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UPS AT A GLANCE

P/E ► 24.1 AVG EV/EBITDA ► 12.6 AVG ROA ► 6% AVG ROE ► 18.2% AVG Debt to Equity ► 3.61 HIGH Current Ratio ► 1.41 AVG Interest Coverage Ratio ► 5.94 AVG

 

 

 

 

 

 

United Parcel Service (NYSE:UPS) is the world’s largest small-package carrier, by revenue and by volume. UPS offers ground, air, and ocean freight shipping and shipping-related services. Every day, UPS ships approximately 14.4 million packages for businesses and individuals around the world.^[1]

UPS aims to grow by increasing its coverage of global small-package markets and developing its auxiliary businesses. UPS’s earnings in coming years will still depend largely on the U.S. economy. In fact, domestic shipping revenue currently accounts for 63% of UPS's total package business. The dependence on the U.S. economy was apparent in the 2Q09 earnings: UPS lost 4.6% of its domestic volume and reported a 49% decline in earnings.^[1]

UPS has ample opportunity grow in the international parcel shipping market. As a result of globalization, the global economy is expanding at roughly twice the rate of American GDP. Recently, UPS also acquired freight carrier and supply chain management businesses. Both have struggled to date but have the potential to contribute significantly to revenue growth if UPS can cross-market them to its parcel service customers. ^[2] However, international package volume, which is already about 14% of domestic shipping volume, fell by 5.5%, an even larger dropped than that seen in the domestic volume.^[1]

Business Overview

UPS was founded in 1907 by 19 year-old Jim Casey as the American Messenger Company, a private messenger service employing local teenagers in Seattle. In 1913, the company moved from messages to packages, began using automobiles, and started making deliveries for retailers.

Realizing that service for retailers was limited, UPS moved into the parcel shipping business shortly thereafter. Despite legal restrictions that it faced initially, UPS offered parcel delivery services between the 48 contiguous United States by 1975. In the 1980s, UPS began flying packages on its own airplanes to avoid the risk associated with relying on commercial airlines. UPS is now the 9th largest airline in the world.

In the 1990s, UPS launched online package tracking, the UPS Logistics Group, and UPS Capital, which offers customers financing for the supply chain purchases that they ship via UPS. These steps marked the beginning of UPS’s first efforts to expand its services beyond shipping, efforts that remain key to UPS’s growth strategy for the coming years. Today, UPS offers business customers supply-chain management, financing, and the option to incorporate UPS shipment data into their own IT systems. For individuals, more than 6,000 franchisee-owned UPS Store and Mail Boxes Etc. locations across the U.S. offer private mail box rentals, packaging supplies for purchase, and convenient drop-off locations for UPS shipments. These services are available in 24 countries and include about 150,000 access points.^[3]

Business and Financial Metrics

Although UPS was able to operate profitably in 2Q09--the company reported operating and net income of $895 and $445 million, respectively--UPS was nonetheless negatively affected by the recession along all three of its business segments.^[4] As the company's revenue was down 16.7% for the quarter, but its operating expenses were down only 14.0%, the company was unable to prevent net income from falling by over 49% as compared to $873 million in 2Q08.^[4] In terms of its decline in operating expense, UPS was helped by a 54.8% decrease in its fuel related expense.^[4] Moreover, despite a 10.5% decline in consolidated average revenue per piece, average daily volume for U.S. Domestic Packages and International Package still fell by 4.6% and 5.5%, respectively, and revenue for each segment fell by 12% and 23.8%, respectively.^[4]

UPS once again reported net income in 3Q09, though the $549 million figure represents a 43.4% drop as compared to 3Q08.^[5] Operating revenue for 3Q09 declined by 14.9% to $11.153 billion, as segment revenue fell throughout each of UPS's three segments, most notably its Supply Chain & Freight segment, which declined by 19.8%.^[5] In response to declining demand, UPS reduced its average revenue per piece by 11.3% overall, and up to 23.6% with its Next Day Air price.^[5] Nonetheless, this did not prevent a drop in average daily package volume, which fell by 3.9% overall.^[5]

Business Segments

Domestic Package Business (United States)

