avatar Fedex Corporation Transportation, Communications, Electric, Gas, And Sanitary Services

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    FINANCIAL RESULTS 38 M anagement’s Discussion and Analysis 63 M anagement’s Report on Internal Control over Financial Reporting 64 Report of Independent Registered Public Accounting Firm 65 Consolidated Financial Statements 69 Notes to Consolidated Financial Statements 88 Report of Independent Registered Public Accounting Firm 89 Selected Financial Data 90 Board of Directors 91 Executive Officers and Senior M anagement 92 Corporate Information


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    M ANAGEM ENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION OVERVIEW OF FINANCIAL SECTION DESCRIPTION OF BUSINESS FedEx provides a broad portfolio of transportation, e-commerce The financial section of the FedEx Corporation (also referred to as and business services through companies operating indepen- “ FedEx” ) Annual Report consists of the follow ing M anagement’s dently, c ompeting c ollec tively and managed c ollaboratively Discussion and Analysis of Results of Operations and Financial under the respected FedEx brand. These operating companies Condition (“ M D& A” ), the Consolidated Financial Statements and are primarily represented by FedEx Express, the w orld’s largest the notes to the Consolidated Financial Statements, and Other express transportation c ompany; FedEx Ground, a leading Financial Information, all of w hich include information about our provider of small-pac kage ground delivery servic es; FedEx significant accounting policies, practices and the transactions Freight, a leading U.S. provider of regional less-than-truckload that underlie our financial results. The follow ing M D& A describes (“ LTL” ) freight services; and FedEx Kinko’s, a leading provider of the principal factors affecting the results of operations, liquidity, doc ument solutions and business servic es. These c ompanies capital resources, contractual cash obligations and the critical form the c ore of our reportable segments. See “ Reportable accounting estimates of FedEx. The discussion in the financial Segments” for further discussion. section should be read in conjunction w ith the other sections of this Annual Report and our detailed discussion of risk factors The key indicators necessary to understand our operating results included in this M D& A. include: • the overall customer demand for our various services; ORGANIZATION OF INFORM ATION Our M D& A is c omprised of three major sec tions: Results • the volumes of transportation and business services provided of Operations, Financ ial Condition and Critic al Ac c ounting through our netw orks, primarily measured by our average daily Estimates. These sections include the follow ing information: volume and shipment w eight; • Results of Operations includes an overview of our consolidated • the mix of services purchased by our customers; 2006 results compared to 2005, and 2005 results compared to • the prices w e obtain for our services, primarily measured by 2004. This section also includes a discussion of key actions and average price per shipment (yield); events that impacted our results, as w ell as a discussion of our outlook for 2007. • our ability to manage our cost structure for capital expenditures and operating expenses and to matc h our c ost struc ture to • The overview is follow ed by a financial summary and analysis shifting volume levels; and (including a discussion of both historical operating results and our outlook for 2007) for each of our four reportable business • the timing and amount of fluctuations in fuel prices and our abil- segments. ity to recover incremental fuel costs through our supplemental fuel surcharges. • Our financial condition is review ed through an analysis of key elements of our liquidity, capital resources and contractual cash Except as otherw ise specified, references to years indicate our obligations, including a discussion of our cash flow s statements fisc al year ended M ay 31, 2006 or ended M ay 31 of the year and our financial commitments. referenced and comparisons are to the prior year. References to our transportation segments mean, c ollec tively, our FedEx • We conclude w ith a discussion of the critical accounting esti- Express, FedEx Ground and FedEx Freight segments. mates that w e believe are important to understanding certain of the material judgments and assumptions incorporated in our reported financial results. 38


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    M ANAGEM ENT’S DISCUSSION AND ANALYSIS RESULTS OF OPERATIONS CONSOLIDATED RESULTS The follow ing table compares revenues, operating income, operating margin, net income and diluted earnings per share (dollars in millions, except per share amounts) for the years ended M ay 31: Percent Change 2006 (1) 2005(2) 2004(3) 2006/2005 2005/2004 Revenues $32,294 $29,363 $24,710 10 19 Operating income 3,014 2,471 1,440 22 72 Operating margin 9.3% 8.4% 5.8% 90bp 260bp Net income $ 1,806 $ 1,449 $ 838 25 73 Diluted earnings per share $ 5.83 $ 4.72 $ 2.76 24 71 (1) Operating expenses include a $79 million ($49 million, net of tax, or $0.16 per diluted share) charge to adjust the accounting for certain facility leases, predominantly at FedEx Express. (2) Results include $48 million ($31 million, net of tax, or $0.10 per diluted share) related to the Airline Stabilization Act charge and a $12 million or $0.04 per diluted share benefit from an income tax adjustment described below. (3) Results include $435 million ($270 million, net of tax, or $0.89 per diluted share) of business realignment costs and a $37 million or $0.12 per diluted share benefit related to a favorable ruling on a tax case and the reduction of our effective tax rate described below. Also see Note 12 to the accompanying consolidated financial statements. The follow ing table show s changes in revenues and operating income by reportable segment for 2006 compared to 2005, and 2005 compared to 2004 (in millions): Revenues Operating Income Dollar Change Percent Change Dollar Change Percent Change 2006/2005 2005/2004 2006/2005 2005/2004 2006/2005 2005/2004 2006/2005 2005/2004 FedEx Express segment (1) (2) (3) $1,961 $1,988 10 11 $353 $ 785 25 125 FedEx Ground segment 626 770 13 20 101 82 17 16 FedEx Freight segment 428 528 13 20 131 110 37 45 FedEx Kinko’s segment (4) 22 1,545 1 NM (43) 61 (43) NM Other and Eliminations (106) (178) NM NM 1 (7) NM NM $2,931 $4,653 10 19 $543 $1,031 22 72 (1) FedEx Express 2006 operating expenses include a $75 million charge to adjust the accounting for certain facility leases, as described below. (2) FedEx Express 2005 operating expenses include a $48 million charge related to the Airline Stabilization Act, as described below. (3) FedEx Express 2004 operating expenses include $428 million of business realignment costs, as described below. (4) The FedEx Kinko’s segment w as formed in the fourth quarter of 2004. The follow ing table show s selected operating statistics (in thousands, except yield amounts) for the years ended M ay 31: Percent Change 2006 2005 2004 2006/2005 2005/2004 Average daily package volume (ADV): FedEx Express 3,287 3,259 3,167 1 3 FedEx Ground 2,815 2,609 2,285 8 14 Total ADV 6,102 5,868 5,452 4 8 Average daily LTL shipments: FedEx Freight 67 63 58 6 9 Revenue per package (yield): FedEx Express $21.75 $20.10 $18.55 8 8 FedEx Ground 7.02 6.68 6.48 5 3 LTL yield (revenue per hundredw eight): FedEx Freight $16.84 $15.48 $14.23 9 9 39


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    FEDEX CORPORATION During 2006, revenue grow th w as primarily attributable to yield grow th in our package businesses increased 8%. Yields improved improvement across our transportation segments, package vol- during 2005 primarily due to inc remental fuel surc harges and ume grow th in our International Priority (“ IP” ) services at FedEx base rate increases. Express and volume grow th at FedEx Ground and FedEx Freight. During 2005, operating income increased primarily due to revenue Yields improved principally due to incremental fuel surcharges grow th in all transportation segments and improved margins at and base rate inc reases. Volumes benefited from IP pac kage FedEx Express and FedEx Freight. FedEx Express benefited from volume grow th of 8% at FedEx Express and volume grow th of 8% the realization of a full year of savings from our 2004 business at FedEx Ground. Pac kage volume grow th at FedEx Ground realignment programs (versus a half year in 2004), w hich reduced accelerated in the second half of 2006. Revenues at FedEx Kinko’s the grow th in salaries, w ages and benefits. grew slightly, as a more c ompetitive environment for c opies slow ed grow th in 2006. Although our fuel c osts inc reased signific antly during 2005, higher revenues from our jet and diesel fuel surcharges at FedEx Operating inc ome inc reased during 2006 primarily due to rev- Express and FedEx Freight more than offset these higher fuel enue grow th and improved margins across all our transportation costs. Salaries and employee benefits expense increased 12% segments. Yield and cost management activities, combined w ith during 2005 primarily due to higher incentive compensation, a full produc tivity gains ac ross all transportation segments, c on- year of c osts assoc iated w ith FedEx Kinko’s and inc reased tributed to our margin grow th. Operating income improvement medical costs. In 2005, purchased transportation increased at w as partially offset by higher costs at FedEx Express to support a faster rate than revenue, reflec ting higher fuel surc harges international volume grow th, expansion costs at FedEx Ground from third-party transportation providers and increased use of and reduced operating profit at FedEx Kinko’s. contract carriers to support international express and domestic W hile fuel costs increased substantially in 2006, fuel surcharges LTL volumes. more than offset the effect of higher fuel costs on our operating Other Income and Expense results based on a static analysis of the year-over-year changes Net interest expense decreased $35 million during 2006 due pri- in fuel prices compared to changes in fuel surcharges. How ever, marily to the reduction in the level of outstanding debt and capital as indicated below, there are other implications that the overall leases as a result of sc heduled payments, inc reased interest high level of fuel prices have to our businesses. For example, in inc ome due to higher c ash balanc es and interest rates, and response to the signific ant fluc tuations in jet and diesel fuel higher capitalized interest related to modification of certain air- pric es during the sec ond and third quarters of 2006, w e tem- craft at FedEx Express. Net interest expense increased $23 million porarily c apped c ertain of our fuel surc harges to ensure our during 2005 mainly due to the full year effec t of borrow ings services remain competitively priced in the marketplace. W hile related to the FedEx Kinko’s acquisition and the impact on com- fluctuations in fuel surcharge rates can be significant from period parisons of the interest on a prior year favorable tax adjustment to period, fuel surcharges represent one of the many individual resulting from the positive resolution of the tax case described c omponents of our pric ing struc ture that impac t our overall below. In 2005, other expense increased $14 million, primarily due revenue and yield. Additional c omponents inc lude the mix of to the w rite dow n of certain individually immaterial investments servic es purc hased, the base pric es and other extra servic e and foreign exchange transaction losses. charges w e obtain for these services and the level of pricing dis- counts offered. In order to provide information about the impact Income Taxes of fuel surcharges on the trend in revenue and yield grow th, w e Our effective tax rate w as 37.7% in 2006, 37.4% in 2005, and 36.5% have included the comparative fuel surcharge rates in effect during in 2004. The 37.4% effec tive tax rate in 2005 w as favorably the past three years in the follow ing discussions of each of our impacted by the reduction of a valuation allow ance on foreign tax transportation segments. credits arising from certain of our international operations as a result of the passage of the American Jobs Creation Act of 2004 Salaries and employee benefits increased 5% in 2006 due largely ($12 million tax benefit or $0.04 per diluted share) and by a low er to increases in w age rates, pension and medical expenses. effective state tax rate. The 36.5% effective tax rate in 2004 w as Pension expense increased $64 million in 2006 due primarily to favorably impacted by a reduction of accruals relating to the tax a reduction in the discount rate. Purchased transportation treatment of jet engine maintenance costs, stronger than antici- increased 11% in 2006 due primarily to the continued increase pated international results and the results of tax audits during in the use of contract carriers to support increasing volumes 2004. In 2004, w e received a favorable ruling regarding the tax at FedEx Ground, increased IP volumes at FedEx Express and treatment of jet engine maintenanc e c osts. The dec ision w as higher fuel surcharges from third-party transportation providers, affirmed by the appellate c ourt in February 2005, and bec ame including our independent contractors. final in M ay 2005, w hen the period for appeal lapsed. As a result, Revenue grow th during 2005 w as attributable to volume and w e rec ognized a one-time benefit of $26 million, net of tax, or yield improvements across all transportation segments and the $0.08 per diluted share in 2004. These adjustments affected both inc lusion of FedEx Kinko’s for the full year. Combined volume net interest expense ($30 million pretax) and income tax expense 40


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    M ANAGEM ENT’S DISCUSSION AND ANALYSIS ($7 million). For 2007, w e expect our effective tax rate to be 38.0% Business Acquisitions to 38.5%. The actual rate, how ever, w ill depend on a number of On M ay 26, 2006, w e announced an agreement to acquire the LTL factors, including the amount and source of operating income. operations of Watkins M otor Lines (“ Watkins” ), a privately held company, and certain affiliates for approximately $780 million in Lease Accounting Charge c ash. Watkins is a leading provider of long-haul LTL servic es. Our results for 2006 included a one-time, noncash charge of $79 Watkins w ill be rebranded as FedEx National LTL and w ill be million ($49 million after tax or $0.16 per diluted share), w hic h included in the FedEx Freight segment from the date of acquisi- represented the impact on prior years to adjust the accounting tion, w hic h is expec ted to oc c ur during the first half of 2007, for certain facility leases, predominately at FedEx Express. The subject to customary closing conditions. charge related primarily to rent escalations in on-airport facility leases. The applicable accounting literature provides that rent On January 24, 2006, FedEx Express entered into an agreement expense under operating leases w ith rent esc alation c lauses w ith Tianjin Datian W. Group Co., Ltd. (“ DTW Group” ) to acquire should be rec ognized evenly, on a straight-line basis over the DTW Group’s 50% share of the FedEx-DTW International Priority lease term. During the first quarter of 2006, w e determined that a express joint venture (“ FedEx-DTW ” ) and DTW Group’s domes- portion of our fac ility leases had rent esc alation c lauses that tic express netw ork in China for approximately $400 million in w ere not being recognized appropriately. Because the amounts cash. This acquisition w ill convert our joint venture w ith DTW involved w ere not material to our financ ial statements in any Group, formed in 1999 and c urrently ac c ounted for under the individual prior period and the c umulative amount w as not equity method, into a w holly ow ned subsidiary and increase our material to 2006 results, w e recorded the cumulative adjustment, presence in China in the international and domestic express busi- w hich increased operating expenses by $79 million, in the first nesses. The acquisition is expected to be completed in the first quarter of 2006. half of 2007, subject to customary closing conditions. The finan- c ial results of this transac tion w ill be inc luded in the FedEx Airline Stabilization Act Charge Express segment from the date of acquisition. During the second quarter of 2005, the United States Department of Transportation (“ DOT” ) issued a final order in its administra- On September 12, 2004, w e ac quired the assets and assumed tive review of the FedEx Express claim for compensation under certain liabilities of FedEx SmartPost (formerly know n as Parcel the Air Transportation Safety and System Stabilization Act. As a Direct), a division of a privately held company, for $122 million in result, w e recorded a charge of $48 million in the second quarter cash. FedEx SmartPost is a leading small-parcel consolidator and of 2005 ($31 million, net of tax, or $0.10 per diluted share), repre- broadens our portfolio of services by allow ing us to offer a cost- senting the DOT’s repayment demand of $29 million and the effec tive option for delivering low -w eight, less time-sensitive w rite-off of a $19 million receivable. packages to U.S. residences through the U.S. Postal Service. The financial results of FedEx SmartPost are included in the FedEx Business Realignment Costs Ground segment from the date of acquisition. During the first half of 2004, voluntary early retirement incentives w ith enhanced pension and postretirement healthcare benefits On February 12, 2004, w e ac quired FedEx Kinko’s for approxi- w ere offered to certain groups of employees at FedEx Express mately $2.4 billion in cash. FedEx Kinko’s is a leading provider of w ho w ere age 50 or older. Voluntary cash severance incentives document solutions and business services. Its netw ork of w orld- w ere also offered to eligible employees at FedEx Express. w ide loc ations offers ac c ess to c olor printing, finishing and Approximately 3,600 employees accepted offers under these pro- presentation services, Internet access, videoconferencing, out- grams. We recognized $435 million of business realignment costs sourcing, managed services, Web-based printing and document during 2004 ($428 million at the FedEx Express segment) as a management solutions. The results of FedEx Kinko’s are included in result of these programs. No material costs for these programs our consolidated financial statements from the date of acquisition. w ere incurred in 2006 or 2005. Over the past few years, w e have taken many steps to bring our expense grow th in line w ith revenue grow th, particularly at FedEx Express, w hile maintaining our industry-leading service levels. The business realignment programs w ere another step in this ongoing process of managing our cost structure to increase our competitiveness, meet the future needs of our employees and provide the expected financial returns for our shareholders. 41


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    FEDEX CORPORATION Outlook The pilots of FedEx Express, w hich represent a small number of Our outlook for 2007 is based on an expectation of global eco- FedEx Express total employees, are employed under a collective nomic grow th of 3%, w hic h is slow er than prior years and a bargaining agreement that became amendable on M ay 31, 2004. return to historical levels. Strong international grow th is expected In ac c ordanc e w ith applic able labor law , w e w ill c ontinue to to help offset moderating grow th in the U.S. We believe oil prices operate under our current agreement w hile w e negotiate w ith w ill continue to remain high and volatile based on w orld events. our pilots. Contract negotiations w ith the pilots’ union began in W hile our grow th is expected to moderate in comparison to our M arch 2004. These negotiations are ongoing and are being medi- strong results in 2006 and 2005, w e expect revenue and earnings ated through the National M ediation Board. We cannot estimate grow th across all transportation segments in 2007, driven by rev- the financial impact, if any, the results of these negotiations may enue grow th in high-margin services, productivity improvements have on our future results of operations. and continued focus on yield management. In M ay 2006, the U.S. Transportation Sec urity Administration At FedEx Express w e antic ipate strong grow th in IP pac kage (“ TSA” ) adopted new rules enhanc ing many of the sec urity volumes and yields, driven by Asia, and a slight improvement in requirements for air c argo on both passenger and all-c argo U.S. domestic volumes and yields. We also anticipate year-over- airc raft. The TSA is c urrently seeking c omments on a draft year increases in volumes and yields at FedEx Ground and FedEx version of a new all-c argo airc raft sec urity program, w hic h Freight, as FedEx Ground c ontinues its multi-year c apac ity w ould implement the new rules. Until the required sec urity expansion plan and FedEx Freight continues to grow its regional program is finalized, w e cannot determine the effect that these and interregional servic es. FedEx Kinko’s w ill foc us on key new rules w ill have, if any, on our cost structure or our operating strategies related to adding new locations, improving customer results. It is reasonably possible, how ever, that these rules or service and increasing investments in employee development future security requirements for air cargo carriers could impose and training, w hich w e expect to result in decreased profitability material costs on us. in the short term. Also, see “ Risk Fac tors” for a disc ussion of these and other We expect to continue to make investments to expand our net- potential risks and uncertainties that could materially affect our w orks and broaden our service offerings, in part through the future performance. integration and expansion of the businesses w e agreed to acquire Seasonality of Business in 2006. Our businesses are seasonal in nature. Seasonal fluctuations All of our transportation businesses operate in a competitive affect volumes, revenues and earnings. Historically, the U.S. pricing environment, exacerbated by continuing high fuel prices. express package business experiences an increase in volumes in While our fuel surcharges have been sufficient to offset increased late November and December. International business, particularly fuel prices, w e cannot predict the impact on the overall economy in the Asia-to-U.S. market, peaks in October and November due if fuel costs significantly fluctuate from current levels. Volatility in to U.S. holiday sales. Our first and third fiscal quarters, because fuel costs may also impact quarterly earnings because adjust- they are summer vacation and post w inter-holiday seasons, have ments to our fuel surcharges lag changes in actual fuel prices historically experienced low er volumes relative to other periods. paid. Therefore, the trailing impact of adjustments to FedEx Normally, the fall is the busiest shipping period for FedEx Ground, Express and FedEx Ground fuel surcharges can significantly affect w hile late December, June and July are the slow est periods. earnings in the short term. For FedEx Freight, the spring and fall are the busiest periods and the latter part of Dec ember, J anuary and February are Our management teams c ontinue to examine additional c ost the slow est periods. For FedEx Kinko’s, the summer months are reduc tions and operational produc tivity opportunities as w e normally the slow est periods. Shipment levels, operating costs and focus on optimizing our netw orks, improving our service offer- earnings for each of our companies can also be adversely affected ings, enhanc ing the c ustomer experienc e and rew arding our by inclement w eather, particularly in our third fiscal quarter. In employees and contractors through effective compensation and addition, the transportation and business services industries are incentive programs. directly affected by the state of the overall global economy. In 2007, w e w ill adopt Statement of Financ ial Ac c ounting Standards (“ SFAS” ) 123R, “ Share-Based Payment.” The new standard w ill require FedEx to record compensation expense for stoc k-based aw ards beginning in 2007, w hic h is expec ted to negatively impact our results by approximately $0.15 per diluted share. See our additional discussion of the adoption of SFAS 123R under “ New Accounting Pronouncements.” 42


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    M ANAGEM ENT’S DISCUSSION AND ANALYSIS NEW ACCOUNTING PRONOUNCEM ENTS FedEx Services provides customer-facing sales, marketing and In December 2004, the Financial Accounting Standards Board information technology support, primarily for FedEx Express and (“ FASB” ) issued SFAS 123R, “ Share-Based Payment.” SFAS 123R FedEx Ground. The costs for these activities are allocated based is a revision of SFAS 123 and supersedes Accounting Principles on metrics such as relative revenues or estimated services pro- Board Opinion No. (“ APB” ) 25. The new standard requires com- vided. We believe these alloc ations approximate the c ost of panies to record compensation expense for stock-based aw ards providing these functions. using a fair value method. Compensation expense w ill be The operating expenses line item “ Intercompany charges” on the recorded over the requisite service period, w hich is typically the accompanying unaudited financial summaries of our reportable vesting period of the aw ard. segments inc ludes the alloc ations from FedEx Servic es to W e w ill adopt this standard using the modified prospec tive the respective segments. The “ Intercompany charges” caption method as of June 1, 2006. We believe that the adoption of this also inc ludes alloc ations for administrative servic es provided standard w ill result in a reduction of diluted earnings per share betw een operating companies and certain other costs such as of approximately $0.15 in 2007. This estimate is impacted by the corporate management fees related to services received for gen- levels of share-based payments granted in the future, assump- eral corporate oversight, including executive officers and certain tions used in our fair value model and the market price of our legal and financ e func tions. M anagement evaluates segment common stock, so the actual effect per diluted share could differ financial performance based on operating income. from this estimate. In addition, certain FedEx operating companies provide trans- The FASB issued FASB Interpretation No. (“ FIN” ) 48, “ Accounting portation and related services for other FedEx companies outside for Uncertainty in Income Taxes,” on July 13, 2006. The new rules their reportable segment. Billings for such services are based on w ill most likely be effective for FedEx in 2008. At this time, w e negotiated rates, w hich w e believe approximate fair value, and have not completed our review and assessment of the impact of are reflected as revenues of the billing segment. FedEx Kinko’s adoption of FIN 48. segment revenues include package acceptance revenue, w hich represents the fee received by FedEx Kinko’s from FedEx Express and FedEx Ground for accepting and handling packages at REPORTABLE SEGM ENTS FedEx Kinko’s locations on behalf of these operating companies. FedEx Express, FedEx Ground, FedEx Freight and FedEx Kinko’s form Package acceptance revenue does not include the external the core of our reportable segments. As of M ay 31, 2006, our revenue associated w ith the actual shipments. All shipment reportable segments included the follow ing businesses: revenues are reflected in the segment performing the transporta- FedEx Express Segment FedEx Express (express transportation) tion services. Such intersegment revenues and expenses are FedEx Trade Netw orks eliminated in the consolidated results but are not separately (global trade services) identified in the follow ing segment information, as the amounts are not material. FedEx Ground Segment FedEx Ground (small-package ground delivery) FedEx SmartPost (small-parcel consolidator) FedEx Supply Chain Services (contract logistics) FedEx Freight Segment FedEx Freight (LTL freight transportation) FedEx Custom Critical (time-critical transportation) Caribbean Transportation Services (airfreight forw arding) FedEx Kinko’s Segment FedEx Kinko’s (document solutions and business services) 43


