The surprising way an online shopping surge crushed UPS earnings

UPS CFO: Want to make trade complexity simpler for customers
UPS CFO: Want to make trade complexity simpler for customers

Packages may have made it under the tree in time for Christmas this year, but UPS failed to deliver for investors. The delivery giant reported fourth-quarter earnings and revenue shy of analyst expectations, and its 2017 forecast also missed estimates.

But that's only part of the story.

"We actually had a good fourth quarter, but what we saw was a tremendous shift in the amount of volume that went to the consumer versus to the business. In fact we looked over the last 10 years and this is the fastest rate of change," Richard Peretz, chief financial officer at UPS, told CNBC. "While volume continued to grow, opportunity continues to grow, because of business to consumer, we saw the impact."

In other words, as consumers turn to the internet more and more frequently to buy more and more goods, delivery companies like UPS are scrambling to keep up.

E-commerce has been growing at double-digit rates for years and the 2016 holiday season was no exception: online sales surged 13 percent, according to the National Retail Federation, trouncing its forecast of 7 to 10 percent growth.

UPS said it delivered 712 million packages globally during the peak holiday season, from Black Friday to New Year's Eve. The season included two additional delivery days, but that sum represented 16 percent growth year over year, surpassing the company's 700 million-shipment expectations. During the quarter, U.S. package volume jumped 5 percent.

Business-to-consumer, or B2C, volumes (which include e-commerce) comprised 55 percent of total volumes — and 63 percent during December alone. Packages were delivered to nearly 2.5 million new addresses.

Delivering to individual consumers' doorsteps is more costly than delivering multiple shipments at the same time to one location, as is the case for shipments between businesses. That so-called last mile of delivery is the most expensive leg of the trip: more individual packages destined to more individual addresses means more pressure to margins, a risk that once again materialized in UPS' results.

In a call with the investment community, management said it's "leaning into the opportunity." The company now plans to pour $4 billion into its network, expanding capacity and automating facilities — a 30 percent jump versus the $3 billion spent in 2016. Peretz said UPS has automated three buildings so far, and will complete 30 to 35 by the time it's done.

Analysts say the issue is that while the e-commerce business continues to grow gangbusters, UPS — and its peers — must spend more to keep up with demand and ensure shipments are delivered on time. It's an issue that has plagued both UPS and FedEx in recent years, most notably during the peak holiday season, when networks handle as much as double the average daily package volume.

"UPS and FedEx are dead center in one of the greatest marco trends of our generation — and yet they can't take full advantage of it," said Donald Broughton, a managing director at Avondale Partners covering transportation. "Bottom line UPS has proven less capable of generating incremental margins on the surge in volumes."

United Parcel Service (UPS) operations in Miami.
Mark Elias | Bloomberg | Getty Images

He says unlike UPS, FedEx has seen outsized growth, with the ground segment posting the highest operating margin within that company. Broughton has a hold rating on UPS and rates FedEx a buy.

In addition to the rapid shift toward e-commerce deliveries, UPS said shipments in its more profitable business-to-business segment slipped last quarter, weighed down in part by weak industrial production trends and a strong U.S. dollar.

For 2017 management issued weaker-than-expected profit guidance, thanks to lower profits from residential deliveries and continued export headwinds associated with the strong dollar.

But UPS does expect better economic growth in the U.S. this year, and "looks forward to working with" the Trump administration and Congress, as tax reform, infrastructure spending and new bilateral trade agreements are potentially rolled out.

On the heels of the disappointing results, shares of UPS tumbled Tuesday, in their worst daily performance in two years. Shares of FedEx also fell in sympathy.

UPS recently changed hands at $109.48, down 6.5 percent, while FedEx shed 2.5 percent to trade at $188.37.

E-commerce growth takes a toll on UPS earnings
E-commerce growth takes a toll on UPS earnings