FedEx's (FDX -2.09%) earnings shocked the market in late September, and there's a real fear that UPS (UPS -1.51%) will follow suit when it reports results on Oct. 26. A lot is going on, so here's a brief summation of what investors need to look out for when UPS shares its third-quarter earnings.
UPS earnings
I'll cut to the chase. The key number to focus on is the U.S. domestic package segment profit margin. But it's not just about one number, of course; it's about the factors that go together to produce the metric and what investors can expect in the future.
A breakout of adjusted operating profit by segment is in the table below. Not only is the U.S. domestic package segment the key profit generator at the company, but it's also forecast to produce the bulk of the company's profit increase in the coming years.
Image source: Getty Images.
For example, at the investor day presentation in June, management outlined plans to increase adjusted operating profit from $8.7 billion in 2020 to $12.4 billion-$14 billion in 2023. The other primary segment, international package, is forecast to increase adjusted operating profit from $3.5 billion in 2020 to $4.3 billion-$4.6 billion, mainly due to revenue increases from market share gains and international expansion.
Moreover, the third segment is now called supply chain solutions following the sale of UPS Freight. Everything points to the U.S. domestic package segment as the key to UPS' prospects.
Within that, UPS has plans to increase the U.S. domestic package margin segment to 10.5%-12% from 7.7% in 2020. That's why the segment's margin performance matters so much.
| UPS Segment |
Adjusted Operating Profit 2020 |
|---|---|
|
U.S. domestic package |
$4.128 million |
|
International package |
$3.532 million |
|
Supply chain and freight |
$1.058 million |
Data source: UPS presentations.
UPS margin plans
The segment's margin outlook has been at the heart of the debate over the stock in recent years. When UPS' management demonstrates it can increase it, the stock gets rewarded; when there are difficulties, it gets punished. As such, the market took to heart CEO Carol Tomé's appointment in 2020 and her subsequent "better, not bigger" framework. In other words, Tomé wants to focus on improving productivity and profitability rather than just chasing revenue growth.
Tomé is undoubtedly taking the right approach. There's never been any doubt that e-commerce volume would grow. However, there's been plenty of debate on whether UPS and FedEx might be trapped in a never-ending game of spending to ramp up capacity while at the same time facing margin challenges from making costly deliveries to residential addresses.
Image source: Getty Images.
Tomé's plan involves expanding sales with small and medium-sized businesses (particularly as they increase their e-commerce activities), growing UPS' presence in healthcare, and being willing to forego revenue growth to ensure revenue quality.
The good and bad news
The good news is that on the second-quarter earnings call, UPS' management said it was on track for a U.S. domestic package margin of 10.1% in 2021. That's a perfectly respectful figure. It's not that far from the bottom end of the 10.5%-12% range targeted for 2023.
The bad news is that the margin progression through 2021 might not be quite as good as many hoped. There are two reasons for this. First, investors were left disappointed on the second-quarter earnings call when management guided toward a U.S. domestic package margin of 9.2% in the second half compared to 11% in the first half.
Second, FedEx's stock slumped in late September on the news that the company suffered an extra $450 million in costs due to "constrained labor markets" during its fiscal first-quarter 2022 earnings. In plain English, the lingering impact of the COVID-19 pandemic is making it hard for FedEx to hire staff and therefore burdening the company with extra costs, such as third-party transportation and higher wages.
Image source: Getty Images.
It's hard not to think that UPS will face similar sorts of issues when it reports. Moreover, the annual question of how FedEx and UPS will deal with the surge of demand during peak delivery days in the Thanksgiving to Christmas period will be even more relevant this year.
What to look out for
All told, management's commentary on U.S. domestic margin will be closely followed by investors in the upcoming results. Don't be surprised if UPS reports some of the issues that FedEx talked about, and that could mean the segment's margin performance will be weaker than many hoped. That said, investors will look for management to demonstrate that underlying progress toward its 2023 targets is progressing as planned.
