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What: Shares of United Parcel Service (UPS -2.29%) dropped more than 10% in early trading today, after the company announced that it expects its fourth-quarter earnings to come in significantly below estimates. Fourth-quarter adjusted diluted EPS is now expected to be $1.25 compared to analyst forecasts of $1.47.
For the second year in a row, UPS failed to execute well during the holiday season. As with last year, the problem was with sufficiently predicting and managing e-commerce demand. However, last year, UPS had insufficient capacity to meet peak demand. This year, it had too much.
According to CEO David Abney in today's press release: "UPS invested heavily to ensure we would provide excellent service during peak when deliveries more than double. Though customers enjoyed high-quality service, it came at a cost to UPS. Going forward, we will reduce operating costs and implement new pricing strategies during peak season."
So what: Essentially, the company invested heavily in building out extra capacity to meet peak demand, only to find that demand was less than expected on certain days. The result was a decline in productivity that hurt its profitability in the quarter.
The issue demonstrates the increasing complexity of predicting demand spikes due to the expansion of e-commerce. For example, last year, consumers and retailers were left disappointed as UPS' operations were hit by severe winter weather and unexpected surges in peak demand from e-commerce. This year, UPS overinvested and shareholders are now paying the price.
Unfortunately, the bad news doesn't stop there. Management also estimated that currency headwinds and increased pension expenses would lead to 2015 diluted EPS coming in at "slightly less" than its target of 9%-13%.
Now what: UPS management is going to have to do a good job convincing investors that it has a handle on how to deal with peak demand in the holiday season. Moreover, investors will ask if the latest disappointment is evidence that UPS is facing increasingly severe challenges in managing e-commerce demand spikes. Particularly, as it's building out network capacity just to deal with a few days' peak demand. UPS' management has a lot of explaining to do in the next few weeks.