On Feb. 9, 2018, published news reports that Amazon.com Inc. was planning to test a new service under which it would pick up products from third-party merchants that sell on its website (much of this merchandise is already in Amazon facilities) and deliver them to retail customers sparked concerns that this could evolve into direct competition for package express giants FedEx Corp. and United Parcel Service Inc. (UPS). While the initial test will involve only independent sellers based in Los Angeles, fears that the company may later expand its delivery services into more traditional areas caused the stocks of the large parcel carriers to drop (see chart 1).

Chart 1

We have seen this kind of disruption scenario before, including last year when Amazon purchased Whole Foods in a bid to disrupt the grocery market and, more recently, in health care with the announcement that Amazon, JP Morgan, and Berkshire Hathaway are forming a health care company to improve the services they offer their employees (see "Tech Disruption: U.S. Healthcare is "Prime" For Change By Amazon And Others," published Feb. 15, 2018, on RatingsDirect).

For logistics companies, the holy grail has always been volume because increased volume improves the cost efficiency of their high-fixed-cost networks. Amazon generates a tremendous amount of package volume and the company's North American revenue (a close proxy for its e-commerce sales) increased by an average of about 25% each year over the last five years. We expect the company's 2018 revenue to grow by about 30%.

We see Amazon's reported test, which follows similar articles last October, as a potential way for it to leverage its volume and logistics infrastructure to generate revenue and help lower its huge ($21.7 billion in 2017) shipping costs by selling empty space on the trucks that it is already using to meet its own transportation needs. Another benefit of the program would be to offer a closer linkage between its wholesale and retail customers. Given the massive scale, global networks, and strong competitive positions of FedEx and UPS (and that Amazon relies on them to move many of its packages), we do not see this limited test as a near-term threat to either company. However, we believe that the long-term implications are less clear and could evolve into a more serious challenge if it undermines market pricing or materially changes the bargaining position of Amazon relative to the established package carriers. The U.S. Postal Service (USPS; unrated), which handles a larger volume of Amazon's "last mile" deliveries to its retail customers, could be affected sooner than the other parcel delivery companies because it is more reliant on that kind of business and trails the private package express companies in implementing technology.

How We View Amazon's Shipping Strategy

We view Amazon's shipping strategy as an extension of its focus on driving demand. As Amazon states: "We believe that offering low prices to our customers is fundamental to our future success, and one way we offer lower prices is through shipping offers." The company's successful Prime membership ecosystem has changed customers perception of shipping in the retail sector and has forced its competitors to provide similar shipping offers to compete. As we will discuss below, Amazon uses a mix of internal and external resources to fulfill its orders and deliveries. However, unlike other retailers Amazon directly leases airfreight capacity and is developing its own airfreight hub. Airfreight is one of the most capital-intensive subsectors of transport, thus execution and volume are critical.

Amazon's shipping costs, including sortation, delivery center, and transportation costs, were $11.5 billion in 2015, $16.2 billion in 2016, and $21.7 billion in 2017. The company expects these costs to rise as customers increasingly take advantage of its shipping offers and additional services. With its substantial capacity and access to third-party customer volumes, we believe that it is a logical next step for Amazon to test its own delivery model.

Amazon's North American revenue, shipping costs, and square footage have expanded at a much faster rate than both U.S. e-commerce retail sales and total U.S. retail sales (see chart 2). In addition, we expect that Amazon will continue to increase its share of overall U.S. retail sales. We also believe that the company's square footage growth, which has spiked since 2015, indicates that it is implementing its strategy to position its merchandise closer to its customers to improve its delivery speeds (and costs). However, this expanded network of warehouses could also provide Amazon with increased capacity to use as part of a localized delivery network.

The concept of retailers as logistics companies predates the rise of e-commerce. A retailer or consumer products company that handles much of its (typically inbound) transportation needs internally is not at all unusual; companies such as Walmart have large private truck fleets that supplement their outside transportation. Overall, the trend in the industry has gradually moved away from private fleets toward a greater reliance on outside providers that specialize in transportation logistics. Therefore, Amazon's reported move to expand its in-house capabilities runs counter to this general trend, as would any move to offer such services to businesses outside its own third-party sellers.

