2023-10-12 16:00:00 ET
Summary
- UPS' prospects may lift from H2'23 onwards, with the labor negotiations already concluded and the management working hard to win back customers.
- However, the management has guided an underwhelming H2'23 performance, with the "US average daily volume to be down by a mid-single-digit percentage YoY" and higher than expected union wages.
- While UPS may offer an excellent 5Y dividend growth CAGR of +12.38%, compared to the sector median of +6.87%, investors may also want to reign in their expectations going forward.
- With crude oil likely to remain elevated, we may see the delivery company's fuel expenses similarly rise, triggering further headwinds to its near-term profitability.
- As a result of these headwinds, UPS investors must also size their income portfolios accordingly, especially since the potential downside may negate its tempting dividends.
We previously covered United Parcel Service, Inc. (UPS) in September 2022, discussing its highly profitable margins during the peak of global supply chain issues, naturally triggering the stock's outperformance compared to the wider market then.
In this article, we will be discussing its mixed performance in FQ2'23, mostly attributed to the diverted volumes during the labor negotiations. The stock may also meet recovery headwinds, as wages and fuel expenses increase moving forward.
We shall discuss further.
The UPS Stock Is A Buy , Thanks To The Stellar Management Team
For now, UPS has been able to report a pretty decent FQ2'23 revenue of $22.05B (-3.7% QoQ/ -10.9% YoY) and adj EPS of $2.54 (+15.4% QoQ/ -22.7% YoY).
This is mostly attributed to its robust pricing power, contributing to the higher gross margins of 25.5% (+1.8 points QoQ/ -0.7 YoY) compared to FY2019 margins of 21.6% (+1.1 points YoY).
It appears that the UPS management team has also competently managed the rising inflation in its day-to-day operations, despite the impacted volumes in the latest quarter.
This is demonstrated by the stable operating expenses of $2.64B (-6% QoQ/ inline YoY) and expanding operating margins of 13.5% (+2.1 points QoQ/ -2 YoY), compared to FY2019 margins of 10.6% (+0.7 points YoY).
UPS Consolidated Package Volumes
Therefore, we are not overly concerned about UPS' Average Daily Package Volume decline to 20.9M ( -4.9% QoQ / 9.4% YoY) in FQ2'23, since the delivery company is also lapping up a tougher YoY comparison, as the macroeconomic outlook remains uncertain with a pronounced tightening in discretionary spending.
UPS Package Volume Domestically & Internationally
For example, UPS's decline in the domestic Average Daily Package Volume to 17.74M (-4.9% QoQ/ -9.8% YoY), has also been observed with FedEx (FDX) at 2.65M (-1% QoQ/ -6.6% YoY) in the latest quarter, albeit less drastic attributed to the latter's smaller scale.
While there have been some headwinds in the previous quarter as some of its delivery volumes are diverted, we believe things may lift from H2'23 onwards, with the labor negotiations already concluded and the management working hard to win back customers.
Early signs have been promising indeed, with the decline already decelerating and some volumes returning by July 2023.
However, investors must also note that the UPS management has guided for an underwhelming H2'23 performance, with the "US average daily volume to be down by a mid-single-digit percentage year-over-year" and higher than expected union wage rates.
As a result of these headwinds, we believe that there may be a near-term impact on its top and bottom-line performance, despite the excellent execution in H1'23.
UPS Valuations
Perhaps this is also why UPS' valuations have normalized from its hyper-pandemic era EV/ Sales mean of 2x and P/E mean of 20.29x. Then again, we are not overly concerned, since the stock's valuations have merely normalized nearer to its 5Y means and the sector medians.
The consensus still estimates that the delivery company may be able to sustain its hyper-pandemic top and bottom lines through FY2025, with the same projected for its direct competitor, FedEx.
Based on the consensus FY2025 adj EPS estimates of $11.36 and UPS' FWD P/E of 16.43x, we are looking at a long-term price target of $186.64, implying a more than decent +19.9% upside potential from current levels.
It is evident that the UPS management has been laser-focused on dividend growth as well, based on the stock's excellent 5Y dividend growth CAGR of +12.38%, compared to the sector median of +6.87%. This has triggered its expanded forward dividend yields of 4.20%, compared to its 4Y average of 2.90% and sector median of 1.60%.
As a result of its attractive prospects of capital appreciation and dividend income, as discussed above, we are cautiously rating the UPS stock as a Buy.
Why The Cautious Buy Rating? UPS Is Exposed To The Volatile Crude Oil Situation - Potentially Impacting Its Profitability
UPS 5Y Stock Price
For one, the UPS stock has returned much of its hyper-pandemic gains, with it currently retesting its 2021-2023 resistance levels of $150s, thanks to the normalization trend in its hyper-pandemic valuations.
Unfortunately, we believe the stock's prospects may be further impacted ahead, potentially triggering more retracements. This is why.
WTI Crude Oil Spot Prices
The ongoing conflicts in Ukraine and Israel have impacted the WTI crude oil prices, with it currently jumping to $86.07 at the time of writing, up by +4.5% from $82.31 in the October 2023 bottom, +28.9% from the YTD bottom of $66.74 in March 2023, and +56.4% from FY2019 averages of $55.
These numbers matter indeed, since the fluctuating crude oil prices impact UPS' operations to a certain extent. For example, the delivery company reported $4.36B in annualized fuel expenses in FQ2'23 ( -14.2% QoQ / -35.7% YoY), based on the quarter's average WTI crude oil prices of $73.76.
With the ongoing conflicts unlikely to abate soon, we believe we may see the WTI crude oil prices remain elevated near $90s moving forward. Based on its historical correlation, we may see its operating profits impacted, given the projected increase in its annual fuel expenses by $0.95B to $5.31B, or the equivalent increase of +21.7%.
These numbers suggest a stark $2B difference to the FY2019 fuel expenses of $3.28B (-4% YoY), though still better than the FQ2'22 annualized fuel expenses of $6.78B when the WTI averaged eye-watering spot prices of $108.72.
Either way, investors cannot deny that UPS' global operations are extremely sensitive to volatile crude oil prices, similar to that of the aviation and metal industries.
As a result of these headwinds, we may see its TTM Free Cash Flow Yield to Dividend Yield Ratio further deteriorate from current levels of 1.12%, compared to its 5Y average of 1.62% and sector median of 3.14%.
UPS investors must also note that the delivery company's net debt levels have also increased to $11.14B by the latest quarter, compared to $10.17B a quarter ago and $5.64B a year ago, though still improved against the $15.77B reported in FY2019.
While most of its long-term debts are at fixed rates, the delivery company is still exposed to $1.56B of floating-rate senior notes. The elevated interest rate environment has naturally triggered its higher interest expenses at an annualized sum of $764M (+1.5% QoQ/ +11.6% YoY) by FQ2'23, higher compared to FY2019 levels of $653M (+7.9% YoY).
These headwinds have also impacted its dividend coverage ratio to 1.45x, compared to its 5Y average of 2.03x and the sector median of 3.58x, implying its reduced capability of increasing its dividends ahead.
As a result of these headwinds, UPS investors must also size their income portfolios accordingly, especially since the potential downside may negate its tempting dividends.
In addition, this buy rating does not come with a recommended entry point, since it depends on individual investors' dollar cost averages and risk appetite, as discussed above.
For further details see:
United Parcel Service: Cost Headwinds In H2'23 - But Buy This Dip