Pairs Trading With These Two Shipping Stocks: $FDX $UPS

Over the past year, the industrials sector has returned a measly quarter of a percent, as investors have flocked to stocks in the tech and consumer defensive areas of the economy.  Within the proverbial smoke and soot of industrials, there are a variety of companies, ranging from toymakers to automakers.   Currently, two stocks that may be flying under the radar here are FedEx Corp (NYSE: FDX) and United Parcel Service Inc. (NYSE: UPS).  While both companies are the two largest shipping and logistics firms in the world with a combined market capitalization north of  $100 billion, each has their own unique differences.  For example, FedEx is the leading express delivery company, as it actually invented ‘overnight’ shipping in the 70s.  UPS, on the other hand, has a greater focus on ground delivery – and it also has a larger global customer base than FDX.  These differences extend to the investing realm, as each stock has its own pros and cons from an analytical standpoint.  Hedge funds also seem to have varying opinions on these stocks, and at the end of the day, it may be best to use a pairs trading strategy to make a profit.

FedEx Corporation (NYSE:FDX)

On the whole, a stagnant economic recovery has muted growth in the shipping industry.  This seems counterintuitive at first, as many may believe there should always be a need for deliveries.  Well, consider the fact that as consumer spending on goods is suppressed, there is less demand for the services of companies like FDX and UPS to deliver those goods.  In 2012, industry forecasts are predicting between 1 and 3 percent growth, as the upside depends on shippers’ ability to expand into foreign markets.  From a dollar standpoint, the industry is expected to generate nearly $160 billion in revenues – FDX and UPS will account for almost 60 percent of this total.

Individually, each company has been growing its revenues rather slowly.  Over the last three years, FDX (1.2%) and UPS (1.0%) have experienced an average revenue growth rate below that of the industry (1.8%), though this is mixed compared to mega-cap competitors like Deutsche Post DHL (DPSGY) at -1.0%, Li & Fung Ltd. (LFUGY) at 11.9%, and Kuhne & Nagel International AG (KHNGY) at -3.4%.  Even though FDX and UPS are not the best shippers in terms of top-line growth, they are dominant in bottom-line development.  Since the recession, FDX has grown its earnings by 8.3% per year, which is slightly less than UPS (9.3%), though both are higher than the industry average of 4.0%.  Peer companies like DPSGY (7.6%), LFUGY (-1.9%), and KHNGY (0.5%) all have lower earnings growth as well.  To investors, healthy EPS figures mean that both FDX and UPS will continue to pay out dividends at their current yields of 0.6% and 2.7% respectively.

Using popular valuation metrics, both companies are undervalued in terms of P/E and P/CF ratios.  In FedEx’s case, its current P/E of 13.9X is below its historical 10-year P/E of 20.5X, while UPS’s current P/E (19.8X) is below its 10-year P/E (23.0X) as well.  Both companies’ P/CF ratios are also below historical averages, which is interesting considering that each company has grown its cash hoard quite nicely in the past year.  Specifically, FDX’s operating cash flow grew by 28.8% last year, with free cash flow almost doubling.  In UPS’s case, its gains were even more impressive, as operating cash flow ballooned by 83.5%, while free cash flow grew by 107.2%.  What is most impressive about UPS is the staggering size of its FCF, which was reported at $5.07 billion last year.  Interestingly, UPS struck a deal in late March acquiring TNT Express, a Dutch packaging company, in an effort to boost its overseas operations.  It is estimated that after this deal, UPS’s European market share increased to 17.3%, which is just below current leader DHL.  This has given UPS a large advantage over FDX, which is left with the region’s scraps, as it only has around 3% market share in this area.

As is seen throughout these comparisons, UPS benefits investors more than FedEx in terms of earnings growth, cash flow growth, dividend yield, and recent expansion efforts. When looking at the three hedge fund managers who hold both stocks in their portfolios, this advantage is strengthened.  Steven Cohen, D.E. Shaw, and Ken Griffin all hold significantly more shares of UPS than FDX, by an average ratio of 10 to 1.  It is important to remember that hedge fund activity is not the end-all-be-all indicator of what investors should do; it is a guide.  For those feeling confident that UPS is a better investment than FDX, it may be beneficial to use a pairs trading strategy by going long UPS/short FDX.