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    FEDEX CORPORATION FEDEX EXPRESS SEGM ENT The follow ing table compares selected statistics (in thousands, The follow ing table c ompares revenues, operating expenses, except yield amounts) for the years ended M ay 31: Percent Change operating income and operating margin (dollars in millions) for 2006/ 2005/ the years ended M ay 31: 2006 2005 2004 2005 2004 Percent Change 2006/ 2005/ Package Statistics (1) 2006 2005 2004 2005 2004 Average daily package volume (ADV): Revenues: U.S. overnight box 1,203 1,184 1,179 2 – Package: U.S. overnight U.S. overnight box $ 6,422 $ 5,969 $ 5,558 8 7 envelope 713 680 667 5 2 U.S. overnight U.S. deferred 901 958 925 (6) 4 envelope 1,974 1,798 1,700 10 6 Total U.S. U.S. deferred 2,853 2,799 2,592 2 8 domestic ADV 2,817 2,822 2,771 – 2 Total U.S. domestic IP 470 437 396 8 10 package revenue 11,249 10,566 9,850 6 7 Total ADV 3,287 3,259 3,167 1 3 International Revenue per package (yield): Priority (IP) 6,979 6,134 5,131 14 20 U.S. overnight box $20.94 $19.77 $18.49 6 7 Total package U.S. overnight envelope 10.86 10.37 10.00 5 4 revenue 18,228 16,700 14,981 9 11 U.S. deferred 12.42 11.46 10.99 8 4 Freight: U.S. domestic U.S. 2,218 1,854 1,609 20 15 composite 15.66 14.69 13.94 7 5 International 434 381 393 14 (3) IP 58.17 55.07 50.75 6 9 Total freight Composite revenue 2,652 2,235 2,002 19 12 package yield 21.75 20.10 18.55 8 8 Other (1) 566 550 514 3 7 Freight Statistics(1) Total revenues 21,446 19,485 17,497 10 11 Average daily freight pounds: Operating expenses: U.S. 9,374 8,885 8,519 6 4 Salaries and International 2,126 1,914 2,093 11 (9) employee benefits 8,033 7,704 7,403 4 4 Total average daily Purchased freight pounds 11,500 10,799 10,612 6 2 transportation 971 843 694 15 21 Revenue per pound (yield): Rentals and U.S. $ 0.93 $ 0.82 $ 0.74 13 11 landing fees 1,696 1,608 1,531 5 5 International 0.80 0.78 0.74 3 5 Depreciation and Composite amortization 805 798 810 1 (1) freight yield 0.90 0.81 0.74 11 9 Fuel 2,786 2,012 1,343 38 50 (1) Package and freight statistics include only the operations of FedEx Express. M aintenance and repairs 1,344 1,276 1,193 5 7 Business realignment costs – – 428 NM NM Airline Stabilization Act charge – 48 – NM NM Intercompany charges 1,542 1,509 1,442 2 5 Other 2,502 2,273 2,024 10 12 Total operating expenses 19,679(2) 18,071 16,868(3) 9 7 Operating income $ 1,767 $ 1,414 $ 629 25 125 Operating margin 8.2% 7.3% 3.6% 90bp 370bp (1) Other revenues includes FedEx Trade Netw orks. (2) Includes a $75 million one-time, noncash charge to adjust the accounting for certain facility leases. (3) The $428 million of business realignment costs, described herein, reduced operating margin by 244 basis points. 44


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    M ANAGEM ENT’S DISCUSSION AND ANALYSIS FedEx Express Segment Revenues Fuel surcharges increased in both 2006 and 2005 due to higher FedEx Express segment total revenues increased in 2006, princi- jet fuel prices. Our fuel surcharge is indexed to the spot price for pally due to increases in IP, U.S. domestic overnight package and jet fuel. Using this index, the U.S. domestic and outbound fuel freight revenues. During 2006, IP revenues grew 14% on an 8% surcharge and the international fuel surcharges ranged as follow s increase in volume and yield grow th of 6%. U.S. domestic pack- for the years ended M ay 31: age revenues grew 6% in 2006 as a result of increased yields. In 2006 2005 2004 2006, freight revenues increased 19%, primarily driven by higher U.S. Domestic and Outbound Fuel Surcharge: yields and grow th in U.S. domestic freight volumes. Low 10.50% 6.00% 3.00% Asia experienced strong average daily volume grow th in 2006, High 20.00 13.00 6.50 w hile outbound shipments from the United States, Europe and Weighted-average 13.69 9.05 4.38 Latin America also increased compared to the prior year. IP and International Fuel Surcharges: international freight c apac ity has inc reased signific antly as a Low 10.00 3.00 2.00 result of our tw o around-the-w orld flights, w hich w e added in late High 20.00 13.00 6.50 2005 and early 2006. This additional capacity resulted in higher Weighted-average 12.58 8.36 3.65 international freight volume. U.S. volumes w ere flat compared to prior year, as grow th in our U.S. domestic overnight services w as In response to the significant fluctuations in jet and diesel fuel offset by declines in deferred volumes that resulted in part from pric es during the sec ond and third quarters of 2006, w e tem- yield management actions. porarily c apped c ertain of our fuel surc harges in November and December 2005 to ensure our services remained competi- IP yield increased during 2006 primarily due to higher fuel sur- tively priced in the marketplace. c harges and inc reases in international average w eight per package and average rate per pound. U.S. domestic composite FedEx Express Segment Operating Income yield increases w ere due to higher fuel surcharges and improved Operating income grew significantly in 2006 as a result of strong yields on U.S. domestic deferred pac kages. Improvements in revenue grow th and improved operating margin. Volume grow th U.S. domestic deferred yield resulted from our continued efforts in higher margin U.S. domestic overnight and IP services con- to improve the profitability of this servic e. U.S. freight yield tributed to yield improvements. Improved yields, combined w ith increases w ere due to an increase in average rate per pound and productivity gains and cost containment, allow ed FedEx Express to higher fuel surc harges. In J anuary 2006, w e implemented an improve operating margin in 2006. Revenue and margin grow th for average list price increase of 5.5% on FedEx Express U.S. domes- 2006 more than offset a one-time adjustment for leases in the first tic shipments and U.S. outbound international shipments, w hile quarter and costs associated w ith our tw o around-the-w orld flights. w e low ered our fuel surcharge index by 2%. In 2006, salaries and benefits increased primarily due to higher FedEx Express segment total revenues increased in 2005, prin- pension costs and w age rates. Fuel costs w ere higher in 2006 pri- c ipally due to higher IP revenues (partic ularly in Asia, U.S. marily due to a 34% increase in the average price per gallon of outbound and Europe) and higher U.S. domestic package rev- jet fuel, w hile gallons c onsumed inc reased slightly, primarily enues. During 2005, IP revenues experienced grow th of 20% on related to the w estbound and eastbound around-the-w orld flights. volume grow th of 10% and a 9% increase in yield. Asia experi- How ever, our fuel surcharges substantially mitigated the impact of enc ed strong average daily volume grow th during 2005, w hile higher jet fuel prices. Purchased transportation costs increased in outbound shipments from the United States, Europe and Latin 2006, though at a slow er rate than in 2005, driven by IP volume America continued to improve. U.S. domestic volumes at FedEx grow th, w hich required a higher utilization of contract pickup and Express increased 2% in 2005. delivery services. Rentals and landing fees increased 5% in 2006, primarily due to the one-time adjustment for leases of $75 million. U.S. domestic composite yield increased 5% in 2005 due to higher fuel surcharges and increases in average w eight per package Operating inc ome for the FedEx Express segment inc reased and average rate per pound. IP yield increased across all regions signific antly during 2005, as w e benefited from a full year of during 2005 due to higher fuel surcharges, an increase in interna- savings from our business realignment programs (versus a half tional average w eight per package and favorable exchange rate year in 2004). During 2005, increases in revenues, savings from differences, partially offset by a decline in international average our business realignment programs, the timing of adjustments to rate per pound. fuel surcharges and cost control efforts more than offset higher fuel c osts, inc entive c ompensation, purc hased transportation and maintenance costs and the Airline Stabilization Act charge of $48 million. 45


  • Page 10

    FEDEX CORPORATION Salaries and benefits w ere higher during 2005 due to higher FEDEX GROUND SEGM ENT incentive compensation, increased medical benefit costs, and The follow ing table c ompares revenues, operating expenses, w age rate increases, partially offset by savings from the busi- operating income and operating margin (dollars in millions) and ness realignment initiatives. During 2005, fuel costs w ere higher selected package statistics (in thousands, except yield amounts) due to a 47% increase in the average price per gallon of aircraft for the years ended M ay 31: Percent Change fuel, w hile gallons c onsumed inc reased slightly. In 2005, pur- 2006/ 2005/ c hased transportation c osts inc reased at a greater rate than 2006 2005 2004 2005 2004 total revenues, led by IP volume grow th requirements and higher Revenues $5,306 $4,680 $3,910 13 20 utilization of contract pickup and delivery services. Operating expenses: Salaries and FedEx Express Segment Outlook employee benefits 929 845 740 10 14 We expect comparatively slow er overall revenue grow th at FedEx Purchased Express during 2007, due in part to more c omparable fuel sur- transportation 2,019 1,791 1,465 13 22 charge levels during the year. Revenue increases w ill be led by Rentals 133 122 98 9 24 IP, w here w e expect volume and yield grow th, particularly in Asia Depreciation and and U.S. outbound as a result of continued strong demand for our amortization 224 176 154 27 14 services. We expect improved U.S. domestic revenue grow th at Fuel 93 48 16 94 200 FedEx Express, driven by expected increases in U.S. domestic M aintenance yields and improved overnight and deferred volumes. and repairs 118 110 95 7 16 As described above, in January 2006 FedEx Express entered into Intercompany charges 526 482 432 9 12 an agreement w ith DTW Group to acquire its 50% share of the Other 559 502 388 11 29 FedEx-DTW International Priority express joint venture and its Total operating domestic express netw ork in China. The acquisition is expected to expenses 4,601 4,076 3,388 13 20 be completed in the first half of 2007. Operating income $ 705 $ 604 $ 522 17 16 Operating margin 13.3% 12.9% 13.4% 40bp (50)bp For 2007, w e expect operating margin w ill continue to improve. Average daily W e expec t improved utilization of the c apac ity added by the package volume (1) 2,815 2,609 2,285 8 14 eastbound and w estbound around-the-w orld flights, partially Revenue per offset by c osts assoc iated w ith c apac ity additions in China package (yield) (1) $ 7.02 $ 6.68 $ 6.48 5 3 and w ith the integration of the DTW Group business into the FedEx Express netw ork. The mix of services on our w orldw ide (1) Package statistics include only the operations of FedEx Ground. netw ork w ill change as w e sell higher yielding traffic into the net- w ork. FedEx Express w ill continue to focus on cost savings and FedEx Ground Segment Revenues productivity enhancement opportunities. Capital expenditures at Revenues increased during 2006 due to volume increases and FedEx Express are expected to be higher in 2007 due to contin- yield improvement, w ith ac c elerating volume grow th in the ued investment in aircraft and sorting capacity associated w ith sec ond half of 2006. Average daily volumes inc reased ac ross package grow th, as w ell as continued investments in China. In all of our servic es, led by the c ontinued grow th of our FedEx M arch 2006, w e broke ground on a new $150 million Asia-Pacific Home Delivery servic e. Yield improvement during 2006 w as hub in the southern China city of Guangzhou. This hub is planned primarily due to increased fuel surcharges, higher extra service to be operational in 2009. W e believe these investments w ill revenue (primarily on our residential, declared value and over- enhance our grow th prospects for these profitable services in size services) and the impact of general rate increases. These emerging markets. inc reases w ere partially offset by higher c ustomer disc ounts and a low er average w eight per package. In January 2006, w e implemented standard list rate inc reases averaging 3.9% and changes to various surcharges. 46


  • Page 11

    M ANAGEM ENT’S DISCUSSION AND ANALYSIS Revenues increased during 2005 principally due to strong vol- FedEx Ground segment operating income increased 16% in 2005, ume grow th. W hile the rise in average daily volume w as led by as revenue grow th and field productivity more than offset higher continued grow th of our FedEx Home Delivery service, average operating expenses. The decrease in operating margin in 2005 daily volumes increased across virtually all of our service lines. w as primarily attributable to operating losses at FedEx SmartPost, Yield increased during 2005 primarily due to higher extra service the increase in purchased transportation, and a one-time $10 mil- revenue and general rate inc reases, partially offset by higher lion charge at FedEx Supply Chain Services for the termination of customer discounts and a low er average w eight per package. a vendor agreement. The FedEx Ground fuel surcharge is based on a rounded average The grow th in salaries and employee benefits, as w ell as other of the national U.S. on-highw ay average prices for a gallon of operating costs, in 2005 w as also due to increases in staffing and diesel fuel, as published by the Department of Energy. Our fuel fac ilities to support volume grow th. Purc hased transportation surcharge ranged as follow s for the years ended M ay 31: increased in 2005 due to the impact of higher fuel costs on con- trac tor settlements, the ac quisition of FedEx SmartPost and a 2006 2005 2004 change in the mix of business at FedEx Supply Chain Services. Low 2.50% 1.80% 1.30% High 5.25 2.50 1.50 FedEx Ground Segment Outlook Weighted-average 3.54 2.04 1.36 We expect the FedEx Ground segment to have revenue grow th in 2007 consistent w ith 2006, led by increased FedEx Home Delivery No fuel surcharge w as in effect from January 2004 to January 2005. servic e. FedEx Ground’s average daily volume is expec ted to increase in 2007 due to increased base business and FedEx Home The financial results of FedEx SmartPost, w hich w as acquired in Delivery volumes. FedEx SmartPost volumes are also expected to September 2004, are inc luded in the FedEx Ground segment grow, aided by the recent bankruptcy of a key competitor. Yields from the date of its ac quisition and w ere not material to 2006 for all services at FedEx Ground are expected to increase in 2007 or 2005 results. from inc reases in list pric es and residential and c ommerc ial FedEx Ground Segment Operating Income delivery area surcharges. FedEx Ground segment operating income increased 17% in 2006, FedEx Ground’s operating margin in 2007 is expected to benefit resulting principally from revenue grow th and yield improvement. from c ontinued c ost c ontrols, produc tivity gains and yield Operating margin for the segment improved in 2006 due to fuel improvements, partially offset by the impac t of our netw ork surcharges, general rate increases, improved productivity and expansion c osts. Capital spending is expec ted to grow as w e the inclusion in 2005 of a $10 million charge at FedEx Supply Chain c ontinue w ith c omprehensive netw ork expansion w ithin the Services related to the termination of a vendor agreement. A por- FedEx Ground segment. During 2007, the multi-phase expansion tion of the operating margin improvement w as offset by higher plan includes the expansion of three hubs and relocation of 48 year-over-year expenses related to investments in new technol- facilities. In addition, in 2007 w e w ill continue to vigorously defend ogy and the opening of additional FedEx Ground facilities. challenges to the status of our ow ner-operators as independent Salaries and employee benefits increased 10% in 2006 principally contractors, as described in “ Risk Factors” and in Note 19 to the due to w age rate increases and increases in staffing and facili- accompanying consolidated financial statements. ties to support volume grow th. Deprec iation expense in 2006 increased at a higher rate than revenue due to increased spend- ing associated w ith material handling and scanning equipment. In 2006, purchased transportation increased 13% due to increased volumes and an increase in the cost of purchased transportation due to higher fuel surcharges from third-party transportation providers, including our independent contractors. 47


  • Page 12

    FEDEX CORPORATION FEDEX FREIGHT SEGM ENT fuel, as published by the Department of Energy. The indexed LTL The follow ing table show s revenues, operating expenses, oper- fuel surcharge ranged as follow s for the years ended M ay 31: ating inc ome and operating margin (dollars in millions) and 2006 2005 2004 selected statistics for the years ended M ay 31: Low 12.5% 7.6% 3.2% Percent Change 2006/ 2005/ High 20.1 14.0 8.4 2006 2005 2004 2005 2004 Weighted-average 16.3 10.8 5.4 Revenues $3,645 $3,217 $2,689 13 20 Operating expenses: FedEx Freight Segment Operating Income Salaries and FedEx Freight segment operating income increased 37% in 2006 employee benefits 1,801 1,650 1,427 9 16 primarily due to LTL revenue grow th, as w ell as our ability to con- Purchased trol costs in line w ith volume grow th. Increased LTL yield and transportation 298 315 254 (5) 24 productivity gains contributed to improved margins in 2006 despite Rentals and landing fees 94 99 100 (5) (1) higher salaries and employee benefits, depreciation and fuel Depreciation costs. W hile fuel costs increased substantially in 2006, fuel sur- and amortization 120 102 92 18 11 charges more than offset the effect of higher fuel costs. Increased Fuel 377 257 172 47 49 staffing to support volume grow th and higher incentive compen- M aintenance sation expense increased salaries and employee benefits in 2006. and repairs 120 128 116 (6) 10 Depreciation costs increased primarily due to investments in Intercompany charges 37 26 21 42 24 operating equipment, w hich in some cases replaced leased Other 313 286 263 9 9 equipment. M aintenance and repairs decreased due to the pres- Total operating ence of rebranding costs in 2005, as w ell as the recent increase in expenses 3,160 2,863 2,445 10 17 the purchase of new fleet vehicles. Purchased transportation Operating income $ 485 $ 354 $ 244 37 45 costs decreased, due to increased utilization of company equip- Operating margin 13.3% 11.0% 9.1% 230bp 190bp ment in our interregional freight services. Average daily LTL FedEx Freight segment operating income increased 45% in 2005 shipments (in thousands) 67 63 58 6 9 primarily due to LTL yield and shipment grow th, as w ell as our Weight per ability to manage c osts during a period of substantial grow th. LTL shipment (lbs) 1,143 1,132 1,127 1 – Higher fuel surc harges and produc tivity gains c ontributed to LTL yield (revenue improved operating margin in 2005 despite higher salaries and per hundredw eight) $16.84 $15.48 $14.23 9 9 employee benefits, purc hased transportation and fuel c osts. Purchased transportation costs increased due to grow th in our FedEx Freight Segment Revenues interregional freight service, efforts to supplement our linehaul FedEx Freight segment revenues increased 13% in 2006 due to 9% operations and higher fuel surcharges from contract carriers. grow th in LTL yield and 6% grow th in average daily LTL shipments. LTL yield grew during 2006, reflecting incremental fuel surcharges FedEx Freight Segment Outlook resulting from higher fuel prices and higher rates. Average daily As desc ribed above, w e have entered into an agreement to LTL shipment grow th w as driven in part by features such as our acquire the LTL operations of Watkins and certain affiliates for no-fee money-back guarantee and our advance notice service, approximately $780 million in c ash. The financ ial results of w hich continue to differentiate us in the LTL market. Watkins w ill be included in the FedEx Freight segment from the date of acquisition, w hich is expected to occur during the first FedEx Freight segment revenues increased 20% in 2005 due to half of 2007. year-over-year grow th in average daily LTL shipments and yield. M arket share gains, driven in part by brand aw areness along We expect revenue grow th in 2007, due to both LTL yield improve- w ith a stronger economy, contributed to the significant increase ment and LTL shipment grow th and as a result of our pending in average daily LTL shipments. LTL yield grew during 2005, acquisition of Watkins. The general LTL rate increase of 5.95% reflecting incremental fuel surcharges due to higher fuel prices, (implemented in April 2006) and a stable industry-pricing envi- higher rates, grow th in our interregional freight service and a sta- ronment are expected to contribute to LTL yield improvement. ble pricing environment. We w ill continue to focus on yield management at FedEx Freight w hile grow ing our regional and interregional services. We also The indexed LTL fuel surcharge is based on the average of the expect continued consolidation among LTL carriers and sustained national U.S. on-highw ay average prices for a gallon of diesel 48


  • Page 13

    M ANAGEM ENT’S DISCUSSION AND ANALYSIS positive economic conditions to provide additional opportunities for FedEx Freight to promote its regional service and other freight solu- tions, such as FedEx Expedited Freight Servic e, a new one-c all solution that assists c ustomers in selec ting freight servic es for time-sensitive, heavyw eight shipments. The acquisition of Watkins w ill result in costs related to rebranding and other integration efforts; how ever, these expenses are not expected to have a material impact on 2007 results of operations. We anticipate increased capital spending at FedEx Freight in 2007, largely on new and expanded facilities and information technology investments. FEDEX KINKO’S SEGM ENT The results of operations for FedEx Kinko’s are included in our consolidated results from the date of acquisition (February 12, 2004). The FedEx Kinko’s segment w as formed in the fourth quarter of 2004. The results of operations from February 12, 2004 (the date of acqui- sition) through February 29, 2004 w ere included in “ Other and Eliminations” (approximately $100 million of revenue and $6 million of operating income). The follow ing table show s revenues, operating expenses, operating income and operating margin (dollars in millions) for the years ended M ay 31, 2006 and 2005 and for the three months ended M ay 31, 2006, 2005 and 2004: Year Ended Percent Three M onths Ended Percent Change 2006 2005 Change 2006 2005 2004 2006/2005 2005/2004 Revenues $2,088 $2,066 1 $542 $553 $521 (2) 6 Operating expenses: Salaries and employee benefits 752 742 1 191 189 185 1 2 Rentals 394 412 (4) 99 100 115 (1) (13) Depreciation and amortization 148 138 7 40 38 33 5 15 M aintenance and repairs 73 70 4 18 19 9 (5) 111 Intercompany charges 26 6 NM 8 1 – NM NM Other operating expenses: Supplies, including paper and toner 274 278 (1) 70 73 69 (4) 6 Other 364 320 14 98 92 71 7 30 Total operating expenses 2,031 1,966 3 524 512 482 2 6 Operating income $ 57 $ 100 (43) $ 18 $ 41 $ 39 (56) 5 Operating margin 2.7% 4.8% (210)bp 3.3% 7.4% 7.5% (410)bp (10)bp Certain prior period amounts have been reclassified to conform to the current period presentation. FedEx Kinko’s Segment Revenues FedEx Kinko’s Segment Operating Income In 2006, a year-over-year increase in package acceptance rev- Operating income decreased in both the fourth quarter and full enue led to modest revenue grow th. Pac kage ac c eptanc e year 2006 as the increase in package acceptance revenues w as revenue benefited year over year from the April 2005 conversion more than offset by a decline in copy product line revenues. In of FedEx World Service Centers to FedEx Kinko’s Ship Centers. 2006, salaries and employee benefits increased due to the addi- FedEx Kinko’s experienc ed dec lines in c opy produc t line rev- tion of FedEx Kinko’s Ship Centers, higher group health insurance enues in 2006 due to decreased demand for these services and a costs and increased costs associated w ith employee training and competitive pricing environment. development programs. Inc reased deprec iation in 2006 w as driven by center rebranding and investments in new technology Revenues in the fourth quarter of 2006 w ere slightly low er due to to replace legacy systems. The increase for 2006 in other oper- declines in copy product revenues, partially offset by increases in ating expenses w as primarily due to increased costs related to package acceptance and retail office supplies revenue. In the technology, strategic and product offering initiatives. fourth quarter of 2005, revenues increased due primarily to signif- icant package acceptance revenue grow th, higher international Operating income increased slightly in the fourth quarter of 2005 revenue and grow th in retail services and signs and graphics, as the increase in package acceptance revenue w as partially partially offset by a decline in domestic copy product line revenue. offset by integration ac tivities, inc luding fac ility rebranding expenses, ramp-up costs associated w ith the offering of pack- aging and shipping servic es and the c entralization of FedEx Kinko’s corporate support operations. Rebranding costs associ- ated w ith the integration of FedEx Kinko’s totaled $11 million in 2005, $5 million in the fourth quarter of 2005 and $3 million in the fourth quarter of 2004. 49


