Express pioneer FedEx continues to refine its portfolio to increase margins and capture a greater share of global trade. Well known for overnight parcel deliveries, FedEx has improved its competitive advantage by building the capacity to handle additional modes of shipping. After purchasing assets in ground delivery and less-than-truckload freight (both domestic U.S. operations) and expanding its asset-light air and ocean forwarding network, FedEx can now handle most shipping modes. Fulfilling more of its customers' needs makes FedEx more difficult to displace and a bigger, stickier part of clients' operations. The firm is also expanding its ability to serve intra-Europe shipments.
FedEx's extensive international shipping network would be difficult and costly to duplicate, giving the company a narrow economic moat. The strength of FedEx's barriers to entry was on full display when competitor DHL left the domestic U.S. parcel delivery market in 2009 after it determined the incumbent duopoly was too powerful to challenge without extended losses. We expect FedEx to exploit its competitive advantages, despite the challenges of global economic cycles and even some shippers (like Amazon) performing their own fulfillment.
The TNT Express acquisition gives FedEx the opportunity to operate and improve ground operations in Europe, where we believe online fulfillment has room to grow. However, we are skeptical that it can replicate the margins there that the U.S. ground system earns, because of the flexible cost structure of the U.S. independent contractor model.
We expect mix shifts to boost returns on invested capital as the firm expands high-ROIC ground operations and reaps the rewards of improving express profitability over five years. In response to weak international priority volume and growth of lower-yield international economy shipments, the firm realigned its fleet to better match demand and reduce costs. In fiscal 2018, the express segment (including TNT) produced about 55% of total sales and 45% of operating income; the higher-margin ground operation generated about 46% of total operating profit on just 28% of total sales.
We identify three sources of economic moat for FedEx: cost advantage, efficient scale, and network effect. Three giants (FedEx, UPS, and DHL) dominate global parcel shipping, and the networks these firms have erected constitute formidable barriers to entry. We believe no firm will try to replicate a global shipping network anytime soon, given the large financial losses one would incur while trying to develop adequate volume to cover the high fixed costs of such a system.
In private U.S. domestic parcel shipping, FedEx is one of only two titans, and rational pricing has been the result. We don't anticipate this will change, even as the U.S. Postal Service captures a significant portion of the rapidly growing e-commerce shipping business. In replicating a network of planes, trucks, sorting sites, rights to fly, and skilled employees, a new entrant would need to use extensive resources before it could win a critical volume of customers from the entrenched strong brands. Even after massive investment, competitor DHL lost nearly $1 billion on U.S. operations in 2007. Facing larger losses because of soft volume during 2008 and beyond, DHL finally quit after a decade of trying to establish its U.S. domestic express delivery business. We consider this to be a textbook example of the power of an efficient-scale economic moat: a worthy competitor foiled by steep barriers to entry erected by the incumbent domestic U.S. integrated shippers. In this high-fixed-cost business, the substantial parcel volume handled by the incumbents provides a cost advantage that makes competing at market prices difficult for low-volume entrants.
The firm's foray into freight forwarding opens a network effect moat source because each additional office in this business makes the rest of the system more valuable to shippers. We also like this business for diversifying away from such asset intensity present in the rest of the company.
Despite the industry's barriers to entry, we constrain FedEx's economic moat rating to narrow rather than wide because we expect the firm to outearn its cost of capital by a slim margin--this tempers our confidence that the firm will reliably exceed its cost of capital two decades from now. We consider two of FedEx's reporting segments to have economic moats: air express and ground shipping operations, But its less-than-truckload freight shipping business (the largest LTL operation in the U.S.) earns low margins subject to economic cycles in part because customers have many alternatives, which drives down pricing. In freight, customer switching costs are low and many truckers can provide adequate service, leaving little opportunity to differentiate the firm's offerings.
We reduced our fair value estimate to $190 per share from $197 as we incorporate the actual annual pension underfundedness reported in the Form 10-K. When the firm recently reported its fiscal fourth-quarter results, we reduced ground margins due to increased residential deliveries and the greater cost of fewer packages per stop. We still have confidence in FedEx's ability to invest capital and engineering expertise in TNT to improve these historically undersupported assets, but mix shifts and a slowing European economy can constrain the pace of such improvements.
