Online Extra: Fred Smith on the Birth of FedEx

Without a question, FedEx Corp. has been one of the great entrepreneurial success stories of the past quarter-century. From the legendary college term paper in which Frederick W. Smith first advanced his idea of an overnight-delivery service to the infamous trip to the Las Vegas casinos -- where he won enough hands of blackjack to help meet a payroll -- the story of how Smith built FedEx (FDX ) into a $27 billion delivery juggernaut has become a part of Corporate Americana. Smith recently sat down with BusinessWeek Atlanta Bureau Chief Dean Foust to discuss the history of FedEx. Edited excerpts follow:

Q: Part of the lore of FedEx is that you wrote a term paper while a grad student at Yale that first explored the idea of an overnight-delivery service -- and that you received a C from a skeptical professor. Was that term paper truly the genesis of FedEx?

A:

The question is prescient because there wasn't a single "eureka" moment. The original idea for FedEx came when I wrote a term paper as an undergraduate -- not as a graduate student, because I never went to graduate school -- about a very simple observation: As society automated, as people began to put computers in banks to cancel checks -- rather than clerks -- or people began to put sophisticated electronics in airplanes -- society and the manufacturers of that automated society were going to need a completely different logistics system.

That was becoming obvious to me both from just reading about it from an academic standpoint, and in those days I used to fly -- I was a charter pilot at the Tweed New Haven airport. I flew around to those airports up there, and all those high-tech companies, including IBM (IBM ) and Xerox (XRX ), that's what their pilots used to talk about -- what a difficult proposition it was to keep their field-service engineers and their parts and logistics systems operating. In fact, a lot of the corporate airplanes up there were doing nothing more than flying [computer] parts and pieces around...when the computer would break down.

That was the paper, and the whole issue about the C on the grade, came from naivete on my part when I was talking to a reporter years and years ago, and he asked what I made. I said, "I don't know, probably made my usual C."

Q: So did you, or did you not make the infamous C on the term paper?

A:

I don't know. It was so long ago, even when that question was asked 20 years ago, I didn't know. I've tried to correct it many times, and usually when a journalist like you listens to the story and realizes how complex the story is, you realize it would take your whole profile to explain it.

Q: What happened after college?

A:

I went off into the Marine Corp, and when I came back, I picked the idea back up. And that's when I started thinking about how you could solve this problem. And the problem had become significantly worse.

If you go back and look at the data, you'll find that in the late '60s and early '70s, when I was coming out of the Marine Corp, the highest p-e stock on the New York Stock Exchange was Emery Air Freight, which was trying to solve this exact problem, but they were trying to use an infrastructure built around mostly passenger air transportation -- the airlines -- which wasn't designed to handle it at all. So they were force-fitting the rapid movement of high-value-added and high-technology products into a transportation system that wasn't designed for it.

So all FedEx was, was a customized system that was designed to solve this problem, to provide transportation capabilities for parts and pieces of the modern age, where you could go from Armonk [N.Y.] to Abilene [Tex.] on the same time cycle that you could go from Armonk to Chase Manhattan [Bank] down in lower Manhattan. To do that, you had to have a nationwide clearinghouse. And it had to be an integrated system where you had trucks and planes in order the give the level of service [that customers needed].

For our network, I used as a model the economic activity of the Federal Reserve banking system, because it was in those days a perfect model of the economic activity in the U.S. And that's where the [Federal Express] name came from. It just stuck in my mind. I wanted something that sounded substantial and nationwide, and American Express had already been taken [laughs].

Q: You're credited with being a pioneer of the hub-and-spoke system.

A:

Delta [Air Lines DAL ] was really one of the pioneers of the hub-and-spoke system. But it was all made possible because the government began to deregulate. Prior to that time, both surface and air transportation were erroneously based on linear routes, so when things began to relax, people could put together networks based on logic.

That is a very big part of the FedEx story which has hardly ever been commented upon: The parallel effect of the relaxation of government regulation which allowed FedEx to begin operations to begin with, in what was really a loophole. And then it was codified when airlines were deregulated in '77-'78. And then in 1980, the federal government deregulated interstate transportation. So it was [deregulation], much of which we induced.

Q: Many Americans probably best associate you with delivering documents, but you're saying the business was really built on delivering spare parts?

A:

[Document delivery] wasn't even permitted from a legal standpoint until 1978, because the Postal Service had a monopoly on delivering mail. They relaxed their standards in 1978 as to what constituted an item that was covered by their monopoly because they...were getting murdered by the Merrill Lynches and others that were trying to move these bond "Blue Books" and these financial prospectuses. They were being assaulted by all these [corporate] users who were saying, "Look, I can't live with the kind of service you're providing."

So they exempted certain types of publications and documents from the postal monopoly. It was called the Private Express Statutes. As long as you were delivering something overnight, and you charged twice as much as the First Class postage stamps, then it was exempt from the Postal monopoly. So we went into that business. But it was driven by exactly the same need by the white-collar trades that the IBMs and Xeroxes had.

Q: Did you have a hard time convincing Wall Street to buy into your dream and fund your startup? Was it a hard sell to get venture capitalists in?

A:

It was a hard sell in certain ways. The FedEx proposition came along when the venture-capital business was really looking for more prosaic types of investments, where you didn't have to create a product and a market all at the same time. By the time we finished the financing, we had three independent marketing studies that indicated that [our] original premise was correct.