  • Page 14

    FEDEX CORPORATION FedEx Kinko’s Segment Outlook Pension Contributions. Net cash provided by operating activities FedEx Kinko’s has initiated a multi-year netw ork expansion pro- reflect voluntary U.S. domestic pension plan contributions of $456 gram to increase the retail locations for customer access to FedEx million during 2006, compared to $460 million during 2005 and $320 Kinko’s business services and the FedEx Express and FedEx million during 2004. Ground shipping netw ork. In addition, FedEx Kinko’s w ill focus Cash Used for Business Acquisitions. During the second quarter on key strategies related to improving customer service and of 2005, w e acquired FedEx SmartPost for $122 million in cash. In employee training and development. The netw ork expansion pro- the third quarter of 2004, w e acquired all of the common stock of gram, combined w ith employee training programs, is anticipated FedEx Kinko’s for approximately $2.4 billion in cash. See “ Debt to result in modest revenue grow th; how ever, profitability w ill be Financing Activities” for further discussion of the FedEx Kinko’s negatively impacted by costs associated w ith adding new loca- acquisition. See Note 3 of the accompanying audited financial tions and expenses associated w ith enhancing service levels. statements for further discussion of these acquisitions. FINANCIAL CONDITION Cash Used for Capital Investments. Capital expenditures w ere higher in 2006 primarily due to expenditures associated w ith vehi- LIQUIDITY c le ac quisitions at FedEx Express and FedEx Freight, fac ility Cash and cash equivalents totaled $1.937 billion at M ay 31, 2006, expansion at FedEx Ground and information technology invest- compared to $1.039 billion at M ay 31, 2005 and $1.046 billion at ments at FedEx Services. In 2005, capital expenditures increased M ay 31, 2004. The follow ing table provides a summary of our cash due to planned airc raft expenditures at FedEx Express. See flow s for the years ended M ay 31 (in millions): “ Capital Resources” for further discussion. 2006 2005 2004 Debt Financ ing Ac tivities. During 2006, $250 million of senior Operating activities: unsecured notes matured and w ere repaid. During 2005, $600 mil- Net income $1,806 $ 1,449 $ 838 lion of senior unsecured notes matured and w ere repaid and $45 Noncash charges and credits 1,997 1,662 1,516 million in tax exempt bonds w ere called and prepaid. Changes in operating assets A new $1.0 billion five-year revolving credit facility w as executed and liabilities (127) 6 666 in the first quarter of 2006, w hich replaced our prior revolving Net cash provided credit facilities. The revolving credit facility is available to finance by operating activities 3,676 3,117 3,020 our operations and other cash flow needs and to provide support Investing activities: for the issuance of commercial paper. Any commercial paper bor- Business acquisitions, row ings reduce the amount available under the revolving credit net of cash acquired – (122) (2,410) facility. At both M ay 31, 2006 and 2005, no commercial paper w as Capital expenditures and outstanding and the entire $1.0 billion under the revolving credit other investing activities (2,454) (2,226) (1,252) facility w as available for future borrow ings. Borrow ings under the Net cash used in revolving credit facility w ill bear interest at short-term interest investing activities (2,454) (2,348) (3,662) rates (based on the London Interbank Offered Rate (“ LIBOR” ), the Financing activities: Prime Rate or the Federal Funds Rate) plus a margin dependent Proceeds from debt issuances – – 1,599 upon our senior unsecured long-term debt ratings. Principal payments on debt (369) (791) (319) Repurchase of treasury stock – – (179) Our revolving c redit agreement c ontains a financ ial c ovenant Dividends paid (97) (84) (66) that requires us to maintain a leverage ratio of adjusted debt Other financing activities 142 99 115 (long-term debt, including the current portion of such debt, plus Net cash (used in) provided six times rentals and landing fees) to capital (adjusted debt plus by financing activities (324) (776) 1,150 total common stockholders’ investment) that does not exceed 0.7 Net increase (decrease) to 1.0. Throughout 2006, w e w ere in compliance w ith this and all in cash and cash other restrictive covenants of our revolving credit agreement and equivalents $ 898 $ (7) $ 508 do not expect the covenants to significantly affect our operations. For more information on our c redit fac ility, see Note 7 of the Cash Provided by Operating Activities. The $559 million increase accompanying consolidated financial statements. in cash flow s from operating activities in 2006 w as principally due We also use capital and operating leases to finance a portion of to inc reased earnings. The $97 million inc rease in c ash flow s our aircraft, facility, vehicles and equipment needs. In addition, from operating ac tivities in 2005 w as largely attributable to w e have a $1.0 billion shelf registration statement filed w ith the increased earnings and improvement in accounts receivable col- SEC to provide flexibility and efficiency w hen obtaining certain lections, partially offset by a $140 million increase in voluntary financing. Under this shelf registration statement w e may issue, contributions to our U.S. domestic pension plans and a decrease in one or more offerings, unsec ured debt sec urities, c ommon in the grow th of operating liabilities. stock or a combination of such instruments. The entire $1.0 billion is available for future financings. 50


  • Page 15

    M ANAGEM ENT’S DISCUSSION AND ANALYSIS Cash Used for Share Repurchases. We did not repurchase any The follow ing table c ompares c apital expenditures by asset shares in 2006 or 2005. During the first half of 2004, w e repur- c ategory and reportable segment for the years ended M ay 31 chased 2.6 million shares at an average price of $68.14 per share, (in millions): Percent Change w hic h dec reased c ash flow s by approximately $179 million. 2006/ 2005/ Based on our c urrent financ ing strategy, w e are issuing new 2006 2005 2004 2005 2004 shares in c onnec tion w ith our equity c ompensation programs Aircraft and related rather than utilizing treasury shares. A total of 5.75 million shares equipment $1,033 $ 990 $ 372 4 166 remain under existing share repurchase authorizations. Facilities and sort equipment 507 496 332 2 49 Dividends. Dividends paid w ere $97 million in 2006, $84 million Vehicles 413 261 212 58 23 in 2005 and $66 million in 2004. On M ay 26, 2006, our Board of Information and Direc tors dec lared a dividend of $0.09 per share of c ommon technology investments 394 331 249 19 33 stock, an increase of $0.01 to our quarterly dividend. The divi- Other equipment 171 158 106 8 49 dend w as paid on July 3, 2006 to stockholders of record as of Total capital the close of business on June 12, 2006. Each quarterly dividend expenditures $2,518 $2,236 $1,271 13 76 payment is subjec t to review and approval by our Board of FedEx Express segment $1,408 $1,195 $ 592 18 102 Direc tors, and w e intend to evaluate our dividend payment FedEx Ground segment 487 456 314 7 45 amount on an annual basis at the end of each fiscal year. FedEx Freight segment 274 217 130 26 67 Other Liquidity Information. We believe that our existing cash and FedEx Kinko’s segment 94 152 36 (38) NM cash equivalents, cash flow from operations, our commercial Other, principally paper program, revolving bank credit facility and shelf registration FedEx Services 255 216 199 18 9 statement w ith the SEC w ill adequately meet our w orking capital Total capital and capital expenditure needs for the foreseeable future and expenditures $2,518 $2,236 $1,271 13 76 finance our pending acquisitions. In the future, other forms of secured financing may be used to obtain capital assets if w e Capital expenditures during 2006 w ere higher than the prior year determine that they best suit our needs. We have been successful primarily due to the purchase of vehicles at FedEx Express and in obtaining investment capital, both domestic and international, FedEx Freight and information technology investments at FedEx although the marketplace for such capital can become restricted Services. In addition, investments w ere made in the FedEx Ground depending on a variety of economic factors. We believe the capi- and FedEx Freight netw orks to support grow th in customer tal resources available to us provide flexibility to access the most demand. Capital expenditures w ere 76% higher in 2005, w ith the efficient markets for financing capital acquisitions, including air- year-over-year increase due to planned aircraft expenditures at craft, and are adequate for our future capital needs. FedEx Express to support IP volume grow th and FedEx Kinko’s rebranding costs. Capital expenditures during 2005 included a full We have a senior unsecured debt credit rating from Standard & year of FedEx Kinko’s. Poor’s of BBB and a commercial paper rating of A-2. M oody’s Investors Servic e has assigned us a senior unsec ured debt Our capital expenditures are expected to be approximately $2.9 c redit rating of Baa2 and a c ommerc ial paper rating of P-2. billion in 2007, w ith much of the year-over-year increase due to M oody’s c harac terizes our ratings outlook as “ stable,” w hile facility expansions at FedEx Express, netw ork expansions at Standard & Poor’s characterizes our ratings outlook as “ positive.” FedEx Kinko’s and vehicle expenditures at FedEx Ground to If our credit ratings drop, our interest expense may increase. If our support netw ork expansions and replacement needs. We also commercial paper ratings drop below current levels, w e may have continue to invest in productivity-enhancing technologies and the diffic ulty utilizing the c ommerc ial paper market. If our senior multi-year capacity expansion of the FedEx Ground netw ork. We unsecured debt ratings drop below investment grade, our access currently expect to fund our 2007 capital requirements w ith cash to financing may become more limited. generated from operations. Because of substantial lead times associated w ith the manufac- CAPITAL RESOURCES ture or modification of aircraft, w e must generally plan our aircraft Our operations are capital intensive, characterized by significant orders or modifications three to eight years in advance. W hile w e investments in aircraft, vehicles, technology, package handling also pursue market opportunities to purchase aircraft w hen they facilities and sort equipment. The amount and timing of capital become available, w e must make commitments regarding our additions depend on various factors, including pre-existing con- airlift requirements years before airc raft are ac tually needed. trac tual c ommitments, antic ipated volume grow th, domestic We are closely managing our capital spending based on current and international economic conditions, new or enhanced services, and anticipated volume levels and w ill defer or limit capital addi- geographical expansion of services, competition, availability of tions w here ec onomic ally feasible, w hile c ontinuing to invest satisfactory financing and actions of regulatory authorities. strategically in grow ing service lines. 51


  • Page 16

    FEDEX CORPORATION CONTRACTUAL CASH OBLIGATIONS The follow ing table sets forth a summary of our contractual cash obligations as of M ay 31, 2006. Certain of these contractual obligations are reflected in our balance sheet, w hile others are disclosed as future obligations under accounting principles generally accepted in the United States. Except for the current portion of long-term debt and capital lease obligations, this table does not include amounts already recorded in our balance sheet as current liabilities at M ay 31, 2006. Accordingly, this table is not meant to represent a forecast of our total cash expenditures for any of the periods presented. Payments Due by Fiscal Year (In millions) 2007 2008 2009 2010 2011 Thereafter Total Amounts reflected in Balance Sheet: Long-term debt $ 844 $ – $ 500 $ – $ 249 $ 539 $ 2,132 Capital lease obligations (1) 24 100 12 96 8 144 384 Other cash obligations not reflected in Balance Sheet: Unconditional purchase obligations (2) 1,182 674 613 791 582 383 4,225 Interest on long-term debt 110 83 83 65 65 1,599 2,005 Operating leases 1,672 1,478 1,290 1,120 984 6,780 13,324 Total $3,832 $2,335 $2,498 $2,072 $1,888 $9,445 $22,070 (1) Capital lease obligations represent principal and interest payments. (2) See Note 18 to the accompanying consolidated financial statements. We have certain contingent liabilities that are not accrued in our costs to modify these aircraft for cargo transport unless w e have balance sheets in accordance w ith accounting principles gener- entered into a noncancelable commitment. Open purchase orders ally accepted in the United States. These contingent liabilities are that are cancelable are not considered unconditional purchase not included in the table above. obligations for financial reporting purposes and are not included in the table above. Such purchase orders often represent author- Amounts Reflected in Balance Sheet izations to purchase rather than binding agreements. We have c ertain financ ial instruments representing potential commitments, not reflected in the table above, that w ere incurred The amounts reflected in the table above for interest on long-term in the normal c ourse of business to support our operations, debt represent future interest payments due on our long-term including surety bonds and standby letters of credit. These instru- debt, w hich are primarily fixed rate. ments are generally required under certain U.S. self-insurance The amounts reflected in the table above for operating leases programs and are also used in the normal course of international represent future minimum lease payments under noncancelable operations. W hile the notional amounts of these instruments are operating leases (principally aircraft and facilities) w ith an initial material, there are no additional contingent liabilities associated or remaining term in excess of one year at M ay 31, 2006. In the w ith them because the underlying liabilities are already reflected past, w e financed a significant portion of our aircraft needs (and in our balance sheet. certain other equipment needs) using operating leases (a type of We have other long-term liabilities reflected in our balance sheet, “ off-balance sheet financing” ). At the time that the decision to including deferred income taxes, nonqualified pension and postre- lease w as made, w e determined that these operating leases tirement healthcare liabilities and other self-insurance accruals. w ould provide economic benefits favorable to ow nership w ith The payment obligations associated w ith these liabilities are not respect to market values, liquidity or after-tax cash flow s. reflected in the table above due to the absence of scheduled In accordance w ith accounting principles generally accepted in maturities. Therefore, the timing of these payments cannot be the United States, our operating leases are not recorded in our determined, except for amounts estimated to be payable w ithin balance sheet. Credit rating agencies routinely use information tw elve months that are included in current liabilities. concerning minimum lease payments required for our operating Other Cash Obligations Not Reflected in Balance Sheet leases to calculate our debt capacity. In addition, w e have guar- The amounts reflected in the table above for purchase commit- antees under certain operating leases, amounting to $34 million ments represent noncancelable agreements to purchase goods as of M ay 31, 2006, for the residual values of vehicles and facili- or services. Such contracts include those for certain purchases ties at the end of the respec tive operating lease periods. of aircraft, aircraft modifications, vehicles, facilities, computers, Although some of these leased assets may have a residual value printing and other equipment and advertising and promotions con- at the end of the lease term that is less than the value specified in tracts. In addition, w e have committed to modify our DC10 aircraft the related operating lease agreement, w e do not believe it is for passenger-to-freighter and tw o-man cockpit configurations, probable that w e w ill be required to fund material amounts under w hich is reflected in the table above. Commitments to purchase the terms of these guarantee arrangements. Ac c ordingly, no aircraft in passenger configuration do not include the attendant material accruals have been recognized for these guarantees. 52


  • Page 17

    M ANAGEM ENT’S DISCUSSION AND ANALYSIS CRITICAL ACCOUNTING ESTIM ATES Certain of the assumptions used to measure our pension obliga- tions and cost are reset every year based on current facts and The preparation of financial statements in accordance w ith circumstances (such as the discount rate). Others are more long- accounting principles generally accepted in the United States term, forw ard-looking assumptions that are evaluated annually requires management to make significant judgments and esti- to determine w hether they continue to be appropriate. For our mates to develop amounts reflected and disclosed in the financial February 28, 2006 actuarial measurement of our qualified domestic statements. In many cases, there are alternative policies or esti- pension plans, w e updated the follow ing long-term assumptions: mation techniques that could be used. We maintain a thorough process to review the application of our accounting policies and • The estimated rate of salary increases w as revised from 3.15% to to evaluate the appropriateness of the many estimates that are 3.46% based on recent actual experience. The salary increase required to prepare the financial statements of a large, global cor- assumption is discussed further below. poration. How ever, even under optimal circumstances, estimates • An updated mortality table w as used for the 2006 ac tuarial routinely require adjustment based on changing circumstances measurement to reflect current trends in mortality experience and new or better information. for non-insured pension plans. As approximately 72% of our The estimates discussed below include the financial statement employees have blue collar job classifications, w e employed the elements that are either the most judgmental or involve the selec- blue collar mortality table. tion or applic ation of alternative ac c ounting polic ies and are • Our retirement rate assumption w as updated to reflect recent material to our financial statements. M anagement has discussed trends in retirements and our expectations for the future in light the development and selection of these critical accounting esti- of the impact of continuing increases in retiree healthcare costs mates w ith the Audit Committee of our Board of Directors and and the cap that exists in our retiree medical coverage. As a w ith our independent registered public accounting firm. result of the update to this assumption, our w eighted-average retirement age increased from 62.0 years old to 63.8 years old. PENSIONS We sponsor defined benefit pension plans covering a majority of • Turnover rates w ere updated to reflect more recent experience our employees. The accounting for pension benefits is determined w herein actual turnover has increased. by accounting and actuarial methods that include numerous esti- Some of the adjustments to these long-term assumptions increased mates, including: discount rates; expected long-term investment our liabilities and future expenses and some decreased them. On a returns on plan assets; future salary inc reases; employee net basis, the impact of these assumption changes (in particular, turnover; mortality; and retirement ages. the increase in the retirement age assumption) partially offset the The determination of our annual pension cost is highly sensitive effect of a decline in the discount rate described below. to changes in these estimates because w e have a large active Follow ing is a disc ussion of the key estimates w e c onsider in w orkforce, a significant amount of assets in the pension plans, determining our pension costs: and the payout of pension benefits w ill occur over an extended period in the future. For example, only 7% of the partic ipants Discount Rate. This is the interest rate used to discount the esti- covered under our principal pension plan are retired and cur- mated future benefit payments that have been earned to date (the rently receiving benefits and the average remaining service life projected benefit obligation and the accumulated benefit obliga- of our employees approximates 13 years. Total pension c ost tion) to their net present value. The discount rate is determined increased approximately $64 million in 2006, $18 million in 2005 each year at the plan measurement date (February 28) and affects and $115 million in 2004, primarily due to changes to these esti- the succeeding year’s pension cost. A decrease in the discount mates. Pension cost in 2007 is expected to be approximately $456 rate increases pension expense. million, an inc rease of $31 million from 2006. Pension c ost is This assumption is highly sensitive, as the follow ing table illustrates: inc luded in the salaries and employee benefits c aption in our consolidated income statements. Discount Sensitivity (in millions) (2) Rate (1) Expense ABO Follow ing are the components of pension cost recognized in our 2007 n/a $2.5 n/a income statements (in millions): 2006 5.912% 2.1 $16 2006 2005 2004 2005 6.285% 1.8 14 Service cost $ 473 $ 417 $ 376 2004 6.780% 1.7 11 Interest cost 642 579 490 (1) The discount rate in effect at the end of a given fiscal year affects the current year’s Expected return on plan assets (811) (707) (597) accumulated benefit obligation (ABO) and the succeeding year’s pension expense. Recognized actuarial losses 110 60 62 (2) Sensitivities show the impact on expense and the ABO of a one-basis-point change in the discount rate. Amortization of transitional obligation (1) – – Amortization of prior service cost 12 12 12 $ 425 $ 361 $ 343 53


  • Page 18

    FEDEX CORPORATION We determine the discount rate (w hich is required to be the rate We review the expected long-term rate of return on an annual at w hich the projected benefit obligation could be effectively basis and revise it as appropriate. Also, w e periodically commis- settled as of the measurement date) w ith the assistance of sion asset/liability studies performed by third-party professional actuaries, w ho calculate the yield on a theoretical portfolio of investment advisors and actuaries to assist us in our review s. high-grade corporate bonds (rated Aa or better) w ith cash flow s These studies project our estimated future pension payments and that generally match our expected benefit payments. This bond evaluate the efficiency of the allocation of our pension plan assets modeling technique allow s for the use of certain callable bonds into various investment categories. These studies also generate that meet a screening criteria that implies a low probability of call. probability-adjusted expected future returns on those assets. We believe this low call probability results in a bond yield w ith W e last performed a detailed asset/liability study for 2004 in a market presumption that the bond w ill not be called. In our connection w ith the introduction of the Portable Pension Account February 28, 2006 measurement date ac tuarial valuation, w e (discussed below ), w hich w ill reduce our liability duration over further refined our sc reens and assumed the c allable bonds time. That study supported management’s estimate of our long- w ould be redeemed at the earliest c all date w ith no c all term rate of return on plan assets of 9.10%. The results of this premium. To the extent sc heduled bond proc eeds exc eed the study w ere reaffirmed for 2005 and 2006 by our third-party pro- estimated benefit payments in a given period, the yield calcula- fessional investment advisors and ac tuaries and support our tion assumes those exc ess proc eeds are reinvested at the current asset allocation strategy, w hich is summarized below : one-year forw ard rates implied by the Citigroup Pension Discount Curve. The continuing trend of declines in the discount Percent of Plan Assets at M easurement Date rate negatively affec ted our primary domestic pension plan 2006 2005 expense by $20 million in 2004, $32 million in 2005 and $101 million Asset Class Actual Target Actual Target in 2006. Pension c ost w ill be negatively affec ted in 2007 by Domestic equities 54% 53% 53% 53% approximately $89 million due to the c ontinuing dec line in the International equities 20 17 20 17 discount rate. Private equities 3 5 2 5 Total equities 77 75 75 75 Plan Assets. Pension plan assets are invested primarily in listed Long duration fixed securities. Our pension plans hold only a minimal investment in income securities 14 15 15 15 FedEx common stock that is entirely at the discretion of third- Other fixed income securities 9 10 10 10 party pension fund investment managers. The estimated average 100% 100% 100% 100% rate of return on plan assets is a long-term, forw ard-looking assumption that also materially affec ts our pension c ost. It is The actual historical return on our pension plan assets, calculated required to be the expected future long-term rate of earnings on on a compound geometric basis, w as 10.0%, net of investment plan assets. At February 28, 2006, w ith approximately $10 billion of manager fees, for the 15-year period ended February 28, 2006. In plan assets, a one-basis-point change in this assumption for our addition, our actual return on plan assets exceeded the estimated domestic pension plans affects pension cost by approximately return in each of the past three fiscal years. $1 million (a decrease in the assumed expected long-term rate of return increases pension expense). We have assumed a 9.10% Pension expense is also affected by the accounting policy used compound geometric long-term rate of return on our principal to determine the value of plan assets at the measurement date. U.S. domestic pension plan assets sinc e 2004 and antic ipate W e use a c alc ulated-value method to determine the value of using the same assumption for 2007. plan assets, w hich helps mitigate short-term volatility in market performance (both increases and decreases). Another method Establishing the expected future rate of investment return on our used in practice applies the market value of plan assets at the pension assets is a judgmental matter. M anagement considers measurement date. The applic ation of the c alc ulated-value the follow ing factors in determining this assumption: method reduc ed 2004 pension c ost by approximately $106 • the duration of our pension plan liabilities, w hich drives the million. The application of the calculated-value method approxi- investment strategy w e can employ w ith our pension plan assets; mated the result from applying the market-value method for both 2006 and 2005. • the types of investment classes in w hich w e invest our pension plan assets and the expected compound geometric return w e Salary Inc reases. The assumed future inc rease in salaries can reasonably expect those investment classes to earn over and w ages is also a key estimate in determining pension cost. the next 10- to 15-year time period (or such other time period Generally, w e c orrelate c hanges in estimated future salary that may be appropriate); and inc reases to c hanges in the disc ount rate (sinc e that is an indicator of general inflation and cost of living adjustments) and • the investment returns w e can reasonably expect our active general estimated levels of profitability (sinc e most inc entive investment management program to achieve in excess of the compensation is a component of pensionable w ages). Due to pay returns w e could expect if investments w ere made strictly in structure trends and our improving financial performance, the indexed funds. average future salary increases based on age, w ere adjusted 54


