FedEx Vies With UPS for More Profit From Ground Deliveries

FedEx Corp. Chairman Frederick Smith says his company is engaged in one of the most significant transformations in corporate history, one he likens to Wal-Mart Stores Inc.'s selling groceries next to dry goods and Dell Computer Corp.'s pitching servers along with personal computers.

His plan, which he hatched a decade ago, is for FedEx to expand from its original business — shipping documents by overnight plane — to shipping packages of all sizes and shapes, with trucks as well as planes and at speeds selected by customers.

It's a shift long awaited by investors. FedEx earns an operating profit margin of 5.5 percent. Rival United Parcel Service Inc. earns 15.5 percent, mostly because of its 80.3 percent market share in U.S. package deliveries via truck.

Smith has spent $4 billion since 1997 to build up his own truck fleet, which now captures 11.6 percent of U.S. ground deliveries. He's also expanded his air cargo fleet, which can now reach within 48 hours countries that generate 9/10 of global economic output.

Wall Street is pressuring FedEx to match UPS's profits fast, even though there's a war going on. “They need to get their margins up,'' says Arthur Hatfield, a Morgan Keegan Inc. analyst in Memphis, Tennessee. “Otherwise, there's no point in being a public company.''

Hatfield gave FedEx shares his highest rating — “outperform'' — on Sept. 21, the day after they hit their 52-week low of $33.15.

Sinking Economy

Smith's transformation of FedEx has been hindered lately by a sinking economy. In the quarter ended Aug. 31, the company's profit from operations fell 27 percent from the year-earlier period to $124 million, or 41 cents a share, as sales rose 5.4 percent to $5.04 billion.

FedEx says it may have earned 45 cents a share in the quarter ended Nov. 30. That would be down from 67 cents in the year-earlier period and 7 cents less than the average analyst estimate prior to September's terrorist attacks in the U.S. The forecast excludes $101 million in government assistance following the attacks.

Even so, FedEx shares surged 33.4 percent in the nine weeks starting Sept. 24. Investors concluded the attacks would not hurt the company as much as first feared, says James Valentine, a Morgan Stanley Dean Witter & Co. analyst.

`A Cyclical Rally'

“FedEx is one of the best ways to play a cyclical rally from an economic recovery,'' says Valentine, who's had an “outperform'' rating on FedEx shares since Jan. 16.

FedEx sold for $45.95 on Nov. 26 — an increase of 15 percent during the year compared with a 6.5 percent drop for UPS and a 12.3 percent drop in the Standard & Poor's 500 Index.

“FedEx is very well positioned to gain market share on a global basis,'' says Ronald Altman, research director at Spears, Benzak, Salomon & Farrell Inc., which owns 2 million FedEx shares.

Some analysts say a recovery could be too far away to justify buying FedEx shares now. “We want to see signs of a bottom in the economy before we get more aggressive,'' says Gregory Burns, a J. P. Morgan Securities Inc. analyst who's had a “market perform,'' or neutral, rating on FedEx since May 8.

Another worry: FedEx generates about one-third of its revenue by shipping high-value electronic equipment, including computers. Global PC sales fell 12 percent to 30.6 million in the quarter ended Sept. 30, according to Gartner Inc.

High-Value Shipments

A recovery in high-value electronic shipments — even to growth rates slower than those of the 1990s — isn't likely before Christmas 2002, says Daniel Scovel, a Needham & Co. analyst.

Gary Yablon, a Credit Suisse First Boston analyst who's had a “hold,'' or neutral, rating on FedEx since 1999, says there's too much optimism in the company's share price, because air express revenue is declining and customers may force FedEx to drop prices more than it already has.

In the spring of 2000, FedEx tacked on a jet fuel surcharge of 4 percent, or about 64 cents for the average express package.

On Oct. 17, the company cut that surcharge by 25 percent. Analysts say the charge could fall further because during the prior 12 months the price of jet fuel had declined by 39 percent to 62 cents a gallon.

As at so many other companies, the wild card in FedEx's push for better results is the ongoing war on terrorism.

Disgruntled Employee

At FedEx, memories are fresh about a disgruntled employee who used a hammer to attack the pilots of a DC-10 shortly after takeoff from Memphis in 1994. The hijacker, a FedEx pilot, intended to crash the plane into the company's Memphis package hub.