Still, given Amazon's own huge and expanding need for transportation, the scale of capacity it could offer to outside parties will likely be quite small relative to what FedEx, UPS, and the USPS offer unless it dramatically increases its investment in transportation assets. Furthermore, some potential customers (e.g. retailers) would likely be loathe to use Amazon to carry their shipments because it is also a competitor. However, that too could change as more and more consumer goods companies (and retailers) work with Amazon as a proven channel to reach American consumers. For example, in two test markets (Chicago and L.A.) Amazon customers can drop off items they purchased on the website at certain Kohl's locations for return to Amazon.

Chart 2

How Are The Parcel Express Companies Positioned?

The package express business requires heavy investments in transportation, facility, and information technology assets. In addition, automation is an important feature of the package express industry and the need for it will only increase as package volumes continue to rise. Like many other transportation businesses that operates a network, package express companies have high operating leverage and need to achieve a certain density of packages on their routes to cover their fixed costs. Amazon has a ways to go before it approaches the scale or level of investment in transportation assets that FedEx and UPS have. For instance, UPS' domestic parcel delivery business had revenue of more than $40 billion in 2017 while FedEx's was around $30 billion (for the six months ended Nov. 30, 2017, annualized). In addition, while Amazon announced that it would charter up to 40 Boeing B767 freighter aircraft in 2016, this compares with FedEx's fleet of about 657 owned aircraft (as of fiscal year-end May 31, 2017) and UPS' fleet of 241 owned aircraft and 340 on charters or leases (see table).

Table

Although Amazon is a large customer for the package express companies, UPS states that its largest customer (not named) accounts for less than 10% of its revenue while FedEx says that its largest customer accounts for less than 3%. We believe that one of the reasons why Amazon has chosen to invest in its own transportation assets is that the package express companies were not willing to commit to the huge investments needed to support Amazon's planned long-term growth and--in particular--were unwilling to meet the retailer's peak holiday needs on their own. At the moment, Amazon arguably needs its transportation partners more than than they need it. However, this dynamic could shift in the future as Amazon continues to expand its network of distribution and fulfillment centers. By design, the company is moving closer to its customers, which should lower its transportation costs (distance) while retaining or improving the timeliness of its deliveries.

Over the longer-term, FedEx and UPS could be adversely affected if Amazon expands its transportation service offerings as it may undermine their pricing in some markets and, perhaps, shift the balance of contract bargaining leverage more favorably in Amazon's direction. Given that, presumably, Amazon would be offering excess space on its own transportation assets, it could charge low rates while still contributing to its own fixed costs and reducing its net spending on deliveries. In this case, the the operating leverage inherent in package delivery would work in the company's favor. Press reports about the Los Angeles test indicate that it would mostly involve trips over short distances, which is a generally low-yield business that FedEx and UPS are less interested in. In that case, Amazon could end up diverting business mostly from other, regional trucking companies and the USPS. Still, to the extent that Amazon is offering transportation at low rates, it could pressure overall pricing in selected markets.

Another benefit of growing its in-house transportation business is that Amazon would be able to meet a larger proportion of its own shipping needs, therefore it would be in a better position to bargain for favorable terms with FedEx, UPS, and the USPS. Potentially, Amazon could even offer to hold back on challenging its transportation providers in their core business as a quid pro quo for more favorable contract terms.

"Disruption" Or Insourcing?

Amazon has disrupted other businesses adjacent to its core retailing activities and now--with JP Morgan and Berkshire Hathaway--is testing how it can improve the health care delivery system for its employees. So how does this situation compare with those?

Notwithstanding the long-term risks cited above, we believe that the package express business differs in some respects from the other businesses that Amazon has entered. While Amazon has some compelling capabilities--such as its high volumes, strong data analytics, and sophisticated fulfillment and sort centers that already contain its customer goods--these factors do not point to any particular business model or technological advantage that the company currently holds over FedEx or UPS. Initially, it seems that Amazon is choosing to vertically integrate an activity (delivery) that--in most cases--specialized outside providers are more skilled at providing. While outside carriers now handle the vast majority of its last-mile logistics, Amazon does have the expertise to specify where its goods originate from in order to efficiently meet its customers' expectations for quick delivery. Arguably, that expertise is as important as transportation expertise. Amazon's indirect labor costs (i.e., the labor costs of the trucking companies they use) are likely rather lower than those of FedEx and UPS, though that is true of all of their other potential competitors and yet few have chosen to venture into direct competition with them given the other barriers to effective entry.