  • Page 19

    M ANAGEM ENT’S DISCUSSION AND ANALYSIS upw ard to 3.46% for our 2006 measurement date, up from 3.15% Cumulative unrecognized actuarial losses w ere approximately over the last three fiscal years. Our primary domestic pension $3.0 billion through February 28, 2006, compared to $2.5 billion at plan expense w ill be negatively affected for 2007 by approximately February 28, 2005. These unrecognized losses primarily reflect the $73 million due to changes in the average rate and timing of future declining discount rate from 2002 through 2006. A portion is also salary increases. A one-basis-point across the board change in attributable to the differenc es betw een expec ted and ac tual the rate of estimated future salary increases affects pension costs asset returns, w hic h are being amortized over future periods. by approximately $1.3 million. Approximately $40 million of the These unrecognized losses may be recovered in future periods increase is due to a change in rate. The remainder of the increase through actuarial gains. How ever, unless they are below a corri- is due to changes in the distribution of salary increases by age and dor amount, these unrecognized actuarial losses are required to to changes in the assumed average ages of hire and retirement. be amortized and recognized in future periods. For example, pro- jected U.S. domestic plan pension expense for 2007 includes $136 Follow ing is information concerning the funded status of our pen- million of amortization of these actuarial losses versus $107 million sion plans as of M ay 31, 2006 and 2005 (in millions): in 2006, $60 million in 2005 and $62 million in 2004. 2006 2005 The net amounts reflec ted in our balanc e sheets related to Funded Status of Plans: pension items include a substantial prepaid pension asset. This Accumulated benefit obligation (ABO): results from excess cash contributions to the plans over amounts Qualified U.S. domestic plans $ 9,591 $ 8,534 that are recognized as pension expense for financial accounting Other plans 499 399 purposes. Amounts ac c rued as liabilities (inc luding minimum Total ABO $10,090 $ 8,933 pension liabilities) relate primarily to unfunded nonqualified Projected benefit obligation (PBO) $12,153 $10,401 plans and international pension plans w here additional funding Fair value of plan assets 10,130 8,826 may not provide a current tax deduction or w here such funding PBO in excess of plan assets (2,023) (1,575) w ould be deemed current compensation to plan participants. Unrecognized actuarial losses, principally due to changes in Effective in 2004, w e amended the FedEx Corporation Employees’ discount rate and investments 3,026 2,500 Pension Plan to add a cash balance feature, w hich w e call the Unamortized prior service cost and other 93 100 Portable Pension Ac c ount. We expec t the Portable Pension Amounts included in balance sheets $ 1,096 $ 1,025 Account w ill help reduce the long-term grow th of our pension liabilities. All employees hired after M ay 31, 2003 accrue benefits Components of Amounts Included in Balance Sheets: under the Portable Pension Account formula. Eligible employees Prepaid pension cost $ 1,349 $ 1,272 as of M ay 31, 2003 w ere able to c hoose betw een c ontinuing Accrued pension liability (253) (247) to accrue benefits under the traditional pension benefit formula M inimum pension liability (122) (63) or ac c ruing future benefits under the Portable Pension Accumulated other comprehensive income 112 52 Account formula. The election w as entirely optional. There w as Intangible asset and other 10 11 no conversion of existing accrued benefits to a cash balance. Net amounts recognized in balance sheets $ 1,096 $ 1,025 All benefits ac c rued through M ay 31, 2003, inc luding those Cash Amounts: applicable to employees electing the Portable Pension Account, Cash contributions during the year $ 492 $ 489 w ill be determined under a traditional pension plan formula. Benefit payments during the year $ 228 $ 194 Ac c ordingly, it w ill be several years before the impac t of the low er benefit provided under this formula has a significant impact The funded status of the plans reflects a snapshot of the state on our total pension liabilities and costs. of our long-term pension liabilities at the plan measurement Under the Portable Pension Account, the retirement benefit is date. How ever, our plans remain adequately funded to provide expressed as a dollar amount in a notional account that grow s benefits to our employees as they come due and current benefit w ith annual credits based on pay, age and years of credited ser- payments are nominal compared to our total plan assets (benefit vice and interest on the notional account balance. An employee’s payments for 2006 w ere approximately 2% of plan assets). pay credits are determined each year under a graded formula Furthermore, our plan assets w ere suffic ient to fully fund the that combines age w ith years of service for points. The plan inter- ac c umulated benefit obligation of our qualified U.S. domestic est credit rate w ill vary from year to year based on the selected plans at M ay 31, 2006 and 2005. U.S. Treasury index, w ith a 4% minimum and a maximum based We made $456 million in 2006 and $460 million in 2005 in tax- on a government rate. Employees are fully vested on completion deductible voluntary contributions to our qualified U.S. domestic of five years of service. pension plans. Currently, w e do not expect any contributions for 2007 w ill be legally required. How ever, w e currently expect to make tax-deductible voluntary contributions to our qualified plans in 2007 at levels approximating those in 2006. 55


  • Page 20

    FEDEX CORPORATION In 2006, the FASB added a projec t to its tec hnic al agenda to LONG-LIVED ASSETS reconsider the accounting for pensions and other postretirement Property and Equipment. Our key businesses are capital inten- employee benefits. The FASB intends to address this project in sive, w ith more than 45% of our total assets invested in our tw o phases. An Exposure Draft on the first phase w as issued in transportation and information systems infrastruc tures. W e M arch 2006. c apitalize only those c osts that meet the definition of c apital assets under ac c ounting standards. Ac c ordingly, repair and In addition to the FASB project, both the U.S. Senate and House maintenance costs that do not extend the useful life of an asset of Representatives are c urrently w orking on bills c onc erning or are part of the cost of acquiring the asset are expensed as defined benefit plan reform. These bills vary in certain respects, incurred. How ever, consistent w ith industry practice, w e capi- but include proposals related to 401(k) plans, cash balance pen- talize certain aircraft-related major maintenance costs on one sion plans and pension plan funding standards. The proposed of our airc raft fleet types and amortize these c osts over their reform related to pension plan funding standards could severely estimated service lives. reduce or eliminate the use of a credit balance for funding pur- poses and could require higher minimum funding requirements. The depreciation or amortization of our capital assets over their Should these bills and the FASB proposal be enacted as currently estimated useful lives, and the determination of any salvage drafted, they could have a material impact on our required con- values, requires management to make judgments about future tributions, balance sheet and pension expense in future years. events. Because w e utilize many of our capital assets over rela- tively long periods (the majority of aircraft costs are depreciated SELF-INSURANCE ACCRUALS over 15 to 18 years), w e periodically evaluate w hether adjust- We are self-insured up to certain limits for costs associated w ith ments to our estimated servic e lives or salvage values are w orkers’ compensation claims, vehicle accidents and general necessary to ensure these estimates properly match the eco- business liabilities, and benefits paid under employee healthcare nomic use of the asset. This evaluation may result in changes in and long-term disability programs. At M ay 31, 2006 there w ere the estimated lives and residual values used to depreciate our approximately $1.2 billion of self-insurance accruals reflected in aircraft and other equipment. These estimates affect the amount our balance sheet ($1.1 billion at M ay 31, 2005). In both 2006 and of depreciation expense recognized in a period and, ultimately, 2005, approximately 43% of these ac c ruals w ere c lassified as the gain or loss on the disposal of the asset. Historically, gains current liabilities. and losses on operating equipment have not been material (typi- The measurement of these costs requires the consideration of cally less than $10 million annually). How ever, such amounts may historic al c ost experienc e, judgments about the present and differ materially in the future due to technological obsolescence, expec ted levels of c ost per c laim and retention levels. W e ac c ident frequenc y, regulatory c hanges and other fac tors ac c ount for these c osts primarily through ac tuarial methods, beyond our control. w hich develop estimates of the undiscounted liability for claims Because of the lengthy lead times for aircraft manufacture and incurred, including those claims incurred but not reported. These modific ations, w e must antic ipate volume levels and plan our methods provide estimates of future ultimate claim costs based fleet requirements years in advance, and make commitments for on claims incurred as of the balance sheet date. We self-insure aircraft based on those projections. These activities create risks up to certain limits that vary by operating company and type of that asset capacity may exceed demand and that an impairment risk. Periodically, w e evaluate the level of insurance coverage of our assets may occur. In addition, opportunistic aircraft pur- and adjust insuranc e levels based on risk toleranc e and pre- chases (primarily aircraft in passenger configuration) that have mium expense. Historically, it has been infrequent that incurred not been placed in service totaled $208 million at M ay 31, 2006 claims exceeded our self-insured limits. Other acceptable meth- and $348 million at M ay 31, 2005. We plan to modify these assets ods of accounting for these accruals include measurement of in the future to place them into operation. claims outstanding and projected payments based on historical development factors. The accounting test for w hether an asset held for use is impaired involves first comparing the carrying value of the asset w ith its We believe the use of actuarial methods to account for these estimated future undiscounted cash flow s. If the cash flow s do liabilities provides a consistent and effective w ay to measure not exceed the carrying value, the asset must be adjusted to its these highly judgmental accruals. How ever, the use of any esti- current fair value. Because the cash flow s of our transportation mation technique in this area is inherently sensitive given the netw orks cannot be identified to individual assets, and based on magnitude of c laims involved and the length of time until the the ongoing profitability of our operations, w e have not experi- ultimate cost is know n. We believe our recorded obligations for enced any significant impairment of assets to be held and used. these expenses are c onsistently measured on a c onservative How ever, from time to time w e make decisions to remove certain basis. Nevertheless, c hanges in healthc are c osts, ac c ident long-lived assets from service based on projections of reduced frequenc y and severity, insuranc e retention levels and other capacity needs and those decisions may result in an impairment factors can materially affect the estimates for these liabilities. charge. Assets held for disposal must be adjusted to their esti- 56


  • Page 21

    M ANAGEM ENT’S DISCUSSION AND ANALYSIS mated fair values w hen the decision is made to dispose of the The annual evaluation of goodw ill impairment requires the use of asset and certain other criteria are met. There w ere no material estimates and assumptions to determine the fair value of our asset impairment charges recognized in 2006, 2005 or 2004. reporting units using a disc ounted c ash flow methodology. In particular, the follow ing estimates used by management can sig- Leases. We utilize operating leases to finance certain of our air- nific antly affec t the outc ome of the impairment test: revenue craft and facilities. Such arrangements typically shift the risk of grow th rates; operating margins; discount rates and expected loss on the residual value of the assets at the end of the lease c apital expenditures. Eac h year, independent of our goodw ill period to the lessor. As disclosed in “ Contractual Cash Obligations” impairment test, w e update our w eighted-average cost of capital and Note 8 to the accompanying consolidated financial state- calculation and perform a long-range planning analysis to pro- ments, at M ay 31, 2006 w e had approximately $13 billion (on an ject expected results of operations. Using this data, w e complete undiscounted basis) of future commitments for payments under a separate fair-value analysis for eac h of our reporting units. operating leases. The w eighted-average remaining lease term Changes in forecasted operations and other assumptions could of all operating leases outstanding at M ay 31, 2006 w as approx- materially affect these estimates. We compare the fair value of imately six years. our reporting units to the carrying value, including goodw ill, of The future commitments for operating leases are not reflected as each of those units. We performed our annual impairment tests in a liability in our balance sheet because these leases do not meet the fourth quarter of 2006. Because the fair value of each of our the accounting definition of capital leases. The determination of reporting units exceeded its carrying value, including goodw ill, w hether a lease is accounted for as a capital lease or an operat- no impairment charge w as necessary. ing lease requires management to make estimates primarily about Intangible Asset w ith an Indefinite Life. We have an intangible the fair value of the asset and its estimated economic useful life. asset of $567 million associated w ith the Kinko’s trade name. This We believe w e have w ell-defined and controlled processes for intangible asset is not amortized bec ause it has an indefinite making this evaluation, including obtaining third-party appraisals remaining useful life. We must review this asset for impairment for material transactions to assist us in making these evaluations. on at least an annual basis. This annual evaluation requires the use Our results for 2006 included a one-time, noncash charge of $79 of estimates about the future cash flow s attributable to the Kinko’s million ($49 million after tax or $0.16 per diluted share), w hic h trade name to determine the estimated fair value of the trade represented the impact on prior years, to adjust the accounting name. Changes in forecasted operations and changes in discount for certain facility leases, predominately at FedEx Express. The rates c an materially affec t this estimate. How ever, onc e an charge related primarily to rent escalations in on-airport facility impairment of this intangible asset has been recorded, it cannot be leases. The applicable accounting literature provides that rent reversed. We performed our annual impairment test in the fourth expense under operating leases w ith rent esc alation c lauses quarter of 2006. Because the fair value of the trade name exceeded should be recognized evenly, on a straight-line basis over the its carrying value, no impairment charge w as necessary. lease term. During the first quarter of 2006, w e determined that a W hile FedEx Kinko’s experienc ed slight revenue grow th w ith portion of our fac ility leases had rent esc alation c lauses that dec reased profitability in 2006, w e believe that our long-term w ere not being recognized appropriately. Because the amounts grow th and expansion strategies support our fair value conclu- involved w ere not material to our financ ial statements in any sions. For both goodw ill and recorded intangible assets at FedEx individual prior period and the cumulative amount w as not mate- Kinko’s, the recoverability of these amounts is dependent on exe- rial to 2006 results, w e rec orded the c umulative adjustment, c ution of key initiatives related to revenue grow th, loc ation w hich increased operating expenses by $79 million, in the first expansion and improved profitability. quarter of 2006. Goodw ill. We have approximately $2.8 billion of goodw ill in our balance sheet resulting from the acquisition of businesses, w hich includes approximately $1.8 billion from our acquisition of FedEx Kinko’s in 2004. Ac c ounting standards require that w e do not amortize goodw ill but review it for impairment on at least an annual basis. 57


  • Page 22

    FEDEX CORPORATION REVENUE RECOGNITION Unbilled Revenue. There is a time lag betw een the completion of We believe the policies adopted to recognize revenue are critical a shipment and the generation of an invoice that varies by cus- because an understanding of the accounting applied in this area tomer and operating company. Accordingly, unbilled revenue is is fundamental to assessing our overall financial performance recognized through estimates using actual shipment volumes and and because revenue and revenue grow th are key measures of historical trends of shipment size and length of haul. These esti- financial performance in the marketplace. Our businesses are mates are adjusted in subsequent months to the actual amounts primarily involved in the direct pickup and delivery of commercial invoiced. Due to strong system controls and shipment visibility, package and freight shipments, as w ell as providing document there is a low level of subjec tivity inherent in these ac c rual solutions and business services. Our employees, independent processes and the estimates have historically not varied signifi- contractors and agents are involved throughout the process and cantly from actual amounts subsequently invoiced. our operational, billing and accounting systems directly capture Shipments in Process. The majority of our shipments have short and control all relevant information necessary to record revenue, cycle times; so, less than 5% of a total month’s revenue is typically bill c ustomers and c ollec t amounts due to us. Certain of our in transit at the end of a period. We periodically perform studies to transportation servic es are provided through independent measure the percentage of completion for shipments in process. c ontrac tors. FedEx is the princ ipal to the transac tion in most At month end, w e estimate the amount of revenue earned on instances and in these cases revenue from these transactions shipments in process based on actual shipments picked up, the is recognized on a gross basis. Costs associated w ith independent sc heduled day of delivery, the day of the w eek on w hic h the contractor settlements are recognized as incurred and included month ends (w hich affects the percentage of completion) and in the purc hased transportation c aption in the ac c ompanying current trends in our average price for the respective services. income statements. We believe these estimates provide a reasonable approximation We recognize revenue upon delivery of shipments or, for our busi- of the actual revenue earned at the end of a period. ness services, logistics and trade services businesses, upon the Future Adjustments to Revenue and Ac c ounts Rec eivable. In completion of services. Transportation industry practice includes the transportation industry, pricing that is put in place may be four acceptable methods for revenue recognition for shipments in subsequently adjusted due to continued negotiation of contract process at the end of an accounting period, tw o of w hich are pre- terms, earned discounts triggered by certain shipment volume dominant: (1) recognize all revenue and the related delivery costs thresholds, and/or no-fee money-bac k guarantee refunds w hen shipments are delivered or (2) recognize a portion of the caused by on-time service failures. We account for estimated revenue earned for shipments that have been picked up but not future revenue adjustments through a reserve against accounts yet delivered at period end and accrue delivery costs as incurred. rec eivable that takes into c onsideration historic al experienc e We use the sec ond method and rec ognize the portion of rev- and current trends. enue earned at the balance sheet date for shipments in transit and ac c rue all delivery c osts as inc urred. W e believe this For 2006 and 2005, revenue adjustments as a percentage of total ac c ounting polic y effec tively and c onsistently matc hes rev- revenue averaged approximately 1%. Due to our reliable on-time enue w ith expenses and recognizes liabilities as incurred. service, close communication w ith customers, strong revenue systems and minimal volume discounts in place, w e have main- Our contract logistics, global trade services and certain trans- tained a c onsistently low revenue adjustment perc entage. A portation businesses engage in some transactions w herein they one-basis-point change in the revenue adjustment percentage act as agents. Revenue from these transactions is recorded on a w ould increase or decrease revenue adjustments by approxi- net basis. Net revenue includes billings to customers less third- mately $3 million. party charges, including transportation or handling costs, fees, commissions, taxes and duties. These amounts are not material. W hile w rite-offs related to bad debts do occur from time to time, they are small c ompared to our total revenue and ac c ounts There are three key estimates that are included in the recogni- receivable balances due to the small value of individual shipping tion and measurement of our revenue and related ac c ounts transactions spread over a large customer base, our short credit receivable under the policies described above: (1) estimates for terms and our strong credit and collection practices. Bad debt unbilled revenue on shipments that have been delivered; (2) esti- expense assoc iated w ith c redit losses has averaged approxi- mates for revenue associated w ith shipments in transit; and (3) mately 0.4% in 2006 and 0.3% in 2005 of total revenue and reflects estimates for future adjustments to revenue or accounts receiv- our strong credit management processes. able for billing adjustments and bad debts. 58


  • Page 23

    M ANAGEM ENT’S DISCUSSION AND ANALYSIS M ARKET RISK SENSITIVE INSTRUM ENTS AND POSITIONS Commodity. We have market risk for changes in the price of jet and diesel fuel; how ever, this risk is largely mitigated by our fuel Interest Rates. W hile w e c urrently have market risk sensitive surc harges. Our fuel surc harges are c losely linked to market instruments related to interest rates, w e have no significant expo- prices for fuel. Therefore, a hypothetical 10% change in the price sure to changing interest rates on our long-term debt because of fuel w ould not be expected to materially affect our earnings. the interest rates are fixed on the majority of our long-term debt. How ever, our fuel surcharges have a lag that exists before they We had approximately $118 million of outstanding floating-rate are adjusted for changes in fuel prices and fuel prices can fluctu- borrow ings at M ay 31, 2006, and $125 million of outstanding ate w ithin certain ranges before resulting in a change in our fuel floating-rate borrow ings at M ay 31, 2005. We have not employed surcharges. Therefore, our operating income may be affected interest rate hedging to mitigate the risks w ith respect to these should the spot price of fuel suddenly change by a significant borrow ings. A hypothetical 10% increase in the interest rate on amount or change by amounts that do not result in a change in our outstanding floating-rate borrow ings w ould not have a mate- our fuel surcharges. rial effect on our results of operations. As disclosed in Note 7 to the accompanying consolidated financial statements, w e had out- Other. We do not purchase or hold any derivative financial instru- standing fixed-rate, long-term debt (exclusive of capital leases) of ments for trading purposes. $2.0 billion at M ay 31, 2006 and $2.3 billion at M ay 31, 2005. M arket risk for fixed-rate, long-term debt is estimated as the potential RISK FACTORS decrease in fair value resulting from a hypothetical 10% increase Our financial and operating results are subject to many risks and in interest rates and amounts to approximately $42 million as of uncertainties, as described below. M ay 31, 2006 and $44 million as of M ay 31, 2005. The underlying fair values of our long-term debt w ere estimated based on quoted mar- Our businesses depend on our strong reputation and the value ket prices or on the current rates offered for debt w ith similar of the FedEx brand. The FedEx brand name symbolizes high-quality terms and maturities. service, reliability and speed. FedEx is one of the most w idely recognized, trusted and respected brands in the w orld, and the Foreign Currency. While w e are a global provider of transportation, FedEx brand is one of our most important and valuable assets. In e-commerce and business services, the substantial majority of our addition, w e have a strong reputation among customers and the transactions are denominated in U.S. dollars. The distribution general public for high standards of social and environmental of our foreign currency denominated transactions is such that responsibility and corporate governance and ethics. The FedEx currency declines in some areas of the w orld are often offset brand name and our corporate reputation are pow erful sales and by currency gains in other areas of the w orld. The principal foreign marketing tools, and w e devote signific ant resourc es to currency exchange rate risks to w hich w e are exposed are in the promoting and protecting them. Adverse public ity (w hether or Japanese yen, Taiw an dollar, Canadian dollar and euro. During not justified) relating to activities by our employees, contractors 2006 and 2005, w e believe operating income w as positively or agents could tarnish our reputation and reduce the value of impacted due to foreign currency fluctuations. How ever, favorable our brand. Damage to our reputation and loss of brand equity foreign currency fluctuations also may have had an offsetting c ould reduc e demand for our servic es and thus have an impact on the price w e obtained or the demand for our services. At adverse effect on our financial condition, liquidity and results of M ay 31, 2006, the result of a uniform 10% strengthening in the value operations, as w ell as require additional resourc es to rebuild of the dollar relative to the currencies in w hich our transactions our reputation and restore the value of our brand. are denominated w ould result in a decrease in operating income of approximately $135 million for 2007 (the comparable amount in We rely heavily on technology to operate our transportation and the prior year w as approximately $116 million). This increase is business netw orks, and any disruption to our tec hnology primarily due to the strong grow th of our international operations. infrastructure or the Internet could harm our operations and our This theoretical calculation assumes that each exchange rate reputation among c ustomers. Our ability to attrac t and retain w ould change in the same direction relative to the U.S. dollar. customers and to compete effectively depends in part upon the In practice, our experience is that exchange rates in the principal sophistication and reliability of our technology netw ork, including foreign markets w here w e have foreign currency denominated our ability to provide features of service that are important to our transactions tend to have offsetting fluctuations. Therefore, the c ustomers. Any disruption to the Internet or our tec hnology calculation above is not indicative of our actual experience in infrastructure, including those impacting our computer systems foreign currency transactions. In addition to the direct effects and Web site, could adversely impact our customer service and of c hanges in exc hange rates, fluc tuations in exc hange rates our volumes and result in inc reased c osts. W hile w e have also affect the volume of sales or the foreign currency sales price invested and continue to invest in technology security initiatives as c ompetitors’ servic es bec ome more or less attrac tive. The and disaster recovery plans, these measures cannot fully insulate sensitivity analysis of the effects of changes in foreign currency us from technology disruptions and the resulting adverse effect exchange rates does not factor in a potential change in sales on our operations and financial results. levels or local currency prices. 59


