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Is UPS' Business About to Fall Off a Cliff?

By Robert Stephens - Apr 1, 2016 at 10:33AM

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Should investors in UPS be worried about the prospect of reduced demand from Amazon?

In UPS(UPS -0.14%) annual 10-K filing for 2015, the company states that "no single customer accounts for 10% or more of our consolidated revenue" and that therefore "we do not believe that the loss of any single customer would materially impair our overall financial condition or results of operations." Nonetheless, a number of UPS investors have become rather concerned about the prospect that could reduce its reliance on UPS, with the former seemingly focused on increasing its in-house shipping capabilities, which could mean its demand for UPS' services will decline. Should investors really be worried?

Amazon delivery
Amazon has recently announced two new initiatives: Amazon Prime Air and Amazon Flex. The former is a forthcoming delivery system that will aim to get packages to customers within 30 minutes of their order, using drones. While it may only be in the pipeline, it is a clear statement that Amazon is focused on improving its in-house shipping capabilities. So is Amazon Flex, a courier service made up of private individuals who act as delivery partners. Although it only serves 16 metro areas in the U.S. right now, there is scope for the service to expand. And with Amazon also expanding its delivery capabilities through the leasing of 20 aircraft that are due to come into use starting April 1, its move toward in-house shipping is clear. 

While it's understandable that Amazon would wish to reduce its shipping costs, since they accounted for 11.6% of its total revenue in 2015 (up from 10.3% in the prior year), the reality is that even if Amazon does increasingly move in-house for its shipping needs, UPS' earnings don't appear to be about to fall off a cliff. UPS would likely suffer from the gradual loss over the medium to long term of an important customer, and this could hold back its top- and bottom-line growth. However, this process would be unlikely to act as a short, sharp shock on the company's financial performance.

In fact, UPS has a number of significant growth opportunities that could help it to offset the gradual loss of Amazon as a customer and allow it to build on the share price growth of 5% since the turn of the year. Even if Amazon does reduce its dependence on UPS, these key growth areas could allow it to generate positive earnings growth -- especially since, as previously mentioned, Amazon accounts for less than 10% of UPS' total sales.

Niche opportunities
UPS is increasingly offering industry-specific solutions, tailoring its services in sectors such as aerospace, automotive, and healthcare to customer needs. UPS focuses on industry trends within those sectors, which allows it to align its logistics expertise to address the challenges that businesses in those segments specifically face, thereby helping its customers to compete. For example, in electronics, UPS is focused on adding value through support in product launches (with the product life cycle getting shorter), post-sales support, and reverse logistics. This approach allows it not only to become a specialist within a particular product area, but to become involved with customers at the strategic planning stage. The fact that UPS is involved at the start of its partners' generation of new ideas becomes integral to their success.

As such, this makes it more difficult for UPS' customers to go elsewhere, since they are more reliant on UPS' input than they otherwise would be. This situation increases the value added by UPS and should help build a higher degree of customer loyalty in the long run. Furthermore, UPS can expand its industry-specific model into new sectors and replicate what has thus far proved to be a successful model. As such, it has the potential to become even less reliant on Amazon moving forward. Sure, there is the potential for this model to be replicated by UPS' peers, but the integral role that UPS is playing with its partners should ensure that they remain loyal.

An improving outlook
UPS is also becoming a more efficient business and is in the process of improving its margins. A key reason for this is a reduction in operating expenses, which fell by 4.8% in 2015 versus the prior year. Furthermore, there is the scope for further improvements to network management, as well as technological developments such as ORION -- UPS' On-Road Integrated Optimization and Navigation software, used to provide more efficient routes to drivers -- both of which should continue to have a positive impact on UPS' margins and efficiency. 

There is also scope for UPS to expand its sales through the growth in e-commerce activity around the globe. Although Amazon is a major e-commerce operator, the global e-commerce market is set to expand rapidly as the availability of the Internet increases in emerging markets around the world. And with UPS rolling out multiple technological improvements to build upon its already well-established delivery network, it appears to be well placed to benefit from an e-commerce tailwind over the long run. For example, the company's Access Point Network, which allows customers to pick up their packages at local businesses, was expanded to 11 countries last year and will be rolled out across more territories next year, with emerging markets likely to be a key focus.

Looking ahead
Clearly, UPS will suffer somewhat from Amazon's move toward using in-house shipping methods. However, this process looks set to be gradual, with Amazon slowly seeking to develop new and innovative means of fulfilling its shipping needs. Therefore, UPS' earnings are unlikely to fall off a cliff. That's especially the case since UPS is not overly reliant on any one customer.

Furthermore, UPS has the scope to expand into new niche areas, benefit from operational improvements that make the business more efficient, and generate higher sales from the growing global e-commerce market. Therefore, while its financial performance could suffer somewhat from reduced demand from Amazon over the medium to long term, UPS is set to offset this through the development of other parts of its business. 

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