The three-man crew — despite injuries that included a fractured skull, a severed ear and a dislocated jaw — subdued the hijacker and landed successfully.

After the September attacks, FedEx officials tightened access to the company's loading docks and cut the number of people flying in jump seats, says David Webb, an A-300 captain and president of the FedEx Pilots Association.

While FedEx canceled a daily flight from Dubai to Mumbai, the company flies within 150 miles of Afghanistan on a nightly flight from Paris to the Philippines. “We're conducting commerce right on the ragged edge,'' Webb says.

Anthrax is a Concern

Anthrax is also a concern, because FedEx hauls 3.9 million pounds of mail for the U.S. Postal Service (USPS) every day and is installing drop boxes at 10,000 post offices. FedEx uses bags and canisters to separate most U.S. mail from other shipments. Still, packages can be deposited in the drop boxes anonymously and loaded onto FedEx airplanes without thorough screening, Webb says.

As a precaution, the company put a few dozen East Coast workers on antibiotics in October.

In early November, Planned Parenthood Federation of America Inc. affiliates around the U.S. received at least 132 FedEx packages containing an unknown powdery substance. Shipping documents for the packages were forged, and at least 33 of the packages also contained threatening letters signed by a domestic terrorist group called the Army of God.

FedEx neither X-rays its packages for explosives nor irradiates them for anthrax on a routine basis, according to the company and its pilots union. “We know the vast majority of our shippers,'' says Alan Graf, FedEx's chief financial officer.

Valid Credit Card

Packages arriving from drop boxes must be labeled with a valid credit card number and are tracked throughout their journey by electronic scanners, Graf says. That electronic trail makes terrorists less likely to target FedEx than the postal service, he adds.

Smith says he saw the potential of trucks a decade ago and didn't respond faster because he was investing in overseas air routes and couldn't afford to fund both endeavors.

He made his big moves into ground deliveries in 1998, when he spent $2.25 billion for Caliber System Inc., and in February, when he spent $1.2 billion for American Freightways Corp. Those companies specialize in package deliveries to businesses. FedEx is supplementing them with a household delivery service that can now reach 80 percent of the U.S. and that should reach 100 percent by next autumn.

'Not Where It Needs to Be'

“FedEx is not where it needs to be on the ground, but it's no longer a distant second,'' says Rich Coyner, corporate traffic manager at Wesco International Inc., a Pittsburgh-based distributor of electrical products.

Coyner recently awarded a $7 million annual shipping contract to UPS after a four-month bidding process that UPS won by capping future rate increases at a lower level than FedEx.

In April 2000, Smith merged sales representatives from FedEx and the former Caliber unit into one group so all of them can sell all of the company's services, not air or ground separately.

Customers can now request air or ground services with a single phone call; until April 2000, they had to make separate calls to each business.

FedEx Ground Improves

Revenue at FedEx Ground, the truck delivery unit, rose 14.8 percent to $623.2 million during the quarter ended Aug. 31. The unit's operating profit rose 40.2 percent to $60.3 million.

Wall Street was heartened. “It demonstrates that FedEx is starting to gain traction,'' says Morgan Stanley analyst Valentine.

In five years, FedEx could be earning $4.40 a share — more than twice analyst estimates of $2.01 for the fiscal year ending May 2002, says Greg Wagener, senior manager at Brinson Partners Inc., which owned 2.8 million FedEx shares in June.

UPS officials say they're not worried about FedEx's ground growth. “We're more than holding our own,'' says United Parcel Service CFO Scott Davis. The two companies, he says, are boosting sales at the expense of smaller trucking firms and the USPS.

No Clear Heir Apparent

No clear heir apparent has emerged for Smith, who is 57. When he underwent a coronary bypass last year, his job was shared by four executives: CFO Graf; Kenneth Masterson, general counsel; T. Michael Glenn, executive vice president of marketing; and Robert Carter, chief information officer.

Smith comes across as a friendly, slightly rumpled college professor. His graying hair reaches the top of his ears, and he speaks in a nasal, high-pitched voice with a Southern twang. His grandfather piloted Mississippi riverboats, and his father started a bus company that grew into Greyhound Lines Inc.