  • Page 24

    FEDEX CORPORATION Our businesses are capital intensive, and w e must make capital Our transportation businesses may be impacted by the price and expenditures based upon projec ted volume levels. We make availability of jet and diesel fuel. We must purchase large quanti- significant investments in aircraft, vehicles, technology, package ties of fuel to operate our aircraft and vehicles, and the price and handling fac ilities, sort equipment, c opy equipment and other availability of fuel can be unpredictable and beyond our control. capital to support our transportation and business netw orks. We To date, w e have been suc c essful in mitigating the impac t of also make significant investments to rebrand, integrate and grow higher fuel c osts through our indexed fuel surc harges, as the the companies that w e acquire. The amount and timing of capital amount of the surcharges is closely linked to the market prices investments depend on various factors, including our anticipated for fuel. If w e are unable to maintain or increase our fuel sur- volume grow th. For example, w e must make c ommitments to charges because of competitive pricing pressures or some other purchase or modify aircraft years before the aircraft are actually reason, fuel costs could adversely impact our operating results. needed. We must predict volume levels and fleet requirements In addition, disruptions in the supply of fuel could have a nega- and make commitments for aircraft based on those projections. If tive impact on our ability to operate our transportation netw orks. w e miss our projections, w e could end up w ith too much or too FedEx Ground relies on ow ner-operators to conduct its opera- little capacity relative to our shipping volumes. tions, and the status of these ow ner-operators as independent We face intense competition. The transportation and business contractors, rather than employees, is being challenged. FedEx services markets are both highly competitive and sensitive to Ground’s use of independent c ontrac tors is w ell suited to the price and service. Some of our competitors have more financial needs of the ground delivery business and its customers. We are resources than w e do, or they are controlled or subsidized by involved in numerous purported class-action law suits and other foreign governments, w hich enables them to raise capital more proc eedings, how ever, that c laim that these ow ner-operators easily. We believe w e compete effectively w ith these companies should be treated as employees and not independent contrac- — for example, by providing more reliable service at compensa- tors. We expec t to inc ur c ertain c osts, inc luding legal fees, tory prices. We cannot, how ever, control w hat our competitors in defending the status of FedEx Ground’s ow ner-operators as charge for their services. If the pricing environment becomes irra- independent contractors. We strongly believe that the ow ner- tional, it could limit our ability to maintain or increase our prices operators are properly classified as independent contractors and (including our fuel surcharge in response to rising fuel costs) or that w e w ill prevail in our defense. Adverse determinations to maintain or grow our market share. In addition, maintaining a in these matters, how ever, c ould, among other things, entitle broad portfolio of services is important to keeping and attracting c ertain of our c ontrac tors to the reimbursement of c ertain customers. W hile w e believe w e compete effectively through our expenses and to the benefit of w age-and-hour law s and result current service offerings, if our competitors offer a broader range in employment and w ithholding tax liability for FedEx Ground. of services or more effectively bundle their services, it could M oreover, if FedEx Ground is compelled to convert its indepen- impede our ability to maintain or grow our market share. dent c ontrac tors to employees, our operating c osts c ould increase and w e could incur significant capital outlays. If w e do not effectively operate, integrate, leverage and grow acquired businesses, our financial results and reputation may Increased security requirements could impose substantial costs suffer. Our strategy for long-term grow th, productivity and prof- on us, espec ially at FedEx Express. As a result of inc reased itability depends in part on our ability to make prudent strategic concerns about global terrorism and homeland security, govern- acquisitions and to realize the benefits w e expect w hen w e make ments around the w orld are adopting or are considering adopting those acquisitions. In furtherance of this strategy, w e recently stricter security requirements that w ill increase operating costs signed agreements to ac quire the LTL freight operations of for businesses, inc luding those in the transportation industry. Watkins M otor Lines and to buy out our joint venture partner in For example, in M ay 2006, the U.S. Transportation Sec urity China, as w ell as to acquire its China domestic express netw ork. Administration (“ TSA” ) adopted new rules enhancing many of W hile w e expect these acquisitions to enhance our value propo- the security requirements for air cargo on both passenger and sition to customers and improve our long-term profitability, there all-cargo aircraft. The TSA is currently seeking comments on a can be no assurance that w e w ill realize our expectations w ithin draft version of a new all-cargo aircraft security program, w hich the time frame w e have established, if at all. We acquired FedEx w ould implement the new rules. Until the required sec urity Kinko’s in February 2004 to expand our portfolio of business ser- program is finalized, w e cannot determine the effect that these vic es and enhanc e our ability to provide pac kage-shipping new rules w ill have on our cost structure or our operating results. services to small- and medium-sized business customers through It is reasonably possible, how ever, that these rules or other future its netw ork of retail locations. How ever, FedEx Kinko’s financial security requirements for air cargo carriers could impose mate- performance has not yet fully met our expectations. Accordingly, rial costs on us. w e have undertaken key initiatives at FedEx Kinko’s relating to revenue grow th, netw ork expansion and improved profitability. There c an be no assuranc e that our ac quisitions w ill be suc - cessful or that w e can continue to support the value w e allocate to these acquired businesses, including their goodw ill. 60


  • Page 25

    M ANAGEM ENT’S DISCUSSION AND ANALYSIS The regulatory environment for global aviation rights may impact • our ability to maintain good relationships w ith our employees our air operations. Our extensive air netw ork is c ritic al to our and prevent attempts by labor organizations to organize groups suc c ess. Our right to serve foreign points is subjec t to the of our employees, w hich could significantly increase our oper- approval of the Department of Transportation and generally ating costs; requires a bilateral agreement betw een the United States and • a shortage of qualified labor and our ability to mitigate this foreign governments. In addition, w e must obtain the permission shortage through recruiting and retention efforts and productiv- of foreign governments to provide specific flights and services. ity gains; Regulatory actions affecting global aviation rights or a failure to obtain or maintain aviation rights in important international • increasing costs for employee benefits, especially pension and markets could impair our ability to operate our air netw ork. healthcare benefits; We are negotiating a new collective bargaining agreement w ith • significant changes in the volumes of shipments transported the union that represents the pilots of FedEx Express. FedEx through our netw orks, customer demand for our various ser- Express pilots are employed under a collective bargaining agree- vices or the prices w e obtain for our services; ment that became amendable on M ay 31, 2004. In accordance • market acceptance of our new service and grow th initiatives; w ith applicable labor law, w e w ill continue to operate under our current agreement w hile w e negotiate w ith our pilots. Contract • any liability resulting from and the costs of defending against negotiations w ith the pilots’ union began in M arch 2004. These class-action litigation, such as w age-and-hour and race dis- negotiations are ongoing and are being mediated through the crimination claims, and any other legal proceedings; National M ediation Board. We c annot predic t the outc ome of • the impact of technology developments on our operations and these negotiations. The terms of any new collective bargaining on demand for our services (for example, the impact that low - agreement c ould inc rease our operating c osts and adversely cost home copiers and printers are having on demand for FedEx affec t our ability to c ompete w ith other providers of express Kinko’s copy services); delivery services. On the other hand, if w e are unable to reach agreement on a new collective bargaining agreement, w e may • adverse w eather conditions or natural disasters, such as earth- be subjec t to a strike, w ork stoppages or slow dow ns by our quakes and hurricanes, w hich can damage our property, disrupt pilots, subjec t to the requirements of the Railw ay Labor Ac t. our operations, increase fuel costs and adversely affect ship- These ac tions c ould have a negative impac t on our ability to ment levels; operate our express transportation netw ork and ultimately cause • w idespread outbreak of an illness, such as avian influenza (bird us to lose customers. flu), severe ac ute respiratory syndrome (SARS) or any other We are also subject to risks and uncertainties that affect many communicable disease, or any other public health crisis; and other businesses, including: • availability of financing on terms acceptable to us and our abil- • economic conditions in the global markets in w hich w e operate; ity to maintain our current credit ratings, especially given the capital intensity of our operations. • the impact of any international conflicts or terrorist activities on the United States and global economies in general, the trans- We are directly affected by the state of the economy. W hile the portation industry or us in partic ular, and w hat effec ts these global, or mac ro-ec onomic , risks listed above apply to most events w ill have on our costs or the demand for our services; companies, w e are particularly vulnerable. The transportation industry is highly cyclical and especially susceptible to trends in • any impacts on our businesses resulting from new domestic or economic activity. Our primary business is to transport goods, so international government regulation, including tax, accounting, our business levels are directly tied to the purchase and produc- labor or environmental rules; tion of goods — key mac ro-ec onomic measurements. W hen • our ability to manage our cost structure for capital expenditures individuals and companies purchase and produce few er goods, and operating expenses and match them to shifting customer w e transport few er goods. In addition, w e have a relatively high volume levels; fixed-cost structure, w hich is difficult to adjust to match shifting volume levels. M oreover, as w e grow our international business, • changes in foreign currency exchange rates, especially in the w e are increasingly affected by the health of the global economy. Japanese yen, Taiw an dollar, Canadian dollar and euro, w hich can affect our sales levels and foreign currency sales prices; 61


  • Page 26

    FEDEX CORPORATION FORWARD-LOOKING STATEM ENTS those c ontemplated (expressed or implied) by suc h forw ard- looking statements, bec ause of, among other things, the risk Certain statements in this report, including (but not limited to) fac tors identified above and the other risks and unc ertainties those c ontained in “ Outlook (inc luding segment outlooks),” you can find in our press releases and other SEC filings. “ Liquidity,” “ Capital Resources,” “ Contractual Cash Obligations” and “ Critical Accounting Estimates,” and the “ Employee Benefit As a result of these and other fac tors, no assuranc e c an be Plans” note to the consolidated financial statements, are “ for- given as to our future results and achievements. Accordingly, a w ard-looking” statements w ithin the meaning of the Private forw ard-looking statement is neither a prediction nor a guaran- Securities Litigation Reform Act of 1995 w ith respect to our finan- tee of future events or circumstances and those future events or cial condition, results of operations, cash flow s, plans, objectives, c irc umstanc es may not oc c ur. You should not plac e undue future performance and business. Forw ard-looking statements reliance on the forw ard-looking statements, w hich speak only as include those preceded by, follow ed by or that include the w ords of the date of this report. We are under no obligation, and w e “ may,” “ could,” “ w ould,” “ should,” “ believes,” “ expects,” “ antic- expressly disclaim any obligation, to update or alter any forw ard- ipates,” “ plans,” “ estimates,” “ targets,” “ projects,” “ intends” or looking statements, w hether as a result of new information, similar expressions. These forw ard-looking statements involve future events or otherw ise. risks and uncertainties. Actual results may differ materially from 62


  • Page 27

    FEDEX CORPORATION M ANAGEM ENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended). Our internal control over financial reporting includes, among other things, defined policies and procedures for conducting and governing our business, sophisticated information systems for proc essing transac tions and a properly staffed, professional internal audit department. M echanisms are in plac e to monitor the effectiveness of our internal control over financial reporting and actions are taken to correct deficiencies identified. Our procedures for financial reporting include the active involvement of senior management, our Audit Committee and a staff of highly qualified financial and legal professionals. M anagement, w ith the participation of our principal executive and financial officers, assessed our internal control over financial reporting as of M ay 31, 2006, the end of our fiscal year. M anagement based its assessment on criteria established in Internal Control – Integrated Framew ork issued by the Committee of Sponsoring Organizations of the Treadw ay Commission (the COSO criteria). Based on this assessment, management has concluded that our internal control over financial reporting w as effective as of M ay 31, 2006. Our independent registered public accounting firm, Ernst & Young LLP, audited management’s assessment and the effectiveness of our internal control over financial reporting. Ernst & Young LLP has issued their report concurring w ith management’s assessment, w hich is included in this Annual Report. 63


  • Page 28

    FEDEX CORPORATION REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Stockholders FedEx Corporation We have audited management’s assessment, included in the accompanying M anagement’s Report on Internal Control over Financial Reporting, that FedEx Corporation maintained effective internal control over financial reporting as of M ay 31, 2006, based on criteria established in Internal Control – Integrated Framew ork issued by the Committee of Sponsoring Organizations of the Treadw ay Commission (the COSO criteria). FedEx Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit. We conducted our audit in accordance w ith the standards of the Public Company Accounting Oversight Board (United States). Those standards require that w e plan and perform the audit to obtain reasonable assurance about w hether effective internal control over financial reporting w as maintained in all material respects. Our audit included obtaining an understanding of internal control over finan- cial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as w e considered necessary in the circumstances. We believe that our audit provides a rea- sonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance w ith generally accepted account- ing principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance w ith generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance w ith authorizations of management and directors of the company; and (3) provide reasonable assurance regarding pre- vention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance w ith the policies or procedures may deteriorate. In our opinion, management’s assessment that FedEx Corporation maintained effective internal control over financial reporting as of M ay 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, FedEx Corporation maintained, in all material respects, effective internal control over financial reporting as of M ay 31, 2006, based on the COSO criteria. We also have audited, in accordance w ith the standards of the Public Company Accounting Oversight Board (United States), the con- solidated balance sheets of FedEx Corporation as of M ay 31, 2006 and 2005, and related consolidated statements of income, changes in stockholders’ investment and comprehensive income, and cash flow s for each of the three years in the period ended M ay 31, 2006 of FedEx Corporation and our report dated July 11, 2006 expressed an unqualified opinion thereon. M emphis, Tennessee July 11, 2006 64


  • Page 29

    FEDEX CORPORATION CONSOLIDATED STATEM ENTS OF INCOM E Years ended M ay 31, (In millions, except per share amounts) 2006 2005 2004 REVENUES $32,294 $29,363 $24,710 Operating Expenses: Salaries and employee benefits 12,571 11,963 10,728 Purchased transportation 3,251 2,935 2,407 Rentals and landing fees 2,390 2,299 1,918 Depreciation and amortization 1,550 1,462 1,375 Fuel 3,256 2,317 1,531 M aintenance and repairs 1,777 1,695 1,523 Business realignment costs – – 435 Other 4,485 4,221 3,353 29,280 26,892 23,270 OPERATING INCOM E 3,014 2,471 1,440 Other Income (Expense): Interest expense (142) (160) (136) Interest income 38 21 20 Other, net (11) (19) (5) (115) (158) (121) Income Before Income Taxes 2,899 2,313 1,319 Provision for Income Taxes 1,093 864 481 NET INCOM E $ 1,806 $ 1,449 $ 838 BASIC EARNINGS PER COM M ON SHARE $ 5.94 $ 4.81 $ 2.80 DILUTED EARNINGS PER COM M ON SHARE $ 5.83 $ 4.72 $ 2.76 The accompanying notes are an integral part of these consolidated financial statements. 65


  • Page 30

    FEDEX CORPORATION CONSOLIDATED BALANCE SHEETS M ay 31, (In millions, except share data) 2006 2005 ASSETS Current Assets Cash and cash equivalents $ 1,937 $ 1,039 Receivables, less allow ances of $144 and $125 3,516 3,297 Spare parts, supplies and fuel, less allow ances of $150 and $142 308 250 Deferred income taxes 539 510 Prepaid expenses and other 164 173 Total current assets 6,464 5,269 Property and Equipment, at Cost Aircraft and related equipment 8,611 7,610 Package handling and ground support equipment 3,558 3,366 Computer and electronic equipment 4,331 3,893 Vehicles 2,203 1,994 Facilities and other 5,371 5,154 24,074 22,017 Less accumulated depreciation and amortization 13,304 12,374 Net property and equipment 10,770 9,643 Other Long-Term Assets Goodw ill 2,825 2,835 Prepaid pension cost 1,349 1,272 Intangible and other assets 1,282 1,385 Total other long-term assets 5,456 5,492 $22,690 $20,404 LIABILITIES AND STOCKHOLDERS’ INVESTM ENT Current Liabilities Current portion of long-term debt $ 850 $ 369 Accrued salaries and employee benefits 1,325 1,275 Accounts payable 1,908 1,739 Accrued expenses 1,390 1,351 Total current liabilities 5,473 4,734 Long-Term Debt, Less Current Portion 1,592 2,427 Other Long-Term Liabilities Deferred income taxes 1,367 1,206 Pension, postretirement healthcare and other benefit obligations 944 828 Self-insurance accruals 692 621 Deferred lease obligations 658 532 Deferred gains, principally related to aircraft transactions 373 400 Other liabilities 80 68 Total other long-term liabilities 4,114 3,655 Commitments and Contingencies Common Stockholders’ Investment Common stock, $0.10 par value; 800 million shares authorized; 306 million shares issued for 2006 and 302 million shares issued for 2005 31 30 Additional paid-in capital 1,468 1,241 Retained earnings 10,068 8,363 Accumulated other comprehensive loss (24) (17) 11,543 9,617 Less deferred compensation and treasury stock, at cost 32 29 Total common stockholders’ investment 11,511 9,588 $22,690 $20,404 The accompanying notes are an integral part of these consolidated financial statements. 66


  • Page 31

    FEDEX CORPORATION CONSOLIDATED STATEM ENTS OF CASH FLOW S Years ended M ay 31, (In millions) 2006 2005 2004 OPERATING ACTIVITIES Net income $ 1,806 $ 1,449 $ 838 Adjustments to reconcile net income to cash provided by operating activities: Lease accounting charge 79 – – Depreciation and amortization 1,548 1,462 1,375 Provision for uncollectible accounts 121 101 106 Deferred income taxes and other noncash items 187 63 (8) Tax benefit on the exercise of stock options 62 36 43 Changes in operating assets and liabilities, net of the effects of businesses acquired: Receivables (319) (235) (307) Other current assets (38) (26) 10 Pension assets and liabilities, net (71) (118) 155 Accounts payable and other operating liabilities 346 365 841 Other, net (45) 20 (33) Cash provided by operating activities 3,676 3,117 3,020 INVESTING ACTIVITIES Capital expenditures (2,518) (2,236) (1,271) Business acquisitions, net of cash acquired – (122) (2,410) Proceeds from asset dispositions 64 12 18 Other, net – (2) 1 Cash used in investing activities (2,454) (2,348) (3,662) FINANCING ACTIVITIES Principal payments on debt (369) (791) (319) Proceeds from debt issuances – – 1,599 Proceeds from stock issuances 144 99 115 Dividends paid (97) (84) (66) Purchase of treasury stock – – (179) Other, net (2) – – Cash (used in) provided by financing activities (324) (776) 1,150 CASH AND CASH EQUIVALENTS Net increase (decrease) in cash and cash equivalents 898 (7) 508 Cash and cash equivalents at beginning of period 1,039 1,046 538 Cash and cash equivalents at end of period $ 1,937 $ 1,039 $ 1,046 The accompanying notes are an integral part of these consolidated financial statements. 67


  • Page 32

    FEDEX CORPORATION CONSOLIDATED STATEM ENTS OF CHANGES IN STOCKHOLDERS’ INVESTM ENT AND COM PREHENSIVE INCOM E Accumulated Additional Other Common Paid-in Retained Comprehensive Treasury Deferred (In millions, except share data) Stock Capital Earnings Loss Stock Compensation Total BALANCE AT M AY 31, 2003 $30 $1,088 $ 6,250 $(30) $ (25) $(25) $ 7,288 Net income – – 838 – – – 838 M inimum pension liability adjustment, net of deferred tax benefit of $12 – – – (16) – – (16) Total comprehensive income 822 Purchase of treasury stock (2,625,000 shares repurchased at an average price of $68.14 per share) – – – – (179) – (179) Cash dividends declared ($0.29 per share) – – (87) – – – (87) Employee incentive plans and other (4,013,182 shares issued) – (9) – – 204 (18) 177 Amortization of deferred compensation – – – – – 15 15 BALANCE AT M AY 31, 2004 30 1,079 7,001 (46) – (28) 8,036 Net income – – 1,449 – – – 1,449 Foreign currency translation adjustment, net of deferred taxes of $5 – – – 27 – – 27 M inimum pension liability adjustment, net of deferred taxes of $1 – – – 2 – – 2 Total comprehensive income 1,478 Cash dividends declared ($0.29 per share) – – (87) – – – (87) Employee incentive plans and other (2,767,257 shares issued) – 162 – – (1) (16) 145 Amortization of deferred compensation – – – – – 16 16 BALANCE AT M AY 31, 2005 30 1,241 8,363 (17) (1) (28) 9,588 Net income – – 1,806 – – – 1,806 Foreign currency translation adjustment, net of deferred taxes of $3 – – – 29 – – 29 M inimum pension liability adjustment, net of deferred taxes of $24 – – – (36) – – (36) Total comprehensive income 1,799 Cash dividends declared ($0.33 per share) – – (101) – – – (101) Employee incentive plans and other (3,579,766 shares issued) 1 227 – – (1) (19) 208 Amortization of deferred compensation – – – – – 17 17 BALANCE AT M AY 31, 2006 $31 $1,468 $10,068 $(24) $ (2) $(30) $11,511 The accompanying notes are an integral part of these consolidated financial statements. 68


  • Page 33

    NOTES TO CONSOLIDATED FINANCIAL STATEM ENTS NOTE 1: DESCRIPTION OF BUSINESS AND SUM M ARY OF number of customers, as w ell as the low revenue per transaction SIGNIFICANT ACCOUNTING POLICIES for most of our services. Allow ances for potential credit losses are determined based on historical experience and current evaluation DESCRIPTION OF BUSINESS of the composition of accounts receivable. Historically, credit FedEx Corporation (“ FedEx” ) provides a broad portfolio of losses have been w ithin management’s expectations. transportation, e-c ommerc e and business servic es through companies operating independently, competing collectively and REVENUE RECOGNITION managed c ollaboratively under the respec ted FedEx brand. Revenue is recognized upon delivery of shipments or the com- These operating companies are primarily represented by Federal pletion of the service for our office and print services, logistics Express Corporation (“ FedEx Express” ), the w orld’s largest and trade servic es businesses. Certain of our transportation express transportation company; FedEx Ground Package System, services are provided w ith the use of independent contractors. Inc . (“ FedEx Ground” ), a leading provider of small-pac kage FedEx is the principal to the transaction in most instances and ground delivery servic es; FedEx Freight Corporation (“ FedEx in those cases revenue from these transactions is recognized on Freight” ), a leading U.S. provider of regional less-than-truckload a gross basis. Costs assoc iated w ith independent c ontrac tor (“ LTL” ) freight servic es; and FedEx Kinko’s Offic e and Print settlements are recognized as incurred and included in the pur- Services, Inc. (“ FedEx Kinko’s” ), a leading provider of document c hased transportation c aption in the ac c ompanying inc ome solutions and business services. These companies form the core statements. For shipments in transit, revenue is recorded based of our reportable segments. on the perc entage of servic e c ompleted at the balanc e sheet date. Estimates for future billing adjustments to revenue and Other business units in the FedEx portfolio are FedEx Trade accounts receivable are recognized at the time of shipment for Netw orks, Inc . (“ FedEx Trade Netw orks” ), a global trade ser- money-back service guarantees and billing corrections. Delivery vices company; FedEx SmartPost, Inc. (“ FedEx SmartPost” ), a costs are accrued as incurred. small-parc el c onsolidator; FedEx Supply Chain Servic es, Inc . (“ FedEx Supply Chain Services” ), a contract logistics provider; Our contract logistics, global trade services and certain trans- FedEx Custom Critical, Inc. (“ FedEx Custom Critical” ), a critical- portation businesses engage in some transactions w herein they shipment c arrier; Caribbean Transportation Servic es, Inc . act as agents. Revenue from these transactions is recorded on a (“ Caribbean Transportation Services” ), a provider of airfreight net basis. Net revenue includes billings to customers less third- forw arding services, and FedEx Corporate Services, Inc. (“ FedEx party charges, including transportation or handling costs, fees, Services” ), a provider of customer-facing sales, marketing and commissions, and taxes and duties. information tec hnology func tions, primarily for FedEx Express and FedEx Ground. ADVERTISING Advertising costs are expensed as incurred and are classified in FISCAL YEARS other operating expenses. Advertising expenses w ere $376 mil- Except as otherw ise specified, references to years indicate our lion in 2006, $326 million in 2005 and $284 million in 2004. fisc al year ended M ay 31, 2006 or ended M ay 31 of the year referenced. CASH EQUIVALENTS Cash in excess of current operating requirements are invested in PRINCIPLES OF CONSOLIDATION short-term, interest-bearing instruments w ith maturities of three The consolidated financial statements include the accounts of months or less at the date of purchase and are stated at cost, FedEx and its subsidiaries, substantially all of w hich are w holly w hich approximates market value. ow ned. All significant intercompany accounts and transactions have been eliminated. SPARE PARTS, SUPPLIES AND FUEL Spare parts are reported at w eighted-average cost. Supplies and RECLASSIFICATIONS fuel are reported at standard cost, w hich approximates actual Certain reclassifications have been made to prior year financial cost on a first-in, first-out basis. Allow ances for obsolescence statements to conform to the current year presentation. are provided, over the estimated useful life of the related aircraft and engines, for spare parts expected to be on hand at the date CREDIT RISK the aircraft are retired from service, and for spare parts currently We routinely grant credit to many of our customers for transporta- identified as excess or obsolete. These allow ances are based on tion and business services w ithout collateral. The risk of credit loss management estimates, w hich are subject to change. in our trade receivables is substantially mitigated by our credit evaluation process, short collection terms and sales to a large 69


