FedEx: Two Bets on Network Effects

FedEx: Two Bets on Network Effects

If you started from scratch and tried to imagine the hardest possible business to start, here's what you might come up with:

• You want a business that's capital-intensive, so there's constant dilution and borrowing.
• You should have a product with little margin for error, but one that requires frequent human input, so there's a limit to how much error can be automated away.
• To make it extra fun, this business should be cyclical, and ideally should have some kind of input whose price fluctuates frequently, and for which a price increase can trigger a recession.
• The business should have an intuitive network effect, but this effect should be hard to measure—the flip side of network effects being great for mature businesses is that they make new businesses that much harder, since the network effect doesn't exist yet.
• Ideally, this business should be the first of its kind, so it's equally hard to explain to investors and customers.
• Of course, no business is truly and completely new; your ideally difficult business ought to look enough like a legacy company to be covered by existing regulations, but to have a model for which those rules don't make sense.

If you want to start the world's most difficult business, you're out of luck because FedEx already exists. The company fits all of these criteria, and while it exists today, with an enterprise value of $88bn, that was a close call. Among other things, in the company's early days FedEx repeatedly defaulted on loans and had trouble paying suppliers, had to ask employees to delay cashing their paychecks, might have forged a loan guarantee1, and the infamous incident in which the CEO knew the company didn't have enough cash on hand to pay a bill due Monday, and won the money for it in Vegas. FedEx raised what was then the largest venture round in history, totalling $52m in equity and debt.2 At one point, the company avoided getting its planes repossessed by a lender only because they successfully argued that the cost of retrofitting cargo planes as passenger planes would eliminate most of the loan recovery.

The economics of package delivery, especially of the kind FedEx focuses on, are not necessarily intuitive. Early on, the company had a small set of cities, and estimated daily demand of 200 packages per day. On the first day, they shipped 6. (This launch was retconned into a "system test," as good a spin as any.) Part of the reason was that they had a limited network. The value of connecting N points through a single hub is a function of the size of N (specifically, about n log(n)). So when FedEx had dumped a lot of money into buying planes to support a network, and found that it didn't have enough demand, the only available solution was—spending more money and growing a bigger network.

Unit economics are tricky in another way: overnight transportation is very valuable to some companies, and its value is often most obvious to the most senior executives who have a) the biggest budgets, and b) the least exposure to logistical complexities. FedEx made a big deal about this in their ads:

The market-clearing price for space on a plane that's about to depart is either close to zero, if it still has space, or infinite, if it doesn't. And pricing is a function of both space and weight. (Originally, it was just by weight, until FedEx got a customer who liked to overnight ten-gallon hats, each of which was individually boxed; priced by weight, they didn't even pay for fuel.)

The upside to this model is that, once it's been worked out, it's exceedingly hard to justify building a direct competitor. FedEx, UPS, Amazon Logistics, and many other operators overlap in plenty of markets, but they each have subsets of the market where it's hard to compete. For FedEx, that's rapid overnight delivery. For documents, that business is getting less important over time, which has been a secular trend for a long time. (The name "Federal Express" comes from an earlier version of the business that never got off the ground, which planned to specialize in overnight delivery of checks between Federal Reserve branches.) But parcels, delivered to either consumers or businesses, are a harder market to disrupt. In fact, while the great supply chain crunch hurts them in the sense that it disrupts their access to spare parts, and means some products aren't available for shipment to customers, it also creates demand for expedited delivery of spare parts—when a $10 million machine can't function until it gets a replacement for a $1 component, the company that transports that component has plenty of pricing power.

The shift from document to package delivery has another impact on FedEx, not because of their customers, but because of their competition. One of the company's key competitors faces very different economics: USPS. USPS doesn't strictly need to turn a profit, but it does need to set aside money for workers' benefits. (This has aroused a lot of controversy because private companies have more flexibility in how often they contribute to pension plans. On the other hand, USPS reports total unfunded pension liabilities of $58.1bn, which is twice as big as GE's $25.5bn shortfall, which appears to be the largest of any US company. So perhaps they should have less flexibility.)

Regardless of exactly how USPS is or should be managed, the question FedEx cares about is: will they be forced to change the way they operate? In a 2019 podcast, FedEx's CEO walked through the outlines of a model on how quickly USPS will have to ask Congress for some combination of extra funding and reform, given the decline in first-class mail revenue and junk mail. If they're forced to cut their budget, that means more parts of parcel delivery will be a FedEx/UPS duopoly, with UPS having an edge on cost and FedEx on speed. The original estimate was that by 2024, and possibly 2022, USPS would be literally out of cash and would have to request more funding. (For what it's worth, their 10-K shows $14.4bn in cash, and they are actually generating $2.6bn each year in operating cash flow less capital expenditures, though their retirement and healthcare liabilities accrue at around $8bn annually. So it really is a political question.)

Interestingly enough, both USPS and FedEx have a similar competitive advantage: FedEx refers to the capital-intensive nature of their business as a moat, which is true, albeit it's not a great moat from an investor's perspective. USPS's competitive moat of sorts is that they have a cost structure determined in part by political concerns, and can choose strategies that deliver the best marginal profit on top of that. So both organizations are operating outside of normal constraints: FedEx is making investments that will get a better return if USPS shrinks, and which have been getting a subpar return other than that (over the last 10 years, FedEx spent a cumulative $48bn in capital expenditures, and increased operating cash flow by $5bn over the same period—and that operating income growth was primarily in the last year).

Network effects cut both ways, which has a positive corollary: when a big competitor's network effect unwinds for exogenous reasons, their competitors can gain share, and that share is often at accretive margins. But it ends up being a tricky political question on both sides. FedEx has to justify investments to shareholders whose payoff comes from an uncertain outcome. Meanwhile, USPS has to justify its existence to Congress when it increasingly provides a poor substitute for email and a package delivery service that has plenty of private sector alternatives. As it turns out, FedEx’s capital expenditures are a form of lobbying, which makes the case for a smaller USPS. But the company also has to continuously make the case to shareholders that this investment will prove worthwhile.

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