Parcel services within the United States generate the majority of UPS’s revenues, 61% or $31.278 billion in 2008.^[7] That makes UPS the market leader in the American small-package market, while FedEx was second with 2008 revenue of $11.6 billion.^[8] UPS includes packages up to 150 pounds, via air and ground delivery, as well as letters in its U.S. Domestic Package segment.^[9] UPS seeks to strengthen its position as the leader in U.S. Domestic shipping by reducing shipment times and expanding its related services—tracking, intra-company shipping for customers with multiple locations, and systems integration options that allow large customers to see UPS data on their own information systems. On 29 May 2008, UPS received a major boon to its core domestic package business. Deutsche Post's American subsidiary, DHL, decided to outsource its air operations to UPS.^[10] The arrangement is for 10 years and will add an additional $1 billion a year to UPS's revenues. ^[11]

International Package Business

UPS’s international package business offers parcel delivery between more than 200 countries and territories and domestic service within 22 countries besides the United States.^[9] Although UPS is geographically diversified in this segment, about 50% of revenue is related to shippin gin Europe.^[7] International small-package shipping generated 22% of UPS’s revenue in 2008, or $11.29 billion.^[7] Largely because projected growth in the international small-package market is high, UPS management expects that the international package business will contribute as much as 33% of revenue by 2010.

Freight and Supply Chain Solutions

UPS reports earnings for its freight and supply chain management businesses together. UPS entered the logistics services and ground freight markets in earnest in 2004-2005 when it acquired Menlo Worldwide Forwarding and Overnite Transportation, leaders in those markets respectively. UPS Supply Chain Solutions offers integrated domestic and international transportation, customs brokerage, and supply chain management services including warehousing and financing. These businesses complement one another because they allow customers to store, import/export, and transport large quantities of material entirely through UPS. In 2008, UPS Freight, Supply Chain Solutions, and other auxiliary businesses generated $8.9 billion, or 17% of UPS's revenue.^[7]

UPS Strategies

Maintaining Core U.S. Package Operations

Though the U.S. small-package market is mature, there is still opportunity for UPS’s growth in that market to outpace the projected 3% average annual growth of U.S. GDP. UPS guards its 54% ground parcel market share assiduously and may yet improve it. In 2006, UPS upgraded sort and connection times at 11 U.S. metropolitan area hubs. UPS claims the upgrades improved the ground service delivery times between more than 3 million pairs of zip codes by one day or more.

Further, management hopes to win customers by offering “bundles” of core and new services—parcel delivery and freight forwarding for example—at attractive prices. Using a single company for all transportation and logistics services should be inherently attractive to customers. But no one company offered a comprehensive array of such services until recently, so customers are accustomed to having multiple transportation contracts. Still bundling may become an effective strategy for winning and retaining customers as UPS gains credibility in its newer businesses—freight, freight forwarding, and supply chain management.

Capturing Express Business

It seems UPS may also be seeking to capture market share from competitors in the express market, which offers generally higher margins than ground shipping. While ground shipments represented 84.2% of the UPS’s U.S. domestic parcel shipments in 2008, they brought in only 68.4% of U.S. domestic parcel revenues. In contrast, 8.7% of U.S. domestic parcels shipped via Next Day Air, generating 21.0% of U.S. domestic parcel revenues in 2008.^[7]

Today, UPS holds only 36% of the express market. The primary express competitor FedEx holds 49%. Growth in the U.S. domestic air market has been slow in recent years. Relatively low interest rates have decreased the cost to UPS’s customers of holding inventory, thereby allowing customers to hold more inventory and substitute time-definite two and three day services (still “express”) for overnight shipping. Still UPS is building the capacity to handle increased air volumes and has expanded the coverage area for next-day 8:00 AM guaranteed service almost 60%, suggesting an interest in capturing market share. Next Day Air list prices remain lower overall than prices for the equivalent FedEx services.

Building Global Capacity

To capitalize on growth in the international (cross-border) and global domestic package markets, UPS has made impressive investments. Since 2000, UPS has acquired four parcel carriers serving global markets—Challenge Air Cargo (Latin America), Lynx Express (United Kingdom), Stolica (Poland) and its own Chinese operation, previously contracted to Yangtze River Express. Since 2005, it has doubled the capacity of its central air hub for Europe (Cologne) and plans to triple the capacity of a Philippines hub. International volumes have grown a CAGR of more than 16% in the last 5 years and have grown steadily more profitable. UPS has the resources to continue making strategic acquisitions and expansions. Continued return on these investments will depend on how quickly UPS transforms its current patchwork of hubs into a network that allows for optimal routing around the world. UPS's international network is already reputed to be better integrated and more balanced than competitor FedEx's.