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    FEDEX CORPORATION PROPERTY AND EQUIPM ENT IM PAIRM ENT OF LONG-LIVED ASSETS Expenditures for major additions, improvements, flight equipment Long-lived assets are review ed for impairment w hen c irc um- modifications and certain equipment overhaul costs are capital- stanc es indic ate the c arrying value of an asset may not be ized w hen such costs are determined to extend the useful life recoverable. For assets that are to be held and used, an impair- of the asset or are part of the c ost of ac quiring the asset. ment is recognized w hen the estimated undiscounted cash flow s M aintenance and repairs are charged to expense as incurred, associated w ith the asset or group of assets is less than their except for certain aircraft-related major maintenance costs on carrying value. If impairment exists, an adjustment is made to one of our aircraft fleet types, w hich are capitalized as incurred w rite the asset dow n to its fair value, and a loss is recorded as and amortized over the estimated remaining useful lives of the the difference betw een the carrying value and fair value. Fair val- aircraft. We capitalize certain direct internal and external costs ues are determined based on quoted market values, discounted assoc iated w ith the development of internal use softw are. c ash flow s or internal and external appraisals, as applic able. Gains and losses on sales of property used in operations are Assets to be disposed of are c arried at the low er of c arrying classified w ith depreciation and amortization. value or estimated net realizable value. Because the cash flow s of our transportation netw orks cannot be identified to individual For financial reporting purposes, depreciation and amortization assets, and based on the ongoing profitability of our operations, of property and equipment is provided on a straight-line basis w e have not experienced any significant impairment of assets to over the asset’s service life or related lease term. For income tax be held and used. purposes, depreciation is generally computed using accelerated methods. The depreciable lives and net book value of our prop- PENSION AND POSTRETIREM ENT HEALTHCARE PLANS erty and equipment are as follow s (dollars in millions): Our defined benefit plans are measured as of the last day of our Net Book Value at M ay 31, fiscal third quarter of each year using actuarial techniques that Range 2006 2005 reflect management’s assumptions for discount rate, rate of W ide-body aircraft and return, salary increases, expected retirement, mortality, employee related equipment 15 to 25 years $4,669 $3,948 turnover and future increases in healthcare costs. We determine Narrow -body and feeder the discount rate (w hich is required to be the rate at w hich the aircraft and related equipment 5 to 15 years 369 330 projected benefit obligation could be effectively settled as of the Package handling and measurement date) w ith the assistance of actuaries, w ho calcu- ground support equipment 2 to 30 years 1,255 938 late the yield on a theoretical portfolio of high-grade corporate Computer and electronic bonds (rated Aa or better) w ith cash flow s that generally match equipment 2 to 10 years 928 758 our expected benefit payments. A calculated-value method is Vehicles 3 to 12 years 743 718 employed for purposes of determining the expected return on the Facilities and other 2 to 40 years 2,806 2,951 plan asset component of net periodic pension cost for our quali- fied U.S. pension plans. Generally, w e do not fund defined benefit Substantially all property and equipment have no material residual plans w hen such funding provides no current tax deduction or values. The majority of aircraft costs are depreciated on a w hen such funding w ould be deemed current compensation to straight-line basis over 15 to 18 years. We periodically evaluate plan participants. the estimated service lives and residual values used to depreci- ate our property and equipment. This evaluation may result in GOODW ILL changes in the estimated lives and residual values. Such changes Goodw ill is recognized for the excess of the purchase price over did not materially affect depreciation expense in any period pre- the fair value of tangible and identifiable intangible net assets of sented. Depreciation expense, excluding gains and losses on businesses acquired. Goodw ill is review ed at least annually for sales of property and equipment used in operations, w as $1.520 impairment by comparing the fair value of each reporting unit billion in 2006, $1.438 billion in 2005 and $1.361 billion in 2004. w ith its carrying value (including attributable goodw ill). Fair value Depreciation and amortization expense includes amortization of is determined using a disc ounted c ash flow methodology and assets under capital lease. includes management’s assumptions on revenue grow th rates, operating margins, discount rates and expected capital expendi- CAPITALIZED INTEREST tures. Unless circumstances otherw ise dictate, w e perform our Interest on funds used to finance the acquisition and modifica- annual impairment testing in the fourth quarter. tion of aircraft, construction of certain facilities and development of c ertain softw are up to the date the asset is ready for its intended use is capitalized and included in the cost of the asset if the asset is actively under construction. Capitalized interest w as $33 million in 2006, $22 million in 2005 and $11 million in 2004. 70


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    NOTES TO CONSOLIDATED FINANCIAL STATEM ENTS INTANGIBLE ASSETS commencement date of all leases is the earlier of the date w e Amortizable intangible assets include customer relationships, become legally obligated to make rent payments or the date w e technology assets and contract-based intangibles acquired may exerc ise c ontrol over the use of the property. Leasehold in business combinations. Amortizable intangible assets are improvements associated w ith assets utilized under capital or amortized over periods ranging from 2 to 15 years, either on a operating leases are amortized over the shorter of the asset’s straight-line basis or an accelerated basis depending upon the pat- useful life or the lease term. tern in w hich the economic benefits are realized. Non-amortizing intangible assets consist of the Kinko’s trade name. Non-amortizing DEFERRED GAINS intangibles are review ed at least annually for impairment. Unless Gains on the sale and leaseback of aircraft and other property circumstances otherw ise dictate, w e perform our annual impair- and equipment are deferred and amortized ratably over the life ment testing in the fourth quarter. of the lease as a reduction of rent expense. Substantially all of these deferred gains are related to aircraft transactions. INCOM E TAXES Deferred income taxes are provided for the tax effect of tempo- FOREIGN CURRENCY TRANSLATION rary differences betw een the tax basis of assets and liabilities Translation gains and losses of foreign operations that use local and their reported amounts in the financial statements. The lia- c urrenc ies as the func tional c urrenc y are ac c umulated and bility method is used to account for income taxes, w hich requires reported, net of applicable deferred income taxes, as a compo- deferred taxes to be recorded at the statutory rate in effect w hen nent of accumulated other comprehensive loss w ithin common the taxes are paid. stockholders’ investment. Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in We have not recognized deferred taxes for U.S. federal income a currency other than the local currency are included in results of taxes on foreign subsidiaries’ earnings that are deemed to be operations. Cumulative net foreign currency translation gains and permanently reinvested and any related taxes associated w ith (losses) in accumulated other comprehensive loss w ere $43 mil- such earnings are not material. Pretax earnings of foreign oper- lion at M ay 31, 2006, $14 million at M ay 31, 2005 and ($13) million ations w ere approximately $606 million in 2006, $636 million in at M ay 31, 2004. 2005 and $430 million in 2004, w hich represent only a portion of total results associated w ith international shipments. AIRLINE STABILIZATION ACT CHARGE During the second quarter of 2005, the United States Department SELF-INSURANCE ACCRUALS of Transportation (“ DOT” ) issued a final order in its administra- We are primarily self-insured for w orkers’ compensation claims, tive review of the FedEx Express claim for compensation under vehicle accidents and general liabilities, benefits paid under the Air Transportation Safety and System Stabilization Ac t employee healthcare programs and long-term disability benefits. (“ Act” ). Under its interpretation of the Act, the DOT determined Accruals are primarily based on the actuarially estimated, undis- that FedEx Express w as entitled to $72 million of compensation. counted cost of claims, w hich includes incurred-but-not-reported Because w e had previously received $101 million under the Act, claims. Current w orkers’ compensation claims, vehicle and gen- the DOT demanded repayment of $29 million, w hich w as made in eral liability, employee healthcare claims and long-term disability December 2004. Because w e could no longer conclude that col- are included in accrued expenses. We self-insure up to certain lim- lection of the entire $119 million recorded in 2002 w as probable, its that vary by operating company and type of risk. Periodically, w e recorded a charge of $48 million in the second quarter of 2005, w e evaluate the level of insurance coverage and adjust insurance representing the DOT’s repayment demand of $29 million and the levels based on risk tolerance and premium expense. w rite-off of a $19 million receivable. LEASES EM PLOYEES UNDER COLLECTIVE BARGAINING Certain of our aircraft, facility and retail location leases contain ARRANGEM ENTS fluctuating or escalating payments and rent holiday periods. The The pilots of FedEx Express, w hich represent a small number of related rent expense is recorded on a straight-line basis over the FedEx Express total employees, are employed under a collective lease term. The cumulative excess of rent payments over rent bargaining agreement that became amendable on M ay 31, 2004. expense is accounted for as a deferred lease asset and recorded In ac c ordanc e w ith applic able labor law , w e w ill c ontinue to in “ Intangible and other assets” in the balance sheets. The cumu- operate under our current agreement w hile w e negotiate w ith lative excess of rent expense over rent payments is accounted our pilots. Contract negotiations w ith the pilots’ union began in for as a deferred lease obligation. In addition to minimum rental M arch 2004. These negotiations are ongoing and are being medi- payments, certain leases provide for contingent rentals based on ated through the National M ediation Board. We cannot estimate equipment usage principally related to aircraft leases at FedEx the financial impact, if any, the results of these negotiations may Express and c opier usage at FedEx Kinko’s. Rent expense have on our future results of operations. associated w ith contingent rentals is recorded as incurred. The 71


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    FEDEX CORPORATION STOCK COM PENSATION DIVIDENDS DECLARED PER COM M ON SHARE W e c urrently apply Ac c ounting Princ iples Board Opinion No. On M ay 26, 2006, our Board of Directors declared a dividend of (“ APB” ) 25, “ Accounting for Stock Issued to Employees,” and its $0.09 per share of common stock. The dividend w as paid on July 3, related interpretations to measure c ompensation expense for 2006 to stoc kholders of rec ord as of the c lose of business on stock-based compensation plans. As a result, no compensation J une 12, 2006. Eac h quarterly dividend payment is subjec t to expense is recorded for stock options w hen the exercise price is review and approval by our Board of Directors, and w e evaluate equal to or greater than the market price of our common stock at our dividend payment amount on an annual basis at the end of the date of grant. For aw ards of restricted stock and to deter- each fiscal year. mine the pro forma effects of stock options set forth below, w e recognize the fair value of the aw ards ratably over their explicit USE OF ESTIM ATES service period. The preparation of our consolidated financial statements requires the use of estimates and assumptions that affect the reported If compensation cost for stock-based compensation plans had amounts of assets and liabilities, the reported amounts of rev- been determined under Statement of Financ ial Ac c ounting enues and expenses and the disclosure of contingent liabilities. Standards No. (“ SFAS” ) 123, “ Ac c ounting for Stoc k Based M anagement makes its best estimate of the ultimate outcome for Compensation,” stock option compensation expense, pro forma these items based on historic al trends and other information net income and basic and diluted earnings per common share available w hen the financial statements are prepared. Changes in for 2006, 2005 and 2004 assuming all options granted in 1996 and estimates are rec ognized in ac c ordanc e w ith the ac c ounting thereafter w ere valued at fair value using the Blac k-Sc holes rules for the estimate, w hich is typically in the period w hen new method, w ould have been as follow s (in millions, exc ept per information becomes available to management. Areas w here the share amounts): nature of the estimate makes it reasonably possible that actual Years Ended M ay 31, results could materially differ from amounts estimated include: 2006 2005 2004 self-insurance accruals; employee retirement plan obligations; Net income, as reported $1,806 $1,449 $ 838 long-term incentive accruals; tax liabilities; accounts receivable Add: Stock compensation allow ances; obsolescence of spare parts; contingent liabilities; included in reported net income, and impairment assessments on long-lived assets (inc luding net of tax 5 4 10 goodw ill and indefinite lived intangible assets). Deduct: Total stock-based employee compensation expense determined NOTE 2: RECENT ACCOUNTING PRONOUNCEM ENTS under fair value based method for all aw ards, net of tax benefit 46 40 37 In December 2004, the Financial Accounting Standards Board Pro forma net income $1,765 $1,413 $ 811 (“ FASB” ) issued SFAS 123R, “ Share-Based Payment.” The new Earnings per common share: standard requires companies to record compensation expense Basic – as reported $ 5.94 $ 4.81 $ 2.80 for stock-based aw ards using a fair value method. Compensation Basic – pro forma $ 5.81 $ 4.69 $ 2.71 expense w ill be recorded over the requisite service period, w hich Diluted – as reported $ 5.83 $ 4.72 $ 2.76 is typically the vesting period of the aw ard. Diluted – pro forma $ 5.70 $ 4.60 $ 2.68 We w ill adopt this standard using the modified prospective basis as of June 1, 2006. We expect the adoption of this standard to See Note 10 for a discussion of the assumptions underlying the result in a reduc tion of diluted earnings per share of approxi- pro forma calculations above. mately $0.15 in 2007. This estimate is impacted by the levels of For unvested stock options and restricted stock aw ards granted share-based payments granted in the future, assumptions used prior to M ay 31, 2006, the terms of these aw ards provide for in the fair value calculation and the market price of our common c ontinued vesting subsequent to the employee’s retirement. stock. Accordingly, the actual effect per diluted share could differ Compensation expense associated w ith these aw ards has been from this estimate. recognized on a straight-line basis over the vesting period. This The FASB issued FASB Interpretation No. (“ FIN” ) 48, “ Accounting provision w as removed from all stoc k option aw ards granted for Uncertainty in Income Taxes,” on July 13, 2006. The new rules subsequent to M ay 31, 2006. For restricted stock grants made w ill most likely be effective for FedEx in 2008. At this time, w e subsequent to M ay 31, 2006, c ompensation expense w ill be have not completed our review and assessment of the impact of ac c elerated for grants made to employees w ho are or w ill adoption of FIN 48. become retirement eligible during the stated vesting period of the aw ard. 72


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    NOTES TO CONSOLIDATED FINANCIAL STATEM ENTS NOTE 3: BUSINESS COM BINATIONS FedEx Express segment and $70 million w as attributed to the FedEx Ground segment based on the expected increase in each FEDEX SM ARTPOST segment’s fair value as a result of the acquisition. On September 12, 2004, w e ac quired the assets and assumed certain liabilities of FedEx SmartPost (formerly know n as Parcel The purchase price w as allocated as follow s (in millions): Direct), a division of a privately held company, for $122 million in Current assets, primarily accounts cash. FedEx SmartPost is a leading small-parcel consolidator and receivable and inventory $ 241 broadens our portfolio of services by allow ing us to offer a cost- Property and equipment 328 effec tive option for delivering low -w eight, less time-sensitive Goodw ill 1,751 packages to U.S. residences through the U.S. Postal Service. The Intangible asset w ith an indefinite life 567 financial results of FedEx SmartPost are included in the FedEx Amortizable intangible assets 82 Ground segment from the date of its acquisition and are not mate- Other long-term assets 52 rial to reported or pro forma results of operations of any period. Total assets acquired 3,021 The exc ess c ost over the estimated fair value of the assets Current liabilities (298) acquired and liabilities assumed (approximately $20 million) has Deferred income taxes (267) been recorded as goodw ill, w hich is entirely attributed to FedEx Long-term capital lease obligations Ground. M anagement relied primarily on internal estimates and and other long-term liabilities (36) the assistance of third-party appraisals to allocate the purchase Total liabilities assumed (601) price to the fair value of the assets acquired, liabilities assumed Total purchase price $2,420 and goodw ill. Indefinite lived intangible asset. This intangible asset represents The purchase price w as allocated as follow s (in millions): the estimated fair value allocated to the Kinko’s trade name. This Current assets, primarily accounts receivable $ 10 intangible asset w ill not be amortized because it has an indefinite Property and equipment 91 remaining useful life based on the length of time that the Kinko’s Intangible assets 10 name had been in use, the Kinko’s brand aw areness and market Goodw ill 20 position and our plans for continued use of the Kinko’s brand. Current liabilities (9) Amortizable intangible assets. These intangible assets represent Total purchase price $122 the fair value associated w ith the business expected to be gen- FEDEX KINKO’S erated from existing customer relationships and contracts as of On February 12, 2004, w e ac quired FedEx Kinko’s for approxi- the acquisition date. Substantially all of these assets are being mately $2.4 billion in c ash. W e also assumed $39 million of amortized on an accelerated basis over an estimated useful life c apital lease obligations. FedEx Kinko’s is a leading provider of approximately seven years. W hile the useful life of these of doc ument solutions and business servic es. Its netw ork of customer-relationship assets is not limited by contract or any w orldw ide loc ations offers ac c ess to c olor printing, finishing other economic, regulatory or other know n factors, a useful life and presentation services, Internet access, videoconferencing, of seven years w as determined at the acquisition date based on outsourcing, managed services, Web-based printing and docu- customer attrition patterns. ment management solutions. The follow ing unaudited pro forma consolidated financial infor- The allocation of the purchase price to the fair value of the assets mation presents the combined results of operations of FedEx and acquired, liabilities assumed and goodw ill, as w ell as the assign- FedEx Kinko’s as if the acquisition had occurred at the beginning ment of goodw ill to our reportable segments, w as based primarily of 2004. The unaudited pro forma results have been prepared for on internal estimates of cash flow s, supplemented by third-party c omparative purposes only. Adjustments w ere made to the appraisals. We used third-party appraisals to assist management combined results of operations, primarily related to higher depre- in its determination of the fair value of certain assets and liabilities, ciation and amortization expense resulting from higher property primarily property and equipment and acquired intangible assets, and equipment values and ac quired intangible assets and including the value of the Kinko’s trade name, customer-related additional interest expense resulting from ac quisition debt. intangibles, technology assets and contract-based intangibles. Accounting literature establishes firm guidelines around how this pro forma information is presented, w hich precludes the assump- Approximately $1.8 billion w as recorded as goodw ill, as the acqui- tion of business synergies. Therefore, this unaudited pro forma sition expands our portfolio of business services, w hile providing a information is not intended to represent, nor do w e believe it is substantially enhanced capability to provide package-shipping indicative of the consolidated results of operations of FedEx that services to small- and medium-sized business customers through w ould have been reported had the acquisition been completed FedEx Kinko’s netw ork of retail locations. Because this w as an as of the beginning of 2004. Furthermore, this pro forma informa- acquisition of stock, goodw ill is not deductible for tax purposes. tion is not representative of the future c onsolidated results of Approximately $130 million of the goodw ill w as attributed to the operations of FedEx. 73


  • Page 38

    FEDEX CORPORATION Pro forma unaudited results for the year ended M ay 31, 2004 OTHER BUSINESS COM BINATIONS w ere as follow s (in millions, except per share data): On M ay 26, 2006, w e announced an agreement to acquire the LTL operations of Watkins M otor Lines (“ Watkins” ), a privately held Revenues $26,056 company, and certain affiliates for approximately $780 million, Net income (1) 836 payable in cash. Watkins is a leading provider of long-haul LTL Basic earnings per common share (1) 2.80 services. Watkins w ill be rebranded as FedEx National LTL and Diluted earnings per common share (1) 2.75 w ill be included in the FedEx Freight segment from the date of (1) Includes $27 million, net of tax, of nonrecurring expenses at FedEx Kinko's, primarily in acquisition, w hich is expected to occur during the first half of anticipation of the acquisition. Also includes $270 million, net of tax, of business realign- ment costs and a $37 million, net of tax, nonrecurring tax benefit at FedEx. 2007, subject to customary closing conditions. On January 24, 2006, FedEx Express entered into an agreement We paid a portion of the purchase price from available cash bal- w ith Tianjin Datian W. Group Co., Ltd. (“ DTW Group” ) to acquire ances. To finance the remainder of the purchase price, w e issued DTW Group’s 50% share of the FedEx-DTW International Priority commercial paper backed by a six-month $2 billion credit facility. express joint venture (“ FedEx-DTW ” ) and DTW Group’s domes- In M arch 2004, w e issued $1.6 billion of senior unsecured notes in tic express netw ork in China for approximately $400 million in three maturity tranches: one, three and five years at $600 million, cash. This acquisition w ill convert our joint venture w ith DTW $500 million and $500 million, respectively. Net proceeds from the Group, formed in 1999 and c urrently ac c ounted for under the borrow ings w ere used to repay the commercial paper backed by equity method, into a w holly ow ned subsidiary and increase our the six-month credit facility. We canceled the six-month credit presence in China in the international and domestic express busi- facility in M arch 2004. See Note 7 for further discussion. nesses. The acquisition is expected to be completed in the first The FedEx SmartPost and FedEx Kinko’s ac quisitions w ere half of 2007, subject to customary closing conditions. The finan- accounted for under the purchase method of accounting. The c ial results of this transac tion w ill be inc luded in the FedEx operating results of the acquired businesses are included in our Express segment from the date of acquisition. consolidated results of operations from the date of acquisition. NOTE 4: GOODW ILL AND INTANGIBLES The carrying amount of goodw ill attributable to each reportable operating segment and changes therein follow s (in millions): Purchase Purchase Goodw ill Adjustments Adjustments M ay 31, 2004 Acquired and Other M ay 31, 2005 and Other M ay 31, 2006 FedEx Express segment $ 527 $– $1 $ 528 $ 2 $ 530 FedEx Ground segment 70 20(1) – 90 – 90 FedEx Freight segment 666 – – 666 (10) 656 FedEx Kinko’s segment 1,539 – 12 1,551 (2) 1,549 $2,802 $20 $13 $2,835 $(10) $2,825 (1) FedEx SmartPost acquisition. The components of our intangible assets w ere as follow s (in millions): M ay 31, 2006 M ay 31, 2005 Gross Carrying Accumulated Net Book Gross Carrying Accumulated Net Book Amount Amortization Value Amount Amortization Value Amortizable intangible assets Customer relationships $ 77 $ (29) $ 48 $ 77 $(16) $ 61 Contract related 79 (57) 22 79 (50) 29 Technology related and other 54 (30) 24 51 (23) 28 Total $210 $(116) $ 94 $207 $(89) $118 Non-amortizing intangible asset Kinko’s trade name $567 $ – $567 $567 $ – $567 The recoverability of the amounts recorded for FedEx Kinko’s goodw ill and trade name is dependent on execution of key initiatives related to revenue grow th, netw ork expansion and improved profitability. 74