There is one historical case to note though. RPS Inc. (originally Roadway Package System), a unit of Caliber System Inc., built up a successful package express business to challenge UPS' dominant position in the U.S. domestic ground parcel delivery market during the 1990s aided by lower labor costs. Caliber was later acquired by FedEx and its operations were absorbed by the company. We believe that UPS is currently better equipped to react to competitive challenges of this type, though the RPS case shows that the barriers to entry in the package express market, while high, are not totally impossible to breach.

One technology that could erode those barriers to entry is driverless trucks. Currently, a worsening shortage of truck drivers is boosting pay and labor costs for trucking companies, indirectly leading to increased costs for their customers. That narrows the labor cost disadvantage of the big package express companies and makes it more difficult for potential competitors to expand at their expense. However, if driverless technology expands and becomes widely accepted it would weaken the limits on capacity growth for those with the capital to invest in more-expensive autonomous trucks.

Although UPS and FedEx have ample resources, their ability to shift to a driverless business model could be hobbled by union contracts (Teamster contracts at UPS) or the desire to avoid unionization (in the case of FedEx, which uses independent contractors for pickups and deliveries). In addition, any technological change that shifts the competitive dynamics further in the direction of increased capital intensity could work to Amazon's advantage. Amazon has a low cost of capital and has historically been quite willing to spend heavily in pursuit of its strategic goals. FedEx and UPS also have fairly low costs of capital, in contrast to the company's retail or grocery competitors, though perhaps not as low as Amazon's (particularly its cost of equity capital).

Whether the pursuit of a third-party package express business is the most attractive application of that capital is a key question. To the extent that it lowers Amazon's in-house delivery expenses by helping to cover the fixed costs of its transportation assets, it may be attractive. However, it may perhaps be less attractive as a direct challenge to the strong package express companies on which Amazon currently relies.

The current focus on Amazon's potential expansion into transportation services is obscuring the broader narrative that the spread of e-commerce has been hugely positive for delivery companies. Aside from Amazon's own growth, the competitive threat posed by that company has pushed other retailers to expand their e-commerce offerings, all of which increases the need for package transportation. Indeed, another group that has benefitted greatly from the explosion of e-commerce has been the owners of warehouses, including commercial property real estate investment trusts (REITs).

Industrial REITs Benefit Either Way

The rapid growth of e-commerce has spurred strong demand for distribution centers, leading to record rent growth and peak occupancy rates for industrial REITs. We expect that the healthy appetite for warehouse space will continue in 2018 as Amazon and traditional retailers accelerate the expansion of their logistics infrastructure to support their e-commerce operations. In fact, the stronger revenue growth and improved debt leverage have led us to upgrade a number of REITs in the industrial sector over the past two years.

The required amount of space for e-commerce fulfillment is generally much more (up to 3x) than what is needed for brick-and-mortar distribution, which has created the need for multi-story mega warehouses (of over 1 million square feet) that can accommodate robotics for greater space efficiency. As retailers continue to expand their footprint into last-mile delivery, the demand for smaller format warehouses closer to densely populated locations will also grow.

Third-party logistics operators (3PLs), such as FedEx, UPS, and DHL (owned by Deutsche Post), are important customers for industrial REITs and contribute a significant portion of their overall revenue. For example, 3PLs are among Prologis' (one of the largest U.S. REITs) top 12 customers in terms of rent. While we expect 3PLs to continue to move a significant volume of e-commerce goods, a more significant entry by Amazon into the package delivery business could have longer-term implications for industrial REITs because it would pressure their occupancy rates and rent if it shifts volume away from 3PL companies and toward its own network. Amazon is already one of the largest tenants for a number of industrial REITs and increasing their exposure to the company could give Amazon more bargaining power in rent negotiations. As is the case for FedEx and UPS, Amazon's growth is a mixed blessing for these companies because more business could lead to potentially less leverage in contract negotiations. In any case, Amazon's outsize influence on its various logistics partners, both positive and negative, will likely continue to grow.