Ratio Analysis (Ups Vs Fdx)

Abstract

This analysis investigates the management policies of the two primary competitors of the Air Delivery & Freight Services industry. I use ratio analysis to peek under the covers of profitability to understand how management, investment and financial management activities impact the overall performance of FedEx and UPS and study how the ratios change over time for FedEx.

Ratio Analysis

Two competitors, FedEx and UPS, dominate the Air Delivery & Freight Services industry in the United States. FedEx is the smaller of the two with a market cap almost a third of the frontrunner UPS. UPS enjoys a higher Price to Earnings while providing a lower Earnings Per Share than FedEx. How does a firm with higher earnings per share trade at a lower price per earnings than their primary competitor? It must have something to do with risk.

Compound Annual Growth

Looking at Table: Compound Annual Growth, gives us a warm and fuzzy feeling about FedEx. Their sales are growing faster, their net income is growing more than twice as fast as UPS both raw and adjusted and their dividend payment compound annual growth is through the roof. There are a couple caveats to this glowing review though. First, FedEx has negative Free Cash Flows available for equity because of their aggressive debt repayment in 2005. If we remove this one time anomaly of negative free cash flows by only looking through 2004, their free cash flow for equity looks quite nice with a CAGR of 292.79% compared to UPS's 13.37% CAGR in free cash flows available for equity. This is one of the downsides to using compound annual growth rates. Because it only compares the beginning and ending balances and assumes stable trends, it does not take volatility between the two balances into account. Furthermore, the dividend payments cannot be used in CAGR because FedEx did not issue dividends until 2002. To account for this, I used $1 for the dividend payments in 2001. This gives a 203.65% CAGR which looks pretty good until you consider the growth from $1 gives a huge jump initially and will flatten out over time. From just this cursory inspection of compound annual growth, FedEx looks impressive.

Common sized comparisons

Next, we will begin to analyze a little deeper by creating a common sized income and balance sheet for the two firms. The common sized statements allow us to remove the difference from sheer firm size, and compare the relative balance between sales and each item on the income statement.

Right from the start, again FedEx looks good, with a top line gross profit margin averaging a full 6.5% above that of UPS. Looking at the bottom line though tells us a different story where UPS manages to bring a consistent average 11% points more down to the bottom line. Looking up the income statement, it appears that the bulk of the difference comes from a drastic difference in operating income due to a significantly higher Other Operating Expense for FedEx. An initial impression is that UPS must manage its operating expenses more efficiently than FedEx, but we will dig into that a little deeper when we analyze the profitability of each firm.

Looking more closely at FedEx across time, several patterns begin to emerge. First, they are reducing the mentioned operating expenses and thus increasing their operating income. They are also reducing their interest expenses, presumably trying to rely less on debt financing. Along with this reduction in interest expense we can see an upward trend in their tax expenses. Because of the downward trend in operating expenses and interest expenses, their net income is showing a nice upward trend and a compound annual growth rate of 26.43%.

I also create a common sized balance sheet to look for differences in asset, liability and equity balances between the two firms. This comparison bears out several differences between the two. First, looking to cash and marketable securities, it appears that FedEx is drastically increasing the balance in this account with a 53.62% CAGR and a consistent upward trend. UPS has a shallower upward trend with more volatility where they temporarily increased this account from 2003 through 2005. Another interesting note is that accounts receivable is showing a downward trend for FedEx while showing a flat or consistent trend across UPS. Next, UPS appears to be based more in short-term assets and FedEx weighted more heavily in long-term assets. UPS also relies more heavily on long-term liabilities, whereas FedEx relies more heavily on short-term liabilities. It appears that FedEx is using accounts payable for debt financing while UPS is using long-term debt. Lastly, FedEx is making up for it's under utilization of debt financing with equity financing. Overall, FedEx is showing a trend toward increasing current assets, primarily through cash, decreasing liabilities and increasing equity.

Profitability

Traditionally, we have been taught that there are some simple ratios such as Net Income Assets (ROA) or Net Income over Equity (ROE) that allow you to gain a broad understanding of the firm's profitability. Table: Profitability has calculated the broad ROA and the traditional ROE is similar to the decomposed ROE. These numbers show that Net Income for FedEx is comparatively much smaller than UPS's Net Income in relation to assets and equity. For each dollar invested in equity UPS earns 23 cents versus FedEx's 15 cents per dollar of equity. Likewise, UPS earns 11 cents versus FedEx's 7 cents per dollar of assets.

While these ratios are interesting, what we really want to know is how profitable are the firms' operating activities. In order to accomplish this, we need to decompose the constituents of ROE to see how dollars are carried through operating activities. The equation we are going to use to accomplish this is:

ROE = Operating ROA + (Spread * Net Financial Leverage)

ROE = (NOPAT Margin * Net Operating Asset Turnover) + (Spread * ((Total-Interest bearing liab. - Cash & Marketable Securities) / Total Equity))

ROE = ((Net Income + Net Interest Expense after Tax)) * ((Current Assets - Cash) - (Total Current Liabilities - Short-Term Debt))

+ (Spread * ((Total-Interest bearing liab. - Cash & Marketable Securities) / Total Equity))

The calculations are actually performed in Table: Profitability under Decomposition of ROE.

The point of this long-winded equation is to find out how profitably the firm can generate operating profits from its