Sector

Transportation & Logistics

Background

Matt Reustle is CEO of Colossus and a former Transport analyst. We cover the factors behind the UPS approach of "bigger not better", Amazon's position in the parcel delivery market, and the secular shifts taking place in the industry.

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Date

February 9, 2022

Episode Number

46

UPS Business Breakdown: Key Takeaways and Dynamics

Background / Overview

United Parcel Service (UPS) is a global logistics and package delivery company with over a century of history, founded in 1907 in Seattle by Jim Casey. Initially a messenger service using bicycles, UPS evolved into a B2B delivery provider for department stores, introducing its iconic brown trucks and uniforms designed for practicality. Over decades, it transformed into a fully integrated national and global logistics network, adapting to regulatory changes and consumer behavior shifts, such as the rise of shopping malls and e-commerce. Today, UPS is the world’s largest package delivery company, handling 25 million packages daily (peaking at 30 million in Q4) and touching 3% of global GDP. With approximately 500,000 employees, including a significant unionized workforce (the largest employer of Teamsters), UPS operates a capital-intensive, asset-heavy network of sortation facilities, trucks, and over 200 aircraft.

Ownership / Fundraising / Recent Valuation

UPS is a publicly traded company with a market capitalization exceeding $200 billion. The transcript does not provide recent transaction details, enterprise values, or multiples, but its scale and longevity suggest a stable, blue-chip profile. No private equity or sponsor ownership is mentioned, and the company’s capital structure supports significant reinvestment and dividend payouts.

Key Products / Services / Value Proposition

UPS operates in the small package delivery market, focusing on parcels (light goods) as opposed to heavy freight. Its core services include:

1. Domestic Ground Delivery: Primarily B2B and residential deliveries, with a shift toward e-commerce-driven residential packages.
2. Air Delivery: Express and next-day services, leveraging a hub-and-spoke model with major hubs in Louisville, Kentucky.
3. International / Cross-Border Delivery: High-margin services moving packages globally, competing with few players like FedEx and DHL.
4. Logistics and Supply Chain Solutions: Supporting businesses with inventory management and distribution, though less emphasized recently.

The value proposition lies in reliability, global reach, and network efficiency. UPS’s integrated network allows cost-effective delivery across geographies, with high barriers to entry due to its scale and infrastructure. Cross-border services are particularly lucrative, offering 25% operating margins despite comprising only 20% of revenue.

Segments and Revenue Model

UPS operates three primary segments:

1. U.S. Domestic Package: The largest segment, generating the majority of revenue through ground and air deliveries.
2. International Package: High-margin cross-border deliveries, contributing 20% of revenue but outsized profitability.
3. Supply Chain Solutions: Smaller, lower-margin services, with the freight business recently divested to focus on core competencies.

The revenue model is volume-driven, with pricing per package varying by service type (ground vs. air, domestic vs. international). Revenue is generated by:

• Price per Package: Approximately $10 for domestic packages, higher for air and international.
• Volume: 25 million packages daily, with seasonal peaks in Q4 (30 million).
• Mix: Shift from B2B (66% a decade ago) to residential (66% today), driven by e-commerce.

Amazon contributes 10% of UPS’s revenue, reflecting lower-margin, high-volume e-commerce deliveries. The company is refocusing on small and medium-sized businesses (SMBs) and high-margin international volumes to improve profitability.

Splits and Mix

Revenue Mix

• Channel Mix: Primarily direct delivery to businesses and consumers, with minimal reliance on third-party distributors.
• Geo Mix: U.S. dominates (part of a $150 billion U.S. small package market), with international contributing 20% of revenue.
• Customer Mix: Historically B2B (department stores, enterprises), now increasingly residential due to e-commerce. SMBs are a strategic focus.
• Product Mix: Ground delivery dominates volume, followed by air and international.
• End-Market Mix: E-commerce is the primary driver, with cross-border e-commerce growing rapidly.

EBITDA Mix

• Domestic Package: Lower margins (10%) due to e-commerce’s higher labor and sorting costs.
• International Package: High margins (25%) due to fewer competitors and pricing power.
• Supply Chain Solutions: Low margins, reduced impact post-freight divestiture.

Historical Mix Shifts

• B2B to Residential: A decade ago, 66% B2B and 33% residential; today, 66% residential, reflecting e-commerce growth.
• Margin Compression: Domestic margins fell from 15% to 10% over 20 years due to smaller, labor-intensive e-commerce packages.
• Strategic Shift: Under new CEO Carol Tomé, UPS is prioritizing SMBs and international volumes over low-margin Amazon business.

KPIs

• Volume: 25 million packages daily, peaking at 30 million in Q4, nearly triple the volume from 20 years ago.
• Operating Margin: Consolidated low-teens, with domestic at 10% and international at 25%.
• Revenue per Package: ~$10 for domestic, higher for international.
• Labor Costs: $20/hour for drivers, with senior drivers up to $50/hour during peaks.
• Sortation Efficiency: 90% automated (up from 50% manual five years ago).
• Growth Trends: Volume growth decelerating as UPS prioritizes margin over volume; revenue growth supported by pricing power (double-digit increases).

