Frederick Smith - May 2012

Thank you. Well, thank you very much, Bruce. It's wonderful to be back at the Wings Club. As Bruce mentioned, he and I have been friends for many, many years, and of course he had the opportunity to work with one of the legends in our industry, Al Yuli, and I wish Al well through Bruce. I brought this tomato up here because I told Ken, when he asked me to do this site lecture, that I would be satisfied if I got out of here and nobody threw any tomatoes at me. So he brought it over to me and he said that it was the only one that they could find unsliced in the house, so we disarmed everybody. I'm going to give it to Steve Laer, who's one of my bosses and a member of the FedEx board of directors. We're very happy to have him on our board. I don't go any place to speak unarmed, so I have a lot of FedExes with me, and in the interest of time I'm not going to introduce them all, but I would like to note Jim Parker, who's our executive vice president of air operations, and then I'd appreciate it if the FedEx folks in the audience stand up. But I'm particularly honored to be here today and given the duty of cutting the cake for The Wings Club 70th anniversary celebration. This organization has always been at the crossroads of the aviation industry, and I'm truly flattered to join the ranks of so many distinguished past speakers for the site lecture, from General Jimmy Doolittle to my friend Herb Kelleher. And of course, as you might imagine, when Herb Kelleher found out that I was going to give this speech, he saw a picture of me in some publication and sent me an appropriately supportive email, as you might imagine, something along the lines of, "Make sure you get the damn haircut." But as those people who just stood up represent FedEx folks around the world, I'm here today representing 300,000 team members, and not only on the team today but people who have served our company in decades past, like Ron Anderson and Alan McArter and some of the other members of The Wings Club that all of you know. I can assure you that I know that my presence here is because of their hard work and their commitment to our famous Purple Promise, which states simply: I will make every FedEx experience outstanding. And I am indeed among many old friends, some of whom I've known since I was President here, as Bruce mentioned, in 1984. I think all of us will agree, since those days our industry has been through amazing change, and so it's always good for me to be back among those who understand the significance of all our industry has accomplished over this past quarter century. Now, when I was the president of the Wings Club, a movie came out that most of you will remember called Back to the Future. And in Back to the Future, the main character Marty McFly alternates between the past, present and the future via Doc Brown's plutonium-powered DeLorean time machine. The movie, I think, is a great framework for a site lecture because it focuses on events that have taken place over a broad time span. The movie is also a good metaphor for the history and evolution of air cargo. Certainly the future of air cargo is built on its past, and like the car, Marty, we've got to use the past to ensure our own successful future. Now before I get started with the main comments about the air cargo industry, I'd like to cover a few notes about FedEx and our broad portfolio of shipping solutions today. As most of you know, we began as Federal Express and created the modern air express industry almost four decades ago. Our history spans the most important era of the modern air cargo industry, and today we have nearly 690 aircraft, which is the largest all-cargo fleet in the world. It's the largest widebody fleet, I think, of any type. Our growth has been spurred by several macroeconomic trends: the increase of high-tech and high value-added goods, the wider access of world markets to each other, just-in-time delivery systems, and of course the rise of the internet. And besides FedEx Express, as we now call it, we also have our other major operating segments: FedEx Ground, FedEx Freight, and FedEx Services, which contains our technology and retail units, the latter being FedEx Office. Now we have several smaller companies within these segments. One of them in the express segment is FedEx Trade Networks, which deals in freight forwarding and ocean services, among other things. Because we transport by air, land and sea, FedEx truly bears witness to the global trends affecting all these areas. Now, sophisticated and widespread as travel has become in the 20th and 21st centuries, we ought to bear in mind that humankind has pursued travel and trade since before recorded history. The evidence of wheels and boats has been found in earth strata dated thousands of years BC, and the wide use of these inventions gave rise to great civilizations. Greece, Rome, China, the Middle East and the British Empire grew prosperous on the rolling wheels and navigable vessels that connected them to their trading partners. Even to the present day, ships and wheel vehicles of all sizes remain key purveyors of trade and culture. We may have 700 airplanes almost, but we have over 990,000 trucks to put that in perspective. But truly, nothing has connected the world like aviation. It's astounding, I think we'll all agree, how much the airplane has done for trade and travel in only the last 100 years. But let's take a closer look at aviation history as it pertains to the movement of goods, the cargo sector. In the beginning, from the invention of flying through World War I, planes were used to carry very expensive, very urgent items which were small or lightweight. With its limited passenger and payload capabilities, an early airplane, say a Curtiss Condor, could only carry important people or very important things such as the US mail. Because after all, as