The recent results from FedEx Corporation (FDX 0.10%) highlighted many of the strategic opportunities and threats facing FedEx and UPS (UPS 0.93%) in the coming years. From a long-term strategic perspective, the results were a mixed bag, but contain more good than bad. That said, let's look at the key takeaways from the earnings report and what it all means for investors.
E-commerce growth comes with challenges
UPS and FedEx both have a growth opportunity from the ongoing increase in e-commerce package deliveries. But for two main reasons, it's also creating challenges. First, both companies have seen margin pressure as a result -- business-to-consumer e-commerce deliveries can be inefficiently packaged, they are sometimes bulky (think trampolines and mattresses), and delivering to residential addresses is relatively more expensive. I'll come back to this point in a moment, especially as there is good news to tell.
The second main challenge from e-commerce comes from the difficulty of dealing with peak demand during the holiday season. It's unfeasible for FedEx and UPS to build out a network just to support a few days' trading, and it's very difficult to exactly predict the timing of these days or the volume that will occur. Both companies took a hit in the severe-weather winter of 2013-2014, and UPS actually invested too much in the winter of 2014-2015 and managed to have overcapacity on days that management expected stronger sales to occur.
FedEx and UPS took a hit during peak delivery season
Unfortunately, these kinds of issues came back during this year's winter season as UPS incurred $125 million in extra costs associated with handling peak demand.
"For Express, operating income for the quarter [was] primarily affected by an estimated net negative impact of approximately $170 million year over year," FedEx CFO Alan Graf said on the earnings call -- peak was a large part of the problem.
It's unusual that the company's Express segment took the hit (you would normally expect the cheaper/slower Ground deliveries to bear the brunt), but as management outlined, customers stayed longer in the "Ground system" this year, resulting in "lower peak volumes at Express and a more concentrated surge in a few days just before Christmas," FedEx Express CEO David Cunningham said on the earnings call.
All told, there's no getting around it: Investors are just going to have to accept that both companies face extra risk during peak delivery periods. Just as it's very difficult for management to predict exactly how and when the peak days will transpire, it's difficult for investors to know what will happen.
Coming back to the issue of e-commerce and its impact on margin -- notably in FedEx and UPS ground operations -- here is a chart to show exactly what's going on. Unfortunately, the hit that UPS took from increased costs due to peak (discussed above) meant its ground margin deteriorated further in its most recent quarter. But as you can see below, FedEx's ground margin has improved in two consecutive quarters, implying the company is getting a handle on e-commerce growth.
The favorable comparison with UPS doesn't end there, as FedEx is doing relatively better with capital spending, too. For example, UPS was forced to increase its capital expenditure expectations to levels above what most analysts had expected. Clearly, it's going to take time before investors see the fruits of UPS' strategic planning.
In comparison, FedEx actually cut its capital spending forecast for 2018 by $100 million to $5.8 billion. Moreover, "At Ground, we are going to see, I think, going forward, reduced capex at Ground as we look at better ways to build out the network," Graf said.
What it all means for investors
All told, the risk of a disappointment from peak is now a permanent fixture of both stocks. But on an underlying basis, FedEx is trending in the right direction on ground margin and cash flow -- the same can't be said for UPS. On balance, FedEx's earnings were a positive, and investors have reason to feel more confident in the company's prospects.