Though he wore leg braces as a child because of a hip disorder, he served as a U.S. Marine pilot in Vietnam. He started FedEx in 1971 and built it into the world's largest overnight delivery company. His shares in the company were worth $915.8 million on Nov. 26.

FedEx's headquarters is a four-story redbrick building on a quiet Memphis street. Smith greets visitors in a conference room that has little decoration except a model Airbus A380 — 800F freighter.

Big Planes

The plane, a triple-deck version of Airbus SAS's planned 550-seat superjumbo, is designed to carry twice as many packages as today's freighters. Smith has ordered 10 for delivery, starting in 2008.

Smith began investing heavily in overseas air routes in the late 1980s, as just-in-time supply chains became more popular and more global. Because of those trends, cross- border air cargo shipments grew an average of 6.7 percent per year from 1995 to 2000, reaching 15.8 million metric tons, according to MergeGlobal Inc., a transportation consultancy in Arlington, Virginia.

MergeGlobal's customers include FedEx and UPS.

Cross-border air cargo shipments experienced their biggest drop ever in 2001, falling 8.4 percent, in part because of the September terrorist attacks, says David Hoppin, a MergeGlobal analyst.

Air Cargo Shipments to Recover

He expects air cargo shipments to recover by 2003 as the global economy expands again, growing an average of 4.2 percent from 2000 to 2005.

Smith placed his biggest bet in Asia, where cargo travels long distances. In 1989, he paid $880 million for Flying Tiger Line Inc., which was started by pilots who'd flown U.S. fighter planes in China during World War II.

FedEx now has 11 intercontinental flights a week into China compared with UPS's six. Every week, it has five flights that land in Hong Kong to pick up cargo bound for non-U.S. countries; UPS has none.

“China is going to be the big economic story of the next 10-20 years,'' Smith says.

FedEx's Asian air express operations are likely to grow, but they don't generate significant profit yet, says Russell Price, an H&R Block Financial Advisors analyst who's had an “accumulate'' or “buy'' rating on FedEx since January.

The company has been even less successful in Europe, where many cities can be connected with overnight trucks and where FedEx faces competition from UPS, TPG NV, and Deutsche Post AG.

Fired 12,000 Workers

FedEx fired 12,000 workers and sold its Brussels hub in 1991. The company restarted with a new, Paris hub in 1996, following a cautious strategy. It uses airplanes to haul packages into and out of Europe and between its major cities, and it limits its capital spending by hiring subcontractors to deliver packages via truck.

The fact that UPS's ground operations move 10 million packages a day in the U.S. — compared with FedEx's 1.6 million — gives UPS additional leverage.

UPS makes so many stops in so many neighborhoods that the incremental costs for each new customer are small, and it has more small-business customers who can't command the 20-30 percent volume discounts that big companies enjoy, says Satish Jindel, president of SJ Consulting Group in Pittsburgh.

Web Competition

Some of FedEx's most intense competition with UPS for new business occurs not on the highway but on the Web. For example, German printing press maker Heidelberger Druckmaschinen AG, a FedEx customer, ships spare parts from its Wiesloch, Germany, factory to U.S. customers 75 times a day. About 5 percent of the shipments routinely get delayed at border crossings.

For six months, FedEx has provided real-time e-mail alerts about delays, says Geoff Loftus, vice president of U.S. logistics. “It gets us working on a problem before our customers have to know,'' he says.

From July 2000 to September 2001, traffic on Fedex.com grew 146 percent to 3.17 million unique visits per month, while traffic on UPS.com grew 50 percent to 5.1 million unique visits, according to Jupiter Media Metrix Inc.

Even the Memphis package hub, which is devoted to air express, illustrates how diversified FedEx has become. Only about a quarter of the 1.5 million packages that pass through each night are overnight-letter envelopes. Most are cardboard packages.

Workers Struggle

Workers find themselves struggling to lift all manner of goods, including metal floors for pickup trucks.

Starting at 11:30 p.m., planes from all over the world land continually on three runways for 2 hours. At the same time, 8,500 workers start arriving at the main gate. As soon as the airplanes stop, workers unload dumpster-size canisters filled with packages.

