2024-01-02 07:30:00 ET
Summary
- A trifecta of income, value, and growth is difficult but not impossible to find in this market.
- United Parcel Service's results were mixed in the third quarter, but there are encouraging signs for the future.
- The company enjoys an A credit rating from S&P on a stable outlook.
- Shares of the logistics giant look to be undervalued to the tune of 25%.
- The cumulative total returns of UPS could outperform the S&P 500 by over 350% through 2025.
Market rallies are a mixed bag to me. On one hand, it is a nice feeling to see the value of my portfolio and my overall net worth climb. But on the other hand, the bang for my investment buck diminishes. Over the long run, it's more advantageous to buy on the cheap when still accumulating.
The 25% surge in the S&P 500 ( SP500 ) in 2023 has made it all the more challenging to find value now. This is because, with the S&P trading at a soft landing forward P/E ratio of 19.6, it is trading at a 17% premium to its historical valuation multiple of 16.8. However, the good news is that even with the S&P near all-time highs, the elusive combination of income, value, and growth can still be found.
The multinational logistics giant, United Parcel Service ( UPS ), I believe is one example of a business that checks off all the boxes. For the first time since June 2022 , I will discuss the company's fundamentals and valuation to outline why I am reiterating my buy rating.
UPS currently sports a 4.1% dividend yield. Whether looking at the 1.5% yield of the S&P 500 or the 3.9% yield of the 10-year U.S. treasury, I believe this is an attractive starting income. It's also made all the more enticing when viewing the fundamentals of UPS.
The company's 60% EPS payout ratio is in line with the 60% EPS payout ratio that rating agencies desire from the logistics industry. Given that UPS is likely in a trough year for earnings, the dividend is still arguably sustainable.
The company's 50% debt-to-capital ratio is moderately elevated versus the 40% debt-to-capital ratio that rating agencies like to see from the logistics industry. However, as I'll highlight in the fundamentals section of this article, UPS' interest coverage ratio through the first nine months of 2023 is fine. Along with the company's industry leadership, that is why S&P awards an A credit rating to UPS on a stable outlook. This implies that the risk of UPS defaulting on debt in the next 30 years is just 0.66%. Put another way, rating agencies currently expect the company to remain a going concern in 151 out of 152 scenarios through 2054.
UPS also looks to be priced at an appealing valuation. Judging by its historical dividend yield and P/E ratio, shares of UPS could be worth $209 each. Relative to the $157 share price (as of January 1, 2024), that suggests shares of the logistics titan are 25% undervalued.
If UPS were to meet the analyst growth consensus and return to fair value, here are the total returns that it could generate in the next 10 years:
- 4.1% yield + 10.6% FactSet Research annual growth consensus + a 2.9% annual valuation multiple expansion = 17.6% annual total return potential or a 406% 10-year cumulative total return versus the 8.6% annual total return potential of the S&P or a 128% 10-year cumulative total return
A Tough Quarter But UPS Is Holding Up
Heading into the third quarter, UPS expected a challenging environment. That's exactly what they had to endure. The company's consolidated revenue dipped by 12.8% year-over-year to $21.1 billion during the quarter. This fell short of the analyst consensus by $410 million .
The biggest factor that weighed on UPS' consolidated revenue in the third quarter was an 11.1% decrease in U.S. Domestic segment revenue to $13.7 billion. That was driven by an 11.5% decline in average daily package volume, which was the result of the drop that peaked in August. This was when the company's average daily volume was down by 15.2% over the year-ago period per CFO Brian Newman's opening remarks during the Q3 2023 earnings call . That was due to both labor negotiations and an unfavorable macroeconomic environment. An average increase of 2% in revenue per piece was unable to offset these headwinds.
There is reason for optimism, though. The company's resolution of its contract dispute with employees in August quickly began to bore fruit. As network volumes returned, UPS' U.S. average daily volume was down just 7.4% in the final week of the quarter according to CEO Carol Tome's opening remarks in the Q3 2023 earnings call.
The company's adjusted diluted EPS plunged 47.5% year-over-year to $1.57 for the third quarter. This topped the analyst consensus by $0.01. UPS wasn't able to completely offset its reduced revenue base with lower operating expenses as total operating expenses fell just 6.3% over the year-ago period (page 5 of 81 of UPS' 10-Q filing ). That explains why adjusted diluted EPS decreased at a faster pace than revenue during the quarter.
Moving to its financial position, UPS is steady. The company's interest coverage ratio was 12.3 through the first nine months of 2023. For a business that has encountered operational headwinds all year, this is a healthy interest coverage ratio. Additionally, UPS had $25.8 billion in adjusted total debt on its balance sheet as of September 30, 2023. Compared to the $14.2 billion in trailing 12 months adjusted EBITDA generated over that time, this is a leverage ratio of just 1.8.
Generating Ample Free Cash Flow To Grow The Dividend
In just the last five years, UPS' quarterly dividend per share has soared 78% higher to the current rate of $1.62 . I wouldn't expect this type of dividend growth to continue in the future. But with a 4%+ dividend yield, the mid-single-digit annual dividend growth that I'm anticipating is more than enough.
UPS produced $4.7 billion in free cash flow through the first three quarters of 2023. Against the $4 billion in dividends paid in that time, this equates to an 85.5% free cash flow payout ratio. Currently, operating cash flows are down by double-digits. Capex is also up by over $800 million (page 6 of 81 of UPS' 10-Q filing).
As UPS' operating cash flow recovers and it reaps the benefits of higher capex, the free cash flow payout ratio should improve. In the meantime, the dividend is still adequately covered.
Risks To Consider
UPS is an otherwise excellent business having a down year, but it has risks that are worth mentioning.
For one, Amazon ( AMZN ) remained UPS' largest customer, accounting for 11.3% of consolidated revenue in 2022 (page 12 of 314 of UPS' 10-K filing ). As the dominant e-commerce retailer builds out its e-commerce delivery network, it will likely rely less on UPS over time. This could negatively impact UPS' revenue. Fortunately, I think that Amazon's efforts to build its delivery network will be solely to bolster its competitive advantage over other retailers. That's why I don't see the company directly competing with UPS and stealing customers from it.
Second, shareholders were also recently reminded of the very real risk that labor strikes present to UPS. If another strike were to eventually happen, UPS' operating results could be unfavorably impacted. The company could lose out on revenue, lose customers, and face higher labor costs due to a strike.
Finally, UPS will need to keep meeting the needs of its customers to maintain and grow its market share. If the company can't keep this up, it could risk losing share to competitors. That could put a damper on UPS' growth story.
Summary: UPS Is A Superb Business That Has It All
If I weren't fortifying my emergency fund for the rest of this month, UPS would be in the running for further investment on my end. The company's 17.9 blended P/E ratio is moderately below its normal P/E ratio of 20.1 per FAST Graphs. If UPS can match the analyst growth consensus and return to its normal valuation multiple, it could generate 47% cumulative total returns through 2025. That is more than triple the 13% cumulative total returns that are expected from the SPDR S&P 500 ETF Trust ( SPY ) through 2025. Thus, my rationale for maintaining my buy rating on shares of UPS.
For further details see:
United Parcel Service: The Total Package For Income, Value, And Growth