represent a rather safe yield play for investors into 2020. So, express could trade in the 11x-13x forward EV/Ebit range on its own.

Elsewhere, the ground unit reported 3Q revenues of $3.39bn, up 12% from last year’s $3bn. Operating income came in at $558m, up 14% from $490m a year ago. The operating margin stood at 16.4%, some 20 basis points higher than 3Q14. This unit could receive a boost if it was spun-off, and it could very easily fetch a valuation of 16x forward EV/Ebit, for an implied enterprise value of $33bn.

Finally, the freight division reported quarterly revenue of $1.43bn, up 6% from last year’s $1.35bn, and operating income of $68m, up 94% from $35m a year ago. Operating margin has almost doubled to 4.8% from 2.6% year-on-year. Give this unit a lowly multiple of 10x forward Ebit, and freight is worth $4.6bn.

Assuming the services unit – whose quarterly revenues were flat year-on-year, but are expected to come in above $1bn in 2015 – is worth nothing – yes, zero –  the implied enterprise value of FedEx, based on the aforementioned assumptions, would be $58bn, for an implied stock price of $188, which is in line with the average price target from brokers.

Yet FedEx’s enterprise value could skyrocket to $70bn if the ground unit received a bullish valuation of 20x Ebit. If ground continues to grow as it has done in the last couple of years, “expect talk of interest from Bill Ackman to emerge again as it did in 2013,” my source concluded.

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