Headline Financials

Long-Term Financial Trends

• Revenue: Grew with e-commerce but faces mix challenges from lower-margin residential deliveries.
• EBITDA Margin: Compressed from 15% to 10% domestically due to e-commerce; recovering through automation and pricing.
• FCF: Strong at $10 billion, supported by reduced CapEx and operational efficiencies.

Value Chain Position

UPS operates midstream in the logistics value chain, between suppliers (businesses, retailers) and end customers (businesses or consumers). Its primary activities include:

• Inbound Logistics: Receiving packages from businesses or e-commerce platforms.
• Operations: Sorting (90% automated), transportation (hub-and-spoke model), and delivery.
• Outbound Logistics: Last-mile delivery to businesses or residences.
• Service: Customer support and tracking.

UPS’s competitive advantage lies in its integrated network, enabling cost-efficient delivery across geographies. The hub-and-spoke model (e.g., Louisville hub) optimizes asset utilization by consolidating packages for transport. The go-to-market (GTM) strategy emphasizes reliability, speed, and global reach, targeting SMBs, enterprises, and high-margin international customers.

Customers and Suppliers

• Customers: Diverse mix of B2B (enterprises, SMBs) and B2C (residential e-commerce). Amazon accounts for 10% of revenue but 20% of e-commerce volume, indicating lower pricing.
• Suppliers: Minimal supplier concentration; key inputs include fuel, labor (Teamsters), and equipment (trucks, planes). Labor is a critical dependency, with union agreements shaping cost flexibility.

Pricing

Pricing is driven by:

• Service Type: Ground (~$10/package), air (higher), international (premium).
• Customer Type: SMBs and international clients yield higher prices; Amazon’s volumes are lower-priced.
• Contract Structure: Long-term agreements with enterprises, shorter-term with SMBs. Pricing power is strong in cross-border (25% margins) due to limited competition.
• Drivers: Mission-criticality (e.g., vaccine delivery), reliability, and network exclusivity. E-commerce has introduced price sensitivity, with Amazon pushing lower rates.

Bottoms-Up Drivers

Revenue Model & Drivers

UPS generates $1 of revenue by delivering a package, with price and volume as primary drivers:

• Price: ~$10 for domestic ground, higher for air and international. Pricing power is strongest in cross-border due to limited competition.
• Volume: 25 million packages daily, driven by e-commerce growth (10% annual market growth). Residential deliveries (66% of volume) are less profitable due to single-package stops.
• Mix:
• Product Mix: Ground dominates, but international is high-margin.
• Customer Mix: Shift to SMBs and away from Amazon’s low-margin volumes.
• Geo Mix: U.S. dominates, but international (20% revenue) drives profitability.
• Growth: Organic growth from e-commerce and pricing power; inorganic growth limited post-freight divestiture.

Cost Structure & Drivers

• Variable Costs: Labor (sorting, delivery) and fuel scale with volume. E-commerce increased labor costs due to smaller packages and more stops.
• Fixed Costs: Facilities ($400 million per sortation center) and equipment provide operating leverage. Automation (90% of sortation) reduces labor dependency.
• Contribution Margin: Domestic ground ~30% (price $10, variable cost ~$7), international higher due to premium pricing.
• Gross Margin: ~25% blended, impacted by e-commerce’s higher variable costs.
• EBITDA Margin: Low teens, improved by automation and mix shift to high-margin volumes.
• Operating Leverage: High fixed costs (facilities, planes) mean volume growth drives margins, but e-commerce’s labor intensity offset this historically.

FCF Drivers

• Net Income: ~$8-9 billion, derived from $13 billion EBITDA less interest, taxes, and depreciation.
• CapEx: $8-9 billion, primarily maintenance post-reinvestment. Historical reinvestment ($400 million per facility) doubled sortation capacity.
• Net Working Capital (NWC): Moderate, with inventory minimal but receivables and payables tied to customer contracts. Cash conversion cycle is efficient due to scale.
• FCF: $10 billion, supported by strong EBITDA and controlled CapEx. Cash conversion is robust (~77% of EBITDA).

Capital Deployment

• Dividends: Primary use of FCF, reflecting shareholder focus.
• M&A: Limited; freight business divested to streamline operations.
• CapEx: Reinvestment period (mid-2010s) upgraded sortation facilities, now shifting to maintenance.
• Buybacks: Not emphasized, with capital prioritized for dividends and network efficiency.

Market, Competitive Landscape, Strategy

Market Size and Growth

• Total Market: Small package delivery is a $450 billion global market, growing 10% annually, driven by e-commerce. The U.S. represents ~$150 billion (33%).
• Growth Drivers:
• Volume: E-commerce adoption, with residential deliveries surging.
• Price: Moderate increases, constrained by Amazon and USPS competition.
• Industry Growth Stack: E-commerce penetration, population growth, and inflation drive market expansion.

Market Structure

• Competitors: Oligopoly with UPS (25% U.S. volume), USPS (~40%), Amazon (20%), and FedEx (15-20%). DHL failed to penetrate the U.S. market.
• MES (Minimum Efficient Scale): High, requiring a national network of sortation centers ($400 million each) and aircraft. This limits new entrants.
• Traits: Capital-intensive, labor-dependent, cyclical, with e-commerce driving secular growth but margin compression.

