Whenever UPS (UPS 0.34%) has an earnings call, analysts usually ask questions around the same subject. Specifically, what are the prospects for UPS' U.S. domestic package segment margin outlook? Fortunately, the company has been reporting good progress on this front, not least due to its strategic initiatives and CEO Carol Tome's "better, not bigger" framework. Here's why it matters and why investors have cause for optimism.
Image source: Getty Images.
Why U.S. domestic package margin matters
There are three connected reasons why the figure is so important.
First, the segment is the most significant contributor to UPS' profit.
Data source: UPS presentations. *Includes the freight business sold in 2021.
Second, the segment is the key to UPS' 2023 financial targets outlined in June's investor day presentation. For reference, management plans to increase overall revenue from $84.6 billion in 2020 to $98 billion-$102 billion in 2023. In addition, adjusted operating profit is forecast to grow from $8.7 billion in 2020 to $12.4 billion-$14 billion.
The key to the growth aspirations is expanding the overall operating margin from 10.3% to 12.7%-13.7%, driven by increasing the U.S. domestic package margin from 7.7% to 10.5%-12%.
As such, the segment is the key to UPS' growth plans.
Third, the segment's margin has long been a debating point in the investment community. On the one hand, the bears will argue that the volume growth associated with burgeoning e-commerce deliveries creates a structural challenge to profit margins at package delivery companies.
In particular, business-to-consumer (B2C) deliveries are often inefficiently packaged, bulky, and are costly to deliver to residential addresses. An example of the friction caused by e-commerce growth comes from FedEx's (NYSE: FDX) closing of contracts with Amazon.com.
The bulls argue that there isn't a problem of volume growth for package deliveries; it's a question of the UPS and FedEx being more selective in generating volume growth.
Image source: Getty Images.
What UPS needs to show investors
Putting these three points together, it's clear that what investors want to see from UPS is a demonstration of a concerted strategy to be more selective in its deliveries, possibly by raising prices, and then to show investors the results of the strategy in action.
The good news is all three things are happening now. Back in 2018, UPS announced a transformation strategy designed to focus the company on four key areas: expansion in international markets, profitable expansion in B2C and business-to-business (B2B) e-commerce deliveries, and most notably, growth in healthcare and small and medium-sized (SMB) business markets.
In addition, Tome took over in 2020, carried forward the transformation strategy and added a "better, not bigger" framework. Right from the start of her tenure, Tome has made it clear that it wasn't just about chasing e-commerce volume growth for the sake of it. Instead, UPS would focus on sweating its existing assets more and working on the transformation goals while controlling volume through pricing and other actions.
Image source: Getty Images.
In this context, investors want to see from the U.S. domestic package segment increasing margin and an increasing revenue-per-package figure without necessarily seeing a significant pickup in volume (although that would help).
Fortunately, that's pretty much what investors are seeing right now. For example, the chart below shows how revenue per piece increased enormously (management will issue a 5.9% general rate increase in 2022) while margin is progressing well toward the 10.5% to 12% target for 2023.
Volumes soared in 2020 during the lockdown period, so 2021 volume figures are coming up against tough comparisons. Still, the result is clear: UPS is improving revenue per piece, and margin is improving. The result is (see first chart above) that the UPS U.S. domestic package segment has generated more profit in the first three quarters of 2021 than it did in each of the full years of 2018, 2019, and 2020.
Data source: UPS presentations. YOY=year over year.
Looking ahead
UPS' strategic initiatives and its "better, not bigger" framework are working, and the company is well on its way to achieving its 2023 aims. Moreover, the key segment's margin is in expansion mode, and hopefully that can continue. If so, UPS will remain an attractive stock for investors.
