Summary
- The company's financials and returns to shareholders were solid in recent years thanks to management's exemplary performance and capital allocation.
- My valuation model outcomes and multiples analysis suggest the stock is almost 20% undervalued at current levels.
- Though even value stocks' fair prices currently heavily depend on the Fed's next moves and rhetoric, so I am Neutral on the stock.
Investment thesis
Being the world's largest package-delivery company, United Parcel Service (UPS), has delivered strong financial results in the last 10 years both in terms of revenue and earnings. Management is striving for increased business efficiency with the help of innovations. The company is well-positioned to benefit from the secular favorable trends of increasing e-commerce volumes. My valuation estimates suggest the stock is almost 20% undervalued, but I consider the level of uncertainty regarding a possible recession as rather high leaving my opinion Neutral on the stock.
Company information
UPS can trace its history to the early 1900s. The company is present in over 220 countries and territories with an average total daily volume of more than 25 million packages.
Apart from over 120,000 vehicles, the company also operates a large fleet of aircraft, and almost half of them are owned by UPS.
The company has three reporting segments: U.S. Domestic Package and International Package. The remaining businesses are reported as Supply Chain Solutions.
Financials
The company's financials are strong both in terms of performance and balance sheet health. Looking back over the last 10 years period, UPS delivered solid and steady revenue growth of 6.1% CAGR. Gross and operating margins were also steadily expanding during the last 10 years, closing at 25.0% and 13.7% in FY 2022, respectively.
Robust financial performance has allowed Free Cash Flow [FCF] per share to almost double from $5.57 in 2013 to $10.72 in 2022. During the last 10 years the company returned to shareholders a total of around $51 billion via dividends and share repurchases.
The company was able to deliver consistently strong results due to the company's commitment to innovation and streamlining its processes. UPS invests heavily in software using cloud-based solutions for transportation and warehouse management. The company is getting awards for its exemplary operating performance.
Some may say that awards are not quantitative, so to understand whether UPS management really did a good job to improve efficiency let's look at the company's revenue per employee dynamics during the last 10 years. According to my calculations, UPS actually did well across this metric delivering a 3% CAGR for revenue per employee.
The company also has a strong Seeking Alpha Quant Dividend Grade offering a very attractive yield, consistency, and growth. Dividends were paid during 22 years in a row including 13 consecutive years of dividend hikes.
The company filed its latest 10-K report for FY 2022 on February 21, 2023 delivering a 3.1% top line growth with a slight decline in operating margin and around 10% decline in EPS. Topline growth was due to an 8.6% increase in average revenue per piece, which was partially offset by softening volumes.
Digging down to segment performance, U.S. Domestic Package demonstrated strong growth in average revenue per piece of 9.5% which enabled to slightly expand operating margin for this segment. Management expects overall average daily Domestic volume year-over-year growth rates will continue to decline in the first half of 2023 and then grow through the remainder of the year as economic conditions improve. In terms of revenue per piece UPS management expects moderate growth in 2023 as pricing initiatives within the company's strategy are to be continued.
The International Package segment was flat due to a 7.5% decline in demand which was almost identical to the increase in average revenue per piece. Expectations of management regarding volumes for the International segment are almost the same as for the U.S. Domestic stream. But in terms of average revenue per piece on the International level the management does not expect robust growth here.
The Supply Chain Solutions Segment declined 5.7% mainly due to lower volume and revenue in forwarding and the impact of divesting UPS Freight in the second quarter of 2021.
The company's 4Q2022 earnings topped consensus expectations in terms of EPS, but financials were flat YoY: revenue and adjusted operating income both declined 3%. It is also important to mention that as an outlook for FY 2023 management expects revenue to decrease 2% to $98 billion with adjusted operating margin narrowing by 60 basis points. In spite of expectations of weakening financials, the company has plans for $3 billion share repurchases in FY 2023.
The company's balance sheet looks strong, with consistently sound liquidity ratios. The current ratio is 1.22 at the moment, which is slightly below its 10-year average. It is worth it to mention though that financial leverage increased during the same period from $5.7 billion to $15.9 billion.
Valuation
To perform a valuation of UPS stock I use the Dividend Discount Model [DDM], since the company has a very strong Dividend Grade, according to Seeking Alpha Quant.
To start gathering assumptions, first, I refer to Gurufocus for the company's WACC, which suggests that cost of capital for UPS is at the 8.97% level. Since we are currently in the Fed's interest rate tightening cycle, for the cost of capital I prefer to be more conservative so I add 103bp to Gurufocus' estimate. The company's dividend for FY 2024 consensus estimate is $6.47 per share. For dividend growth rate I also prefer to be conservative so I rounded down to 7% from the 5Y average for Dividend Growth Rate 10Y CAGR.
Putting up all the assumptions together my DDM arrived at the conclusion that the stock is 18% undervalued, indicating a fair price of around $216 per share.
To cross-check my valuation exercise please let me refer to Seeking Alpha Valuation Quant Ratings , where UPS stock got a "b-" grade. As you can see below, current valuation multiples of UPS are slightly lower than the sector median and the company's 5 year averages, indicating that stock is undervalued in comparison to industry and its historical valuation metrics.
If we multiply the company's FY 2024 consensus EPS estimate of $12.3 per share by the benchmark forward PE, we arrive at a fair price of around $218 per share.
To sum up valuation, I believe there is an attractive upside potential for the stock which is supported by my DDM calculations together with multiples analysis.
Risks to consider
There is no reward without risk, so we should bear in mind that there are some of them inherent to investing in UPS stock.
First of all, UPS is highly dependent on global trade and macroeconomic conditions. Given the current Federal Reserve interest rate tightening cycle, the risk of an economic downturn is increasing, which could have significant impact on the company's financial performance. About 20% of company's revenues are generated outside of the U.S. so foreign exchange rates fluctuations may also put pressure on the bottom line. I see a potential economic downturn together with possible adverse foreign exchange fluctuations as the company's biggest risk by far at the moment.
Second, the competition within the package delivery industry is fierce. There are numerous competitors, both large and small size, so pricing competition is very intense. In addition, in recent years we saw that the company's recent largest customer now became its competitor. I mean Amazon ( AMZN ) here, which invests heavily in its own delivery business.
And last but not least, I also consider the company's pension plan as a significant risk. The pension plan is subject to risks associated with changes in interest rates that may affect the value of the company's financial obligations under the benefits plan. Demographic factors like life expectancy or number of retirees are out of UPS' management's control.
Takeaway
Overall, I believe that UPS is well-positioned to benefit from secular shifts to e-commerce where logistics between seller and buyer is impossible without package-delivery services. The company's financial performance has been very solid in recent years with management striving to achieve higher margins with the help of strategic initiatives. In the long run I see UPS stock as a good investment, but due to currently high uncertainties on the Fed's next steps which will affect probability levels for recession, I give UPS a "Hold" rating.
For further details see:
United Parcel Service: Attractively Valued But Uncertainty Is High