UPS' High-Class Problem

While the magnitude and late timing of peak shipping season crimped  United Parcel Service's (UPS) fourth-quarter earnings, our take is that robust demand is a high-quality problem to endure. We expect the firm to adjust operations and pricing to better contend with consumer demand during compressed peak seasons like 2013 and 2014, and management shared optimistic expectations for all three reporting segments in the year to come.

UPS did not reap expected operating leverage benefits because necessary overtime, weekend operations, and an unusually large cadre of temporary employees drove up compensation expenses faster than volume expanded. Demand was indeed strong and late: Consolidated quarterly average daily package volume increased 6% and December deliveries surged a sharp 20%. U.S. domestic average daily package volume improved 5.6% overall, with ground and deferred growth outpacing that of next-day air, consistent with downshifting in the past several years. International package average volume increased 8.2% in domestic and a strong 9.5% in export; in the latter, exports in the European sector grew 13%, a solid sign of health for the region.

Management expects 2014 earnings per share to grow 11%-16% over adjusted 2013 results, boosted by $2.7 billion of share repurchases. We expect UPS to deploy part of its planned $2.5 billion of capital expenditures on expansion and technology to deal with peak pinch points. Among other initiatives, UPS plans to improve its forecasting methodology and escalate deployment of route-planning tools. We expect the firm to wield its considerable budget and tech know-how to adapt to demand shifts, and we regard the quarter as a bit of a speed bump that can be mitigated with investment, forecasting, and perhaps differential pricing on last-minute shipments.

Extensive Shipping Network Produces Industry-Leading Margins and ROICs
UPS is the colossus among global parcel shipment companies, and we consider its economic moat to be the widest among all freight transportation firms. The company crafted its moat by assembling an integrated global shipping network that's unlikely to be matched by any but a few global players. Despite its extensive unionization and asset intensity, UPS produces returns on invested capital about double its cost of capital and margins well above its competitors'; we credit the firm's leading package density and outstanding operational efficiency, enhanced by extensive technology investment. UPS and its competitors have turned to Asia and developing nations for growth, and we think UPS has ample runway left to build speed. Even existing operations have revenue expansion potential via pricing power, because UPS operates as a rational duopoly in its largest market, U.S. high-service parcel delivery.

UPS earns higher margins than its peers by its mix (FedEx (FDX) has expanded ground operations, but still earns a majority of its revenue in its low-margin express segment) and by funneling substantially greater package volume through its efficient assets. In the U.S. parcel market, FedEx's express and ground units together handled about 8.8 million average parcels daily in fiscal 2013, but UPS moved 14.4 million in calendar 2013. Within this total, the disparity is even greater in U.S. ground, where UPS moved on average 12.1 million parcels per day and FedEx about half of that: 6.3 million including SmartPost. Another aspect of UPS' margin advantage lies in its use of integrated assets to transport U.S. urgent and ground shipments through the same pickup and delivery network. In contrast, FedEx uses parallel networks of drivers and trucks to separately handle ground and express shipping. In addition to the greater efficiency of UPS' single system, clients appreciate the convenience of using the same driver to handle both express and ground packages.

Moat Is Widest of All Freight Transportation Firms
UPS earns its wide economic moat from efficient scale, cost advantage, and the network effect. Extensive express, ground, and freight networks demand a huge quantity of trucks, trailers, terminals, sorting equipment, IT systems, and skilled labor. Replicating these assets in the absence of sufficient package flow would be costly, and few entities would endure the financial losses during the necessary density-building phase. As evidenced by DHL's worthy effort, such a project would require at least a decade of effort. Even a global shipping powerhouse like DHL failed to displace UPS and FedEx on their massive home turf--these two competitors constitute the efficient scale in high-service U.S. domestic parcel delivery. In this high-fixed-cost business, the substantial parcel volume handled by the incumbents provides a cost advantage that makes competing at market prices difficult for low-volume entrants. Compared with FedEx, UPS produces superior margins via greater package volume, concentration on high-margin ground shipping, and use of a single network rather than parallel air and ground operations. The firm produces attractive ROICs averaging around 15% (excluding the 2007 pension withdrawal expense) despite its intensely asset-based operations. The firm does have substantial asset-light operations in its freight forwarding and contract logistics operations, and the former boast network effects typical of this model--additional offices make the entire system more valuable to shippers. We believe with near certainty that the firm will outearn its cost of capital for the next 10 years, and we consider excess normalized returns more likely than not two decades from now. We consider UPS' economic moat to be one of the widest in the transportation universe.

Macroeconomic Factors Add Uncertainty
Rapid changes in shipping demand during the recent recession demonstrate that the cone of uncertainty surrounding modeling estimates can widen quickly because of macroeconomic factors. UPS derives nearly a fourth of its total revenue from international sources, but it still relies heavily on the U.S. market. The UPS driver team is unionized, but UPS recently minimized the risk of service disruption by signing the current labor contract well before the expiration of the previous agreement.