What Should UPS and FedEx Do With SurePost and SmartPost?

By Markets Fool.com

In an earlier article, I looked at the three big changesfacingFedEx Corp. and United Parcel Service in the shipping marketplace. Two of them, the shift in consumer preference toward slower/lower-cost delivery options and burgeoning e-commerce deliveries, have contributed to the growth of FedEx's SmartPost and UPS's SurePost. Both services offer lower-cost ground delivery options and use the U.S. Postal Service, or USPS, for final delivery to residential consumers. As such, SmartPost and SurePost both carry risk due to their reliance on the USPS. Let's consider those risks, and why they matter to FedEx and UPS.

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SmartPost and SurePost
The two businesses share three principal risks, each related to the use of the USPS for final delivery:

  • USPS is a self-supporting governmental agency, and is therefore subject to a significant amount of public influence over its business operations.
  • Using USPS for final delivery suggests a loss of control over service quality for FedEx and UPS.
  • USPS partners with FedEx and UPS, but it's also a competitor and has been increasing its efforts to win e-commerce package delivery business.

Political risk
Despite being intended as a self-supporting entity, USPS reported a $5.5 billion loss in 2014, and is laden with significant retiree healthcare obligations. As such, discussion of future postal reform is never far from the political agenda. Whether any future reform will affect the business relationships with FedEx and UPS, and particularly with SmartPost and SurePost, is unknown at this point, but it's obviously an issue.

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USPS delivering for you -- and also for UPS and FedEx. Source: USPS.

Quality control
Second, ensuring customer satisfaction is a key component of protecting the brand name of both FedEx and UPS. Indeed, UPS profitability suffered during the last holiday season as it invested in ensuring high-level service during peak demand. With this in mind, the arrangement with the USPS confers a loss of control for FedEx and UPS.

Essentially, deliveries are made to the local USPS hub, and postal workers then deliver the parcels to residential customers. Given that the USPS fell short of its own goal for customer satisfaction last year (a rating of 74.8% versus its target of 82.5%), it's somewhat concerning for investors that both companies rely on USPS in this manner.

Increasing competition
The U.S. Postal Service is increasing its efforts to compete with both companies. For example, it offered seven-day-a-week delivery during the last holiday season.Moreover, it was reported to have aggressively cut prices in order to take business from FedEx and UPS.This is a reminder that , despite being leading players, both businesses face competition. Indeed, FedEx reported that SmartPost volume declined 7% in the third quarter due to the loss of a major contract.

What it means to FedEx and UPS
The loss of that contract wasn't a huge issue for FedEx; after all, SmartPost only contributed 4.3% of total revenue in the third quarter, and even with the decline in volume, the program's revenue actually increased 1%.

In truth, SmartPost and SurePost contribute much more in volume growth than they do in profit. FedEx's ground daily volume (as distinct from FedEx Ground segment volume) was 2.2 times that of FedEx SmartPost, and the former contributed more than 10 times the revenue of the latter.

The story is similar with UPS. The company doesn't break out SurePost revenue in its reporting, so it's hard to get a handle on the program's share of revenue. However, according to the company's most recent annual 10-K filing, "UPS SurePost volume increased more than 45% in 2014, and accounted for approximately half of the overall volume growth" for the U.S domestic package segment. The segment, though, only grew revenue by 5.2% and adjusted operating profit by 1.6% in 2014. In other words, the 45% increase in SurePost volume didn't lead to a significant jump in overall revenue and volume growth.

The takeaway
SmartPost and SurePost both carry risks due to their reliance on the USPS, but the two services don't yet contribute a significant amount to profitability for FedEx and UPS. As such, both companies could probably stomach some increased competition from the USPS, particularly if it only results in losing low-margin work.

The question for FedEx and UPS is whether they want to carry on increasing SmartPost and SurePost shipping volumes, and carry the risks outlined above, or rein in volume growth by trying to shift retailers to their traditional ground offerings.

My view is that both management teams shouldn't focus too much on expanding SmartPost and SurePost, and instead try to maximize profitability in their ground operations via being selective in the type of delivery work they take on board.

The article What Should UPS and FedEx Do With SurePost and SmartPost? originally appeared on Fool.com.

Lee Samaha has no position in any stocks mentioned. The Motley Fool recommends FedEx and United Parcel Service. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.