we all know, unlike earthbound ships and vehicles, it cost a lot of money and technology to get a heavy aircraft to break the bonds of gravity and stay in the air over long distances. So it was primarily the United States government, beginning in 1911, that funded the air cargo industry to get the mail delivered. Small cargo planes were also used for important goods such as emergency medical supplies, military parts during World War I, or newspaper delivery. In short, cargo aviation was a government-subsidized industry in the early days. It was not until the mid-1930s that Douglas came out with their famous DC-3, a plane that could support itself for commercial services and revenues rather than government subsidy. People began placing more value on their time and on access to the marketplace. As a result, the DC-3 came into more general use for passengers and light cargo. Still, the cost of moving goods by airplane as compared to a vessel or a vehicle was not competitive, and the payload of a DC-3 was about 6,000 pounds or 24 passengers. So even the DC-3 was still limited mainly to carrying high-value and smaller shipments. Then World War II came along, and the DC-3 became the workhorse of the war. About 10,000 of them were built during World War II. Money was poured into derivatives: the DC-4 and DC-6, and all the big prop airplanes were used worldwide during the early postwar years. More than 100 airlines flew them, often using ex-military aircraft. Some people in those days had grandiose visions of cargo planes becoming the ships of the sky, but truth was that boats and wheels still remained the prime instruments of trade. Most cargo shipments from the end of the war until the 1970s were moved by either the US government or the military. One problem with military aircraft, particularly the roll-on/roll-off types that became prevalent after the war, was that they could not be efficiently adapted to commercial use. Delta, for instance, tried with the Lockheed C-130 but experienced only limited success. So in the 50s and 60s, passenger airliners went to other planes and the cargo industry loped along. That's not to say there wasn't a growing need for fast, reliable long-haul cargo transportation. Our senior vice president of flight, who's an avid aviation enthusiast as well as being a great professional in the business, sent me not long ago a copy of the March 1946 issue of Flying magazine that discussed the birth of the Flying Tiger Line. And in it, it talks about the various iterations that Flying Tigers went through. The motto of the early Flying Tigers was "We haul anything anywhere." They used stainless steel Kogas designed for use with the short runways of the traffic for World War II operations in the Pacific. The Flying Tiger Line was able to fly coast to coast such cargo as penicillin, fruit, furniture, dresses, wine, 8,000 baby chicks, and many other random items that needed to be moved on an urgent basis. One enthusiastic farm implement company executive told Bob Prescott, the founder of Flying Tigers, in 1946, "If we could slash our inventories by using airplanes to assure one-day service on replacement parts from the factory, we could pass on important savings to our customers." That observation was as true yesterday as it was at the end of World War II. But in fact, it would take a confluence of three factors in the 1970s to make Flying Tigers a viable company as the air cargo industry matured and became a major force in the world's economy. One was the rise of the four Asian tigers and Japan in the decades after World War II. Second was the increased manufacture of electronic products in those countries. And the third was the introduction of the Boeing 747. Beginning in the 1960s, Japan, Hong Kong, Singapore, Taiwan and South Korea evolved into major manufacturing locations. This was particularly driven by the purchase of electronics and automobiles by American and European consumers. Significant investment in these Asian countries, including modern infrastructure and high-tech factories, produced high growth rates that continued well into the 1990s. The world economy was booming so much in the 1960s that travel and transport demand had outgrown the airliners then in service. But as we all know, in January 1970, Boeing changed the game when it introduced the 747 that revolutionized aviation. Its operating costs were an attention-getting 30% lower per passenger seat or unit of payload than any other commercial aircraft. It was two and a half times bigger than the largest jet airliners in service at that time, the Boeing 707 and the McDonnell Douglas DC-8. The freighter versions of these latter four-engine aircraft and a few cargo and convertible versions of even smaller 727s, DC-9s, 737s and BAC 1-11s were put in service in niche markets. However, none of these all-cargo aircraft produced profits for their operators. There simply wasn't enough high-yield point-to-point freight to justify flying an all-cargo aircraft in general service. Of course, there were niche exceptions to that, Alaska and so forth. Now, if any of you attended Joe Sutter's site lecture here five years ago, you know how the 747 became a great cargo airplane. In that speech, Joe tells the story of how in the 1960s, Boeing was competing for a contract to develop a jumbo freighter for the US Air Force. The SST, or supersonic transport, was viewed by almost everyone in the industry as the passenger plane of the future. However, after they lost the Air Force competition to the C-5A, Boeing focused on a passenger version of its 747 design, but it viewed it only as an interim passenger aircraft to be shortly replaced by the SST. To make sure that the 747 remained viable after the passenger business went supersonic, it was decided to also make the 747 an excellent commercial freighter for its afterlife. Of course, no