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Parcel delivery: a rock and a hard place

FedEx and UPS are being rapidly featurized by Amazon’s growing logistics business. With an unparalleled lead in e-commerce, data and capital, Amazon is set to shake up the package delivery industry. Can the old incumbents adapt to a new competitive, low margin environment, or will they struggle to survive?

Following on from last month’s blog about the exponential growth of Amazon Logistics, I thought it would be interesting to look at the rapidly evolving package delivery industry from the perspective of the incumbent parcel companies – namely FedEx and UPS. These old guard of the transportation industry are being “featurized” by Amazon at an accelerating pace, and the high fixed cost structure of their business leaves them vulnerable to severe disruption.

To understand why Amazon has suddenly become such an existential threat to the parcel companies, it is instructive to consider the following: i) Amazon has nearly 40% share of the U.S. e-commerce market; ii) Amazon has a significant data and technological advantage; and iii) Amazon has an equally significant cost of capital advantage. On the first point, Amazon’s dominant and growing share of U.S. e-commerce volume means it is inevitable for the company to get involved in shipping its own packages, as it would have sufficient volume and volume growth to efficiently feed its own delivery network. Amazon’s data advantage – it knows exactly what customers are buying and where they’re shipping to – allows it to build the most efficient network of warehouses and distribution centers, fill them with the relevant inventory, and ship to its customers at a lower cost than third party parcel services. And access to cheap and patient capital means that Amazon can swing for the fences when it does decide to build its own logistics network.

So how does one compete with a company that can spend an incremental ~$3.5 billion in 9 months on top of business-as-usual investments to launch a service that outperforms the core offerings of the incumbents? FedEx elected to part ways with Amazon last August and bet its future on serving the multitude of smaller e-commerce shippers. UPS on the other hand has remained frenemies with Amazon, though both parties would prefer to severe their co-dependence.

FedEx faces a more difficult path than UPS, as it is trying to lean into e-commerce growth without the benefit of Amazon’s volume. E-commerce volume is 40% of the US parcel market and growing at over 10% compared to 3% market growth, which implies B2B volume (FedEx’s mainstay) is actually shrinking. Of the e-commerce volume, Amazon controls almost half, and half of that is shipped by Amazon Logistics. For the segment of the market not controlled by Amazon, UPS, USPS and other parcel companies are all competing for share.

Exacerbating FedEx’s problems is the fact that unlike UPS, it operates entirely separate Ground and Express networks in the U.S. Whereas UPS can drive greater density in its single network covering both ground and air, FedEx Ground and Express networks have zero interoperability despite substantial geographic overlap. For example, a package shipped via Express can’t be delivered by a Ground driver even if both are going to the same address, which results in material inefficiencies. In fact, our conversations with industry experts indicate that UPS is nearly twice as efficient as FedEx when it comes to miles per stop and stops per hour, primarily due to the additional density created by a single network. Unfortunately for FedEx, combining the Ground and Express networks will likely be extremely painful, involving significant labour cost increases or massive layoffs, and management has displayed a persistent unwillingness to consider the option. 

Amazon’s decision to spend ~$3.5 billion in operating expenses during the last 9 months of 2019 to transform its 2-day Prime shipping into a 1-day offer was also an immense shock to both competing retailers and parcel companies. E-commerce packages are already lower yielding (lighter and shorter zone distance) and higher cost (lower density) than B2B packages to begin with, which can be seen in the parcel companies’ declining margins. To move from 2-day shipping to a 1-day standard would be cost prohibitive for everyone except Amazon. It is our understanding that retailers can offer 2-day shipping across the U.S. with just 5 to 7 distribution locations around the country; 1-day shipping would require at least 50 to 60 locations, but most retailers simply can’t store that much inventory and the parcel companies can’t assist because they don’t carry inventory. Amazon has nearly 170 fulfilment centers and 500 total facilities across the US, which allows it to feasibly offer affordable 1-day shipping to its merchants (and its own products) – albeit still at an incremental annual cost of $4 billion to $5 billion. Consider that FedEx has cash on balance sheet of $2.3 billion, free cash flow of zero and is restricting its capex investment – there is no way that it can match Amazon’s 1-day shipping standard. UPS is healthier than FedEx, but even it would consume substantially all its free cash flow to offer such a service.

As one would expect, competing with Amazon in a capital-intensive business is a challenge even during the best of times. And this is before we consider what might happen if, or when, Amazon starts offering its Logistics service to third party shippers at rates that FedEx and UPS can’t afford to match. Under such a scenario, it seems inevitable for the duopoly pricing structure to break down and margin degradation to become the norm. Yet they can’t choose not to compete for volume, because their high fixed cost businesses demand growth to be sustained. For the parcel companies, they truly are stuck between a rock and a hard place.

The Montaka funds have a short position in FedEx (NYSE: FDX).

  

Daniel Wu is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.