FedEx: Gaining on the Ground

Dismissed as an also-ran to UPS not long ago, it has roared back by building a bang-up ground network

Two years ago, FedEx (FDX ) founder Frederick W. Smith watched in frustration as his company's vaunted air express service took a beating. Rival United Parcel Service Inc. (UPS ), fresh off the biggest public stock offering in U.S. history, was spending lavishly on new Airbus delivery planes, building out a network of computers and wireless devices, and extending its trademark precision to the airborne delivery business. Meanwhile, more FedEx customers were bypassing costly shipments altogether and moving documents with e-mail. To Wall Street, it looked as if FedEx was doomed to years of shrinking margins and lost business. Some analysts even went so far as to suggest that FedEx would disappear in a takeover.

No one is doubting FedEx' survival today. The king of overnight shipments is enjoying a resurgence, thanks to the surprising growth of a ground-delivery service that Smith cobbled together from acquisitions and independent truckers. Finally able to offer an alternative to costly air delivery, FedEx has added a growing number of big consumer-goods companies, such as Williams-Sonoma (WSM ) and Tupperware (TUP ). Last summer alone, the Memphis company picked up an estimated 140,000 to 150,000 new daily deliveries because of a threatened strike by UPS drivers.

This surprising turnaround elicits grudging respect from UPS--but so far, little return fire. "FedEx has done a lot with its ground operation," says Kurt Kuehn, UPS's director of investor relations. "It has become a real good competitor." But despite its loss of market share, UPS has chosen not to launch a price war. To the contrary, it announced in November that it would hike prices up to 3.9% in 2003, a move that FedEx and other shippers quickly matched. "UPS doesn't like losing market share, but we're not going crazy to get it back," says Kuehn.

UPS still controls 80% of all U.S. ground shipments, compared with 15% for FedEx. But the FedEx Ground unit is growing far faster. FedEx' domestic average daily volume of packages rose 11.8% in the three months ended Aug. 31, while UPS's fell 2.1%. Even more important is the contribution to the bottom line. FedEx Ground generates 12% operating margins, nearly quadruple those for the company's air express unit. That's a big reason why the parent company's net income in the quarter ended in August rose 45%, to $158 million, on 8% higher sales. For fiscal 2003, ending May 31, FedEx is projected to earn $811 million--up 14% from last fiscal year--on 7% higher revenues of $22.2 billion, according to Lazard Freres LLC.

By the middle of next year, FedEx should be generating 31% of its total operating earnings from ground shipments, says James L. Winchester, a transportation analyst at Lazard--up from just under half that in 2001. And offering customers a less costly alternative to air delivery smooths out the historic boom-and-bust nature of its business. "FedEx is a different animal today," Winchester says. "It's no longer a cyclical company, whipsawed in every downspin of the economy."

While most of the ground service so far has been business-to-business, FedEx is now aggressively pushing into an area long dominated by UPS--home delivery. From a small base--FedEx does not break out the number of home deliveries it makes--the fledgling service is expected to grow 140% this year. No wonder FedEx stock has risen about 15% in the past 12 months, to about $52 per share, slightly better than the gain for UPS.

FedEx had no choice but to go with ground delivery after seeing customers flee to UPS's lower-priced networks of trucks. But when it first launched the service five years ago, few observers expected it to catch on so quickly. The key decision for FedEx was to resist building a system from scratch, which could easily have cost it $3 billion right off the bat. Instead, it spent $1.2 billion to build a system by purchasing several regional trucking companies and hiring independent, and therefore nonunion, truckers operating nationwide out of 27 hubs. Those drivers deliver packages under long-term contracts in vehicles sporting the FedEx logo. "It's a system unique to the trucking business," says Dan Sullivan, chief executive of FedEx Ground. With demand burgeoning, FedEx plans to spend $1.8 billion more over the next six years to add more truckers.

FedEx Ground's strategy is markedly different from that of UPS. While UPS relies on a brown army of tight-knit unionized drivers, FedEx' truckers are essentially entrepreneurs, motivated by a pay system that rewards them for timeliness and how much they deliver. At the hubs, FedEx uses digital technology to track every package from pickup to dropoff. Packages that enter one of FedEx' hubs never touch human hands. The bar codes are automatically scanned, posting the package's place in the delivery cycle online, as they move along conveyor belts to other trucks or storage. That highly automated process enables FedEx to charge $5 to deliver a five-pound package on the ground, compared with $20 for air express service--prices similar to those charged by its archrival. UPS, with its legendary attention to detail and popular drivers, still holds a slight edge in terms of customer service, according to a survey by J.D. Powers. But FedEx is catching up.

Customers got a good look at the FedEx ground system when many of them turned to it out of fear of strikes by UPS drivers and port workers earlier this year. Both threats quickly passed, but many customers liked what they got from FedEx and stayed on. "The threat of a port strike was a godsend for FedEx," says Brian Clancy, principal of industry consultant MergeGlobal Inc. "It made people rethink intercontinental air freight as a backup to ships."

FedEx now has the right mix of services going forward. The company is shifting more packages to ground delivery, positioning air express as a premium service for customers willing to pay top dollar. That has enabled it to continue making money in the air, especially in its international unit, where it still dominates, says T. Michael Glenn, FedEx' CEO of corporate services. Although international growth slowed in 2002 to 3%, those overseas markets remain highly profitable. FedEx takes in $44.70 in revenue per package on its international air routes--twice what it gets in the U.S.

No one expects FedEx to elbow aside UPS as the world's dominant shipper anytime soon. But thanks to its new strategy, FedEx is sailing much more smoothly through this downturn. For investors, this is one turnaround that was delivered in the nick of time.

By Charles Haddad in Atlanta

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