2023-09-05 08:26:34 ET
Summary
- UPS has shown growth in revenue and net income, but analysts expect this to decline in the coming years.
- They have done a decent job deleveraging their balance sheet but at the cost of slight share dilution.
- They have a strong ROIC compared to WACC, indicating value generation.
- They are overvalued through a corporate DCF. WACC was used as a discount factor and calculated through CAPM.
Preview
United Parcel Service ( UPS ) is the world's leading package delivery company and a provider of global supply chain management solutions. Founded in 1907, it has a global presence in over 220 countries and territories. In 2022, it delivered an average of 24.3 million packages per day, totaling 6.2 billion packages during the year. Its strategy focuses on growing in the parts of its market that value its end-to-end network, including SMBs, healthcare, international, and certain large enterprise accounts. It is executing its Customer First, People Led, Innovation Driven strategy to evolve its business to be better and bolder.
In this article, I will evaluate UPS based on five categories:
- Growth
- Balance Sheet
- Share Repurchases/Stock-Based-Compensation
- A Fairly-Priced Stock
- Management's Decisions through the Return on Invested Capital ("ROIC") Metric
I will then assign my rating for the stock based on the performance of these categories and personal interpretation of the information.
Growth
For Growth, I want to see a long-term increase in Revenue, Net Income, and Free Cash Flow. UPS has done a fine job growing revenue through 2022 but had dipped the last year. Analysts expect this growth decline to continue in the upcoming years, and I will account for this in my DCF. However, after benefiting greatly from higher shipping charges in 2021, Net Income and Free Cash Flow have been on the decline. Regardless, the long-term charts show growth in these aspects even through cyclical declines. For that, I will give the Growth Category a "Pass". One might ask why I don't focus on the dividend. This is because many companies make raising the dividend a priority even when they can't afford it. I prefer to invest in a company that shows growth in more impactful metrics over the long run.
Revenue UPS (Author) Net Income UPS (Author) Free Cash Flow UPS (Author)
Balance Sheet
I like this chart for UPS. A capital-intensive company can get in trouble when the Debt/EBITDA ratio rises above (3) due to limitations on borrowing and high interest rates eating the profits alive. UPS has done a fine job deleveraging itself to a safe range over the last couple of years. For threat, I will give the Balance Sheet Category a "Pass".
Stock-Based Compensation and Share Repurchases
Over the long run, the share dilution chart looks fine. I'm not really liking how they have actually diluted investors since 2019. This makes the debt paydown look less riveting. They have also increased Stock-Based Compensation, but the capital employed for share-repurchases is greater, so it's not too bad. Overall, these charts are "meh", but the SBC/Share Repurchases Category will receive a "Pass".
Share Dilution UPS (Author) SBC UPS (Author)
Risk and Discount Factor
For my Discounted Cash Flow Analysis ("DCF"), I am using Free Cash Flows to The Firm ("FCFF"), also known as Unlevered Free Cash Flow. If Unlevered Free Cash Flows are being used, the firm's Weighted Average Cost of Capital ("WACC") should be used as the discount rate. This is because one must take into account the entire capital structure of the company to include the shares of all investors. A portion of the WACC will be found by using the Capital Asset Pricing Model ("CAPM"). The assumptions are shown here:
WACC UPS (Author)
This riskiness of UPS is measured by a Beta of 1.08. Beta does not necessarily measure volatility, but it measures sensitivity to the rest of the market. Beta of greater than 1 means the stock is more sensitive to the market, and eludes a higher risk, which means investors require a higher return. Beta of less than 1 means the stock is less sensitive to the market, and eludes a lower risk, which means investors require a lower return.
The Risk-Free Rate used was the current 10-year Treasury Bond Rate of 4.17%. This would be a guaranteed return an investor could gain risk-free, so it only makes sense an investor should gain a higher return for more risk.
The Market Risk Premium is simply the Expected Return of a broad index minus the Risk-Free Rate. This would be the premium an investor would need to invest in UPS versus a simple broad index or ETF. This value was found on Damodaran Online .
Using the Capital Asset Pricing Model ("CAPM"), we arrive at an Expected Return of the Security of 8.91%. After factoring in debt obligations, we arrive at a WACC of 8.26%. This will be used as the base case discount factor moving forward.
Discounted Cash Flow
The DCF models a Base Case Scenario, a Bull Case, and a Bear Case. Assumptions are shown in the tan boxes.
From the top down, assumptions for each category are explained:
- WACC - Base Case was previously calculated. Bull and Bear are deviations of the Base Case. This should account for any noise in the WACC calculations.
- Terminal Growth Rate ("TGR") - This is the rate we believe the security will grow indefinitely. Generally, a solid Base Case assumption is 2.5% to represent long-term market inflation. I have deviations from this for the Bull and Bear Case, respectively.
- Revenue Growth - For all cases, I input analyst estimates for 2024 and 2025. For the remainder years, I input reasonable assumptions based on historical averages.
- Earnings Before Taxes ("EBIT") - Each case follows a different range of average historical margins.
- Taxes - Average of historical rates.
- Depreciation and Amortization - Average of historical rates.
- Capital Expenditures - Average of historical rates.
- Change in Net Working Capital - Average of historical rates.
Discussion
By modifying my switches for each assumption, I arrive at the following price distribution:
Base Case - Fair Value of $149, for (-13%) upside.
Bull Case - Fair Value of $220 for (24%) upside.
Bear Case - Fair Value of $101 for (-66%) upside.
Overall, I would say UPS is grossly overvalued through a corporate DCF analysis. Even the Bull Case only has a (24%) upside, with the Bear toting a (-66%) upside. There is evidence that investing in UPS is much worse than just investing in a broad index or ETF from a risk-reward standpoint given the current price, fundamentals, and environment. For this reason, I will give a massive "Fail" in this category.
Return on Capital
One good way to evaluate management's decisions is by looking at Return on Invested Capital ("ROIC"). UPS boasts a high average ROIC of 23%. The reason I look at this metric last is because one crucial step is comparing this number to the WACC. If WACC is the internal cost of capital, then the ROIC better be higher, to ensure the company is generating value and not destroying it. Since we have already calculated WACC to be around 8%, it's very clear that an average ROIC of 23% means UPS is a value generator, not a destroyer. Because of this, a "Pass" will be given in this category.
Review
UPS is a fine company. They grow over the long run, they have a healthy balance sheet, and they have done a decent job with share allocation. They also boast a high ROIC compared to WACC, signaling their management knows how to allocate capital. The thing holding UPS back right now is the unfathomable entry price, considering analysts' estimate of revenue in the upcoming year is very bleak. I just don't see the advantage of buying into UPS here, although I wouldn't knock someone for maintaining their position. For that, I assign a "Hold".
For further details see:
UPS: Delivering On Key Metrics, But Grossly Overvalued