UPS (UPS 0.02%) delivered anther good quarter, but questions remain about its potential to expand profit margins while servicing burgeoning e-commerce growth from Amazon (AMZN -2.56%) and other customers. The jury is definitely out on the matter. That said, if I was on that jury, I'd be arguing in UPS' favor. Here's why.

Why margin matters

The question has been bothering investors in UPS and FedEx for some time. Yes, everybody loves a revenue growth opportunity. However, nobody loves margin pressure, and there's little doubt that delivering inefficiently packaged business-to-consumer (B2C) deliveries to low density, hard to find, residential addresses is a more costly activity.

The main focus of the matter is the company's U.S. domestic package segment, responsible for around half of UPS profits in 2020. Margins have declined over the years, and the transportation company has had difficulty significantly improving the segment's operating profit. All of which comes at a time when the segment's revenue increased nearly 50% from 2014-2020.

UPS U.S. domestic margin segment.

Data source: UPS presentations. Chart by author.

Moreover, the segment's adjusted operating margin actually declined in the fourth quarter to 8.8% from 9% in the same quarter of last year.

Indeed, the pressure on costs from B2C e-commerce deliveries is evident in the performance in the quarter. The segment's revenue rose 17.4%, but expenses were up 17.7%. CFO Brian Newman noted on the earnings call that "total delivery stops increased by 15.7% due to high growth in single-piece shipments, and lower delivery density increased cost by $185 million."

Packages in a shipping warehouse

Image source: Getty Images.

These are exactly the kind of issues associated with B2C e-commerce deliveries to residential addresses. Contrast this with easy-to-deliver bulk business-to-business (B2B) deliveries to work locations.

So does this mean that the case is closed, and investors should feel pessimistic about UPS' profit growth prospects? Is UPS consigned to delivering low profitability deliveries for large customers like Amazon? The latter is a key question, considering Amazon is now responsible for around 13.3% of UPS sales.

It's not all doom and gloom. In fact, there's plenty of evidence to suggest UPS has a great opportunity to improve margins. Here are five key points.

Cost savings and recovering B2B volumes

First, in CEO Carol Tome the company has a leader committed to improving margins. Both Newman and Tome made it clear on the earnings call that they plan to expand operating margin in the segment in 2021. Part of their plans includes a $500 million reduction in non-operating expenses in 2021.

Second, UPS has suffered margin pressure due to surging B2C volumes at a time when B2B volumes collapsed due to the COVID-19 pandemic. For example, B2B shipments made up around 46% of its total in 2019, but were at 33% in the fourth quarter. As the economy improves in 2021, that figure should improve and be beneficial to margins. 

Revenue growing faster than volume, sequential margin expansion

Third, Tome argues that the fact that revenue growth is now significantly exceeding volume growth is a demonstration of management's plans to improve the quality of its earnings. She has a point. It's a sign that UPS is focusing more on profitable deliveries rather than chasing volume growth per se. Indeed, revenue per piece in the segment rose 7.8% to $10.09 in the fourth quarter compared to the same period last year.

UPS U.S. domestic package growth.

Data source: UPS presentations. Chart by author.

Fourth, the segment's adjusted operating profit margin usually declines sequentially from the third to the fourth quarter. If you look closely, you can see this in the first chart above. However, the margin actually expanded this year to 8.8% in the fourth quarter from 8.6% in the third quarter. Again, it's a sign that management is increasing its focus on margin.

Don't worry about Amazon

Fifth, during the earnings call Credit Suisse analyst Allison Landry asked whether UPS was taking action to "reduce exposure to some of the low-margin but high-volume business" from its largest customers. This is almost certainly a reference to customers like Amazon.

Packages outside a residential address.

Image source: Getty Images.

While Tome didn't address that specific issue, she did outline the work that UPS is doing to service small and medium sized business (SMB). Indeed, SMB volume rose 28.5% in the fourth quarter with some customers growing at 100% a year.

The fact that analysts are asking such questions, and UPS is seeing such strong growth with SMBs, is de facto an acknowledgement that there's enough e-commerce growth to go around and Amazon's expansion of its own delivery capability is not really a threat to UPS.

Looking ahead

All told, raising the segment's profit margins will be a challenge, but there's enough evidence to suggest that UPS can meet it. As such, investors should stay positive on the company's prospects in 2021.