Days of fourth quarters past: e-commerce changes UPS' end-of-year game

For UPS Inc. and its legion of shippers, fourth quarters may never be the same.

For generations, UPS could count on the fourth quarter, and the busy holiday season accompanying it, to be its most profitable period. But as the company has discovered, the quarter has become an unpredictable animal that even the parcel industry's master operator has not yet been able to tame.

With e-commerce becoming the dominant force in holiday shipping, UPS has been forced to adjust its operations to handle a new and somewhat unfamiliar type of transaction. Furthermore, this new type of transaction is not nearly as lucrative as the business-to-business (B2B) traffic that had been its bread and butter for more than a century. As Chief Financial Officer Kurt Kuehn told analysts today in discussing the company's quarterly results, it "will take a few years" for UPS to return to the fourth-quarter profitability it became accustomed to.

UPS' challenges became evident on Jan. 23 when it pre-announced that fourth-quarter profits would come in significantly below expectations. UPS officially confirmed the warning today when it disclosed its fourth-quarter earnings per share came in flat over the 2013 period and 22 cents per share below what it originally forecast. Revenue was up 6.1 percent year-over-year to $15.9 billion, which the company said reflected an 8.1-percent increase in volumes across its three product lines: domestic package, international package, and supply chain and freight.

For UPS, the profit shrinkage was due to the higher costs of an unprecedented build-out of its U.S. network to handle a sustained level of peak traffic that didn't occur. Although pre-holiday volumes swelled well beyond an average shipping day when about 16.5 million pieces move across UPS' global network, traffic flows did not reach the levels that the company had anticipated except for on "Cyber Monday" and on Dec. 22, UPS' busiest delivery day of the cycle. The year-long planning came after a difficult 2013 holiday season when a torrent of last-minute online orders, combined with inclement weather in parts of the country, overwhelmed UPS' network and led to late deliveries of thousands, if not millions, of packages.

UPS RE-EVALUATES 2014 STRATEGY
CEO David P. Abney, who just lived through his first peak season at the helm, told analysts that UPS would re-evaluate its decision in 2014 to deploy its domestic air and ground network the day after Thanksgiving, now known as "Black Friday." In years past, only UPS' air network was operational on that day. In the future, UPS plans to implement peak-season delivery surcharges on a "segmented" basis, with the focus to be on residential deliveries and the company's "SurePost" product operated in conjunction with the U.S. Postal Service. The surcharges will be phased in over a multi-year period as contracts come up for renewal, Abney said.

Abney also said that UPS plans to expand its "permanent" hub capacity and scale back or phase out work on facilities used for temporary purposes. In his prepared remarks, Abney said that in the future, use of purchased transportation, such as contract road carriage and intermodal services, will be "optimized," but he did not provide any further details.

UPS is renowned for having a nimble and efficient infrastructure capable of flexing when shipping patterns change. Managing the changes wrought by e-commerce, however, may turn out to be the company's biggest challenge to date. In the U.S., annual online sales are expected to grow four times faster than gross domestic product (GDP). International e-commerce is projected to rise seven times faster than annualized world GDP. What's more, secular changes in online distribution patterns aimed at positioning goods closer to the end customer have led to a trade-down in delivery services, further pressuring UPS' margins, Kuehn said.

In the past, the majority of UPS' business consisted of business-to-business services. Now, however, business-to-consumer (B2C) volumes account for nearly half of UPS' traffic composition. The company had not expected to confront this change in mix so quickly, and the shift presents it with several challenges. First, B2C business lacks the profitable delivery density characteristics of B2B services. Second, while UPS and rival FedEx Corp. currently dominate the B2B world, the two companies face pressure in the B2C space from the U.S. Postal Service (USPS), whose offerings generally underprice them. Finally, as William J. Greene, transport analyst for Morgan Stanley & Co., pointed out in a research note yesterday, the extreme seasonal swings inherent in B2C commerce require further investment in carrier network capacity, which, in turn, adds to pricing pressures.

Greene's note says that UPS faces a crucial strategic decision: Either defend its market share position through aggressive pricing, or maintain its return on invested capital at the risk of losing share. Greene said he believes UPS should opt for the former strategy to repel advances from the USPS and from a cadre of regional B2C players that can affect pricing trends on the margin.

On the shipper side, John Haber, CEO of Spend Management Experts, a consultancy, said today that UPS' purported peak-season surcharges would whack e-commerce companies hard in the 2015 holiday season. Haber urged shippers to act now to evaluate all carrier options because UPS is likely to make "material pricing changes" during the year rather than just waiting until each January to roll out price hikes on its tariffs.