One of UPS Inc. (NYSE:UPS) founder Jim Casey’s favorite slogans was “constructive dissatisfaction,” the idea that no matter how well the company was doing, it could always do better. That mantra was in full flower Wednesday morning during UPS’ analyst call to discuss its third-quarter results.
The results, as many had forecast, were strong. Adjusted diluted earnings per-share hit $2.28, 42 cents a share above estimates of analysts polled by Barchart. Revenue across UPS’ three main business units — domestic package, international package and supply chain and freight — climbed nearly 16% to $21.2 billion. Operating profits for the international and supply chain and freight segments — the latter being all of the company’s non-package operations — ran well into the double digits, with international margins soaring 23.6% year-on-year. Revenue for the high-margin small to midsize (SMB) customer category increased 18.7%, the highest year-on-year growth rate in 16 years.
Yet UPS CEO Carol Tomé and CFO Brian Newman spent the better part of the hour-long call discussing improvements needed to streamline the biggest ship in the shipping business. The catalyst of their comments was the year-over-year decline in operating profit for the U.S. small-package division, the company’s biggest unit. Adjusted profits in the quarter fell to $1.13 billion from $1.24 billion as costs ran ahead of revenues, the Atlanta-based company said.
Some of the cost pressures were planned, such as $179 million in network costs to improve transit times for SMB customers. “It was the right thing to do, but it did put pressure on the expense line,” Tomé said. Other expenses, however, were more extreme than anticipated. The company experienced higher benefit costs and lower productivity in the quarter as it absorbed and trained new hires. UPS reported higher-than-normal turnover rates, which also affected productivity, the company said.
In addition, UPS in the quarter reported lower delivery density, which robbed the company of cost synergy opportunities. Part of the low-density numbers may be attributed to the tilt in mix to residential deliveries, which don’t have the favorable density profile of business-to-business (B2B) traffic. B2C shipments accounted for 61% of UPS mix, a historically high number. Other than automotive and health care, B2B vertical traffic, which was virtually flattened in the early days of the COVID-19 pandemic as nearly all businesses shut down, remains weak and will stay soft into 2021, the company said.
The year-on-year drop in U.S. operating profits may have also caused some dissatisfaction on Wall Street Wednesday morning. As of noon on an otherwise weak day for equities, UPS shares were down more than 4.7% to about $163 a share. UPS’ shares have roughly doubled in price from its mid-March lows.
UPS will likely experience unprecedented volume growth during the peak holiday shipping cycle, as seasonality combined with health concerns relating to in-store shopping will send e-commerce orders and delivery demand into orbit. In addition, large-scale surcharges on its largest customers should help the top and bottom lines. However, achieving sustainably profitable operating revenues in systemwide operations and in corporate spending is a multiyear story that will start next year, Tomé told analysts.
To that end, Tomé laid her first marker: UPS’ 2021 capital expenditures are being modeled at about $4 billion, an enormous drop from $6.7 billion in 2020. To help achieve that goal, all major expenses will be up for review except for several core initiatives like continued SMB investment and IT enhancements, Tome’ said.
The company also plans to heavily “sweat its (physical) assets” during 2021 to wring as much productivity as possible out of them, Tomé said. In addition, volumes will be optimized to generate “value share growth” rather than “volume share growth,” Tomé said, a not-so-subtle sign to big customers holding huge price discounts that the pendulum has swung away from them.
The company launched the second phase of its three-step “Transformation” initiative in September. Part of Phase 2 included the offering of voluntary separation packages to about 11,000 employees. About 1,600 have accepted the package, Tomé said. There will be “more activities” on that front in the months to come, she said, without elaborating. The second and especially the third transformation phases will focus on driving out unnecessary and unproductive costs, Tomé said.
Tomé, who spent 17 years on UPS’ board before being named CEO earlier this year, had been CFO of home improvement giant Home Depot Inc. (NYSE:HD), which based on annual revenue is a bigger company than UPS. In her first analyst call in July, she spoke candidly about the deficiencies in UPS’ cost structure and how it weighed on achieving adequate returns on invested capital. She returned to the topic Wednesday. For example, UPS operators are required to produce 462 different reports each week. UPS also had 21 internal committees tasked with decision-making about different parts of the company, she noted, adding that the number of committees has been reduced to six.
Those examples may be granular but in Tomé’s view they represent the cultural challenge that she, the first UPS CEO to have never worked for the company, faces in bringing about change to a 113-year-old company with many layers of bureaucracy and processes.
She promised that the pace of change would not be incremental. “We are now doing it in a meaningful way,” she said.