Industrials

Brooke Sutherland is a Bloomberg Gadfly columnist covering deals. She previously wrote an M&A column for Bloomberg News.

(Corrected )

United Parcel Service Inc.'s holiday-season scorecard is out, and for the third year in four it reads   e-commerce: 1, company: 0.

The $96 billion package-delivery company on Tuesday reported weaker-than-expected earnings-per-share for its peak holiday quarter and underwhelmed analysts with its outlook for 2017. A significant part of UPS's earnings woes are related to the strong U.S. dollar, but the company also cited a huge (11.5 percent) surge in shipments to residences from businesses. That online shopping boost is great for revenue, but not for margins. UPS's brown trucks typically only drop off one package at a time when they deliver to homes and have to make more frequent stops, resulting in higher costs.

Feeling the Pinch
UPS has faced margin pressure in its U.S. domestic package segment,
Source: Bloomberg

It's the latest example of UPS getting caught somewhat flatfooted by the e-commerce boom, and that's making the threat posed by Amazon.com Inc.'s recent interest in starting its own logistics business loom all the larger. UPS and its rival FedEx Corp. have tried to downplay the immediate impact of having the e-commerce giant as a competitor and Amazon for its part has insisted it's trying to supplement the carriers rather than replace them, despite a steady drumbeat of investments in shipping capabilities

And yet, UPS keeps giving investors reason to be concerned. After being under-prepared for the holiday rush in 2013 and over-prepared in 2014, UPS finally seemed to get a handle on package volume and hiring for its peak season in 2015. To its credit, it appears to have been successful on that front again in 2016. But delivering packages on time is one thing; doing so at a manageable cost is another and that's what threw things off kilter. UPS shares dropped as much as 7.1 percent. 

Damaged Goods
The slide in UPS shares was steep on Tuesday. The last time it declined by this much was following the company's disappointing report on the 2014 holiday season.
Source: Bloomberg

Riding the wave of its 2015 holiday season triumph, UPS initiated 2016 guidance for as much as $5.90 in adjusted EPS last February, reconfirming that call as recently as November. The actual full-year profit it reported on Tuesday was $5.75, within its guidance range but closer to the lower end. (Interestingly, that's not all that far off from the $5.73 analysts had been calling for going into UPS's 2016 forecast announcement.) 

UPS says it recognizes the need for new initiatives to deal with the surge in e-commerce traffic and it's upping its capital expenditures to about $4 billion in 2017. That money will go toward further automating its network, building on the success of its Orion vehicle routing system, which draws out the most efficient path for drivers. Increasing its network investments makes sense, but it also makes sense for investors to wonder when all of this spending is going to pay off in higher margins.

Delivery Problems
UPS missed analysts' fourth-quarter adjusted EPS estimates by the widest margin since the first quarter of 2014
Source: Bloomberg

Another way UPS plans to deal with the surge is through pricing. Both UPS and FedEx now charge based on size, rather than just weight, in an effort to cut down on inefficient packaging and cram more deliveries onto their trucks. In November, among other things, UPS said it was modifying its pricing formula in a manner that could yield higher rates for certain packages. UPS had promised to raise ground rates by an average net 4.9 percent starting in December, on top of a 4.9 percent increase in 2016 -- and that won't be the end of it. Chief Commercial Officer Alan Gershenhorn said Tuesday that the company would continue to make adjustments to make sure it's aligning its prices with the cost of handling the package traffic.

And this is where we come back to Amazon. The higher the company's shipping expenses, the more motivated it is to invest in its own logistics operations. Corporations that ship in bulk pay discounted rates, but Amazon still spends a significant chunk of its revenue on shipping. Shipping costs amounted to $10.5 billion in the first nine months of last year, a 43 percent increase from the same period a year earlier. Revenue, by contrast, grew by 29 percent through Sept. 30. Small businesses and retailers under pressure to offer free shipping also don't appreciate high prices and the more they're pushed, the more likely they are to consider a cheaper Amazon option as an alternative.

UPS has made a lot of progress on e-commerce deliveries, but it offered little to convince investors that it's shooing the Amazonian elephant.   

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

(The fifth paragraph of this story was updated to add that UPS's earnings were within its guidance range but on the lower end.)

  1. It's also expanding the criteria for packages that require an additional handling charge.

To contact the author of this story:
Brooke Sutherland in New York at bsutherland7@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net