Amazon to UPS, USPS and FedEx - it's your turn next

Profile picture for user gonzodaddy By Den Howlett March 21, 2016
Summary:
Amazon's announcement of buying into air freight sets up an interesting discussion around the competitive positions of FedEx, UPS and USPS. They may have much more to fear than they think.

Major US carrier revs 2013-15
via dahowlett

Last week I expanded upon Stuart Lauchlan's take around Walmart and Amazon. This week he pokes at potential threats to FedEx from Amazon. That gives me an opportunity to expand upon Lauchlan's concerns about FedEx that were dismissively brushed off by the company but which in reality may impact FedEx and UPS - assuming of course that Amazon delivers on its implied objective to become a world class logistics play. First, let's look at the market as a whole.

Profiling the runners and riders

If we aggregate the revenues of the three big US carriers, that is UPS, FedEx and USPS then we find that in the current year, the combined 'market' is currently worth about $180 billion to those businesses, growing from a combine $160 billion in 2013. That's substantial growth by any standards. See the chart at top right to see what I mean. We know from Amazon's playbook that it looks for markets that have scale and this is one heck of market. Again, to put it into perspective, check out this graphic from UPS 2015 annual report:

UPS facts 2015

 

Mind boggling isn't it?

However, the profile of each business is different. FedEx, while currently the smallest of the three, has the better international footprint with 402 aircraft operating both nationally and internationally compared to UPS 237 aircraft. It is an open question whether FedEx will finally occupy the number two slot once it acquires TNT Express but that deal has the advantage of including a fleet of 25 TNT cargo planes that serve European destinations but also go as far as Hong Kong and Moscow. This is not a completely 'clean' deal and FedEx will be challenged to make the acquisition work in the context of its global operations. The acquisition also serves as something of a management distraction when viewed against macro market trends, chief of which is the massive expansion in e-commerce, of which it is estimated that Amazon is fueling a full 50%.

UPS, while larger than FedEx is more vulnerable to moves by Amazon, largely because it is thought that Amazon shovels as much as 30% of its packages via UPS. If true then that number could add up to about $3 billion a year going in UPS direction, although reports suggest it is a fraction of that, possibly as little as $1 billion, with more going towards USPS. Based upon my experience in the US with Amazon and UPS, that sounds plausible, albeit Amazon also uses small local carriers for some of its Prime business. USPS? It is what it says on the tin, the US Postal Service. Amazon uses USPS for US shipping goods under four pounds and while there are plenty of customer complaints about failure to properly deliver, I've only experienced one major problem related to import duty. There is little doubt that USPS in particular is a slack operation but I'm not convinced that is where Amazon's guns are focused. I'll explain why shortly.

Moving on, what did Amazon do?

Amazon gets into air freight

Earlier this month it was reported that:

After running a secretive trial since last summer with five Boeing 767s leased from freight carrier Air Transport Services Group (ATSG), Amazon confirmed Wednesday an agreement to let ATSG run a dedicated air-cargo network and expand the operation to four times its size. As part of the deal, Amazon also has the right to acquire just shy of one-fifth of ATSG for more than $600 million.

This is a very smart move because:

  1. Amazon has already signaled it would like a 49% stake in ATSG, a move that was initially rejected but which, over the next 57 years will almost certainly turn into an outright purchase. As it stands, the deal with ATSG gives Amazon a seat on the board and so an inside view of how this business operates. It will learn a great deal at minimal risk.
  2. $600 million for 20% of a modest sized freight business is not going to break the bank at Amazon, which last reported $15.8 billion in cash and cash equivalents. Especially given that deal is spread over some five years according to reports.
  3. Amazon's stock price trajectory makes it a very attractive partner in the medium term, subject to all the usual caveats about getting over excited with Amazon's spectacular performance to date.
  4. Amazon/ATSG will initially operate out of its hub at Wilmington, Ohio. This includes a $200 million package sorting center and warehousing facility that DHL built but which lies dormant after DHL pulled out five years ago. (A commenter with knowledge of the situation says the port authority stripped the facility following DHL's departure. The original note was based upon previously published but uncontested reports.) Industry experts say this is a smart move because it gives Amazon a near immediate on ramp to providing a logistics operation. (This has to be questionable in light of fresh facts.)
  5. ATSG regulatory filings say that the company has made investments in Sweden and created a joint venture to operate in China. This last part is crucially important to Amazon with its own ambitions of cracking that market.

How does this fit into the big picture?

Here there are some factors worth discussing.

Ben Thompson offered the notion that Amazon Prime acts as a seductive tax that helps Amazon (among other things) with 'Fulfilled by Amazon' its de facto third party warehousing service that it provides to vendors as a way of smoothing out two day Prime deliveries. Estimates vary but Prime may currently represent $5.3 billion in near cost free to generate revenue. It is a classic subscription play where the $99 annual fee is sufficiently low for most people to shrug and say 'yes.' Prime's two day free shipping is an extraordinary value IF you are a regular Amazon customer. I find shipping costs in the US to be borderline extortionate for some items and while the ubiquity of UPS/FedEx offices drives a convenience factor, it doesn't make up for what I find to be a barely human service. Prime solves for that.