We didn't have to create some completely new technology. We used existing technology -- planes, trucks. And then once we put the network in place...the secret was to get the network up fast enough to have a product to sell. But from the minute we started operations, with almost no exceptions, the traffic continued to rise.

Q: How small was the original FedEx network?

A:

We started out with eight planes and we covered something like 35 or 40 cities and we added each month.

Q: Any surprises from where you envisioned the business was back in 1973 to where it is now?

A:

I knew the idea was profound. There wasn't any doubt in my mind about that. The fundamental forces that were driving it were inexorable. But I don't know if I foresaw the way things evolved. I think you meet circumstances the way they come, and then you adapt to them.

In addition to the fundamental idea, and the deregulation that went on, a companion thing happened that was very important for FedEx and for the business world. It occurred to me very shortly into this proposition that it was self-limited if we couldn't constantly improve what we were doing. If people were going to use FedEx in lieu of having incalculable amounts of money tied up in inventories, it "absolutely, positively" had to be there when promised. The business had to operate with a level of precision and reliability that heretofore had not been possible in the service business.

And that led to the very simple recognition that we had to use information technology to an extent that had never been done before. We had to basically create a whole industry to do that.

It wasn't just the tracking system. We had to develop a completely new printing methodology. Nobody had ever crash-printed sequential, bar-code-readable numbers. They'd printed lots of universal product codes for soup cans. But they'd never printed "multiform, sequentially numbered" things that could be machine-read.

And no one had ever contemplated building a handheld computer that was this small [holds his hands close together] and then communicating that information on a real-time basis. We had to assemble all these radio frequencies and put the equipment in the truck. When we developed this tracking system, it meant you could actually keep up, for the first time ever, with inventory that was moving as well as inventory that was stationary.

Combined with the deregulation that I mentioned, this has allowed just monumental change in the way businesses run their supply chains. Absent those two things, you wouldn't have Wal-Mart (WMT ), you wouldn't have Dell (DELL ). You wouldn't have logistics costs going from 16.5% of GDP down to about 9.5% today.... I don't know of any other human activity of the size and scope of U.S. logistics where costs have gone from 16.5% of GDP to 9.5% in 25 years. That's a big deal. That's what's allowed us to spend much more on Lipitor and stuff like that [chuckles].

Q: For all of your company's successes, one notable failure was ZapMail back in the 1980s. Why did it fail?

A:

All Zap[Mail] was, was the recognition that space technology was going to allow you to have little-bitty satellite dishes, because you could put up a great big antenna [on a satellite]. We'd gone into the document business. We'd gone into the technology sector. And it occurred to us that with the Space Shuttle, you could build a very, very big antenna in space, and the movement of images or documents could be done digitally with these small satellite dishes.

The target market was people with branches. So we would go to people who had 300 branches, and say, "We'll put these little dishes up on your roof, and put a digital facsimile in here for you. And if you also want us to deliver it, we'll deliver it. You won't get it in two minutes, but you'll get it within two hours." So we'd zap it through the network and deliver it.

Q: So why didn't it succeed?

A:

Because the Challenger blew up in 1986. We started [ZapMail] off in a hybrid fashion. The original network -- I'm sure our technologists wouldn't like this -- but it was kludged together through landlines [phone lines]. The idea was that we'd launch the satellite and then disconnect the landlines, and what you'd have is the same thing we'd done in the transportation business -- nondiscriminatory levels of service regardless of the traffic lane. If you had a branch in Outback, Montana it could communicate with the home office in Manhattan just as if it was sitting right down the street.

What I just described to you was the [ultimate] plan for Zap. But you couldn't launch a satellite that's as big as this building with a rocket. It had to be in the Space Shuttle. We had a contract with RCA (GE ) to launch the satellite, and once the Space Shuttle blew up, then the business proposition was no longer viable. Had [the Challenger tragedy] not happened, this company might have gone down a different axis.

In retrospect, it was never a "bet the company" thing. It was a very small write-off in relation to the advantages we got. Had it succeeded, I don't know that FedEx might not have been a very different type of a company.

Q: You talked about the contributions that FedEx has made to the "just-in-time" inventory revolution. Where do you think the business goes from here? What's the future?

A:

The thing about FedEx today is that it kind of lives in the midst of a force field, as I like to describe it, of three or four things that are going on:

One, the revolution about fast-cycle distribution in logistics continues -- for lots of different reasons -- but the fundamental reason is that if you come up against a competitor who's using this methodology and you're not, he wins and you don't. Dell is able to do what it does because it's got much better fundamental economics than some of its competitors because it has built around this fast-cycle DNA. I could give you a hundred different examples.

The second thing is globalization. The movement of goods across borders is increasing at a rate that is, depending on the year, three to four times the rate of growth of goods production in general. The statistics in the last decade were 10% for the former and 2.5% for the latter.

The third thing that's going on is that of the things that are produced, more and more of them tend to be high-tech or high-value-added. The number of chips in an automobile is unbelievable. I just got a new TrailBlazer to substitute for my old TrailBlazer. In the new Trailblazer, it looks like I'm in a [Boeing] 777. All of this navigation [instruments] and XM Radio and so forth.

And the last is the growth of the Internet. What the Internet allows people to do for the first time in human history is to communicate with a standard protocol at extremely low cost and provide whatever someone wants to sell in a visual basis.

So you take all four of those things...those are very profound trends, and we sit right in the middle of those. And there really aren't many competitors in that space. FedEx has got very big markets, a very good position.