American SST was ever built, and the European Concorde proved to be uneconomical. As a consequence, the 747's compelling costs as both passenger liner and freighter created significant increases in demand for travel and shipping by air. In the latter regard, the 747 air freighter for the first time gave air cargo a starring role in the air transportation system instead of its being an afterthought in the underbellies of passenger planes. Now, finally you had the plane to carry computers, electronics and high-value perishables such as flowers across vast distances. The international air cargo market came to resemble the sea freight and surface freight markets with large point-to-point consolidations. As the 747 began to dominate long-haul services, an upstart network called Federal Express began flying from Memphis in the spring of 1973 with less than 200 packages rattling around in 14 small Dassault Falcons going to 25 cities on our first day. The FedEx hub-and-spokes distribution system was one uniquely developed to deliver overnight express packages from one point to any other on the network. This capability was unprecedented. Also, we created an integrated air/ground express network that was a first in the air cargo industry. And we understood at FedEx that information about the package is as important as the package itself, so we also originated the first tracking system to enable people to keep tabs on their shipments. Federal Express's creation was driven by the automation of society and the incoming use of computers and electronic devices for many applications. There was a growing need to move small, important shipments randomly throughout the US absolutely positively overnight, as our iconic advertising touted in those early days. So combined with deregulation in the 1970s, you had all the elements in place for air express and air cargo to materially change modern logistics in the long-distance international marketplace. The right plane, the 747F, and the proliferation of high-tech, high value-added goods around the world built unprecedented prosperity throughout Asia and connected both North America and Europe to all parts of the world with almost unbelievable economics compared to the past. At the same time, the new US air express delivery model made domestic all-cargo operations profitable. These two developments came together in the 1990s as FedEx began to meet customers' needs for international air express shipments by expanding abroad and by purchasing Flying Tigers in 1989 for its extensive route authorizations and facilities, particularly in the burgeoning Asian market. Subsequently, with the growing importance of air commerce, most international bilateral aviation treaties were liberalized to allow freighter operations to align with global trade flows. Now, all these factors combined to usher in the golden age of air cargo. Today, international air cargo and air express is a $78 billion business that transports 35% of the value of all goods traded internationally, worth some $1 trillion dollars, but it represents only 2% of the tons moved. In 2010, the value of goods transported by air was about $32.70 a pound, as compared to $0.87 per pound for goods moved by sea. Air cargo is a critical part of the airline business, which is part of a value chain that supports 32 million jobs and $3.5 trillion of economic activity around the world. Now, at the same time the air cargo industry was transforming into a major worldwide business, the shipping business was also undergoing big changes. I think the story can be told through the life of one man, Malcolm McLean, a friend of mine who passed away 11 years ago. Malcolm invented the shipping container, a contribution to maritime trade so phenomenal that he has been compared to the father of the steam engine, Robert Fulton, according to a Harvard Business School article. McLean began as a truck driver during the Depression who saw all the time being wasted as he waited at port for stevedores to unload truck cargo and put it onto ships. By the 1950s, states began adopting new trucking weight restrictions and levying fees. McLean saw a way around all of this through the use of coastal shipping vessels which could handle most of the transport but work in tandem with trucks that could then make shorter, lighter-weight hauls to final destinations. This eventually led to his invention of the box, or the cargo shipping container, constructed of heavy steel to protect contents and withstand rough seas. These standardized containers were stacked in the holds of ships. Eventually, ports redesigned their dockyards to accommodate the lifting and storage of these containers. The labor savings and efficiencies, in addition to the ability to transport more cargo across oceans to Asia and Europe, gave a much-needed reinvigoration to the shipping industry that continues to this day. Now, over the years, these container ships, unlike aircraft, have gotten bigger, better and quantumly more efficient to run. Today, they run more than three and a half times the size of a football field and have capacities up to 15,000 20-foot equivalent units. On the other hand, the 777F, today's most efficient long-range air freighter, while more cost-efficient and longer range than the original 747Fs, is not materially larger than the early 747s from 40 years ago. As you can see from this slide, one of the largest container ships today has 138 times the capacity of the Boeing 777's payload of 112 tons. With the massive growth of the sea container market, customer service over the last several years has improved significantly, with daily sailings between most major ports, better schedule reliability and enhanced shipment information capability. Now, why do I share information about the evolution of maritime shipping with the Wings Club? Because open ocean shipping is inextricably tied to