Our assumption for medium-term capital expenditure as a percentage of revenue is 7%, as the firm continues to invest in TNT improvements, ground automation, and capacity. However, by fiscal 2023 express refleeting of expensive 767 and 777 aircraft should be completed; thus our expectation of a decline from the recent levels of capital expenditures at 8% of sales.
We expect FedEx to increase consolidated organic revenue by about 5% per year on average going forward, via both greater volumes and slightly increased rates. Our revenue projections assume ground sales grow at about 7% annually, based on organic growth (including from e-commerce shipments), with margins likely to remain the highest of any sector (14% midcycle). We project long-term midcycle EBIT margins at the express (including TNT) and freight segments to average 7.5% and 7.0%, respectively. These estimates produce consolidated operating margins of about 8%.
FedEx is chiefly exposed to the health of the U.S. and global economies. As FedEx expands operations in Europe and Asia, continuing success depends not only on busy, healthy domestic and global economies, but also on continued stable conditions in these regions. Domestically, in nearly all states the firm immunized itself from the risk that ground drivers, who are currently contractors, may seek to become classified as employees by moving ground route owners to a multiple-route-owning independent contractor model. We think freight operations could organize more easily, although only a few terminals have voted to join the Teamsters and multiple terminals in the past few years have voted against joining the union. Currently in FedEx's U.S. operations, only express pilots are in a collective bargaining agreement, but on a global basis other employees are unionized, and this increased substantially with the TNT acquisition. While the current work arrangements pose little problem for FedEx, more widespread unionization, such as among express drivers, could reduce FedEx's ability to flex shipping capacity to match demand. In the U.S., however, the systemwide vote required by the Railway Labor Act presents a threshold for unionization greater than if express could organize into locals. The TNT Express acquisition was completed in 2016, and integration is still underway; FedEx will also need to contend with European unions as it works to improve TNT's lagging margins.
Fred Smith, FedEx's founder and the pioneer of overnight national delivery, remains at the helm of a largely independent board that has guided the firm through years of growth and profitability. As chairman, president, and CEO, Smith received $16.7 million in total compensation in fiscal 2018, principally via $1.3 million in salary, $7.1 million in option awards, and $7.7 million in nonequity incentive plan compensation. Smith's compensation in fiscal 2016 and 2017 was approximately $16.8 million and $15.6 million, respectively. FedEx cut costs in 2009, including reducing Smith's base salary 20%, lowering named executive base pay 10%, and freezing merit increases across the company. In fiscal 2018, FedEx paid four additional named executive officers between $6.0 million and $8.2 million in total compensation including increased actuarial value of pension plans. We think Smith's option awards and material equity position--about 8% of total outstanding FedEx shares--align his interests with other shareholders'. Smith is 74, but the firm's mandatory board retirement at 75 years of age applies only to nonmanagement directors. For years, Smith has said officers including himself have two backups, just like in his Marine Corps training, but the plan has not been shared externally.
Raj Subramaniam became president and COO on March 1, following COO David Bronczek's retirement. He has worked for FedEx for 27 years, including in multiple executive leadership roles and in several geographic regions. Several segment heads are new to their role, but in general they boast long FedEx tenure. Freight CEO John Smith assumed his role in mid-2018, and the firm appointed Henry Maier as CEO of ground in 2013. On the other hand, Alan Graf has served as CFO since 1998 and was CFO of express before that. While Bronczek was a strong leader and had worked for FedEx since its early days, we are not concerned about Subramaniam's appointment--he's already a proven FedEx leader.
As an example of responsible capital deployment, we believe the firm's patience in bidding for TNT Express was rewarded when, in early 2015, the euro weakened such that FedEx's price in dollars was dramatically lower than what it would have been just a year earlier, when UPS was attempting to purchase TNT. Clearly, the TNT operations needed investment of capital and expertise, perhaps more than FedEx anticipated before owning the business. Overall, we believe FedEx acts in the best interests of shareholders, and we consider its governance to be solid, in line with that of other large-cap transport and industrial companies.
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