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The horizontal analysis showed that FedEx's profits in 2009 were just 5% of their profits in 2007. Given that EBIT contributes to the T3 component of the Z-score, which is the most significant component by weighting, this would explain why the Z-score dropped so much. The other major contributor to the Z-score is the drop in the company's market cap. The market cap is deemed important in part because the market's view of company reflects the most known information at the time. The market has a strong ability to predict financial distress. A depressed stock price indicates that investors need a greater percentage return on the expected future cash flows from the company in order to invest -- an indicator that the market believes the firm's risk level has increased. The market cap contributes to the T4 component, which is the smallest component of the Z-score. However, the decline in the market cap was substantial, so this variable also contributed to the lower Z-score for 2009.
Appendix 4: Summary of Four Items
One of the major factors in creditworthiness is the firm's degree of leverage. In the annual report, CEO Fred Smith indicates that the long-term trend for FedEx is reduced debt and increased equity. FedEx has $1 billion less in debt vs. five years ago, despite the recent troubles. The company has turned to debt to offset sluggish revenues and the inability to make dramatic cuts to its cost structure, but a two or three-year survey is sometimes inappropriate, particularly if the first is sufficiently large and with stable revenue flows. This statement by Mr. Smith reflects that truth -- that sometimes a long-term view is valuable. FedEx has generally improved its financial position over the long-run; no matter what the short-term performance indicates the firm is well-positioned even vs. just a few years ago.
The second reason for optimism with respect to FedEx is that the company is highly correlated with the economy as a whole. The company cites global economic conditions for much of its revenue decline in the past year in the Annual Report. Furthermore, FedEx stock has a beta of 1.14 (MSN Moneycentral, 2010), indicating that the company's performance has a reasonable degree of correlation with the performance of the broader market -- the market believes there is only a limited amount of firm-specific risk associated with FedEx. FedEx is considered by the market to be an economic bellwether (Credeur, 2009), a position it holds specifically because its performance is so greatly correlated with the economy. Therefore, if the economy is expected to recover in a year or two, and FedEx is positioned to survive beyond that, there is little cause for concern with regards to the company's future.
The third point that supports the contention that FedEx is in a strong financial position is that some of their bottom line profitability issues are behind them. A note in the annual report (p.14) indicates that tax rates for the company were significantly higher than normal in both 2008 and especially in 2009 as a result of impairment charges that company took for Kinko's. In particular, the move to eliminate the Kinko's brand and replace it with FedEx Office resulted in the impairment of a considerable amount of goodwill associated with Kinko's. Because these impairment writedowns are not tax deductible, the effective tax rate for the company was far higher that it normally is. Now that the Kinko's writedowns have been completed, the tax rate is expected to return to normal in the coming years.
The company also notes (p. 20) that many of the actions undertaken in fiscal 2009 were intended to set the company up for a leaner future. These austerity measures had most of their negative impact on the 2009 fiscal year, but would begin to see benefits in subsequent years. The company lowered its cost structure and planned to add more cost-containment initiatives. Although the firm expects revenue declines in 2010 will offset these gains, a position of no-change is a strong one for 2010 and the benefits of these changes on the company's bottom line will become evident in 2011 and beyond.
Appendix 5: The Financial Statements
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