the air cargo industry and accounts for many of the changes we are seeing for the future of air cargo. Now, some of these trends actually hark back to those that emerged post-World War II, but now instead of the Asian tigers, you have the rise of the BRIC countries: Brazil, Russia, India and China. These countries, along with other developing nations, account for the majority of world trade and growth. The rise of China into an economic superpower has been nothing short of astounding. Over the last decade, manufacturing in China has produced consumer goods at lower prices than could have been imagined just a few years ago. In addition, it has become the world manufacturing center for high-tech and high value-added goods like electronics that are small but produced in great numbers. And in this age of instant technology gratification, the world is hungry for these products, all on display at your fingertips over the internet. Now, of course, that's been very good for express air cargo. We take care of all of the details such as customs clearance and provide, in essence, a clipper ship service for the computer age. You can see from the next chart the strong correlation between the air cargo business and billings for semiconductors, those parts so critical to computers, smartphones and other high-tech gadgets. But as we all know, there's a cloud hanging over today's industrial horizon, and that's the high price of oil. It's a villain we didn't have to deal with mid-century in a world of cheap gas and tail fins. We've certainly had our challenges in the last four decades with the price of oil. I'll never forget in the fall of 1973, the first oil embargo and the effect that it had on a fledgling FedEx. We almost went under before we'd barely begun. But for the most part, during the late 70s and through the 90s, we enjoyed cheap oil. In 1999, it's hard to remember, but oil was $16 a barrel. In July 2008, a barrel increased to $147, a 900% increase in less than a decade. It's important to note that global oil prices in recent years reflect the increase in demand of emerging economies versus temporary supply disruptions that caused price spikes and economic slowdowns in the 1980s and 1990s. In this regard, I strongly recommend the May 8th report of Securing America's Future Energy, which you can get online, which gives an excellent comprehensive analysis of petroleum markets today. Given these trends, it should not surprise you that FedEx Express began several years ago a major air fleet modernization program that will substantially reduce the amount of fuel required to move our airborne traffic. We're also researching biofuels and using more electric power and natural gas in our vehicle operations to reduce cost and petroleum consumption at the corporate level. But with high fuel prices, it is increasingly expensive for all kinds of transportation, but it's been hard on aviation because, as we all know, planes consume vast quantities of jet fuel. Let's compare a 747 and a large container ship both going from Los Angeles to Hong Kong. For a ship, it takes one ton of fuel to move 330 tons of cargo. For the plane, it takes about 330 tons of fuel to move the same amount of cargo. The result of such high fuel cost is a muted profit outlook near term for air cargo as a whole. In short, traditional air cargo profitability is being squeezed by spiking fuel prices, lower volumes of electronic shipments and falling yields. According to IATA's most recent report, growth will be anemic in the US and Europe but positive worldwide due to the strength of emerging markets that I just mentioned. Des Vertannes, IATA's global head of cargo, said, "Despite a positive outlook for world trade, the mix of freight and increasing cost is favoring maritime over air." All those big ships I mentioned earlier are nibbling away at the air cargo business, and those bites will become bigger when the Panama Canal expansion is completed in 2014. The expansion will permit large ships from Asia to travel directly to our East Coast ports instead of all floating on the west coast and shipping them cross country by air or road. With 15% of the world's maritime fleet unable to use the canal today because the ships are too large, the expansion project will have a major effect on world trade. The next chart I'm going to put up demonstrates more clearly what's happening between air cargo and sea cargo. As fuel prices have increased over the first decade of the 21st century, air express, thank goodness, has been growing, but commodity air freight has been stagnant, and these trends are expected to continue unless there is a substantial reverse in energy cost. Now, at a certain value per kilo, air freight can actually be a cheaper means of transport than ocean. As you can see from this chart, if the value of the cargo is high, it's actually cheaper to move by air rather than sea and avoid high carrying cost for a lengthy ocean voyage. But as fuel costs rise, the more valuable the cargo must be per pound to justify shipping by air, but less expensive shipments are more often going by sea. To give you a real-life example of air-to-sea mode shift, let's look at a perishable, high-value retail product that most of us use from time to time: cut flowers. The cut flower business has long been mostly the preserve of the air freight industry, but like everyone else, flower shippers are now looking to cut cost. A recent article in Air Cargo Management described a joint venture between Flora Holland, operator of the largest flower auction in Europe, and TransFresh, a subsidiary of fruit producer Chiquita. TransFresh specializes in controlled atmosphere shipping containers which can better handle fragile cargo such as cut flowers, which not only need a certain temperature but also reduced air in the container to curb blossom degradation. Combine that with the much