United Parcel Service's (NYSE: UPS) recently released third-quarter results left the market underwhelmed, and the stock sold off slightly in the aftermath. Its report followed disappointing results from package delivery rival FedEx Corporation (NYSE: FDX). Consequently, investors must be wondering what lies ahead for UPS in the fourth quarter?
Two conclusions from the third quarter
There are two key takeaways from the third-quarter results and earnings call upon which investors should focus for the fourth-quarter.
- How UPS will deal with peak demand during the holiday season
- How increases in revenue per package caused by dimensional weight pricing are being masked by the negative impact of lower fuel surcharges
Both FedEx and UPS have plans for dealing with peak demand. During the harsh winter of 2013, both shippers faced higher expenses due to a combination of greater-than-expected peak demand and network disruptions caused by poor weather.
UPS responded by investing in extra capacity, but got tripped up when the structure of peak demand proved difficult to predict -- in short, UPS had too much capacity on days when demand was lower than forecast. Meanwhile, FedEx's separate air and ground networks are believed to have granted the company greater flexibility in dealing with peak.
There is no doubt that dealing with peak will be the biggest concern in the fourth-quarter for UPS and, on the earnings call, Chief Commercial Officer Alan Gershernhorn outlined plans to adopt pricing initiatives to smooth out demand, network capacity expansions, and collaboration efforts with customers in order to better align their plans with UPS's capacity.
In addition, he discussed how the wide-scale shift to dimensional weight pricing -- shipping costs are based on a combination of box size and weight, rather than just weight -- has helped encourage customers to optimize packaging. FedEx has also increased its adoption of dim-weight pricing.
Clearly, the message from the earnings call was that UPS is taking a more holistic approach to dealing with peak this year -- it's not just about expanding capacity. But is this having ramifications for other parts of the business?
UPS volumes and pricing
One of the possible consequences of dim weight pricing is customers cutting back on volumes. In a sense, this is good for UPS -- at least, it's good when customers optimize deliveries without walking away from using UPS (or even FedEx) due to dim-weight pricing.
With this in mind, here is a look at growth in volume and pricing in UPS Ground (which reports within the U.S. domestic package segment, and is responsible for more than 70% of total revenue) along with the key number in this analysis, namely revenue.
As you can see in the chart above, the third quarter saw a decline in ground volume for the first time since 2011. However, this would not be a concern if average revenue per piece was rising strongly -- that lower volume/higher price shift is exactly the kind of dynamic you might expect with dim weight pricing. The idea is that, ultimately, ground revenue should increase. Unfortunately, as the chart shows, after a nice pick up in the first-quarter, both pricing and revenue growth slowed in the last two quarters. Is this a sign of a problem?
Yes and no.
Yes in the sense that no one wants to see volume growth turn negative, although that was not solely due to dim-weight pricing, and management actually gave a bullish prognosis for the fourth quarter. Management argued that a slowdown in the industrial sector caused business-to-business, or B2B, shipments to slow in the quarter which hurt volume. However, the pace of growth of business-to-consumer, or B2C, "increased in the quarter" according to the earnings release, and CFO Richard Peretz said this regarding overall outlook on the earnings call: "In the U.S., we expect higher average daily volume growth in the fourth quarter to be around 4% to 5%".
No, because part of the slowdown in pricing growth was due to lower fuel surcharges caused by the decline in jet fuel prices. Indeed, the U.S. domestic package segment's revenue per package took a 2% drop from lower fuel surcharges in the first-quarter, a 3% dip in the second, and a 2.5% drop in the third.
Assuming these figures apply to ground, adding them back to the data in the chart above would produce the following rough estimate for the underlying growth rate in last three quarters.
Clearly, lower fuel surcharges have reduced pricing and revenue growth.
UPS's obvious focus in the fourth quarter will be dealing with peak demand, but investors should also look out for an increase in ground volume. The company's underlying revenue per package is fine -- it's just that lower fuel surcharges are acting as a headwind to stronger revenue growth.
The good news is that energy prices are starting to come up against easier comparisons, so the fuel surcharge issue should be reducing, and UPS should see pricing and revenue growth increase in 2016. Just keep an eye on ground volume in the fourth quarter.
Lee Samaha has no position in any stocks mentioned. The Motley Fool recommends FedEx and United Parcel Service. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.