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Feb.09, 2015

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COMMENTARY THE JOURNAL OF COMMERCE 63 Satish Jindel PLAYING THE NUMBERS WHEN UPS ON Jan. 23 pre-announced fourth-quarter earnings, it shouldn't have been a surprise. Yet some ana- lysts said they were "troubled by the company's inability to get peak (operating expenses) right during what is increasingly becoming the most important quarter of the year" and were concerned "that UPS got the service but not the cost, which is going to leave the market wondering if it can only have one or the other." By calling out UPS's failure to meet its earnings estimate, the ana- lysts highlighted the shortcoming of sell-side equity research, which depends heavily on the company's guidance instead of independent research. Instead of wondering about UPS, the market should be evaluat- ing its reliance on the sell-side equity research model whereby the ana- lysts either lack hands-on industry experience, attempt to cover too many companies superficially, or lack resources to undertake indepen- dent research on new developments impacting the reported companies. Many factors contributing to the earnings shortfall were in the pub- lic domain: details of the operating plan for the peak season, the high level of on-time service achieved by the network from Thanksgiving through Christmas and labor issues at West Coast ports, which impacted the consistency of products arriving from China. There were other relevant rea- sons: Amazon was a large B2C customer of UPS during the 2013 peak season, but switched much of its distribution model to drop parcels directly into destination post offices for the U.S. Postal Service. And UPS provided incentives for shippers to overestimate the peak-period volume. E-commerce, with a compound annual growth rate of 14 percent since 2008 driven by free shipping, has created huge spikes and unpre- dictability in volume for retailers and delivery companies. Parcel carriers are aggressively address- ing the challenges of managing cost and revenue, illustrated by UPS and FedEx. E-commerce growth, however, has resulted in business-to- consumer parcel volume increasing from 20 percent of total UPS volume to 45 percent in 10 years. Analysts need to undertake i ndependent resea rch on t he impact of e-commerce if they want the market to use their research reports for investment decisions. They also should study the impact on company fiscal quarters, where November and December as peak months for B2C shipping are split into two quarters. As expected, after UPS's pre- announcement, FedEx reaffirmed its earnings on the same day, out of concern that UPS's results would be viewed as a precursor for FedEx's own results. Although UPS has a high fixed-cost model compared to a more variable cost structure of FedEx Ground, the market also failed to note that the fiscal quar - ters for the two companies include different months. UPS uses the calendar year as its fiscal year, while FedEx's fiscal year starts on June 1 and ends on May 31 of the following year. It should be noted that FedEx does not even use the same quarters, whereby it would have started on July 1 instead of June 1. With Januar y being a slow month, and December seasonally very high, a quarter that goes from December through February allows cost overrun in the peak of December with the lull of January to ease the pain of reporting unpleasant finan- cials associated with challenges in matching demand with capacity. Prior to facing the peak-season impact in 2013, UPS posted its high- est quarterly operating ratios for the fourth quarter and its lowest for the first quarter. If the fiscal quarter was matching that of FedEx's fiscal quar- ters, this fourth-quarter shortfall would have been less pronounced. While UPS has to address the cost and revenue aspect of sharp increase in online retail orders, it should change its fiscal year to report November and December months in two quarters. There are many advan- tages of such change, such as freeing management to divert more atten- tion to the peak operation instead of working on budget for the com- ing year. Examples of large publicly traded companies that have changed fiscal years include Monsanto, Mor- gan Stanley and Viacom. Moving forward, UPS can't ignore the importance of online retail on its parcel delivery business. Even though it has a reputation sup- ported by a track record of being one of the best operators in the industry, it must find a solution to manage the sharp increase in e-commerce vol- umes and lack of predictability of volume spikes to offer high on-time performance while generating tar- geted return for the shareholders. The disconnect between UPS's earnings shortfall in the fourth quarter and equity analysts' fail- ure to realize that in advance is an affirmation of equity analysts covering too many companies. As a result, they are unable to do inde- pendent research to understand the challenges parcel carriers face in meeting the needs of online retail- ers in this rapidly evolving world of e-commerce driven by free shipping. UPS wrote the book on par- cel industry. Even its rival, FedEx Ground (which was RPS), copied UPS to develop its parcel network and delivery methods. UPS needs to re-establish its place in the par - cel industry by coming up with the right model to handle e-commerce- driven peak-season volumes. JOC Satish Jindel is president of SJ Consulting Group with offices in Pennsylvania and India and was a member of the founding team of FedEx Ground, reporting to its president.

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