Have UPS and FedEx Really Turned the Corner?

It's been an interesting year for package delivery giants UPS (UPS -0.04%) and FedEx (FDX -0.40%). They've gone from being seen as victims of the COVID-19 pandemic to being viewed as among its few long-term beneficiaries, and their stocks have moved accordingly. But have they turned the corner in terms of generating margin expansion alongside volume growth from e-commerce deliveries?

Outperforming in 2020

Shareholders have watched as UPS and FedEx have outperformed the S&P 500 this year; the stocks are up 37% and 50%, respectively, compared to 6.1% for the index. Those are startlingly strong moves, and show how far we've come since the dark days of March, when the market feared that the global economic slump caused by efforts to stem the pandemic would lead to dramatic revenue and earnings declines for all transportation companies. 

Image source: Getty Images.

However, the reality is that a combination of surging business-to-consumer (B2C) demand and a gradual recovery in business-to-business (B2B) deliveries contributed to surprisingly good results for both companies.

FedEx reported its fiscal fourth-quarter (March to May) earnings at the end of June. Revenues for its ground segment (which handles the bulk of its e-commerce deliveries) were up 20%, driven by B2C growth. Moreover, even though B2B shipping was understandably weak, management said that it had seen week-over-week growth since the end of April. 

Enter UPS

The scene was set for UPS, and it didn't disappoint when it reported second-quarter results at the end of July. The table below shows how revenue surged in the U.S. domestic package segment led by a whopping 65.2% year-over-year increase in B2C volume, while B2B volume declined 21.9%. The decline in higher-margin B2B volumes hurt, but under the circumstances, the segment's margin held up pretty well.

However, the really positive surprise came from the international segment, where a combination of outbound volume for Asia (as the economy recovered) and B2C revenue in Europe led to a near 27% increase in income.

Speaking on the earnings call, new CEO Carol Tome said "At the beginning of the second quarter, we assumed demand would slow. Instead, we saw just the opposite."

Data source: UPS presentations. bps = basis points, where 100 basis points equal 1 percentage point.

Near and long-term considerations

Clearly, UPS had a very good quarter under the circumstances and investors were rewarded with a strong share price rise after the results. However, is it a case of the company merely benefiting from stronger-than-expected environment? More importantly, have UPS and FedEx demonstrated that they can grow their e-commerce shipping volumes without facing margin declines and a never-ending need for capacity investments in order to service a low-margin B2C business?

In the near-term, margins in the U.S. domestic package segment should get a boost as B2B volumes continue to recover. Tome noted that B2B shipments were 27% of its total in early May, but rose to 37% at the end of June, compared to around 46% for the full year of 2019. On the other hand, CFO Brian Newman said that "the U.S. domestic margin could be lower in the second half of the year relative to the first half" as recently hired workers started to receive new benefits.

As ever, analysts pursued the longer-term questions during the earnings call. Tome responded that "you should expect the margin to start to go in the right direction" in 2021 and beyond. Turning to the issue of capital spending, she expressed a desire to be "better, not bigger" when an analyst asked if " a multiyear potential capital investment program" was "around the corner"

"We will get the network righted before we think about investing more dollars in the network," Tome went on. "That suggests lower capital intensity going forward."

What does it all mean for investors

All told, UPS had a great quarter. Its new CEO is using the right language to assuage investors' fears that margins will remain under permanent pressure from B2C growth and that capital spending will need to be ramped up. That said, the near-term margin pressure coming in the second half is a reminder that it's far from clear that U.S. domestic margins will expand in 2021 and beyond as Tome hopes.

Similarly, FedEx's earnings also showed a company that's achieved sequential growth in ground margin -- a very good sign in itself. However, just as with UPS, its year-over-year margin in the key segment (FedEx ground) declined, and it's far from clear whether FedEx will achieve long-term margin expansion in the segment. 

In the wake of these strong share price gains -- UPS now trades at around 20 times forward earnings estimates, while FedEx trades at about 22 -- it would be understandable if investors decided to take a breather until they can see the margin progression in the second half, as well as how the companies will deal with what's likely to be very heavy peak demand during the holiday season.

Both shippers are making progress on their margin issues, but the jury is still out. Investors will want to see more evidence of concerted progress before they start to conclude that margins will expand along with burgeoning e-commerce growth.