Competitive Positioning

UPS positions as a reliable, high-quality provider, targeting SMBs and international markets. It competes on:

• Price: Mid-to-high, with premium pricing for air and cross-border.
• Service: High reliability, critical for B2B and vaccine deliveries.
• Reach: Global network differentiates it from Amazon’s U.S.-focused logistics.

Market Share & Relative Growth

• UPS Share: 25% of U.S. volume, stable but pressured by Amazon’s 20% and USPS’s 40%.
• Growth: UPS’s volume growth lags market (10%) as it prioritizes margins. Revenue growth is supported by pricing power.

Competitive Forces (Hamilton’s 7 Powers)

1. Economies of Scale: High MES ($400 million per facility, 200+ aircraft) creates barriers. UPS’s integrated network optimizes asset turnover.
2. Network Effects: Limited; hub-and-spoke model benefits from volume but lacks user-driven network effects.
3. Branding: Strong, with brown trucks symbolizing reliability. Supports premium pricing in international markets.
4. Counter-Positioning: Amazon’s low-margin strategy disrupts UPS, but UPS counters with high-margin focus (SMBs, international).
5. Cornered Resource: Unionized labor (Teamsters) ensures workforce stability but limits cost flexibility compared to FedEx’s contractor model.
6. Process Power: Automation (90% sortation) and hub-and-spoke efficiency provide cost advantages.
7. Switching Costs: Moderate; B2B contracts and reliability create stickiness, but e-commerce customers are price-sensitive.

Strategic Logic

• CapEx Bets: Defensive reinvestment ($400 million facilities) doubled sortation capacity, addressing e-commerce. Now shifting to maintenance.
• Economies of Scale: Achieved MES, but diseconomies (e.g., Q1 underutilization) are a risk. Automation mitigates this.
• Vertical Integration: Limited; UPS focuses on core delivery, divesting freight to avoid low-margin adjacencies.
• Horizontal Expansion: Emphasis on cross-border e-commerce and SMBs, leveraging network strengths.
• M&A: Minimal, with divestitures (freight) prioritizing focus over scale.

Valuation

The transcript cites a $200 billion market cap, with no enterprise value or multiples provided. Assuming $100 billion revenue, $13 billion EBITDA, and $10 billion FCF, implied multiples are:

• P/E: ~20x (assuming $10 billion net income).
• EV/EBITDA: ~15x (assuming $200 billion EV).
• FCF Yield: 5% ($10 billion FCF / $200 billion market cap).

These suggest a mature, cash-generative business trading at reasonable multiples, supported by pricing power and efficiency gains. However, Amazon’s competition and cyclical risks may cap upside.

Key Dynamics and Unique Aspects

1. E-Commerce Paradox: E-commerce drives 10% market growth but compresses margins (15% to 10% domestically) due to smaller packages, more stops, and labor-intensive sorting. This challenges the traditional high-fixed-cost, high-margin model, requiring automation and mix optimization.
2. B2B to Residential Shift: The reversal from 66% B2B to 66% residential reflects e-commerce’s impact, reducing efficiency (3 packages per B2B stop vs. 1 per residential). UPS’s pivot to SMBs aims to restore profitability.
3. Automation as a Game-Changer: Moving from 50% manual to 90% automated sortation saves ~10% per package, enhancing operating leverage. A $400 million facility doubles capacity (100,000 packages/hour), but long payback periods (400 million packages) highlight capital intensity.
4. Pricing Power in Niches: Cross-border delivery (20% revenue, 25% margin) leverages UPS’s global network, a monopoly-like position with few competitors. This contrasts with price-sensitive domestic e-commerce.
5. Labor Dynamics: Unionized labor (Teamsters) ensures stability but raises costs ($20-$50/hour). Flexible workers and automation reduce dependency, improving cost structure.
6. Amazon’s Disruption: Amazon’s 20% volume share and low-margin strategy pressure UPS. By limiting Amazon’s volumes (10% revenue), UPS prioritizes profitability, a strategic shift under Carol Tomé.
7. Cyclical vs. Secular: Historically cyclical, UPS is pursuing secular margin stability through automation, flexible labor, and high-margin focus, mirroring railroads’ playbook.
8. Management Impact: Carol Tomé’s “better, not bigger” strategy—divesting freight, prioritizing SMBs, and implementing pricing power—has restored efficiency, with peak seasons now manageable compared to past chaos.

Conclusion

UPS’s business model is a capital-intensive, asset-heavy logistics network optimized for scale but challenged by e-commerce’s margin compression. Its hub-and-spoke model, automation, and global reach create high barriers to entry, while strategic shifts under new leadership enhance profitability. The company’s focus on SMBs, international deliveries, and cost flexibility positions it to navigate Amazon’s disruption and cyclical risks, with strong FCF supporting shareholder returns. However, competition from Amazon and USPS, combined with labor costs, remains a headwind. The interplay of e-commerce growth and margin optimization defines UPS’s future.