The market wasn't exactly thrilled with the recent quarterly results from United Parcel Service (NYSE:UPS), and the stock continues to underperform perennial rival FedEx Corporation (NYSE:FDX). Let's take a look at the key points from the earnings report and what they mean for the investment thesis behind UPS stock.

Internet shopping and e-commerce, package delivery concept

Image source: Getty Images.

United Parcel Service failed on three counts

As 2017 ended, I identified three ways UPS needs to impress investors in 2018:

  • Successful execution during the peak delivery period.
  • Improving U.S. domestic package margin, which has been pressured by burgeoning e-commerce deliveries and extra costs associated with network expansion.
  • A moderation, or at least the projection of a moderation, in capital spending -- something that has eaten into free-cash-flow (FCF) generation in recent years.

Unfortunately, the recent results suggest that UPS is failing on all three.

More peak delivery challenges

If there's one thing that has differentiated UPS from FedEx in recent years, it's that the latter has dealt with peak delivery periods much better than the former. That trend appears to be continuing this year. FedEx's second-quarter earnings presentations (given just before Christmas) saw management lauding its "best peak ever."

Meanwhile, UPS said the "variability of digital demand created challenges during the peak period, as volume accelerated above our projections," in the words of Myron Gray, president of U.S. operations. Clearly, UPS is struggling to get a firm grip on peak delivery periods. In fact, the surge caused by strong online orders during Cyber Weekend -- package volume increased 20% year over year -- pushed UPS's network "above its maximum capacity" and created an increased operating expense of $125 million.

As you can see below, the increased costs weighed heavily on profit in the quarter, and if not for a substantial increase in freight segment profitability, UPS's total operating profit would have declined.

UPS Operating Profit

Q4 2017

Q4 2016

Difference

U.S. Domestic Package

$1,264

$1,338

$(74)

International Package

$760

$706

$54

Supply Chain & Freight

$270

$179

$91

  Total operating profit

$2,294

$2,223

$71

Data source: UPS presentations. Figures in millions.

More margin pressure

The chart below shows the ongoing pressure on UPS's and FedEx's margins (within their most relevant segments), which largely owes to e-commerce related growth. Online orders pressure margin for a variety of reasons. For example, they are usually business-to-consumer, and delivering to residential addresses tends to carry higher operating costs. Moreover, they tend to be inefficiently packaged and/or come in bulky packages (think trampolines and mattresses).

It will be interesting to see what FedEx reports on its ground margin in its upcoming third-quarter 2018 earnings report.

ups domestic package and fedex ground margin growth

Data source: UPS and FedEx presentations. Basis points, where 100bp equals 1%. FedEx figures adjusted to the nearest UPS quarter.

Capital spending

UPS and FedEx have both been ramping capital expenditures in recent years in an effort to modernize, expand, and improve their networks -- largely to support e-commerce volume growth. As a consequence, free-cash-flow growth has been pressured. For example, UPS's adjusted FCF of $3.57 billion in 2017 was flat even as adjusted operating profit increased 2.6%, while FedEx's FCF was negative $186 million in its fiscal 2017.

UPS made $5.2 billion in capital expenditures in 2017, representing nearly 7.9% of revenue, and the midpoint of management's guidance of $6.5 billion to $7 billion in 2018 represents 9.6% of the analyst consensus revenue forecast. As you can see below, that's far higher than in any year of the last decade.

Indeed, CFO Richard Peretz answered a question about this during the earnings call, saying, "At the end of the day, the next few years, we expect these kind of levels, somewhere between 9% and 10%, 8.5% and 10% of revenues to stay." 

UPS CAPEX To Revenue (TTM) Chart

UPS CAPEX To Revenue (TTM) data by YCharts.

What does it mean for investors?

There's no way to sugarcoat the disappointment in performance during the peak delivery period, and UPS appears to be having ongoing difficulty in growing U.S. margin.

Turning to the issue of capital spending eating into FCF, management argues that the increased spending is accretive to its business and necessary to take advantage of the growth opportunity ahead. That may well be the case, but in the meantime, FCF generation growth is likely to be muted, and UPS and FedEx still need to demonstrate that they can expand margin in the segments most exposed to e-commerce.

Lee Samaha has no position in any of the stocks mentioned. The Motley Fool recommends FedEx. The Motley Fool has a disclosure policy.