An idea that was dismissed in 1965 may become a stock market winner. Fred Smith, the founder of FedEx, was then a 21-year-old undergraduate at Yale.
He wrote an economics term paper (essay in British parlance) featuring a new business plan. In the 1960s, the shipping of packages was done by trucks and passenger flights. There was no dedicated air freight for packages. Fred Smith’s paper made the case for carrying important packages by air.
The paper was given a “C” grade. The professor said that it was poorly thought out. It was based on outlandish assumptions of the market size.
Most students would be deterred by a poor grade. But, Smith did not give up. After graduation, Smith was conscripted by the Marines in Vietnam.
He returned to America and founded FedEx in 1971. He started with 14 planes and over 100 trucks. FedEx operated in 25 American cities.
Smith had devised a unique model for FedEx. Packages from around the country would be sent to a central hub — Memphis, Tennessee. It would then be flown out on specific routes (spokes). Trucks would deliver the last mile. This “hub and spoke” system is common today, but was revolutionary in 1971.
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It was not all clear skies at the start. In the first two years, FedEx bled cash. Its operating losses were US$29 million (US$182 million in today’s money). FedEx faced a severe cash crunch. Smith did not have money to make payroll at one stage in 1973. This was long before venture capital flowed into start-ups. Interest rates were 7 times higher than today. The 10-year US treasury rate was 12%.
Smith was desperate, but he backed his own luck. He flew to Las Vegas from Texas. He won US$27,000 (US$170,000 in today’s money) at the blackjack tables. This bonanza helped him keep the lights on. It also gave him immense confidence. It seemed that Karmic forces were behind him.
FedEx finally became profitable in 1975. FedEx gradually gained a reputation as the gold standard in delivery. It delivered packaged efficiently. The onset of the fax machine reduced demand for couriered documents. But that was just a brief setback.
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The rise of e-commerce in the last 20 years accelerated Fedex’s growth. The introduction of the bar code cemented Fedex’s allure. It helps the tracking of packages. FedEx also pioneered online tracking in the late 1990s.
Today, FedEx generates US$84 billion ($112.75 billion) in revenue. It delivers 12 million packages a day. The company is in a magic circle of corporations whose names have become a verb. Packages are “FedExed” in the same way, people are “Skyped” or “Googled”.
Along with its rival United Parcel Service Inc, or more popularly called UPS, FedEx is an excellent proxy for the growth of e-commerce. With e-commerce gaining momentum, more packages need to be delivered. FedEx and UPS have seen their package volume rise by a quarter since the pandemic.
The whiff of normalisation has not dented the e-commerce surge. People have now got used to ordering items ranging from books to beauty products. In fact, both FedEx and UPS recently delivered their best-ever revenue: Fedex’s FY ended in May 2021 while UPS ended in December 2021.
Apart from e-commerce, the two giants delivered over 2 billion vaccine doses.
The street expects FedEx to generate US$3 billion in free cash flow for the current FY2022 — that’s five times the pre-Covid level.
Both companies have pricing power. Inflation is eroding the margins of many businesses, but the business of delivery is not one of them. It is capital-intensive, restricting the field. FedEx has raised its prices by 6%. UPS and the US Postal service have also hiked.
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The largest users of delivery services are fast-growing e-commerce giants Amazon.com and eBay. They had little choice but to swallow these hikes.
The valuation does not capture the potential. FedEx has risen 54% since the pandemic and UPS has more than doubled in that period. Yet, the duo is trading at 5% forecast FCF yield.
UPS is not only generating cash, but it is generous with its payouts. Its dividend yield is 4%.
Smith’s professor may have erred by giving him a “C”. Investors should not make the same error. The delivery business deserves a better rating.
Nirgunan Tiruchelvam is head of consumer sector equity at Tellimer and author of Investing in the Covid Era. He does not hold any position in the stocks mentioned in these columns.
Photo: Fedex
