It's fair to say that investors approached UPS (NYSE:UPS) third-quarter earnings with a sense of trepidation. After all, its main rival FedEx (NYSE:FDX)gave a horrible earnings report in September, taking a $450 million hit due to constrained labor markets caused by the lingering impact of the COVID-19 pandemic. What would UPS report?
An excellent report
The answer to this question is that a super set of third-quarter earnings served to silence the doubters. And I know because I was one of them.
The critical number to follow with UPS is its U.S. domestic package segment margin. Not only is the segment the most significant earnings generator for the company, but the growth in its margin is the key to its 2023 targets laid out on its investor day presentation in June.
As a reminder, the company aims to increase revenue from $84.6 billion in 2020 to $98 billion-$102 billion in 2023, with adjusted operating profit rising from $8.7 billion to $12.4 billion-$14 billion. Margin expansion is key to the plan. Management expects the operating profit margin to expand from 10.3% in 2020 to 12.7%-13.7% in 2023, driven by the U.S. domestic package segment expansion from 7.7% in 2020 to 10.5%-12% in 2023.
Whichever way you look at it, the segment's margin is the key to the 2023 targets. Armed with this knowledge, investors had three reasons for concern going into the quarter:
- FedEx's recent problems cast some doubt on UPS' ability to contain costs in the quarter.
- Management's guidance on the second quarter for the second-half U.S. domestic margin of 9.2% compared to 11% (resulting in a full-year margin of 10.1% for the segment) in the first half suggested a weakening trend.
- The segment's margin has long been a bull and bear battleground -- the concern is that surging, hard-to-deliver e-commerce deliveries would result in ongoing margin pressure.
UPS hits it out of the park
Fortunately, the company delivered on just about everything in the quarter. The highlights are as follows.
First, the adjusted operating margin in the U.S. domestic margin segment was 10% in the quarter, and management now expects the segment to deliver a 10.5% margin for the full year -- a figure already at the bottom end of the 2023 range for 10.5%-12%. During the UPS earnings call, CFO Brian Newman put it down to "higher than planned for improvements in revenue per piece and productivity gains."
Revenue per piece increased by 12% in the segment -- a figure significantly ahead of the cost per piece increase of 10.4%. Moreover, there will likely be more revenue per piece in the future, not least because management is planning for a general rate increase of 5.9% in 2022.
While UPS did suffer some cost and supply chain issues in the quarter, management is doing an excellent job of offsetting them by raising prices and being more selective in its revenue generation. In addition, the shift in revenue mix (relatively more higher-margin business-to-business, or B2B deliveries) benefited margin.
Second, in the other significant international segment, both the adjusted operating margin of 23.5% in the quarter and the guidance for a full-year margin of 23.9% are above management's target of 21.5% for 2023.
The numbers are adding up for UPS because the company is making progress on its strategic initiatives. In a sense, UPS was in the right place at the right time with the COVID-19 pandemic. E-commerce volumes surged during the pandemic, and many small and medium-sized businesses (SMB) accelerated investment in e-commerce capability. As such, UPS' strategic initiative to improve its revenue quality by targeting SMBs was almost designed to succeed during the pandemic.
Indeed, SMB average daily volume increased 10.9% year over year, and SMBs now contribute more than 27% of U.S. volume for UPS.
UPS still has to deal with the challenges of peak delivery days during the holiday season. Still, if the evidence of the third quarter is anything to go by, it's not facing anything like the difficulties encountered by FedEx. Meanwhile, the SMB initiatives continue to gain momentum as UPS grows alongside its customers rolling out their delivery expansion plans.
It all adds up to a company that is well on track to hit its 2023 targets, and it wouldn't be surprising if management raises its expectations in early 2022.