lower cost of sea shipping compared to air, and you can understand why the flower industry is keen to shift more of its supply chain to ocean transport. One consultant discussing Kenya's rose-growing industry estimated that in five years' time, you'll see about 20% of Kenya's flower volumes transferred from air to sea. In the largest cargo lanes, high fuel prices make it difficult to fly all-cargo freighters profitably, with 3:1 and 2:1 traffic imbalances between Asia and Europe and Asia and the US respectively exacerbating the problem. Moreover, international air cargo is becoming more volatile, with both the frequency and amplitude of business cycles increasing and electronic product introductions becoming more episodic. This makes it very difficult for many operators to effectively utilize all-cargo aircraft over longer periods of time. Despite these factors, air freight yields have been declining in real terms for many years, while new main deck all-cargo capacity has been increasing. So in general, freighter flying has finally gone back to the future, where most operations are marginally profitable at best. The takeaway from this evolution of the air cargo industry is that the air express sector will continue to grow long-term as the integration of the world's economies generates more small shipments moving directly from point of production to end user. Another major factor undermining the future market for main deck commodity air freight services has been the significant additional underbelly capacity produced as a byproduct of long-range passenger services. These relatively small compartments and the containers and ULDs that fit in them lend themselves to the movement of smaller shipments being pulsed out around the world. In short, the bigger commodity consignments are increasingly moving by sea, and dedicated express networks and underbellies are capturing more urgent, lighter shipments. So in many ways, the future of air cargo is akin to the early days of the industry when planes carried the mail or some other small, valuable product, as opposed to the larger shipments that went on the sea. One of our customers, Metatronics, which manufactures hearts and valves and surgical kits, is a perfect example of that, moving emergency shipments throughout our network and putting their parts in forward stocking locations where we can move them out in the shortest possible time frame. Now, at FedEx, we will continue to work hard to take advantage of that express air cargo sweet spot and bundle it with our ground, freight and ocean capabilities to remain a key player in the evolving air cargo industry. It's been part of our strategy for quite a while to make sure we can offer our customers every major shipping option possible. It's been said many times that the only certainty in life is change. That's been true in my life, and it's certainly been true in the life of FedEx. No matter what's happening in our industry now, I'm sure it will not be the same 10 years from now, but that's what makes the journey so exhilarating. And Back to the Future: Marty is berated by his principal as being a slacker just like his old man. The principal says, "No McFly has ever amounted to anything in the history of Hill Valley." To which Marty retorts, "Yeah, well, history is going to change. It always does." Marty, at FedEx, we're looking forward to it, and I hope all of you are too. Thank you.

If anyone has a few questions, we'll be glad to take them. The question is: what happens to the Postal Service over a long period of time? While the package business is an important business to us, it's really a quite small component of the Postal Service's business, and they are looking, by their own figures, at a revenue degradation of about 7% per year, a mail volume degradation, as everything moves to digital transmission. I did a little home survey at my house of all the mail that came into my house over six months as to what could not be digitally transmitted. I'm not talking about packages, obviously, but the only two things I could find were credit cards, which are likely to be in your smartphone in the future, and the little sticker that went on my license plate that said it was renewed for another year. So this is, and I don't say those things facetiously, I'm just giving them as examples. Think about what you receive at your house. So I think the Postal Service, being very clever with their no-address direct mail you see advertised and so forth, but the real question is what happens to the postal service, and will there be a postal service? So we look at that as both a risk and an opportunity, because if they're not in that business, obviously the traffic is going to go someplace. But I suspect that they'll be around for some period of time. The Congress should let the postmaster do what he's recommended, but of course, politics being what they are, they won't let him do what he's recommended, so we'll just have to wait and stay tuned.

Well, we are expanding into domestic markets around the world. We bought a great company in the United Kingdom several years ago; it's doing very, very well. About a year ago, we bought a terrific company in Mexico, and it has really been a jewel. We have recently bought companies in Poland and France which are involved in the domestic trades in those businesses, and we've announced inside Europe a significant organic expansion into the intra-European ground and domestic markets, either indigenous expansion or with these tuck-in acquisitions. So we will definitely be doing that. Obviously, some of the other markets we're looking carefully at, and so we do intend to expand overseas. It lowers our pickup and delivery cost for intercontinental traffic, and it gives us a broader portfolio to sell to the customers, which, as the IT people would say, is a very sticky relationship.

Thank you.