Most investors in United Parcel Service (NYSE:UPS) already know about the company's difficulties in dealing with peak demand in the fourth quarter. UPS has now disappointed investors with holiday season operations for two consecutive years. In 2013, the company found itself with insufficient capacity to meet peak demand, then in 2014 it overcompensated and built out too much. This is clearly the issue analysts and investors are focusing on, so let's look at what management wants you to know about it.

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Brand protection

First, management was keen during its latest conference call to stress the importance of protecting UPS' brand and reputation, which took a hit the previous winter when the company could not meet the demand for holiday season shipping. In response, UPS took great steps to ensure it was ready for peak demand in 2014.

However, the measures taken came at a price. As CEO David Abney said during the call: "[W]e erred on the side of caution and built an operating plan that would provide superior service if volume levels exceeded expectations, contributing to higher than expected costs." 

The extra costs hurt profitability in the quarter, with total operating expenses increasing 15.9%, leading to a 2.9% reduction in total adjusted operating profit. While the increased costs hurt investors, the service delivered would surely have pleased retailers, and keeping customers happy is requisite to winning and retaining business.

E-commerce growth prospects good

Second, management pointed out that the continued rise of e-commerce provides a strong growth opportunity for the company. It is easy to lose sight of this point, particularly as the surge in demand for e-commerce deliveries lies behind the problems UPS reported in the fourth quarter. However, investors shouldn't forget the potential for growth. As Abney said on the earnings call:

Fortunately for UPS, there are opportunities for growth outside general economic expansion. E-commerce is expected to outpace global GDP growth by fourfold and cross-border e-commerce at seven times. Concentrated investment in growth industries like health care and retail put UPS in the position to capitalize on market expansion.

In other words, UPS anticipates good end demand from e-commerce and other growth industries -- it just needs to better manage the spike in peak demand created by e-commerce during the holiday season.

Peak pricing surcharge

Third, Abney announced plans for surcharges on customers during peak periods: "We will be implementing peak residential surcharges that are differentiated from our nonpeak time of year on a customer segmented basis. These surcharges will focus on SurePost and residential packages."

Some customers are not going to like these surcharges, and consequently might take their business elsewhere. However, investors need to recall that UPS missed fourth-quarter earnings estimates because its costs were too high in relation to revenue during peak periods -- not because the level of package volumes and revenue fell below expectations for the quarter.

Indeed, Abney said, "These pricing strategies will be designed to ensure we're properly compensated for the value we provide. We will align revenue with cost." It strikes me that UPS might just be willing to forgo some marginal volume in residential packages at peak periods simply to increase overall profitability.

Measures to improve productivity

Fourth, management discussed a few ways it intends to improve the company's profitability. Abney outlined two measures that caught my eye:

  • The "control tower," introduced in 2014 and intended mainly for capacity management, will now "also be utilized more for revenue and yield growth opportunities."
  • Hub capacity will be expanded "in key areas, ultimately reducing the need for temporary sorts."

The "control tower" simply refers to the process whereby UPS manages the flow of shipping volumes with its large customers. The expansion of permanent hub capacity will reduce the need to take on and train additional staff during peak season.

Costs and capital expenditures going up

Fifth, on a more concerning note, management acknowledged UPS this year would incur more costs than originally anticipated.

"[F]or 2015, as we look at the year, continued investment in making the business model more flexible and adaptable will weigh more on operating margin expansion than originally anticipated," according to CFO Kurt Kuehn.

So, after costs rose more than expected last year, UPS has had to cut margin expectations again in 2015. Kuehn forecast that 2015 capital expenditures would rise to $3 billion from $2.3 billion in 2014. The $3 billion figure is at the top of the 4.5%-5%, as a share of revenue, targeted for 2015-2019 at the investor day presentation in November.

Source: Morningstar research, author's analysis.

All told, UPS protected its brand in 2014, but it came at the cost of profitability. Going forward, the plan is to increase productivity and take measures to better manage the flow of shipping volumes around peak season. UPS' end demand remains strong, but investors will want to keep an eye on future margin and capital expenditure requirements.