'Tis the Season to Upgrade FedEx: What You Need to Know

By Rich Smith Markets Fool.com

'Twas the night before the night before Christmas, and all through the house, hardly an upgrade was stirring -- and UPS (NYSE: UPS) shareholders think Aegis Capital is a louse. Why? This morning, some parents across the country are frantically wrapping presents, while others are looking worriedly out the window, and wondering if the UPS guy will arrive on time.

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Next week, we'll doubtless be treated to stories reporting on how the U.S. Post Office, UPS, and FedEx (NYSE: FDX) failed to deliver packages on time this year. As for today, we'll just content ourselves with a quick report from boutique New York investment bankAegis Capital, which found time to squeak out two last stock ratings before the holiday arrives -- initiating coverage on FedEx with a buy rating, but leaving UPS with a rating of only "hold."

Here's what you need to know.

It's just what I always wanted: A buy rating from Aegis Capital! Image source: Getty Images.

1. Why to buy FedEx

Rather than spoil the holiday spirit right off the bat, let's start with the good news: Aegis Capital loves FedEx stock. Calling the company "one of the recognized global market leaders in the parcel delivery marketplace," Aegis argues that FedEx's "dominant global brand" and "structural advantages" make it something "no new competitor" can hope to challenge "in any short-term time frame."

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In addition to the brand name, FedEx has built a global package delivery network that two guys and a truck cannot hope to match. Even if you can imagine a new rival coming onto the scene, it seems a given that such a competitor must spend both money and time to build a comparable delivery network if it wants to take on FedEx.

Both these advantages explain why FedEx stock, currently priced at 27.5 times earnings per S&P Global Market Intelligence data, costs more than the average S&P 500 stock (which sells for 26 times earnings). But Aegis believes the stock deserves to be priced even higher -- at $215 a share, or 12% above what it currently costs.

2. What's wrong with UPS?

Now for the bad news. Like FedEx, Aegis believesthat UPS is a "recognized global market leader." Like FedEx, it sports a well-known name, and has built a big delivery network. Additionally, Aegis believes "the market is moving toward UPS's strengths" in logistics management and ground transport. Yet for some reason, Aegis simply doesn't like UPS'stock as much as it does FedEx's.

Rating FedEx a buy today, Aegis rates UPS only "hold," and assigns the stock a $120 price target that implies barely 3% upside from today's prices. Granted, UPS stock also pays a 2.7% dividend yield that is three times more generous than the 0.8% dividend yield that FedEx stock delivers -- but that can't make up for the lack of stock price appreciation potential, which is why Aegis says it prefers FedEx.

3. Is Aegis right?

Aegis Capital doesn't have much of a record on Motley Fool CAPS to go on -- no long track record of outperformance that might lead us to take the analyst's advice at face value. Instead, let's look at the facts:

Aegis Capital believes that both FedEx and UPS are superior businesses with wide moats that protect them from competition. They're both superior to the average business found on the S&P 500, but at 27.5 times earnings, FedEx stock costs more than the average S&P 500 stock, while UPS (at 20.3 times) earnings costs less than the average. Despite this, Aegis is telling us to buy the more expensive stock.

Does that make sense?

The most important thing: Valuation

I would argue it does not make sense -- but not for the reason you might think. According to S&P Global projections, most analysts who follow these two stocks see UPS growing earnings at just under 10% annually over the next five years, while giving FedEx a slight advantage in growth rate -- 13%. So if Aegis is of the opinion that superior businesses are worth buying no matter how much they cost, then it might make some sense to weight your buying toward the stock that's growing faster (again, regardless of stock price). It might make sense, in other words, to buy FedEx stock but only hold UPS.

I'm of a different opinion, though. I'm of the opinion that valuation matters. And if you ask me, FedEx, at 27.5 times earnings, with a 13% growth rate, has a PEG ratio of more than 2.0; while UPS at 20.3 times earnings with less than 10% growth also has a PEG north of 2.0. Both stocks therefore cost about twice what a value investor should be looking to pay for them.

Additionally, S&P Global data show that both stocks generate free cash flow (FCF) far below their reported net income. FedEx generated $942 million in FCF over the past 12 months (less than 51% of reported net income). UPS generated $3.8 billion in FCF -- about 76% of reported net income. In each case, the companies' actual cash profits imply they're even more expensive than their PEG ratios make them look.

In short: At the risk of playing Grinch this Christmas, I think Aegis Capital is wrong to recommend FedEx as a buy. (It's also giving UPS too much credit by rating it only "hold," and not "sell.") At today's prices, neither one of these stocks is a bargain, and investors expecting them to continue rising from their already overpriced levels are waiting on a Christmas miracle that may never come.

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Fool contributorRich Smithdoes not own shares of, nor is he short, any company named above. You can find him onMotley Fool CAPS, publicly pontificating under the handleTMFDitty, where he currently ranks No. 346 out of more than 75,000 rated members.

The Motley Fool recommends FedEx and United Parcel Service. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.