Cola Wars Essay

Submitted By lilnas_escobar
Words: 1038
Pages: 5

We identify three moat sources for UPS: network effect, cost advantage, efficient scale, and technology. Global parcel shipping is dominated by UPS, FedEx, and DHL, and the networks these firms have erected constitute formidable barriers to entry. In fact, we believe no firm will try to replicate a global shipping network anytime soon, given the massive financial losses one would incur while trying to develop sufficient volume to cover the high fixed costs of such a system. UPS is one of only two titans in U.S. domestic parcel shipping, and rational pricing has been the result. We don't anticipate this will change. In replicating a network of planes, trucks, sorting sites, rights to fly, and skilled employees, a new entrant would burn through tremendous resources before it could win away a critical volume of customers from the entrenched strong brands. In fact, even after tremendous investment, able competitor DHL lost nearly $1 billion on U.S. operations in 2007. Facing larger losses because of soft volume during 2008 and beyond, DHL finally threw in the towel after a decade of trying to establish its U.S. domestic express delivery business. We consider this to be a textbook example of the power of an efficient-scale economic moat: a worthy competitor foiled by steep barriers to entry erected by the incumbent domestic U.S. integrated shippers. In this high-fixed-cost business, the substantial parcel volume handled by the incumbents provides a cost advantage that makes competing at market prices difficult for low-volume entrants. The firm's foray into freight forwarding opens a network-effect moat source because each additional office in this business makes the rest of the system more valuable to shippers. We also like this business for diversifying away from such asset intensity present in the rest of the company.

Despite the industry's barriers to entry, we constrain UPS's economic moat rating to narrow rather than wide because we expect the firm to outearn its cost of capital by a slim margin--this tempers our confidence that the firm reliably will exceed its cost of capital two decades from now. We consider UPS's air express and ground shipping operations to have economic moats, but its less-than-truckload freight shipping business (the largest LTL operation in the U.S.) earns low margins subject to economic cycles in part because customers have many alternatives, which drives down pricing. Customer switching costs are low and many truckers can provide adequate service.

UPS earns its wide economic moat from efficient scale, cost advantage, and the network effect. Extensive express, ground, and freight networks demand a huge quantity of trucks, trailers, terminals, sorting equipment, IT systems, and skilled labor. Replicating these assets in the absence of sufficient package flow would be costly, and few entities would endure the financial losses during the necessary density-building phase. As evidenced by DHL's worthy effort, such a project would require at least a decade of effort. Even a global shipping powerhouse like DHL failed to displace UPS and FedEx on their massive home turf--these two competitors comprise the efficient scale in high-service U.S. domestic parcel delivery. In this high-fixed-cost business, the substantial parcel volume handled by the incumbents provides a cost advantage that makes competing at market prices difficult for low-volume entrants. Compared with FedEx, UPS produces superior margins via greater package volume, concentration on high-margin ground shipping, and use of a single network rather than parallel air and ground operations. The firm produces attractive ROICs averaging around 15% (excluding the 2007 pension withdrawal expense) despite its intensely asset-based operations. The firm does have substantial asset-light operations in its freight forwarding and contract logistics operations, and the former boast network effects typical of this model--additional offices make the…