  • Page 39

    NOTES TO CONSOLIDATED FINANCIAL STATEM ENTS Amortization expense for intangible assets w as $25 million in NOTE 7: LONG-TERM DEBT AND OTHER FINANCING 2006, $26 million in 2005 and $14 million in 2004. Estimated amorti- ARRANGEM ENTS zation expense for the next five years is as follow s (in millions): The components of our long-term debt w ere as follow s (in millions): 2007 $23 M ay 31, 2008 21 2006 2005 2009 18 Unsecured debt $2,006 $2,255 2010 16 Capital lease obligations 310 401 2011 8 Other debt, interest rates of 4.03% to 9.98% due through 2008 126 140 NOTE 5: BUSINESS REALIGNM ENT COSTS 2,442 2,796 Less current portion 850 369 During the first half of 2004, voluntary early retirement incentives $1,592 $2,427 w ith enhanced pension and postretirement healthcare benefits w ere offered to certain groups of employees at FedEx Express From time to time, w e finance certain operating and investing w ho w ere age 50 or older. Voluntary cash severance incentives activities, including acquisitions, through borrow ings under our w ere also offered to eligible employees at FedEx Express. $1.0 billion revolving credit facility or the issuance of commercial Approximately 3,600 employees accepted offers under these pro- paper. In July 2005, w e executed a new $1.0 billion five-year grams. Costs w ere also incurred for the elimination of certain revolving credit facility, w hich replaced and consolidated our prior management positions, primarily at FedEx Express and FedEx revolving credit facilities. Borrow ings under the credit facility w ill Services. We recognized $435 million of business realignment bear interest at short-term interest rates (based on the London c osts during 2004 ($428 million related to the FedEx Express Interbank Offered Rate (“ LIBOR” ), the Prime Rate or the Federal Segment). No material costs for these programs w ere incurred Funds Rate) plus a margin dependent upon our senior unsecured in 2006 or 2005. At both M ay 31, 2006 and M ay 31, 2005, business long-term debt ratings. The revolving credit agreement contains realignment related accruals w ere immaterial. certain covenants and restrictions, none of w hich are expected to significantly affect our operations or ability to pay dividends. NOTE 6: SELECTED CURRENT LIABILITIES Our commercial paper program is backed by unused commit- The components of selected current liability captions w ere as ments under the revolving credit facility and borrow ings under the follow s (in millions): M ay 31, program reduce the amount available under the credit facility. At 2006 2005 M ay 31, 2006, no commercial paper borrow ings w ere outstanding Accrued Salaries and Employee Benefits and the entire amount under the credit facility w as available. Salaries $ 236 $ 202 The components of unsecured debt (net of discounts) w ere as Employee benefits 655 658 follow s (in millions): Compensated absences 434 415 M ay 31, $1,325 $1,275 2006 2005 Accrued Expenses Senior unsecured debt Self-insurance accruals $ 523 $ 483 Interest rate of 7.80%, due in 2007 $ 200 $ 200 Taxes other than income taxes 305 288 Interest rate of 2.65%, due in 2007 500 500 Other 562 580 Interest rate of 3.50%, due in 2009 500 499 $1,390 $1,351 Interest rate of 7.25%, due in 2011 249 499 Interest rate of 9.65%, due in 2013 300 299 Interest rate of 7.60%, due in 2098 239 239 Other notes, due in 2007 18 19 $2,006 $2,255 75


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    FEDEX CORPORATION Our capital lease obligations include leases for aircraft, as w ell as NOTE 8: LEASES certain special facility revenue bonds that have been issued by We utilize certain aircraft, land, facilities, retail locations and municipalities primarily to finance the acquisition and construction equipment under capital and operating leases that expire at var- of various airport facilities and equipment. These bonds require ious dates through 2039. We leased approximately 16% of our total interest payments at least annually, w ith principal payments due aircraft fleet under capital or operating leases as of M ay 31, 2006. at the end of the related lease agreement. In addition, supplemental aircraft are leased by us under agree- Our other debt inc ludes $118 million related to leases for air- ments that generally provide for cancellation upon 30 days notice. c raft that are c onsolidated under the provisions of FIN 46, Our leased facilities include national, regional and metropolitan “ Consolidation of Variable Interest Entities, an Interpretation of sorting facilities and administrative buildings. ARB No. 51.” The debt accrues interest at LIBOR plus a margin The components of property and equipment recorded under cap- and is due in installments through M arch 30, 2007. See Note 17 ital leases w ere as follow s (in millions): for further discussion. M ay 31, 2006 2005 We issue other financ ial instruments in the normal c ourse of Aircraft $114 $232 business to support our operations. Letters of credit at M ay 31, Package handling and 2006 w ere $586 million. The amount unused under our letter of ground support equipment 167 167 credit facility totaled approximately $63 million at M ay 31, 2006. Vehicles 34 36 This facility expires in July of 2010. These instruments are gener- Other, principally facilities 166 167 ally required under certain U.S. self-insurance programs and are 481 602 used in the normal course of international operations. The under- Less accumulated amortization 331 329 lying liabilities insured by these instruments are reflected in the $150 $273 balance sheets, w here applicable. Therefore, no additional liabil- ity is reflected for the letters of credit. Rent expense under operating leases w as as follow s (in millions): Scheduled annual principal maturities of debt, exclusive of capital For years ended M ay 31, leases, for the five years subsequent to M ay 31, 2006, are as 2006 2005 2004 follow s (in millions): M inimum rentals $1,919 $1,793 $1,560 2007 $844 Contingent rentals 245 235 143 2008 – $2,164 $2,028 $1,703 2009 500 2010 – Contingent rentals are based on equipment usage. 2011 250 A summary of future minimum lease payments under c apital Long-term debt, exclusive of capital leases, had carrying values of leases at M ay 31, 2006 is as follow s (in millions): $2.1 billion compared w ith an estimated fair value of approximately 2007 $ 24 $2.2 billion at M ay 31, 2006, and $2.4 billion compared w ith an esti- 2008 100 mated fair value of $2.6 billion at M ay 31, 2005. The estimated fair 2009 12 values w ere determined based on quoted market prices or on the 2010 96 current rates offered for debt w ith similar terms and maturities. 2011 8 We have a $1 billion shelf registration statement w ith the SEC to Thereafter 144 provide flexibility and efficiency w hen obtaining financing. Under 384 this shelf registration statement w e may issue, in one or more Less amount representing interest 74 offerings, either unsecured debt securities, common stock or a Present value of net minimum lease payments $310 combination of such instruments. The entire $1 billion is available for future financings. 76


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    NOTES TO CONSOLIDATED FINANCIAL STATEM ENTS A summary of future minimum lease payments under noncan- Option-vesting periods range from one to four years, w ith approx- celable operating leases (principally aircraft, retail locations and imately 90% of stock option grants vesting ratably over four years. facilities) w ith an initial or remaining term in excess of one year at At M ay 31, 2006, there w ere 7,998,267 shares available for future M ay 31, 2006 is as follow s (in millions): grants under these plans. Aircraft and Related Facilities and Equipment Other Total The w eighted-average fair value of these grants, c alc ulated using the Black-Scholes valuation method under the assumptions 2007 $ 632 $1,040 $ 1,672 indicated below, w as $25.78 per option in 2006, $20.37 per option 2008 586 892 1,478 in 2005 and $18.02 per option in 2004. 2009 555 735 1,290 2010 544 576 1,120 The key assumptions for the Black-Scholes valuation method 2011 526 458 984 include the expected life of the option, stock price volatility, risk- Thereafter 3,934 2,846 6,780 free interest rate, dividend yield, forfeiture rate and exercise price. $6,777 $6,547 $13,324 M any of these assumptions are judgmental and highly sensitive. Follow ing is a table of the key w eighted-average assumptions The w eighted-average remaining lease term of all operating used in the option valuation calculations for the options granted leases outstanding at M ay 31, 2006 w as approximately six years. in the three years ended M ay 31, and a discussion of our method- W hile certain of our lease agreements contain covenants gov- ology for developing each of the assumptions used in the erning the use of the leased assets or require us to maintain valuation model: certain levels of insurance, none of our lease agreements include 2006 2005 2004 material financial covenants or limitations. Expected lives 5 years 4 years 4 years FedEx Express makes payments under certain leveraged oper- Expected volatility 25% 27% 32% ating leases that are sufficient to pay principal and interest on Risk-free interest rate 3.794% 3.559% 2.118% c ertain pass-through c ertific ates. The pass-through c ertifi- Dividend yield 0.3229% 0.3215% 0.3102% cates are not direct obligations of, or guaranteed by, FedEx or FedEx Express. Expected Lives. This is the period of time over w hich the options During the first quarter of 2006, a one-time, noncash charge of granted are expected to remain outstanding. Generally, options $79 million ($49 million after tax or $0.16 per diluted share) w as granted have a maximum term of 10 years. We examine actual recorded, w hich represented the impact on prior years to adjust stoc k option exerc ises to determine the expec ted life of the the accounting for certain facility leases, predominantly at FedEx options. An increase in the expected term w ill increase compen- Express. The charge related primarily to rent escalations in on- sation expense. airport facility leases. Because the amounts involved w ere not Expected Volatility. Actual changes in the market value of our material to our financial statements in any individual prior period stock are used to calculate the volatility assumption. We calcu- or to 2006 results, w e recorded the cumulative adjustment in the late daily market value changes from the date of grant over a past first quarter, w hich increased operating expenses by $79 million. period equal to the expec ted life of the options to determine volatility. An increase in the expected volatility w ill increase com- NOTE 9: PREFERRED STOCK pensation expense. Our Certificate of Incorporation authorizes the Board of Directors, Risk-Free Interest Rate. This is the U.S. Treasury Strip rate posted at its discretion, to issue up to 4,000,000 shares of preferred stock. at the date of grant having a term equal to the expected life of the The stoc k is issuable in series, w hic h may vary as to c ertain option. An inc rease in the risk-free interest rate w ill inc rease rights and preferences, and has no par value. As of M ay 31, 2006, compensation expense. none of these shares had been issued. Dividend Yield. This is the annual rate of dividends per share over NOTE 10: STOCK COM PENSATION PLANS the exercise price of the option. An increase in the dividend yield w ill decrease compensation expense. STOCK OPTION PLANS Forfeiture Rate . This is the estimated perc entage of options Under the provisions of our stock incentive plans, key employees granted that are expec ted to be forfeited or c anc eled before and non-employee directors may be granted options to purchase becoming fully vested. This percentage is derived from historical shares of common stock at a price not less than its fair market experience. An increase in the forfeiture rate w ill decrease com- value at the date of grant. Options granted have a maximum term pensation expense. Our forfeiture rate is approximately 8%. of 10 years. Vesting requirements are determined at the discre- tion of the Compensation Committee of our Board of Directors. 77


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    FEDEX CORPORATION The follow ing table summarizes information about our stock option plans for the years ended M ay 31: 2006 2005 2004 Weighted- Weighted- Weighted- Average Average Average Exercise Exercise Exercise Shares Price Shares Price Shares Price Outstanding at beginning of year 17,359,382 $51.96 17,349,307 $46.39 17,315,116 $38.88 Granted 3,324,135 90.82 2,718,651 76.21 3,937,628 64.96 Exercised (3,345,827) 43.33 (2,540,324) 39.14 (3,724,605) 31.05 Forfeited (238,164) 79.25 (168,252) 63.27 (178,832) 46.71 Outstanding at end of year 17,099,526 60.82 17,359,382 51.96 17,349,307 46.39 Exercisable at end of year 9,657,410 47.79 9,660,334 42.34 8,747,523 38.28 The follow ing table summarizes information about stock options outstanding at M ay 31, 2006: Options Outstanding Options Exercisable Weighted- Weighted- Weighted- Average Average Average Range of Number Remaining Exercise Number Exercise Exercise Prices Outstanding Contractual Life Price Exercisable Price $15.34 – 22.16 96,674 1.4 years $17.70 96,674 $17.70 23.81 – 35.69 1,671,125 1.8 years 30.14 1,671,125 30.14 35.89 – 53.77 5,450,650 5.2 years 44.81 4,820,318 43.65 55.94 – 83.73 6,428,018 6.9 years 66.67 2,911,443 63.42 84.57 – 117.52 3,453,059 9.0 years 91.28 157,850 91.59 15.34 – 117.52 17,099,526 6.2 years 60.82 9,657,410 47.79 Total equity compensation shares outstanding or available for grant represented approximately 8.1% at M ay 31, 2006 and 6.8% at M ay 31, 2005, of the total common and equity compensation shares outstanding and equity compensation shares available for grant. RESTRICTED STOCK PLANS Under the terms of our restricted stock plans, shares of common stock are aw arded to key employees. All restrictions on the shares expire ratably over a four-year period. Shares are valued at the market price at the date of aw ard. Compensation related to these plans is recorded as a reduction of common stockholders’ investment and is amortized to expense over the explicit service period. Annual compensation cost for the restricted stock plans w as approximately $29 million for 2006, $26 million for 2005 and $25 million for 2004. The follow ing table summarizes information about restricted stock aw ards for the years ended M ay 31: 2006 2005 2004 Weighted- Weighted- Weighted- Average Average Average Shares Fair Value Shares Fair Value Shares Fair Value Aw arded 233,939 $90.12 218,273 $80.24 282,423 $67.11 Forfeited 13,791 78.42 21,354 55.41 10,000 43.41 At M ay 31, 2006, there w ere 1,076,617 shares available for future aw ards under these plans. 78


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    NOTES TO CONSOLIDATED FINANCIAL STATEM ENTS NOTE 11: COM PUTATION OF EARNINGS PER SHARE The 37.4% effective tax rate in 2005 w as favorably impacted by the reduc tion of a valuation allow anc e on foreign tax c redits The calculation of basic earnings per common share and diluted arising from certain of our international operations as a result earnings per common share for the years ended M ay 31 w as as of the passage of the Americ an J obs Creation Ac t of 2004 follow s (in millions, except per share amounts): ($12 million tax benefit or $0.04 per diluted share) and by a low er 2006 2005 2004 effec tive state tax rate. The 36.5% effec tive tax rate in 2004 Net income $1,806 $1,449 $ 838 w as favorably impacted by a reduction of accruals relating to Weighted-average shares of the tax treatment of jet engine maintenance costs, stronger than common stock outstanding 304 301 299 antic ipated international results and the results of tax audits Common equivalent shares: during 2004. Assumed exercise of In 2004, w e received a favorable ruling regarding the tax treatment outstanding dilutive options 19 18 19 of jet engine maintenance costs, w hich w as affirmed by the Less shares repurchased appellate court in February of 2005, and became final in M ay of from proceeds of assumed 2005, w hen the period for appeal lapsed. As a result w e recog- exercise of options (13) (12) (14) nized a one-time benefit of $26 million, net of tax, or $0.08 per Weighted-average common diluted share in 2004. These adjustments affected both net interest and common equivalent expense ($30 million pretax) and income tax expense ($7 million). shares outstanding 310 307 304 Basic earnings per The significant components of deferred tax assets and liabilities common share $ 5.94 $ 4.81 $ 2.80 as of M ay 31 w ere as follow s (in millions): Diluted earnings per 2006 2005 common share $ 5.83 $ 4.72 $ 2.76 Deferred Deferred Deferred Deferred Tax Assets Tax Liabilities Tax Assets Tax Liabilities NOTE 12: INCOM E TAXES Property, equipment, leases and intangibles $ 329 $1,559 $ 301 $1,506 The components of the provision for income taxes for the years Employee benefits 413 648 397 453 ended M ay 31 w ere as follow s (in millions): Self-insurance accruals 339 – 311 – 2006 2005 2004 Other 360 78 319 77 Current provision Net operating loss/credit Domestic: carryforw ards 64 – 54 – Federal $ 719 $ 634 $ 371 Valuation allow ance (48) – (42) – State and local 79 65 54 $1,457 $2,285 $1,340 $2,036 Foreign 132 103 85 930 802 510 The net deferred tax liabilities as of M ay 31 have been classified Deferred provision (benefit) in the balance sheets as follow s (in millions): Domestic: 2006 2005 Federal 151 67 (22) Current deferred tax asset $ 539 $ 510 State and local 13 (4) (7) Noncurrent deferred tax liability (1,367) (1,206) Foreign (1) (1) – $ (828) $ (696) 163 62 (29) $1,093 $ 864 $ 481 The valuation allow ance primarily represents amounts reserved for operating loss and tax credit carryforw ards, w hich expire over A reconciliation of the statutory federal income tax rate to the effec- varying periods starting in 2007. As a result of this and other fac- tive income tax rate for the years ended M ay 31 w as as follow s: tors, w e believe that a substantial portion of these deferred tax 2006 2005 2004 assets may not be realized. Statutory U.S. income tax rate 35.0% 35.0% 35.0% Increase resulting from: State and local income taxes, net of federal benefit 2.1 1.7 2.3 Other, net 0.6 0.7 (0.8) Effective tax rate 37.7% 37.4% 36.5% 79


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    FEDEX CORPORATION NOTE 13: EM PLOYEE BENEFIT PLANS Ec onomic and market c onditions at the measurement date impact these assumptions from year to year and it is reasonably PENSION PLANS possible that material changes in pension cost may be experi- We sponsor defined benefit pension plans covering a majority of enced in the future. Additional information about our pension plan our employees. The largest plan covers certain U.S. employees c an be found in the Critic al Ac c ounting Estimates sec tion of age 21 and over, w ith at least one year of servic e. Eligible M anagement’s Discussion and Analysis. employees as of M ay 31, 2003 w ere given the opportunity to Actuarial gains or losses are generated to the extent that actual make a one-time elec tion to ac c rue future pension benefits results differ from those assumed. These ac tuarial gains and under either a cash balance formula w hich w e call the Portable losses are amortized over the remaining average service lives of Pension Ac c ount or a traditional pension benefit formula. our ac tive employees if they exc eed a c orridor amount in the Benefits provided under the traditional formula are based on aggregate. average earnings and years of servic e. Under the Portable Pension Account, the retirement benefit is expressed as a dol- Establishing the expected future rate of investment return on our lar amount in a notional account that grow s w ith annual credits pension assets is a judgmental matter. M anagement considers based on pay, age and years of credited service, and interest on the follow ing factors in determining this assumption: the notional account balance. In either case, employees retained • the duration of our pension plan liabilities, w hich drives the all benefits previously accrued under the traditional pension ben- investment strategy w e can employ w ith our pension plan assets; efit formula and continue to receive the benefit of future salary inc reases on benefits ac c rued as of M ay 31, 2003. Eligible • the types of investment classes in w hich w e invest our pension employees hired after M ay 31, 2003 accrue benefits exclusively plan assets and the expected compound return w e can reason- under the Portable Pension Account. ably expec t those investment c lasses to earn over the next 10- to 15-year time period (or such other time period that may Plan funding is actuarially determined and is subject to certain tax be appropriate); and law limitations. International defined benefit pension plans pro- vide benefits primarily based on final earnings and years of • the investment returns w e can reasonably expect our active service and are funded in accordance w ith local law s and income investment management program to achieve in excess of the tax regulations. Substantially all plan assets are actively managed. returns w e could expect if investments w ere made strictly in indexed funds. The w eighted-average asset allocations for our primary pension plan at February 28 w ere as follow s: We review the expected long-term rate of return on an annual 2006 2005 basis and revise it as appropriate. Also, w e periodically commis- Actual Target Actual Target sion detailed asset/liability studies performed by third-party Domestic equities 54% 53% 53% 53% professional investment advisors and actuaries to assist us in this International equities 20 17 20 17 evaluation. These studies project our estimated future pension Private equities 3 5 2 5 payments and evaluate the efficiency of the allocation of our pen- Total equities 77 75 75 75 sion plan assets into various investment c ategories. These Long duration fixed studies also generate probability-adjusted expec ted future income securities 14 15 15 15 returns on those assets. The study performed for 2004 supported Other fixed income securities 9 10 10 10 the reasonableness of our 9.10% return assumption used for 2004 100% 100% 100% 100% based on our liability duration and market conditions at the time w e set this assumption (in 2004). The results of this study w ere The investment strategy for pension plan assets is to utilize a diver- reaffirmed for 2005 and 2006 by our third-party professional sified mix of global public and private equity portfolios, together investment advisors and actuaries. w ith public and private fixed income portfolios, to earn a long-term investment return that meets our pension plan obligations. Active POSTRETIREM ENT HEALTHCARE PLANS management strategies are utilized w ithin the plan in an effort to Certain of our subsidiaries offer medical, dental and vision cov- realize investment returns in excess of market indices. erage to eligible U.S. retirees and their eligible dependents. U.S. employees c overed by the princ ipal plan bec ome eligible for Our pension cost is materially affected by the discount rate used these benefits at age 55 and older, if they have permanent, con- to measure pension obligations, the level of plan assets available tinuous service of at least 10 years after attainment of age 45 if to fund those obligations and the expec ted long-term rate of hired prior to January 1, 1988, or at least 20 years after attainment return on plan assets. of age 35 if hired on or after J anuary 1, 1988. Postretirement We use a measurement date of February 28 for our pension healthcare benefits are capped at 150% of the 1993 per capita and postretirement healthcare plans. M anagement review s the projected employer cost w hich has been reached and, therefore, assumptions used to measure pension costs on an annual basis. these benefits are not subject to additional future inflation. 80


