The key word to take away from the latest earnings report from UPS (NYSE:UPS) is "uncertainty." In a move unlikely to surprise anyone, UPS followed FedEx (NYSE:FDX) in withdrawing its full-year guidance due to the impact of the COVID-19 pandemic. However, the real issue is that the coronavirus has caused a shift in the company's revenue streams, making it much harder to track progress on its long-term margin expansion plans. Let's take a closer look.   

First, let's start with some numbers from the company's April 28 report. As you can see in the table below, UPS revenue actually increased in the quarter compared to the year-ago period, but adjusted total operating income decreased by a whopping 26.4%. The contrast is most striking in the U.S. domestic package segment, where a high-single-digit revenue increase matched with a 42.2% fall in operating profit. 

Segment

First-Quarter 2020 Revenue

Change (YOY)

First-Quarter 2020 Adjusted Income

Change (YOY)

U.S. domestic package

$11,456 million

9.3%

$401 million

(42.2%)

International package

$3,383 million

(2.2%)

$558 million

(8.8%)

Supply chain and freight

$3,196 million

(0.8%)

$158 million

(25.1%)

Total

$18,035 million

5.1%

$1,117 million

(26.4%)

YOY = year-over-year. Data source: UPS.

What's going on at UPS?

It's no surprise to see weakness in the international package segment in light of the pandemic's slowing of economies worldwide. Meanwhile, the supply chain and freight segment is highly attuned to the macro economy (internationally and the U.S.), and even a small drop in revenue can lead to a big fall in profits if freight rates are collapsing. Both segments suffered in the quarter, but both can look forward to better days after the pandemic is contained and economies recover.

All of which turns the focus back to the U.S. domestic package segment and the question of why its profits disintegrated so much.

A shift in the revenue mix

It comes down to a shift in revenue toward more business-to-consumer (B2C) revenue compared to business-to-business (B2B) revenue. B2C deliveries tend to be less profitable because they often involve inefficiently packaged items -- part of the reason UPS and FedEx increasingly charge by dimension as well as by weight. In addition, delivering individual B2C items to multiple residential addresses tends to be more expensive than delivering a large number of packages to a single business address.

UPS CFO Brian Newman, discussing the segment during the recent earnings call, pointed out:

  • Commercial deliveries declined after five consecutive quarters of growth.
  • B2C volume "spiked early in the period ... which drove an increase in overall miles driven of nearly 10% and about a 15% increase in total average daily stops."
  • "By the end of the quarter, B2C approached 70% of our volume, and average package weight decreased by about a third of a pound."

In a nutshell, the COVID-19 pandemic led to a collapse in B2B deliveries, but thanks to the stay-at-home measures taken to contain the pandemic, there was a surge in B2C deliveries. Ultimately, this led to the outcome of U.S. domestic segment revenue rising but profit falling dramatically.

Packages on a conveyor belt

Image source: Getty Images.

What it means to investors

The outcome in this quarter is a dramatic reminder to investors of the long-running bull-versus-bear debate over UPS and FedEx. Bulls believe burgeoning e-commerce growth will lead to a revenue growth opportunity for both companies over the long term, and that it's right for both to be spending on expanding and automating their networks in order to prepare for it.

Meanwhile, the bears argue that B2C deliveries are inherently lower-margin, and profits will suffer accordingly. In addition, bears argue that both companies are embarking on a never-ending capital spending ramp in order to service growth and that free cash flow generation will be constrained as a consequence.

Frankly, on the evidence of the first-quarter earnings report, it's hard to argue that the bear case wasn't strengthened by recent events.The first quarter's results remind us that there is a debate over the long-term margin profile at both UPS and FedEx.

That said, some perspective is needed. The results for the first quarter, and probably for a few quarters to come, represent abnormal conditions. This certainly highlights the bear case about the shift toward B2C deliveries, but the second quarter of 2020 will likely be a multiyear low point in B2B deliveries. In addition, the global economy will surely recover in time; the debate is over the timing and shape of the recovery.

On balance, I'd rather be a buyer than a seller of UPS stock right now. However, anyone buying the stock needs to appreciate that it's going to be a while before it's definitively clear that e-commerce deliveries can translate into margin expansion at UPS.