United Parcel Service (UPS 1.81%) beat analyst expectations with its third-quarter results, and reaffirmed its forecast for adjusted diluted EPS of $4.90-$5 for the full year. In short, this earnings report served to demonstrate that the company is back on track after a difficult 2014.
Earnings highlights
A quick look at the headline numbers:
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Q3 revenue of $14.29 billion versus analyst estimates of $14.2 billion
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Q3 adjusted diluted non-GAAP EPS of $1.32 versus analyst estimates of $1.29
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Full-year guidance of adjusted non-GAAP EPS of $4.90-$5 versus analyst estimates of $4.95
Third-quarter revenue came in slightly ahead of estimates, but the real news is that EPS came in at $0.03 more, or 2.3% higher, than analyst estimates -- an indication that the company is able to generate better margin than Wall Street thought.
Going into these earnings, the market would most likely have been concerned about two things:
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Will there be a repeat of last year's problems with Christmas deliveries?
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How is the company dealing with the structural changes, and margin challenges, caused by the volume mix shift toward e-commerce package growth?
UPS confident about Christmas
The first question is a concern, because as Fools already know, at the time of its second-quarter results the company was forced to lower its full-year EPS target to $4.90-$5 from $5.05-$5.30. It did so partly as a consequence of having to increase its planned investments in technology and operational expansion by $75 million -- investments made to deal with the kind of unprecedented peak holiday demand it had last year.
Moreover, UPS has already announced plans to hire 90,000 to 95,000 seasonal workers this year -- a move that seems justified in the light of rival FedEx's (FDX 1.18%) forecast that its demand will hit a peak of 22.6 million shipments on Dec. 15, a forecast that's nearly double its shipment numbers from seven years ago.
The good news is that this time around, UPS didn't increase costs, and CEO Kurt Kuehn declared, "We expect another robust peak season and we are confident our network is prepared to operate at the highest level."
U.S. domestic package margin improving
The second question is arguably more concerning from a long-term point of view. Essentially, FedEx and UPS are facing a challenge (and an opportunity) from burgeoning e-commerce demand, principally emanating from business-to-consumer, or B2C, demand. While the increase in volumes provides an obvious opportunity for revenue growth, it also challenges margin, because B2C packages tend to be lightweight and generate less revenue per piece.
Here are the key numbers from the third quarter. The figures below show that UPS generated more than 65% of its profit from the U.S. domestic package segment. Within that segment, Ground-based shipments make up more than 72% of revenue.
Moreover, as customers have increasingly sought out cheaper, slower delivery services -- such as Ground -- and B2C deliveries grow, UPS investors can expect its Ground-based revenue to grow faster than that of other delivery methods. In fact, within the U.S. domestic package segment in the third quarter, Ground revenue grew 7.7%, Deferred grew 5.9%, and Next-Day Air grew only 1.1%.
| Segment | Revenue (in $millions) | Revenue Growth | Operating Profit (in $millions) | Operating Profit Growth | Margin | Margin Expansion (in basis points) |
|---|---|---|---|---|---|---|
| U.S. Domestic Package | 8,691 | 5.3% | 1,279 | 7.8% | 14.7% | 35 |
| International Package | 3,183 | 5.5% | 460 | 10.3% | 14.5% | 63 |
| Supply Chain Freight | 2,416 | 7.4% | 215 | 7% | 8.9% | (3) |
| Total | 14,290 | 5.7% | 1,954 | 8.3% | 13.7% | 33 |
Source: UPS Presentations. 100 basis points = 1%.
The good news from the results is highlighted in bold above: In a nutshell, UPS managed to increase its operating margin in its U.S. domestic package segment by 35 basis points. Indeed, its total operating margin increased 33 basis points. This is positive, because it implies that the company is dealing with the structural shift toward more Ground-based revenue without suffering margin contraction.
In addition, UPS has followed FedEx in instigating dimensional weight pricing. In plain English, this means all packages (including packages under three cubic feet which were previously exempt) will be priced by volume as well as weight. The changes take effect for UPS on Dec. 29, and Jan. 1 for FedEx. Analysts believe that the changes could effect up to two-thirds of UPS domestic ground shipments.
The change is planned to result in a 4.9% increase in freight pricing, and it's likely to encourage shippers to cut down on unnecessarily large packaging -- something that will help UPS and FedEx deal with growing capacity demands.
The takeaway
Overall, this is a positive set of results from a company that has underperformed its rival and the broader market in 2014. In reaction, the market rewarded UPS stockholders with an initial uptick in the share price, and investors can look forward to the upcoming company investor conference on Nov. 13 with more confidence.