What Thompson doesn't state is that once you get the 'Prime habit' then it doesn't make sense to be scouring Google to find local stores. Provided you can wait then two days is just fine. Amazon though has gone one step further, experimenting with same day delivery. This is the service that is causing most angst among the big three with both FedEx and UPS attempting to play catchup. The very fact these companies are attempting to best Amazon on this element of service should  tell you something about the perceived Amazon threat. More broadly though I agree with Thompson that this latest announcement is a first step towards a much bigger goal - becoming a global player in the logistics business. In saying that, we're back to Amazon using its global reach and network as the foundation for the creation of an entirely new business model that it can develop and experiment with, using itself as its first customer at relatively little risk.

The FedEx thing

Lauchlan was, in my view, rightly alarmed at FedEx's dismissive answers to questions about Amazon. But it extends beyond that into topics like same day delivery and omni-channel. During the latest earnings call, Fred Smith, CEO at FedEx was clearly irritated by continuing questions on these points. Example:

Fred Smith

We all likely agree the same day delivery is a relatively small market today and likely will be even in the future. What is FedEx doing to prepare a partner with local delivery/final mile firms if the market turns out to be larger than expected? Mike.

Mike Glenn

FedEx currently offers same-day delivery in 23 markets and we've seen volume growth in key segments such as retail, e-commerce, healthcare, and others. FedEx Same-Day City plays an important role on our e-commerce suite of services and customers are responding well to the uniformed professionalism of our business model. Having said that it still represents and let you offering in very small percentage of our overall portfolio, but we are able to scale when demand dictates.

Fred Smith

Nate also asked a question about FedEx ground and the productivity of our independent service providers, I think Henry answered that in just a moment ago. So, we will move on to one by David Ross of Stifel, China has been grabbing a lot of headlines in recent months, please discuss the importance of China's economy to the FedEx global express network? Dave Bronczek.

Dave Bronczek

Yes thanks Fred, and thanks for the question David. Obviously, China is a very important to us, but they are not more important than all the rest of the world. I mean they are a part of the rest of the world for us. There’s a lot of multinational companies that are in China that we do business with in China and exporting out of China. So, I would say that we’re always watching how the economy is in China, but it is not causing us any problem or any concern right now because our customers there are for the most part multinational customers.

Was Smith blowing off the analysts or what? Or what about this exchange?

Rob Salmon

Hi, good afternoon guys. With regard to the omni-channel retailing, I’m curious, which network that is running through when you're getting the from store to home, I would imagine anything that’s going interest store is running across the B2B network probably predominantly in Express, but was hoping to get a little bit of perspective related to which respect of network that runs through and the impact to return on invested capital and revenue per unit would be really helpful?

Mike Glenn

This is Mike Glenn. Regarding our metro service capabilities, we have a variety of services. We have Express service for the premium packages that require specific delivery time. We have Ground services that can serve metro eight areas. We also have SmartPost services that can serve Metro. So, we have a variety of services to meet that need. Should also mention Same-Day City, which is operated by our FedEx office team, also has the capability to serve metro toward our home delivery. So, we have a wide variety of service capabilities and we are well suited to participate in that market segment.

Fred Smith

This is Fred Smith speaking. Let me again remind the people that follow FedEx that our services are a portfolio, which are broadly used by customers. I think I’m correct well into the 90% of our customers might use Express and Ground, over 70% use Express, Ground and Freight. And I think based on the emails and the comments that I get on the internet, every man, women and child in America uses FedEx Office. So again our job is to try to improve earnings, returns, cash flows and we have told you that we are confident that we can do that, and I think a little bit on this call not so much is in the past, if you attempt to try to bisect FedEx into some of the parts analysis you’re going to get surprised.

My take

Smith may feel irked but that's not going to help one jot if and when Amazon kicks the crap out of them on its $10 billion shipping spend. Again, to put that into perspective, if you weigh that spend against the numbers I quoted at the top, then Amazon alone represents 5.5% of all revenue among the leading three carriers. That's something of an over simplification but you get the picture.

The bigger problem as I see it is Amazon can skim the cream off the shipping costs by concentrating upon air freight fulfillment, an admittedly profitable segment for FedEx and UPS, leaving the thin margin crumbs of last mile delivery to those players. One or other of them will have to pick it up, so why not concentrate the problem to one piece of the logistics puzzle and use that as a lever to further reduce cost? That must be obvious to the big players.

The ire with which Smith addressed questions is telling and the abject failure to get close to answering the direct analyst question is not comforting. Smith's job is to set out the FedEx story and most of the time he does a very good job. But these Amazon threats are no longer an illusion. It's real. FedEx is in a much tougher spot than it might wish to admit. The upcoming TNT purchase and stock repurchases will drain the company of cash at a time when its current cash position is weak. Like Walmart, that hampers its ability to respond or be proactive in markets where, as Smith knows, fixed costs are high. FedEx is banking upon Amazon discovering just how costly it will be to become a competitor in this space but I believe that's a weak argument because Amazon can cherry pick. FedEx does however have a strong track record in developing genuine logistics innovation through technology, a skill that Amazon does not (yet) have.

UPS has some hard thinking to do. Amazon spends a lot with it and while UPS has shown itself to be more resilient and adaptable to changing markets, the margins on that last mile delivery will have to be addressed.

The ATSG deal clearly spells out that Amazon sees this as a minimum five year play and right now, Amazon has only put its toe in the water. Five years is a very long time in technology but then I think about what's happened in retail and wonder - could Amazon truly become a global logistics player? It might just.