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Rain, Sleet, or High Oil Prices: Can This Firm Deliver?

We think this firm is poised to gain 20%-plus.

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Following is a sampling of stocks that recently jumped to 5 stars. By way of background, we award a stock 5 stars when it trades at a suitably large discount--i.e., a margin of safety--to our fair value estimate. Thus, when a stock hits 5-star territory, we consider it an especially compelling value.

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FedEx Corporation
Moat: Narrow | FV Uncertainty: Medium | Price/Fair Value Ratio*: 0.74 | Three-Year Expected Annual Return*: 21.9%

What It Does: FedEx (FDX), which pioneered overnight delivery in 1973 and remains the world's largest express delivery firm, derives two thirds of its revenue from its express division. The company's ground segment delivers small parcels at a lower cost than express to the entire United States, and the freight segment provides less-than-truckload freight services. FedEx Kinko's provides document production technology, Web-based printing, Internet access, and ground and express shipping services.

What Gives It an Edge: According to Morningstar analyst Keith Schoonmaker, FedEx's broad U.S. parcel shipping network, dense shipment volume, and international presence establish an economic moat matched only by its close competitor United Parcel Service (UPS). As evidence of FedEx's moat, Schoonmaker points to DHL's recent struggles in the U.S. express delivery market, which underscore the powerful barriers to entry in this industry: Despite its global shipping expertise, DHL's U.S. operations generated annual losses approaching $1 billion. Unlike FedEx, DHL lacks a complete network and established pipeline of parcel traffic, so it could not turn a profit without enduring tremendous up-front expenses. In the domestic market, Schoonmaker contends that FedEx and UPS are rational competitors, passing through fuel price increases in order to stay healthy and raising general rates to compensate for inflation, rather than competing away their profits. Also, FedEx has deepened its U.S. offerings by acquiring heavy freight trucking capability, and it has established a retail presence by acquiring Kinko's (now FedEx Office). Furthermore, FedEx derives 28% of revenue from international operations and continues to expand global operations, with particular focus on China.

What the Risks Are: FedEx faces several risks. As the firm expands into developing nations such as China and India, continuing success depends not only on busy, healthy domestic and global economies, but also on continued stable conditions in these regions. Domestically, drivers who are currently contractors may seek to become classified as employees; indeed, a small number of drivers in three facilities recently voted to approve collective bargaining. Widespread unionization may reduce FedEx's ability to flex shipping capacity to match demand.

What the Market Is Missing: Schoonmaker believes the market is punishing FedEx shares unjustly due to recent slower-than-historical earnings growth, owing mainly to higher fuel prices. In Schoonmaker's view, high fuel prices will not only constrain earnings until FedEx's fuel surcharges catch up to jet and diesel fuel price increases, but also burden the general economy such that customers downshift to slower, less-profitable FedEx shipping products. While Schoonmaker admits that this double hit to FedEx should result in margin contraction as the economy remains soft, he counters that the firm should also benefit when the economy recovers. Also, Schoonmaker thinks the market may be considering the recent write-down of intangible assets added in the 2004 acquisition of Kinko's. Although noncash write-downs do not affect Schoonmaker's valuation, they confirm his opinion that FedEx overpaid for low-margin retail assets in exchange for high-margin packages. Nonetheless, Schoonmaker argues that FedEx will still remain one of two powerful integrated shippers in the U.S.--a lucrative and defendable long-run position. With short-term issues hampering the stock, Schoonmaker believes investors have a rare opportunity to purchase FedEx at a substantial discount to its fair value.

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, Aug. 22, 2008.

Jeff Viksjo does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.