8/5/2010
By David Urani, Research Analyst

As we all know, the vast recession we've been in (technically its over but effectively it's not) has caused most businesses to trim down operations to the bone to match weak end demand. As a result, when demand does show signs of coming back, those businesses actually have to hurry to get everything back up to speed. The first thing one does to prepare for a rebound in business is to build inventories back up, and lately we've been seeing a big inventory rebuilding process. In fact, of the 2.4% increase in GDP reported by the BEA in the second quarter, change in private inventories accounted for 1.05%, or $75.7 billion. Not to say inventory rebuilding isn't "real" growth, but it makes you wonder what kind of economic strength really lies beneath it. However, while the build in inventories does raise some questions for the road ahead, it also provides opportunity for some.

Manufacturing Report Shows Inventory Restocking

The ISM manufacturing index came in with a reading of 55.5 for July which was taken as a positive by the market since it beat consensus expectations of 54.0. In addition, any reading above 50 indicates expansion, so the fact that the sector is still growing is good news. Employment also rose to a reading of 58.6 from 57.8 and exports rose 0.5 points to 56.5. The report did have a couple yellow flags that warrant pointing out however. For me, the most significant item was the 4.4 point rise in inventories combined with the 5.0 point drop in new orders. The difference between the new orders and inventory components was actually the smallest since February 2008. Accelerating inventories combined with slowing new orders indicates production may have to begin to pull back to avoid oversupply (the production component did in fact slow to 57.0 from 61.4). Therefore, looking to August there is reason to expect a bit of cautiousness from producers.

Expeditors International Flies to Record Profit

As I mentioned above, manufacturers' inventories are rising quickly and it's been a bonanza for international transporters. Earnings reports throughout the sector have been blowouts, with the likes of FedEx (FDX) and UPS (UPS) reporting strong airfreight volumes, largely from inventory restocking efforts worldwide. Businesses are now in a frenzy to rebuild supplies as demand picks up, and that has spurred great demand for urgent air shipments. In fact, the International Air Transport Association (IATA) reports that June international air freight demand was 6% higher than the pre-recession peak in 2008.

Enter Expeditors International (EXPD) whose main business is air shipment logistics; they posted record profits of $0.42 for the quarter. Breaking down the numbers, here are a few highlights:

• Airfreight revenue +97.4% y/y (+31.0% q/q)
• Ocean freight revenue +64.9% y/y (+29.5% q/q)
• Asia revenue +98.1% y/y (+38.2% q/q)
• U.S. revenue +37.8% y/y (+15.6% q/q)

And the one red flag:

• Consolidated gross margin 27.6% versus 36.9% in 2Q09 (30.1% in 1Q10)

Record high air shipments raised total sales to a remarkable level, particularly shipments to and from Asia, but also in all of its other geographies. Gross margin has been contracting quickly because of shipping capacity constraints and the subsequent rise in transportation rates, but that wasn't enough to offset the vast economies of scale that came with the strong revenue result. While virtually the entire economy digs itself out of a hole, airfreight is one industry that is in fact running on all cylinders.

David Urani
Wall Street Strategies