They place the canisters on trains and pull them next to conveyor belts, so that another gang of workers can unload them. At one point, hundreds of packages a minute pour onto what looks like an airport luggage carousel 30 feet high and hundreds of yards long.

Here workers turn the packages right side up so they can be scanned and then nudged by computer-controlled switches through a labyrinth of additional conveyors and then onto outbound planes.

A Persistent Concern

A persistent Wall Street concern is that Smith maintains separate courier routes for express, ground and freight operations, even though he's merged sales operations. That means FedEx sometimes sends two trucks to the same customer: one for air express and another for freight. UPS uses a single network.

“The UPS model apparently produces a higher return on equity,'' says Burns, the J. P. Morgan analyst.

FedEx insists that it needs separate networks to provide superior service. SJ Consulting's Jindel agrees, saying FedEx hasn't done enough to publicize the advantages of its separate networks. For example, FedEx offers money- back guarantees on home deliveries and UPS doesn't.

FedEx didn't start television ads for its ground services until this past October, even though it agreed to buy Caliber in 1997.

“It shouldn't have taken four years to roll out,'' says Joseph Martha, a Mercer Consulting Group analyst in Cleveland.

CFO Graf contends that FedEx needed time to buy trucks and build package hubs for Caliber to make sure it didn't degrade FedEx's on-time performance.

Focus on Cost Cutting

Smith has continued to focus on cost cutting. Since May 2000, FedEx has cut expenses at its Express unit by 10 percent, or about $150 million a year, mostly by ordering used aircraft, Graf says.

FedEx imposed a hiring freeze and trimmed services, including priority overnight delivery on Sunday.

FedEx is also making cuts in an area that Smith once said held great promise: logistics. Last spring, FedEx wrote off $22 million in assets in a unit that specializes in logistics — that is, the coordinated movement of finished or unfinished goods through a customer's factories.

The write-off covered physical assets like warehouses, which FedEx no longer wants to own because they hamper its ability to react as customers' needs change, says Doug Witt, president of supply chain services.

Logistics Unchanged

During 2001, FedEx's logistics revenue will likely remain unchanged, at $350 million, while UPS's will grow 23 percent to $1 billion, says Richard Armstrong, president of Armstrong & Associates Inc., a logistics consulting firm in Stoughton, Wisconsin.

FedEx hurt its growth by using logistics to boost truck and airplane revenue rather than as a strategic focus in itself, says Armstrong.

In addition, UPS has a cash hoard of $1.9 billion — a big advantage, Armstrong says. UPS uses its finance arm, UPS Capital, to loan money to startup companies and then manage their supply chains.

FedEx has used its logistics expertise to sell transportation services. In 1999, the company designed a system in which Hughes Electronics Corp.'s DirecTV unit bills customers and ships satellite dishes as soon as it receives an order.

Dish Shipments

FedEx managed the system as dish shipments on its trucks and planes grew to as many as 12,000 a day now from 25 per day in 1999.

Smith is also getting a boost from his USPS contract, which he expects will generate $7.2 billion in revenue over seven years. FedEx earns a 15 percent operating margin on the Express Mail portion of the contract, says CSFB's Yablon.

The postal service will save $1 billion, or about 15 percent of mail-hauling costs, says Paul Vogel, vice president of operations. Previously, FedEx and the postal service were flying half-empty planes, Vogel says.

After the September attacks, the postal service asked FedEx to carry 1 million additional pounds per day, says David Webb of the pilots union. The company agreed to take 200,000 additional pounds a day, Webb says, and may take more after Christmas.

Vogel says he hopes FedEx and the postal service will expand their contract. Graf confirms they're in talks, declining to provide specifics. The company also hauls mail for the French and Swedish post offices.

U.S. Economy Imponderable

Smith says his quest for bigger profit is dependent on how quickly the U.S. economy recovers. Consumer confidence, he says, is an unknown that could change everything.

“That's largely related to how well the Bush administration pursues the war on terrorism,'' Smith says.

As for his ongoing corporate transformation, Smith continues to preach optimism. “If the economy starts going up and we don't deliver, that might make people skeptical,'' he says, “but I'm very confident we will.''

He says he thinks he's bought himself some time on Wall Street by continuing to cut costs. Now, he says, it's time to dazzle investors with a bigger profit.

Bloomberg News