What FedEx Corp.'s Results Mean for United Parcel Service's Prospects

By Markets Fool.com

The market gave a warm welcome to 's recent estimate-busting quarterly results, but does that imply that is also set to deliver strong numbers when it reports next month? It's always interesting to compare the rivals -- not least because they report in the middle of each others' quarters -- so let's take a look at what FedEx's results imply about UPS' business trends.

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SOLUTIONS LIKE UPS ACCESS POINT ARE EXPANDING TO SERVICEECOMMERCE GROWTH -- AND SEBASTIAN VETTEL. IMAGE SOURCE: UNITED PARCEL SERVICE

Five key themes
FedEx's third-quarter earnings were discussed in more detail in an earlier article, so let's focus here on the takeaways that are relevant to UPS:

  • Peak demand and e-commerce delivery continues to exceed expectations.
  • FedEx's ground operating income margin fell to 12.6% in the third quarter compared to 16.5% in the same period last year, partly pressured by peak and e-commerce demand.
  • FedEx is undertakingpricing initiativesin order to increase margins and adapt to customer behavior.
  • Capital spending requirements increased.
  • 's recent cargo network expansion might not be a competitive threat.

Starting with peak demand and e-commerce deliveries, Executive Vice President Michael Glenn described a "historic" peak season "driven by the continued growth of e-commerce." Moreover, he outlined how residential deliveries exceeded expectations in the quarter, amid talk of a "retail revolution."

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For example, Glenn disclosed that FedEx had multiple days of delivering more than 25 million packages. This kind of bullish commentary is important at a time when business-to-business deliveries are under pressure due to a slowing industrial economy. FedEx and UPS need strong residential delivery growth in order to offset weak industrial demand.

Takeaway: E-commerce delivery growth appears to be strengthening for UPS and FedEx.

Ground margin
While increasing e-commerce demand is obviously a positive, it can also produce margin pressure. For example,evidence suggests that the cost of servicing peak demand during the holiday season is significantly reducing the historic boost in profitability that occurs in UPS' fourth quarter.

Indeed, FedEx's ground margin declined by 390 basis points (where 100 basis points equals 1%), with 60 basis points attributed to higher costs driven by peak demand based on volume and package size, according to CFO Alan Graf. Purchased transportation costs reduced margin by 30 basis points and network expansion by a further 30. In other words, 120 basis points of that margin reduction could arguably be blamed on the cost of servicing strong e-commerce demand.

Takeaway: Burgeoning e-commerce demand is a positive for revenue growth, but is also pressure operatingmargins.

Pricing initiatives to influence customer behavior
CEO Fred Smith talked of the "extraordinary growth of oversized shipments" in the ground segment, and Glenn outlined how FedEx would start applying a surcharge for packages longer than 60 inches; the length at which the fee kicks in will be reduced to 48 inches in June.

In common with pricing initiatives made by UPS to smooth out peak demand, and a dimensional-weight pricing model adopted by both companies, FedEx is taking additional measures to moderate customer behavior and maximize profitability.

Takeaway: Expect UPS to similarly implement more pricing changes to increase margins.

Capital spending
Smith disclosed that FedEx was investing in fleet modernization (for its express segment) and expanding the ground segment's facilities. Graf went on to suggest that capital spending would come in around $5 billion annually during the next couple of years, excluding spending due to the TNT acquisition. Most of the spending increase relates to the ground segment, and as you can see below, that would be a significant increase compared to previous years -- which is likely to pressure free cash flow growth.

DATA SOURCE: FEDEX CORPORATION PRESENTATIONS, ANALYST ESTIMATES. DATA IN MILLIONS OF U.S. DOLLARS; EXCLUDES CAPITAL SPENDING ON TNT.

Takeaway: FedEx's increasing capital expenditure requirements confirm the need for delivery companies to spend in order to service e-commerce demand. UPS has been forced to do the same in recent years.

The Amazon "threat"
FedEx's management spent time addressing Amazon's recent moves to expand its own delivery network. Glenn argued that Amazon's strategy was to make local deliveries from Amazon distribution centers. Local deliveries aren't typically FedEx's market, and he repeated the assertion, made by UPS CEO David Abney, that FedEx and UPS continue to see Amazon as a good customer rather than a threat.

Takeaway: The Amazon threat makes great editorial copy, but UPS, the U.S. Postal Service, and FedEx will remain the key players in domestic e-commerce deliveries.

The bottom line
The trends in FedEx's earnings are broadly positive for UPS, but investors need to keep an eye on the increasing cost of servicing e-commerce demand. UPS stock is likely to suffer if the company is forced to increase capital expenditures or cut margin guidance.

While fears of Amazon eating UPS' lunch are largelyoverblown, it will be interesting to see if UPS implements new pricing initiatives to manage burgeoning e-commerce demand. In short, business trends remain in favor of both companies, but look out for margin and capital spending guidance.

The article What FedEx Corp.'s Results Mean for United Parcel Service's Prospects originally appeared on Fool.com.

Lee Samaha has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Amazon.com and FedEx. The Motley Fool recommends 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.