United Parcel Service (UPS +1.27%) delivered earnings that beat analyst expectations on Tuesday, and the market reacted positively by taking the stock above $100. Diluted EPS came in at $1.12 for the quarter -- ahead of analyst estimates of $1.09 -- but that's only part of the story. On closer inspection, there are a few positive takeaways from the results and commentary. Most also reflect positively on FedEx Corp. (FDX +3.02%) -- but one doesn't. Let's take a closer look.
It's worth noting that, despite beating analyst estimates, the company left its full-year guidance unchanged. Management still expects $5.05 to $5.30 in earnings. In a sense, the positive news in the report isn't really about the numbers per se; it's more a matter of how the numbers confirm the directional trends in UPS' business.
Dimensional weight pricing
The first conclusion relates to its dimensional weight-pricing initiative. Simply put, it's a way of pricing packages by dimension, as well as weight. The benefit is that customers are encouraged to package small weight items more efficiently. (UPS had previously applied dim weight pricing to larger-weight packages). In doing so, UPS can increase the yield on what's carried in a delivery truck.
It's an initiative that FedEx is also undertaking this year. That's a good thing because it curtails the possibility of a price war between the two. And with both companies taking the initiative, it's likely that the learning curve of retailers will be steeper.
There have been fears that smaller customers would react negatively, and FedEx and UPS would suffer as a consequence. The first feedback on the issue came nearly a month ago from FedEx, and it was tentatively positive.
Turning back to UPS, the best way to gauge the reaction is to look at its U.S. Domestic Package results. The segment generated more than 61% of operating profit in the quarter, and within the segment, ground-based revenue made up around 72% of the segment's revenue in the quarter.
Because the impact of dim weight pricing will be felt most in UPS ground operations -- particularly e-commerce deliveries -- it's a good sign that U.S. Domestic Package operating profit increased by 10.5% in the quarter, It also suggests that FedEx can continue to successfully implement dim weight pricing.
Ground volumes and pricing
Second, let's take a more detailed look at the trading dynamics of Ground-based revenue. The following chart pretty much tells the story. You can see from that chart that there appears to be a trade-off between volume, revenue growth, and pricing -- which increased for the first time in five quarters.
The end result? As noted above, operating profit in the U.S Domestic Package segment increased 10.5% in the quarter -- a good result.
Source: United Parcel Service presentations. Growth rates are year on year.
Peak demand?
Third, management was keen to argue on the earnings call that dim weight pricing is a measure intended to alter customer behavior, and also help the company deal with the increasing complexity of peak demand spikes in the holiday season. I've previously argued that UPS's underlying productivity has held up well since the last recession despite being subject to significantly changing end markets. The problem has been dealing with peak demand during the holiday season.
On that note, outgoing CFO Kurt Kuehn answered a question on dim weight pricing from UBS analyst Tom Wadewitz as follows:
We are pursuing a consistent revenue management strategy. We have talked last year that following peak season, we were going to migrate and to being more price disciplined. And so, this is not a one-time issue. It's just a continuation of our strategy.
In response to a later question on pricing, Chief Commercial Officer Alan Gershenhorn said, "But I just want to reiterate that we are firm in our strategy to further align the revenue with the cost throughout the year including peak season."
In other words, the dim weight pricing initiative is also an ongoing effort to help the company better manage peak demand -- the problem area for the company.
Business-to-Business e-commerce and a possible warning for FedEx
Fourth, Gershenhorn disclosed that its Business-to-Business, or B2B, growth was "for the first time in a very, very long time... ...a bit stronger " than its Business to Consumer, or B2C, growth. This is a good sign because B2B deliveries are typically seen as being more profitable, partly due to the fact that businesses tend to standardize packaging and deliveries.
Fnally, CEO David Abney made some interesting commentary on the FedEx/TNT Express deal: "I'll just remind everyone that the FedEx, TNT deal that is a complex deal and we expect that regulatory agencies will be as stringent on this deal as they have been on previous deals."
Indeed, UPS knows all about the process, because it failed to buy TNT a couple of years ago.
The takeaway
All told, this was a positive report for UPS, and also for FedEx. Dim weight pricing appears to be working, and it may help UPS deal better with peak demand. The strength of B2B e-commerce growth augers well for margin in the future; again, this is good for both companies. Although if Abney is right, FedEx's bid for TNT Express might not go as smoothly as many think.
