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United Parcel Service Inc
FedEx Corp.’s (FDX) plan to boost air cargo profit margins to 10 percent or more, partly by replacing junkyard-ready jets with more efficient models, will be challenged by a yearlong wait for the first of the new planes.
FedEx is refreshing its fleet with Boeing Co. (BA) 767s that list for about $8 billion after the Express unit’s operating margins dropped about half in five years. More than 15 percent of the shipper’s 660 aircraft are models last built in the 1980s, and Chief Executive Officer Fred Smith said upgrading is a “very big part of achieving double-digit margins.”
While the company can begin to revise routes and improve its network now, “many of the moves that will result in major cost savings will be dependent on the arrival of the 767s,” said David Vernon, a New York-based analyst with Sanford C. Bernstein & Co. “They are going to be a little bit hamstrung by the delivery of those aircraft.”
Driving profit margin growth at Express is important since it accounted for more than 60 percent of the Memphis, Tennessee- based company’s $42.7 billion in sales in fiscal 2012. The margin that year shrank to 4.8 percent (FDX) from 8.8 percent in 2007 as higher fuel and maintenance expenses pushed up costs to fly older aircraft.
FedEx plans to disclose more details later this year on a revamp that will take advantage of its new planes. Other options for achieving double-digit margins are capturing the most profitable aspects of international business, improving yields and reducing costs, said Jess Bunn, a company spokesman.
“During challenging times in the past, FedEx has found ways to operate more efficiently, and that will be a great benefit as our company moves forward,” he said in an e-mailed statement.
FedEx gained 0.1 percent to $92.79 at the close in New York. The shares (FDX) have risen 11 percent this year.
The company has said it will receive the first three of its 46 767s in fiscal 2014 with the remainder arriving through 2019. The aircraft will replace Boeing MD-10s, last made in 1989, as well as Airbus SAS A310s.
Boeing had a 78-order backlog for 767s as of the end of June and builds about two of the jets a month at its wide-body plane factory in Everett, Washington. The 767s can be used for long-haul domestic or international flights, while FedEx operates the second-hand Boeing 757s that it began adding in 2007 primarily on shorter U.S. routes.
While the 757s have been out of production since 2005, they’re replacing FedEx’s Boeing 727s, which are even older. FedEx has 41 of the three-engine jets last that ended production in 1984, the most still in use by any passenger or freight carrier. Competitor United Parcel Service Inc. (UPS) got rid of the last of its 727s by the end of 2008, according to regulatory filings.
The 727 costs up to $3,500 more per hour to operate than the larger 757, and heavy maintenance checks every couple of years probably cost FedEx several million dollars per jet, Vernon said.
The aircraft require a three-member crew, a pilot, co-pilot and flight engineer, instead of the two people on more-modern jets. They have no resale value, Kevin Sterling, an analyst at BB&T Capital Markets in Richmond, Virginia, said in a telephone interview.
“Who’s in the market for a 727?” he asked. “No one. The only thing they are good for is the engine. FedEx might just sell the engines and park the planes in the desert.”
The engines are probably worth $1 million each or less, he said.
Another driver in FedEx’s fleet upgrade is a surge in the past three years in jet-fuel prices, which remain 60 percent higher than a 2010 low after a climb this year to $3.01 a gallon yesterday.
FedEx spent $3.9 billion on jet fuel in fiscal 2012, compared with $3.2 billion in fiscal 2011 and $2.3 billion in 2010, according to company filings.
“The fuel efficiency alone will probably save 17 to 20 percent for the newer planes versus the older planes,” Sterling said. “If they can get other planes out back in service I think it’s highly likely they will speed the retirements. It’s a balancing act. They have to make sure they don’t disrupt service.”
Restructuring the Express network will help FedEx grapple with declines in airborne shipping as customers seek cheaper alternatives amid tepid economic growth.
An economic bellwether because it carries everything from mobile devices to pharmaceuticals, FedEx lowered its forecast for U.S. growth to 2.2 percent for this fiscal year, down from 2.3 percent in December.
“For our aspirational goals we needed a little bit stronger growth than what we’ve had,” Chief Financial Officer Alan Graf said on a June 19 earnings call. “We now realize we’ve got to adjust the networks that we built for higher gross domestic product growth than we’re actually seeing.”
FedEx retired 24 jets last month to cut capacity in its domestic Express business. Taking them out of service added to five jets grounded last quarter and planned retirements of 21 more in the company’s 2013 fiscal year.
The company is “focusing more on replacing 727s as a domestic route structure,” David Campbell, an analyst at Thompson Davis & Co. in Richmond, Virginia, said in an interview. “The focus right now is on cutting the cost of the domestic system and this is one way to do it without increasing capital expenditures.”
FedEx is adding fewer 757 jets than the number of 727s it’s retiring, so it will have to remap its network to accommodate a smaller fleet made up of bigger planes that can carry more per flight.
The shipping company may have to collapse regional hubs, restructure air routes, reassign aircraft to different markets, add and remove trucks in some cities and consolidate package stations, Vernon said.
“The biggest risk is not to drop the ball and lose any customer efficiency,” Sterling said. “If they are doing this restructuring and take out too many planes too fast and cut back service levels, customers will be upset and go to” rivals such as Atlanta-based UPS and Deutsche Post AG (DPW)’s DHL express and freight business.
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