Building Supply Chain Solutions

Supply Chain Solutions has fallen short of expectations to date. The acquisitions of Overnite in 2005 and Menlo Worldwide Forwarding in 2004 increased the scale of the business dramatically. Revenues reached $8.9 billion in 2008, up 5.8% from the previous year. However, operating profits did fall by $383 million, from $278 million in 2007, resulting in a $105 million operating loss.^[7] Freight and SCS’s disappointing performance in previous years was a drag on overall profits and casts doubt on whether “bundling” of multiple services can be an effective strategy in the near future. Critics acknowledge that difficulty integrating the acquired businesses was to be expected. Forwarding and customs brokerage in particular lie outside of UPS’s core areas of competence. Still, service glitches related to the integrations have turned some established Overnite and Menlo customers away. The recovery of their revenues and for this segment during 2008 indicate that UPS has been able to better integrate these services into the company, however, as the only unprofitable segment during 2008, this process has yet to be completed.^[7]

Trends and Forces

As long as UPS depends on its core U.S. package business for the majority of its revenue, UPS stock will be cyclical. U.S. domestic package volume reflects the health of U.S. economy. UPS benefits when other businesses thrive and shares in some of retailers’ holiday season spike. In the 1970s and 80s, carriers like UPS benefited additionally from the growth of mail order businesses. Consumers turning to the internet for purchases they might otherwise buy in stores has had the same effect. Production indexes—particularly the industrial production index—are good indicators of the impact the economy has on carriers because the volume of material produced by the economy correlates more closely to carriers’ volume than the dollar value of that material (or GDP) does.

The growth of UPS’s less developed businesses will depend also on the following macroeconomic trends and forces:

International Trade

Small package shipping now generates about $125 billion in revenues globally, of which about $60 billion derive from U.S. domestic shipments. UPS has 48-50% share in the U.S. domestic market, but more room to grow abroad, where markets are less mature. The U.S. domestic package market is expected to grow about 3% annually, tracking U.S. GDP. In contrast, the international market is expected to grow 5-6% annually in coming years, at nearly twice the rate of global GDP. Increased international trade not only boosts growth in less developed economies, but also results in increased demand for transportation services. Further, international markets are generally more fragmented than the U.S. market, offering more opportunities for large carriers like UPS to grow by acquisition.

Global Sourcing

Increased international trade in finished goods translates into more packages shipped longer distances. But the potential benefits of international trade for UPS are not limited to growth in the parcel carrier market. Many developed world businesses already purchase materials they use from abroad, and this practice, known as global sourcing, is on the rise. For businesses, the downside of global sourcing is complex supply chains that present previously unknown risks. For businesses facing import/export regulations and international transportation logistics for the first time, the appeal of outsourcing supply chain management is obvious. UPS Supply Chain Solutions hopes to capitalize on a projected increase in the market for third-party supply chain managers.

Fuel Costs

Fuel costs represent a significant expense for any transportation business and fuel prices have increased significantly over the last year. UPS spent $4.13 billion on fuel in 2008, a increase of over 39% from 2007.^[12] Fuel costs did decline by 53.8% in 2Q09 as compared to 2Q08, still, fuel costs represent only 5-7% of operating expenses each year, too little to be a driver of growth or share price.^[4] Fuel surcharges, which pass fuel costs on to customers, are standard practice in the transportation business. UPS calculates surcharges for a given period based on fuel prices six weeks earlier, absorbing some loss when prices increase sharply but making a profit on surcharges when prices fall. There is little reason to expect that this practice will change in the near future, despite the threat of increasing prices.

Union Labor

All non-management UPS employees are union members, and contract negotiations with the Teamsters union will continue to affect the long-term outlook for the company. While UPS has managed to avoid union conflict by renegotiating contracts ahead of deadlines and taking advantage of poor union financial planning to barter, the threat of a strike periodically looms over UPS stock prices. The last strike was in August 1997; because the company did not go public until November 1999, the effect of a strike on the stock price remains untested in actual trading.

Competition

In its core U.S. small-package business, UPS competes primarily with FedEx. The two companies offer nearly identical arrays of ground and express services but differ in size, ground & express market share, reputation, and often price. FedEx had $37.95 billion in 2008 revenue compared to UPS’s $51.49 billion. UPS has more than triple FedEx’s share of the ground shipping market but lags 36% to 49% in express/air shipping.