  • Page 45

    NOTES TO CONSOLIDATED FINANCIAL STATEM ENTS The follow ing table provides a reconciliation of the changes in the pension and postretirement healthcare plans’ benefit obligations and fair value of assets over the tw o-year period ended M ay 31, 2006 and a statement of the funded status as of M ay 31, 2006 and 2005 (in millions): Postretirement Pension Plans Healthcare Plans 2006 2005 2006 2005 Accumulated Benefit Obligation (“ABO”) $10,090 $ 8,933 Changes in Projected Benefit Obligation (“PBO”) Projected benefit obligation at the beginning of year $10,401 $ 8,683 $ 537 $ 496 Service cost 473 417 42 37 Interest cost 642 579 32 32 Actuarial loss (gain) 858 907 (109) – Benefits paid (228) (194) (39) (36) Amendments, benefit enhancements and other 7 9 12 8 Projected benefit obligation at the end of year $12,153 $10,401 $ 475 $ 537 Change in Plan Assets Fair value of plan assets at beginning of year $ 8,826 $ 7,783 $ – $ – Actual return on plan assets 1,034 746 – – Company contributions 492 489 27 28 Benefits paid (228) (194) (39) (36) Other 6 2 12 8 Fair value of plan assets at end of year $10,130 $ 8,826 $ – $ – Funded Status of the Plans $ (2,023) $ (1,575) $(475) $(537) Unrecognized actuarial loss (gain) 3,026 2,500 (110) (1) Unamortized prior service cost and other 96 104 2 4 Unrecognized transition amount (3) (4) – – Prepaid (accrued) benefit cost $ 1,096 $ 1,025 $(583) $(534) Amount Recognized in the Balance Sheet at M ay 31: Prepaid benefit cost $ 1,349 $ 1,272 $ – $ – Accrued benefit liability (253) (247) (583) (534) M inimum pension liability (122) (63) – – Accumulated other comprehensive income (1) 112 52 – – Intangible asset 10 11 – – Prepaid (accrued) benefit cost $ 1,096 $ 1,025 $(583) $(534) (1) The minimum pension liability component of Accumulated Other Comprehensive Income is show n in the Statement of Changes in Stockholders’ Investment and Comprehensive Income, net of deferred taxes. Our pension plans included the follow ing components at M ay 31, 2006 and 2005 (in millions): U.S. Plans Qualified Nonqualified International Plans Total 2006 2005 2006 2005 2006 2005 2006 2005 ABO $ 9,591 $ 8,534 $ 239 $ 166 $ 260 $ 233 $10,090 $ 8,933 PBO $11,569 $ 9,937 $ 271 $ 181 $ 313 $ 283 $12,153 $10,401 Fair Value of Plan Assets 9,969 8,699 – – 161 127 10,130 8,826 Funded Status $ (1,600) $(1,238) $(271) $(181) $(152) $(156) $(2,023) $(1,575) Unrecognized actuarial loss 2,859 2,414 109 27 58 59 3,026 2,500 Unamortized prior service cost 77 86 14 14 5 4 96 104 Unrecognized transition amount (4) (5) – – 1 1 (3) (4) Prepaid (accrued) benefit cost $ 1,332 $ 1,257 $(148) $(140) $ (88) $ (92) $ 1,096 $ 1,025 The PBO is the actuarial present value of benefits attributable to employee service rendered to date, including the effects of estimated future pay increases. The ABO also reflects the actuarial present value of benefits attributable to employee service rendered to date, but does not include the effects of estimated future pay increases. Therefore, the ABO as compared to plan assets is an indication of the assets currently available to fund vested and nonvested benefits accrued through M ay 31. 81


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    FEDEX CORPORATION The measure of w hether a pension plan is underfunded for financial accounting purposes is based on a comparison of the ABO to the fair value of plan assets and amounts accrued for such benefits in the balance sheets. Although not legally required, w e made $456 million in tax-deductible voluntary contributions to our qualified U.S. pension plans in 2006 compared to total tax-deductible voluntary contributions of $460 million in 2005. Currently, w e do not expect any contributions for 2007 w ill be legally required. How ever, w e currently expect to make tax-deductible voluntary contributions in 2007 at levels approximating those in 2006. We have certain nonqualified defined benefit pension plans that are not funded because such funding provides no current tax deduction and w ould be deemed current compensation to plan participants. Primarily related to those plans and certain international plans, w e have ABOs aggregating approximately $499 million at M ay 31, 2006 and $399 million at M ay 31, 2005, w ith assets of $161 million at M ay 31, 2006 and $127 million at M ay 31, 2005. Plans w ith this funded status resulted in the recognition of a minimum pension liability in our balance sheets. This minimum liability w as $122 million at M ay 31, 2006 and $63 million at M ay 31, 2005. Net periodic benefit cost for the three years ended M ay 31 w as as follow s (in millions): Pension Plans Postretirement Healthcare Plans 2006 2005 2004 2006 2005 2004 Service cost $ 473 $ 417 $ 376 $42 $37 $35 Interest cost 642 579 490 32 32 25 Expected return on plan assets (811) (707) (597) – – – Recognized actuarial losses 110 60 62 – – – Amortization of transition obligation (1) – – – – – Amortization of prior service cost 12 12 12 (1) (1) – $ 425 $ 361 $ 343 $73 $68 $60 Increases in pension costs from the prior year are primarily the result of changes in discount rate. Weighted-average actuarial assumptions for our primary U.S. plans, w hich comprise substantially all of our projected benefit obliga- tions, are as follow s: Pension Plans Postretirement Healthcare Plans 2006 2005 2004 2006 2005 2004 Discount rate 5.912% 6.285% 6.78% 6.08% 6.16% 6.57% Rate of increase in future compensation levels 3.46 3.15 3.15 – – – Expected long-term rate of return on assets 9.10 9.10 9.10 – – – Benefit payments, w hic h reflec t expec ted future servic e, DEFINED CONTRIBUTION PLANS are expected to be paid as follow s for the years ending M ay 31 Profit sharing and other defined contribution plans are in place (in millions): c overing a majority of U.S. employees. The majority of U.S. Pension Plans Postretirement Healthcare Plans employees are covered under 401(k) plans to w hich w e provide 2007 $ 289 $ 30 discretionary matching contributions based on employee contri- 2008 295 30 butions. In addition, some employees are covered under profit 2009 342 32 sharing plans w hich provide for discretionary contributions, as 2010 348 33 determined annually by those business units. Expense under 2011 390 34 these plans w as $104 million in 2006, $97 million in 2005 and 2012-2016 $2,759 $196 $89 million in 2004. These estimates are based on assumptions about future NOTE 14: BUSINESS SEGM ENT INFORM ATION events. Ac tual benefit payments may vary signific antly from Our operations for the periods presented are primarily repre- these estimates. sented by FedEx Express, FedEx Ground, FedEx Freight and FedEx Future medical benefit costs are estimated to increase at an annual Kinko’s. These businesses form the core of our reportable seg- rate of 12% during 2007, decreasing to an annual grow th rate of 5% ments. Other business units in the FedEx portfolio are FedEx in 2019 and thereafter. Future dental benefit costs are estimated to Trade Netw orks, FedEx SmartPost, FedEx Supply Chain Services, increase at an annual rate of 6.5% during 2007, decreasing to an FedEx Custom Critical and Caribbean Transportation Services. annual grow th rate of 5% in 2013 and thereafter. A 1% change in M anagement evaluates segment financial performance based these annual trend rates w ould not have a significant impact on the on operating income. accumulated postretirement benefit obligation at M ay 31, 2006 or 2006 benefit expense because the level of these benefits is capped. 82


  • Page 47

    NOTES TO CONSOLIDATED FINANCIAL STATEM ENTS As of M ay 31, 2006, our reportable segments included the follow - on metrics such as relative revenues or estimated services pro- ing businesses: vided. We believe these alloc ations approximate the c ost of providing these functions. FedEx Express Segment FedEx Express FedEx Trade Netw orks In addition, certain FedEx operating companies provide trans- portation and related services for other FedEx companies outside FedEx Ground Segment FedEx Ground their reportable segment. Billings for such services are based on FedEx SmartPost negotiated rates, w hich w e believe approximate fair value, and FedEx Supply Chain Services are reflected as revenues of the billing segment. FedEx Kinko’s FedEx Freight Segment FedEx Freight segment revenues include package acceptance revenue, w hich FedEx Custom Critical represents the fee received by FedEx Kinko’s from FedEx Express Caribbean Transportation Services and FedEx Ground for accepting and handling packages at FedEx Kinko’s loc ations on behalf of these operating c ompanies. FedEx Kinko’s Segment FedEx Kinko’s Pac kage ac c eptanc e revenue does not inc lude the external FedEx Services provides customer-facing sales, marketing and revenue associated w ith the actual shipments. All shipment rev- information technology support, primarily for FedEx Express and enues are reflected in the segment performing the transportation FedEx Ground. The costs for these activities and certain other services. Intersegment revenues and expenses are eliminated in costs such as corporate management fees related to services the consolidated results but are not separately identified in the received for general corporate oversight, including executive offi- follow ing segment information as the amounts are not material. cers and certain legal and finance functions, are allocated based The follow ing table provides a reconciliation of reportable segment revenues, depreciation and amortization, operating income (loss) and segment assets to consolidated financial statement totals for the years ended or as of M ay 31 (in millions): FedEx FedEx FedEx FedEx Express Ground Freight Kinko’s Other and Consolidated Segment Segment Segment Segment (1) Eliminations (2) Total Revenues 2006 $21,446 $5,306 $3,645 $2,088 $(191) $32,294 2005 19,485 4,680 3,217 2,066 (85) 29,363 2004 17,497 3,910 2,689 521 93 24,710 Depreciation and amortization 2006 $ 805 $ 224 $ 120 $ 148 $ 253 $ 1,550 2005 798 176 102 138 248 1,462 2004 810 154 92 33 286 1,375 Operating income 2006 (3) $ 1,767 $ 705 $ 485 $ 57 $ – $ 3,014 2005 (4) 1,414 604 354 100 (1) 2,471 2004 (5) 629 522 244 39 6 1,440 Segment assets (6) 2006 $14,673 $3,378 $2,245 $2,941 $(547) $22,690 2005 13,130 2,776 2,047 2,987 (536) 20,404 2004 12,443 2,248 1,924 2,903 (384) 19,134 (1) Includes the operations of FedEx Kinko’s from the formation of the FedEx Kinko’s segment on M arch 1, 2004. (2) Includes the results of operations of FedEx Kinko’s from February 12, 2004 (date of acquisition) through February 29, 2004 (approximately $100 million of revenue and $6 million of oper- ating income). (3) Includes a $79 million one-time, noncash charge to adjust the accounting for certain facility leases ($75 million at FedEx Express). (4) Includes $48 million related to the Airline Stabilization Act charge. (5) Includes business realignment costs of $428 million in the FedEx Express segment, $1 million in the FedEx Ground segment and $6 million in Other and Eliminations. (6) Segment assets include intercompany receivables. The follow ing table provides a reconciliation of reportable segment capital expenditures to consolidated totals for the years ended M ay 31 (in millions): FedEx FedEx FedEx FedEx Express Ground Freight Kinko’s Consolidated Segment Segment Segment Segment Other Total 2006 $ 1,408 $ 487 $ 274 $ 94 $ 255 $ 2,518 2005 1,195 456 217 152 216 2,236 2004 592 314 130 36 199 1,271 83


  • Page 48

    FEDEX CORPORATION The follow ing table presents revenue by service type and geo- NOTE 16: GUARANTEES AND INDEM NIFICATIONS graphic information for the years ended or as of M ay 31 (in millions): W e ac c ount for guarantees and indemnific ations in ac c or- Revenue by Service Type danc e w ith FIN 45, “ Guarantor’s Ac c ounting and Disc losure 2006 2005 2004 Requirements for Guarantees, Including Indirect Guarantees of FedEx Express segment: Indebtedness of Others,” w hic h requires the rec ognition and Package: measurement of certain guarantees and indemnifications. U.S. overnight box $ 6,422 $ 5,969 $ 5,558 U.S. overnight envelope 1,974 1,798 1,700 W ith the exception of residual value guarantees in certain oper- U.S. deferred 2,853 2,799 2,592 ating leases, a maximum obligation is generally not specified in Total domestic package our guarantees and indemnific ations. As a result, the overall revenue 11,249 10,566 9,850 maximum potential amount of the obligation under such guaran- International Priority 6,979 6,134 5,131 tees and indemnific ations c annot be reasonably estimated. Total package revenue 18,228 16,700 14,981 Historically, w e have not been required to make significant pay- Freight: ments under our guarantee or indemnification obligations and U.S. 2,218 1,854 1,609 no amounts have been recognized in our financial statements for International 434 381 393 the underlying fair value of these obligations. Total freight revenue 2,652 2,235 2,002 We have guarantees under certain operating leases, amounting Other 566 550 514 to $34 million as of M ay 31, 2006, for the residual values of vehi- Total FedEx Express segment 21,446 19,485 17,497 cles and facilities at the end of the respective operating lease FedEx Ground segment 5,306 4,680 3,910 periods. Under these leases, if the fair market value of the leased FedEx Freight segment 3,645 3,217 2,689 asset at the end of the lease term is less than an agreed-upon FedEx Kinko’s segment (1) 2,088 2,066 521 value as set forth in the related operating lease agreement, w e Other and Eliminations (2) (191) (85) 93 w ill be responsible to the lessor for the amount of suc h defi- $32,294 $29,363 $24,710 ciency. Based upon our expectation that none of these leased Geographical Information(3) assets w ill have a residual value at the end of the lease term that Revenues: is materially less than the value specified in the related operating U.S. $24,172 $22,146 $18,643 lease agreement, w e do not believe it is probable that w e w ill be International 8,122 7,217 6,067 required to fund any amounts under the terms of these guarantee $32,294 $29,363 $24,710 arrangements. Accordingly, no accruals have been recognized for Noncurrent assets: these guarantees. U.S. $13,804 $13,020 $12,644 In conjunction w ith certain transactions, primarily the lease, sale International 2,422 2,115 1,520 or purc hase of operating assets or servic es in the ordinary $16,226 $15,135 $14,164 course of business, w e sometimes provide routine indemnifica- (1) Includes the operations of FedEx Kinko’s from the formation of the FedEx Kinko’s seg- tions (e.g., environmental, fuel, tax and softw are infringement), ment on M arch 1, 2004. (2) Includes the results of operations of FedEx Kinko’s from February 12, 2004 (date of the terms of w hich range in duration and are often not limited. acquisition) through February 29, 2004 (approximately $100 million of revenue). The fair market value of these indemnifications is not believed to (3) International revenue includes shipments that either originate in or are destined to be significant. locations outside the United States. Noncurrent assets include property and equipment, goodw ill and other long-term assets. Flight equipment is allocated betw een geographic FedEx’s publicly held debt (approximately $1.4 billion) is guaranteed areas based on usage. by our subsidiaries. The guarantees are full and unconditional, joint and several, and any subsidiaries that are not guarantors are minor NOTE 15: SUPPLEM ENTAL CASH FLOW INFORM ATION as defined by Securities and Exchange Commission (“ SEC” ) regu- Cash paid for interest expense and income taxes for the years lations. FedEx, as the parent company issuer of this debt, has no ended M ay 31 w as as follow s (in millions): independent assets or operations. There are no significant restrictions 2006 2005 2004 on our ability or the ability of any guarantor to obtain funds from its subsidiaries by such means as a dividend or loan. Subsequent Interest (net of capitalized interest) $145 $162 $151 to M ay 31, 2006, through a consent solicitation process, w e have Income taxes 880 824 364 obtained the ability to amend one of our public debt indentures to allow us at any time to c ause the release and disc harge of FedEx Express amended tw o leases in 2004 for M D11 aircraft, certain subsidiary guarantors from their respective guarantees. w hich required FedEx Express to record $110 million in 2004 in both fixed assets and long-term liabilities. 84


  • Page 49

    NOTES TO CONSOLIDATED FINANCIAL STATEM ENTS Spec ial fac ility revenue bonds have been issued by c ertain The amounts reflected in the table above for purchase commit- municipalities primarily to finance the acquisition and construc- ments represent noncancelable agreements to purchase goods or tion of various airport facilities and equipment. These facilities services. Commitments to purchase aircraft in passenger configu- w ere leased to us and are accounted for as either capital leases ration do not include the attendant costs to modify these aircraft or operating leases. FedEx Express has unconditionally guaran- for cargo transport unless w e have entered into noncancelable teed $755 million in princ ipal of these bonds (w ith total future commitments to modify such aircraft. Open purchase orders that principal and interest payments of approximately $1.2 billion as are cancelable are not considered unconditional purchase obliga- of M ay 31, 2006) through these leases. Of the $755 million bond tions for financial reporting purposes. principal guaranteed, $204 million w as included in capital lease FedEx Express is c ommitted to purc hase c ertain airc raft. obligations in our balance sheet at M ay 31, 2006. The remaining Deposits and progress payments of $64 million have been made $551 million has been accounted for as operating leases. tow ard these purchases and other planned aircraft-related trans- ac tions. In addition, w e have c ommitted to modify our DC10 NOTE 17: VARIABLE INTEREST ENTITIES aircraft for passenger-to-freighter and tw o-man cockpit config- FedEx Express entered into a lease in July 2001 for tw o M D11 air- urations. Future payments related to these activities are included craft. These assets w ere held by a separate entity, w hich w as in the table above. Aircraft and aircraft-related contracts are sub- established to lease these aircraft to FedEx Express and is ow ned ject to price escalations. The follow ing table is a summary of our by independent third parties w ho provide financing through debt aircraft purchase commitments as of M ay 31, 2006 w ith the year and equity participation. The original cost of the assets under the of expected delivery by type: lease w as approximately $150 million. A300 A310 A380 Total FIN 46 required us to consolidate the separate entity that ow ns 2007 5 1 – 6 the tw o M D11 airc raft. Sinc e the entity w as c reated before 2008 10 – – 10 February 1, 2003, w e measured the assets and liabilities at their 2009 2 – 2 4 carrying amounts (the amounts at w hich they w ould have been 2010 – – 4 4 recorded in the consolidated financial statements if FIN 46 had 2011 – – 3 3 been effective at the inception of the lease). As a result of this Thereafter – – 1 1 c onsolidation, the ac c ompanying M ay 31, 2006 balanc e sheet Total 17 1 10 28 includes an additional $115 million of fixed assets and $118 mil- lion of long-term debt. The M ay 31, 2005 balance sheet includes NOTE 19: CONTINGENCIES an additional $120 million of fixed assets and $125 million of long- Wage-and-Hour. We are a defendant in a number of law suits filed term debt. In M arch 2006, FedEx Express provided notification to in federal or California state c ourts c ontaining various c lass- the lessor of our intent to purchase these aircraft in M arch 2007. ac tion allegations under federal or California w age-and-hour law s. The plaintiffs in these law suits are employees of FedEx NOTE 18: COM M ITM ENTS operating companies w ho allege, among other things, that they Annual purc hase c ommitments under various c ontrac ts as of w ere forced to w ork “ off the clock” and w ere not provided w ork M ay 31, 2006 w ere as follow s (in millions): breaks or other benefits. The plaintiffs generally seek unspeci- Aircraft- fied monetary damages, injunctive relief, or both. Aircraft Related (1) Other (2) Total To date, one of these w age-and-hour c ases, Foster v. FedEx 2007 $179 $205 $798 $1,182 Express, has been c ertified as a c lass ac tion. The plaintiffs in 2008 431 113 130 674 Foster represent a class of hourly FedEx Express employees in 2009 459 61 93 613 California from October 14, 1998 to present. The plaintiffs allege 2010 659 67 65 791 that hourly employees are routinely required to w ork “ off the 2011 460 66 56 582 clock” and are not paid for this additional w ork. The court issued Thereafter 157 8 218 383 a ruling in Dec ember 2004 granting c lass c ertific ation on all (1) Primarily aircraft modifications. issues. In February 2006, the parties reached a settlement that (2) Primarily vehicles, facilities, computers, printing and other equipment and advertising and promotions contracts. has been preliminarily approved by the court. FedEx Express con- tinues to deny liability, but entered into the settlement to avoid the cost and uncertainty of further litigation. The amount of the proposed settlement w as fully ac c rued at the end of the third quarter of 2006 and is not material to FedEx. 85


  • Page 50

    FEDEX CORPORATION W ith respect to the other w age-and-hour cases, w e have denied We strongly believe that FedEx Ground’s ow ner-operators are any liability and intend to vigorously defend ourselves. Given the properly classified as independent contractors and that w e w ill nature and preliminary status of these other w age-and-hour prevail in these proceedings. Given the nature and preliminary c laims, w e c annot yet determine the amount or a reasonable status of these claims, w e cannot yet determine the amount or a range of potential loss in these other matters, if any. reasonable range of potential loss in these matters, if any. Race Discrimination. On September 28, 2005, a California federal Other. FedEx and its subsidiaries are subject to other legal pro- district court granted class certification in Satchell v. FedEx ceedings that arise in the ordinary course of their business. In the Express, a law suit alleging discrimination by FedEx Express in the opinion of management, the aggregate liability, if any, w ith Western region of the United States against certain current and respect to these other actions w ill not materially adversely affect former minority employees in pay and promotion. The district our financial position, results of operations or cash flow s. court’s ruling on class certification is not a decision on the merits of the plaintiffs’ claim and does not address w hether w e w ill be NOTE 20: RELATED PARTY TRANSACTIONS held liable. Trial is currently scheduled for February 2007. We have In November 1999, FedEx entered into a multi-year naming rights denied any liability and intend to vigorously defend ourselves in agreement w ith the National Football League Washington this case. Given the nature and preliminary status of the claim, w e Redskins professional football team. Under this agreement, FedEx cannot yet determine the amount or a reasonable range of poten- has c ertain marketing rights, inc luding the right to name the tial loss in this matter, if any. It is reasonably possible, how ever, Redskins’ stadium “ FedExField.” In August 2003, Frederic k W. that w e could incur a material loss as this case develops. Smith, Chairman, President and Chief Executive Officer of FedEx, On M ay 24, 2006, a jury ruled against FedEx Ground in Issa & personally acquired an approximate 10% ow nership interest in Rizkallah v. FedEx Ground, a California state court law suit brought the Washington Redskins and joined its board of directors. in July 2001 by tw o independent contractors w ho allege, among A member of our Board of Directors, J.R. Hyde, III, and his w ife other things, that a FedEx Ground manager harassed and dis- together ow n approximately 13% of HOOPS, L.P. (“ HOOPS” ), the criminated against them based upon their national origin. The jury ow ner of the NBA M emphis Grizzlies professional basketball aw arded the tw o plaintiffs a total of $60 million (w hich includes team. M r. Hyde, through one of his companies, also is the gen- $50 million of punitive damages), plus attorney’s fees and other eral partner of the minority limited partner of HOOPS. During 2002, litigation expenses in an amount to be determined later. We FedEx entered into a $90 million naming rights agreement w ith intend to vigorously contest the jury verdict, including the amount HOOPS that w ill be amortized to expense over the term of the of the damages aw ard. We cannot yet determine the amount or a agreement, w hich expires in 2024. Under this agreement, FedEx range of probable loss, if any, in this matter. It is reasonably pos- has c ertain marketing rights, inc luding the right to name the sible, how ever, that w e could incur a material loss. Grizzlies’ arena “ FedEx Forum.” Pursuant to a separate 25-year Independent Contractor. FedEx Ground is involved in numerous agreement w ith HOOPS, the City of M emphis and Shelby County, purported class-action law suits and other proceedings that claim FedEx has agreed to pay $2.5 million a year for the balance of the that the c ompany’s ow ner-operators should be treated as term if HOOPS terminates its lease for the arena after 17 years. employees, rather than independent contractors. These matters FedEx also purchased $2 million of municipal bonds issued by the include Estrada v. FedEx Ground, a class action involving single M emphis and Shelby County Sports Authority, the proceeds of w ork area contractors that is pending in California state court. w hich w ere used to finance a portion of the construction costs Although the trial court has granted some of the plaintiffs’ claims of the arena. for relief in Estrada ($18 million, inclusive of attorney’s fees, plus equitable relief), w e expect to prevail on appeal. Adverse deter- minations in these matters c ould, among other things, entitle c ertain of our c ontrac tors to the reimbursement of c ertain expenses and to the benefit of w age-and-hour law s and result in employment and w ithholding tax liability for FedEx Ground. On August 10, 2005, the J udic ial Panel on M ulti-Distric t Litigation granted our motion to transfer and consolidate the majority of the class-action law suits for administration of the pre-trial proceed- ings by a single federal court — the U.S. District Court for the Northern District of Indiana. 86

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