UPS faces mix/margin challenges as COVID-19 skews shipping choices

UPS Inc. (NYSE:UPS) has long planned for the day when business-to-consumer (B2C) traffic would become the truly dominant force in its volume mix. The extraordinary events of the past 60 days may have pulled that day forward faster than anyone could have expected.

On April 28 the Atlanta-based shipping and logistics giant posted adjusted first-quarter earnings per share of $1.15, below analysts’ consensus range of $1.21 to $1.24 per share. Adjusted net income fell to $1 billion from $1.2 billion in the first quarter of 2019. Revenue climbed to $18 billion from $17.2 billion, due mostly to strong demand from U.S. e-commerce customers and gains in healthcare volumes. 

U.S. domestic revenue, which makes up roughly two-thirds of UPS’ overall volume, grew by 9.3% year-over-year (y/y), well above analysts’ expectations. Ground volumes rose 7.2%, and next-day air volumes continued their impressive run, up 20.3% y.y. Both figures also exceeded most analyst expectations.

The growth numbers, however, proved a double-edged sword. By the end of the quarter, B2C traffic, the main driver of e-commerce, accounted for an unprecedented 70% of UPS’ global traffic mix, with the remainder being business-to-business (B2B) commercial traffic that came to a virtual standstill by quarter’s end as governments’ worldwide stay-at-home orders and social-distancing measures shuttered virtually all brick-and-mortar enterprises.

In the U.S., UPS’ first-quarter ratio of B2C to B2B traffic was about 55% to 45% in favor of B2C before the mandates went into effect, according to company estimates. In the past few years, the ratio has oscillated between a 50-50 split to 55%-45% toward B2C, the company said.

B2B traffic is a higher-margin business for UPS because the company can deliver multiple packages per stop. By contrast, B2C deliveries are more costly propositions because, with the exception of densely populated urban areas, they typically involve one package per stop, and require drivers and vehicles to operate over longer distances. 

UPS paid the price for the massive shift to B2C in the quarter. In the U.S., its miles driven rose 10% y/y, while its daily stops jumped by 15%. 

Because of the presence of lower-cost rivals like FedEx Corp., (NYSE:FDX), the U.S. Postal Service (USPS) and, Inc., (NASDAQ:AMZN), it is almost impossible for UPS to implement B2C price increases to offset such sudden and dramatic cost spikes. UPS’ ongoing multi-year program to re-engineer its U.S. distribution network is designed to boost the productivity of e-commerce package flows. This is expected to reduce costs and bolster profits without the need to push for price hikes. The full benefits of the initiative won’t be felt for another two to three years, however.

The first-quarter results illustrated UPS’ current dilemma. Domestic profit margins fell by more than three full percentage points year-over-year, while adjusted operating income dropped to $401 million, a nearly $300 million decline. UPS executives sidestepped analysts’ queries as to whether it will need to re-think its long-term B2C pricing strategy should its traffic mix permanently stay at or near such elevated levels.

In all, UPS suffered a $140 million bottom-line hit due to disruptions from the coronavirus pandemic. It also received a $110 million higher-than-expected poke from self-insurance accruals from an increased frequency in accident-related claims. Company executives said they plan to beef up safety initiatives in response to the unfavorable trend.

In addition, the small to midsize business (SMB) segment, probably UPS’ top priority, was impacted as many SMBs could not pivot quickly enough to e-commerce models to offset the impact of the sudden changes in their regular ordering and shipping activities.

UPS is doing what it can to mitigate any financial disruptions. It has slashed its 2020 capital expenditures by $1 billion to about $5.7 billion. It suspended its stock repurchase program, which the company said will save it an additional $783 million. UPS said it had $2.6 billion in operating cash flow and $1.6 billion in adjusted free cash flow at quarter’s end. Executives said the company’s liquidity position and overall financial condition remain strong, and it is committed to preserving its $4.04 per share annual dividend.

The company’s international segment posted $558 million in adjusted operating profit on revenue of $3.38 billion. In the 2019 quarter, adjusted operating income came in at $612 million on slightly higher revenue. After pronounced weakness in January and February, Asian export volumes rose 15% in March as Chinese factories resumed operations following the country’s early fight with the coronavirus. Demand strength continued into April, UPS said. European activity remains weak, reflecting the continent’s transition to a post-COVID-19 business environment, UPS said.

Much of the end-of-quarter gains out of Asia came from end users’ inventory restocking needs. Given the profound demand destruction in the U.S. and elsewhere, it is an open question as to how the segment will perform in the second quarter should the restocking need wane, analysts said.

The UPS Supply Chain and Freight unit posted a $53 million y/y decline in adjusted operating profit on slightly lower revenue. Weakened economic activity depressed volumes at the unit’s Coyote brokerage operations and at its UPS Freight less-than-truckload (LTL) business. The one exception was the unit’s Marken healthcare logistics business, which posted double-digit gains in revenue and operating profit.

As of 1:30 p.m. EDT on Tuesday, April 28, UPS shares were trading down 4.26% to $98.18 per share.