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Online Sales Critical To Holidays

No disrespect to Santa Claus, but FedEx and UPS wouldn't mind stealing some of the Big Guy's thunder this Christmas season when it comes to delivering presents.

The world's two biggest freight delivery companies could use a strong holiday season — driven by a rise in online shopping — to help offset recent sluggishness in their financial performances.

There's reason for optimism.

According to Nielsen's annual Holiday Spending Forecast, released Nov. 18, nearly half of shoppers — 46% — plan to shop online this holiday season. That's up from 30% in 2012. And thanks to improved consumer confidence, overall spending is expected to rise about 2%.

More online shopping means more package deliveries. And financial results of FedEx (FDX) and UPS (UPS) often act as an indicator for consumer spending. Combined, the two control about 90% of the U.S. package delivery market.

"They are both making hay from strong consumer demand for online fulfillment, and are the two likely companies to deliver orders from Amazon (AMZN) and other online marketplaces," said Keith Schoonmaker, analyst at Morningstar.

A healthy holiday season would help both companies turn around their struggling numbers.

Memphis, Tenn.-based FedEx has logged lower or flat earnings in three of its last five quarters. Results have been similar at Atlanta-based UPS, which has reported lower earnings twice in the last five quarters. The companies have been hurt on a couple of fronts, according to a recent report from market researcher Trefis.

While the economic recovery in the U.S. "continues to buoy ground shipping volumes" this year, the report says, "weak consumer spending impacts volumes for expensive shipping services such as air freight.

In addition, lower prices of services have hurt revenue yields for UPS and FedEx.

On the bright side, Trefis notes that a recovery in the global macroeconomic environment, although sluggish, bodes well for both UPS and FedEx. In addition, strengthening domestic markets and weak international currencies "have increased volume shipments and revenues, albeit at lower prices," the report said.

Dominating The Big Picture

UPS and FedEx both use aircraft and ground delivery vehicles such as trucks, vans and even motorcycles to get packages from one place to another. They specialize in small-parcel and less-than-truckload shipments.

In addition to delivery services, the companies provide logistics, supply-chain and other solutions.

Last year FedEx got most of its revenue, 61%, from its FedEx Express service. FedEx Ground accounted for 24% of revenue and FedEx freight contributed 12%. The rest came from other services.

UPS' revenue breakdown last year was similar. Its biggest chunk of revenue, 61%, came from its U.S. Domestic Package business. Its International Package unit contributed 22%, while its Supply Chain and Freight unit took care of the other 17%.

FedEx and UPS are far and away the biggest players in IBD's Transport-Air Freight group, which consists of five companies.

UPS has about $55 billion in annual sales and provides delivery services to more than 220 countries and territories.

FedEx logged $44.3 billion in revenue last fiscal year, which ended in May. It also provides services to more than 220 countries.

The No. 3 company in the group, Atlas Air Worldwide Holdings (AAWW), had $1.6 billion in sales last year. It gets revenue from a variety of sources in addition to air cargo, including outsourced air services and passenger flights.

Others in the group are Air Transport Services Group (ATSG), which has about $580 million in annual sales; and Air T (AIRT), with around $102 million.

Collectively, the stocks in the Transport-Air Freight group are up 33% since the beginning of the year, and rank 53rd among the 197 industries tracked by IBD.

Powerful Economic Moats

The biggest shift in the freight delivery market in recent years, and the one driving much of its current demand, is the ongoing rise in online shopping.

"Business-to-consumer (B2C) volume has become a higher proportion of the freight mix ... and continues to be the fastest organically growing package segment, driven primarily by Internet retailing," Citigroup analyst Christian Wetherbee noted in a recent industry report.

B2C orders will likely be the primary driver of domestic volume for UPS and FedEx in coming months, he says, particularly amid a sluggish environment for business-to-business spending.

Since 2004, e-commerce has risen at an average rate of 12% a year in the U.S. and has produced nearly $140 billion in domestic sales so far this year.

UPS and FedEx have seen similar rises in B2C package volume. FedEx's B2C volume has grown 10% a year since 2004, Wetherbee notes, while UPS's has grown 7% a year.

As online orders grow, so will business at UPS and FedEx because of their dominant positions in the ground delivery market.

"They both have powerful economic moats regarding future returns and competitive advantage," said Morningstar's Schoonmaker.

He cites DHL's decision a few years ago to exit the ground and air express markets in the U.S as evidence of the "powerful hold" that UPS and FedEx have on the domestic industry.

There's ample room to grow business overseas as well. For now, however, international markets continue to pose challenges to both UPS and FedEx.

"We've seen a slowing of international express shipments that's happened since the recession," Schoonmaker said. "Both UPS and FedEx have been right-sizing their capacity to match lower demand for international shipping.

Neighborhood Market Share

Because freight shipping companies rely so heavily on consumer and business spending, they are particularly susceptible to economic conditions.

If the U.S. economy continues to improve — and overseas markets follow suit — UPS and FedEx stand to benefit.

The near-term outlook looks rosy enough. Analysts expect FedEx to report a 12% earnings gain this fiscal year, which ends in May. They see fiscal 2015 profit rising 26%.

UPS, which operates on a traditional calendar fiscal year, should deliver 5% earnings growth in 2013 and 15% growth in 2014.

One thing analysts will keep an eye on is how freight delivery companies deal with the higher expenses associated with online orders.

Wetherbee notes that in the B2C market, carriers don't usually visit each residence in a neighborhood every day. So when more packages are delivered, it usually means more stops per driver — and higher costs.

But as volume density in the B2C market increases, these costs should come down.

"It is more likely that UPS or FedEx will at least be in each neighborhood every day, limiting the incremental expense of delivering to more homes," Wetherbee said. "But pricing still needs to be increased to ensure that the incremental stops do not result in margin pressure.

Cost-Cutting Technology

New technologies continue to play a key role in helping FedEx and UPS operate more efficiently.

Trefis notes that FedEx Ground has introduced automatic planning systems across its major hubs, designed to improve transit times across numerous shipping lines. This effort should lead to higher operating margins in future quarters.

Meanwhile, UPS looks to lower its operational and fuel expenses by increasing the rollout of its On-Road Integrated Optimization and Navigation (ORION) software.

ORION is designed to improve ground-fleet delivery times and lower fuel costs by optimizing the efficiency of routes.

"UPS expects complete integration of its proprietary ORION software within the 55,000 operational routes in the U.S. by 2017, and a global roll-out subsequently," Trefis noted.