Why UPS’ Higher Margins Can Make You a Profit

Shipping and logistics is a business where capital intensity and network size really matters. The world's largest parcel delivery company, United Parcel Service (NYSE: UPS  ) , is showing its biggest two competitors, FedEx (NYSE: FDX  ) and DHL, why its business structure generates higher margins, and thus superior profitability.

Here you will see the rationale behind UPS' hard-to-match integrated global shipping network and how it managed to build the widest economic moat among all freight transportation firms.

Fundamentals
Delivering on average 16.9 million packages per day on a global basis, UPS leads in package density. Along with its outstanding operational efficiency and extensive technology investment, this produces returns on invested capital, or ROIC that almost double its cost of capital.

The trick that explains why UPS earns higher margins than its peers has to do with the fact that the company funnels substantially greater package volume through its efficient assets. Handling greater parcel density helps reduce overall per-parcel shipping costs, but the strategic use of assets also makes a significant difference. UPS uses many of its assets to handle both express and ground shipments, earning greater margins compared with other parcel shippers, like FedEx.

Volume comparisons
If you take a look at the U.S. parcel market (the most important market by far in terms of revenue generation), FedEx handled about 8.8 million daily average parcels through its express and ground units together during fiscal 2013. UPS, on the other hand, moved 14.4 million daily in calendar 2013; this is a substantial 63% difference. If you consider just U.S. ground then the disparity is even greater, since UPS moved on average 12.1 million parcels per day and FedEx only moved about half of that (6.3 million, including SmartPost).

Integrated assets
In addition to volume superiority, the extra advantage that contributes to UPS' higher margins lies in its use of integrated assets to transport U.S. urgent and ground shipments through the same pickup and delivery network. In contrast, FedEx does not use this system and holds parallel networks of drivers and trucks. This company handles ground and express shipping separately, significantly increasing its cost structure.

There's also a convenience factor for clients, as they appreciate using the same driver to handle both express and ground packages. This is not a minor detail, as the relationship with clients adds significantly to UPS' business structure.

Hard to displace
As you probably know, the parcel shipping business requires an amount of assets very hard to replicate in the absence of sufficient package flow. Simply put, it would just be extremely costly. That's why UPS' trucks, trailers, terminals, sorting equipment, IT systems, and skilled labor become a deterrent for new competitors, which would have to endure huge financial losses during a long density-building phase.

DHL has shown that it takes at least a decade to build up to a point where it can compete with the bigger boys, and the company is still managing to make its business more efficient on U.S. soil. Unfortunately, this company still fails to displace the massive UPS and FedEx on their home turf.

Risks
Basically there are two risks that UPS faces. The first one has to do with the global and U.S. economic environment. The recent recession proved that it can generate rapid changes in shipping demand and affect profitability. The U.S. market is key, as only a fourth of UPS' total revenue comes from international sources. The good news is that prospects for American GDP growth are positive, and the country will probably grow more than last year.

The other risk is the company's high unionization. However, concerns over this risk have been mitigated in the short and mid-term due to the fact that UPS signed the current labor contract well before the expiration of the previous agreement. This minimizes potential service disruptions.

Bottom line
To sum it up, the factors that make UPS a great investment case and an amazing company to hold for long-term investment are its greater package volume, concentration on high-margin ground shipping, and use of a single network rather than parallel air and ground operations.

However, its competitors should not be underestimated, as they hold a good position and well-established brands as well.

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