2024-01-17 14:50:38 ET
Summary
- UPS underperformed due to a soft global environment and a prolonged negotiation of its Teamster contract, causing volume diversion.
- 3Q23 may be the bottom of the cycle for UPS as it saw average daily volume improve at the end of the quarter.
- Supportive outlook for 2024: recovering diverted volumes, improving global macro, and cost optimizations offsetting the Teamster contract.
United Parcel Service ( UPS ) underperformed the broader market particularly in 2H23 owing to a soft global environment where some countries were in recession, pressuring international and freight forwarding volumes, and a prolonged negotiation and ratification of its Teamster contract caused customers to divert away volume domestically. Nonetheless, the stock was down about 13% in the past year but now has interestingly opened up the opportunity for a better outlook in 2024, especially in the second half.
3Q23 may prove to be the bottom of the cycle
Quarterly revenue fell 12.8% y/y to $21B, marking one of the worst quarters since the COVID-19 pandemic. This was mainly due to declining r eal exports and industrial production because of softening global demand and consumer conditions did not significantly improve. On the domestic side, customers diverted away volume until the contract with the Teamsters was fully ratified in September. Average daily volume ((ADV)) was at its lowest in August, down 15% y/y, worse than the ADV in the week exiting the June quarter which was down about 12% y/y. However, ADV reached an inflection point in late September, reducing y/y declines to about 7%-8%.
In 3Q23, c onsolidated operating profit was $1.6B, down 48.7% y/y while consolidated operating margin was 7.7%. Diluted earnings per share was $1.57, falling 47.5% y/y.
Full year guidance lowered unsurprisingly
During the 3Q23 earnings update call, management expects FY23E consolidated revenue to be between $91.3B and $92.3B and consolidated operating margin to be between 10.8% and 11.3%.
We can deduce that the guidance implies about a 4.7% y/y decline in revenue for 4Q23E at the midpoint. Market consensus calls for a 5.6% y/y decline, however. While we do believe that the volume diversions have moderated in the quarter, we think it might still take at least another quarter or two for the recovery to be complete again. Hence, we pencil in a more significant recovery in 2H24E.
As a reference, UPS took a full year before it was able to completely recover in terms of diverted volume during the Teamster strike in 1997. Another point of reference would be FedEx Ground volume which peaked in y/y growth in August 2023 and has decelerated throughout the remainder of 2023. This reflects the antecedent ADV diversion to FedEx ( FDX ) and the subsequent and gradual recovery of volume back to UPS. Thus, we estimate that diversion was probably an ~8% drag to ADV in 3Q23 and it would've moderated to a ~3% drag in 4Q23. That said, there's some risk that the guided numbers for 4Q may still be a tad high and the company might manage expectations during the 4Q23 earnings call, mentioning that it might take a bit longer to fully recover, which we believe would be in 2Q24E.
Labor efficiency to offset wage growth
The 2023-2028 Teamster contract front-loads most of the wage growth in the first year of about 46% or $1.9B. So if we spread it out over five years, it roughly equates to about $800M annually on average.
UPS is improving labor cost efficiency by reducing operations and overhead functions by 2,300 positions in 3Q23. Through automated facilities equipped with smart package technology (50% installed as of 2Q23, more completed by October 2023), we believe UPS can save $1B+ per year which is only about 2% of compensation and benefits expenses, thus achievable. So through cost optimization, operating margin is still likely to more than offset the Teamster contract impact.
Revenue growth has reached an inflection point
Quarterly revenue y/y growth for both UPS and FedEx are quite correlated as seen in the chart below. The divergence in 2H23 is mainly attributable to the diverted volumes away from UPS due to the Teamster contract, which we expect to normalize over 2024. The deceleration in FedEx revenue y/y declines in the last quarter points to a likely bottoming of this cycle and also roughly also coincides with a four-year cycle historically.
Based on softening global rates outlook in 2024, we believe the global economy would enter into a period of moderate growth, which should benefit both domestic and international parcel volumes.
Valuation
UPS trades at about 17 times forward earnings which is around its 5-year historical average. The current valuation is about three turns cheaper than the S&P 500 which trades at about 20 times forward earnings. We think that UPS can average 10%-15% EPS growth in 2024E-2025E due to recovery in diverted volumes, operating margin expansion due to optimized sorting facilities, and a supportive global macro backdrop. The growth profile is more attractive than the broader index as the consensus for EPS growth for the S&P 500 in the next year is in the high single digits.
While the stock may react negatively if the company guides conservatively in the next quarterly earnings report, we believe it would present a good buying opportunity.
Himalayas Research, Koyfin
For further details see:
UPS: Delivering A Turnaround Story In 2024