The lag is explained by the two companies’ histories. FedEx has been in the next-day business since it was founded in 1973 while UPS launched Next Day Air in 1982, the year that FedEx first promised 10:30 AM delivery. It was 1990 before UPS matched this promise. FedEx remains the brand best-associated with speed.

Historically, price has been an issue in UPS's competition with FedEx. When UPS Next Day Air Service launched, UPS charged about half FedEx’s rates, a move that helped to bring UPS’s air (Next and Second Day) volumes to 140,000 packages per day within one year. UPS still has a reputation for being less expensive than FedEx, but it is difficult to compare the two when only some customers pay list prices.

In the mature U.S. market, prices for small-package services are generally stable. The parcel shipping business has high fixed costs and therefore presents significant barriers to entry. In the U.S., the parcel market is scarcely fragmented. Without the prospect of new market entrants disrupting pricing, there is little incentive for UPS or its competitors to compete aggressively on price.

Yield, defined as revenue per package, is one important metric in the small-package business. UPS yields were strong in fiscal year 2008, though not quite as strong as FedEx's yields for the most recent fiscal year.^[13]

Yield varies with the strength of prices overall. It also varies with the mix of packages a carrier transports. Faster and heavier packages drive yields up. For that reason, it is important when comparing yields to compare only between like services and to be aware of whether any of the carriers is pushing to change their package mix (to more Next Day Air service over 2nd day service for example). The UPS and FedEx services are similar but not exactly equivalent.

Within a service category, price alone determines yield. It is hardly surprising that FedEx yields seem to exceed to UPS yields overall. FedEx has long had a reputation for being the more expensive carrier. But true prices for carrier service are not transparent as carriers negotiate individual contracts with larger business customers.

Like yields, profits can be difficult to compare across carriers. It is important when comparing profits to know whether any of the carriers compared expects imminent volume growth. The high fixed-cost structure of the transportation business forces carriers to invest in network expansions long before they see the volume increases that make expansions profitable. Profits may therefore rise and fall in cycles that correspond to major capital investments.

Passenger Airlines and Packages Carriers

Both passenger airlines and package carriers are capital intensive. In 2007 FDX and UPS had capital intensity ratios of $0.68 and $0.79 respectively. The two largest passenger carriers, AMR and United Airlines (NASDAQGS: UAUA), had capital intensity ratio of $0.80 and $0.83 respectively.

The packages carriers have far less exposure to fuel price volatility than passenger carriers because they rely on indexed fuel surcharges. In 2007 FDX and UPS fuel costs as a percent of revenues were 10% and 6% respectively. AMR and UAUA had fuel costs of 29% and 25% respectively. One might wonder why the passenger carriers do not also relay on indexed fuel surcharges.

The package carriers actually are more labor intensive than the passenger carriers. In 2007 FDX and UPS posted labor intensity ratios of 39.0% and 63.9% respectively. The two largest passenger carriers, AMR and UAUA, had labor intensity ratios of 29.5% and 21.2% respectively. Southwest Airlines (NYSE: LUV) had half the revenues of United but operated with a labor intensity ratio of 32.6%.

The number of employees per aircraft is a more telling indicator of the package carriers labor intensity. In 2007 FDX and UPS had 432 and 1,587 employees per aircraft respectively. The top two passenger carriers, AMR and UAUA, had 131 and 138 employees per aircraft.

References

1. ↑ ^{1.0 1.1 1.2} UPS 2Q09 10-Q, pg. 27-28
2. ↑ UPS 1Q08 Earnings Release
3. ↑ UPS 2008 10-K, pg. 5
4. ↑ ^{4.0 4.1 4.2 4.3 4.4} UPS 2Q09 10-Q
5. ↑ ^{5.0 5.1 5.2 5.3} UPS 2009 3Q 8-K
6. ↑ UPS 2008 10-K, Item 6.
7. ↑ ^{7.0 7.1 7.2 7.3 7.4 7.5 7.6} UPS 2008 10-K, Item 6
8. ↑ 2008 FDX 10-K, Item 6
9. ↑ ^{9.0 9.1} UPS 2008 10-K, Item 1
10. ↑ Wall Street Journal
11. ↑ http://www.tmcnet.com/usubmit/2008/05/28/3469337.htm
12. ↑ 2008 UPS 10-K, pg. 28
13. ↑ UPS 2008 10-K, pg. 19