2023-09-06 04:10:07 ET
Summary
- United Parcel Service leverages its global scale and duopoly with FedEx to achieve cost efficiencies and deter new competition.
- Customer-centric approach and tech investments continue to strengthen the brand.
- UPS faces tough earnings ahead due to economic slowdown, high labor costs, and rising operational expenses.
- UPS's tech-driven strategies aim to improve efficiency and position it for future earnings growth post economic slowdown.
- UPS’s projected 6% CAGR over five years lacks a margin of safety.
Investment Thesis
I believe United Parcel Service, Inc. ( UPS ) stock is currently a hold. While the company has a strong business model and has made strategic investments in technology to improve efficiency, the short-term financial outlook is challenging due to macroeconomic factors like economic slowdown, high labor costs, and rising fuel prices. In my opinion, the projected 6% CAGR for the next five years doesn't provide a sufficient margin of safety, especially when compared to the yield of the U.S. 5-year treasury bond, which is over 4%.
Company Overview
UPS operates in over 220 countries and provides services like package delivery and supply chain management. It has three main segments: U.S. Domestic Package, International Package, and Supply Chain & Freight. The U.S. Domestic Package focuses on deliveries within the U.S., while the International Package offers global shipping options. The Supply Chain & Freight segment provides logistics and transportation services to businesses. In my view, UPS has a well-structured business model that covers both domestic and international markets. Its Supply Chain & Freight segment adds another layer of service, catering to businesses that require logistics solutions. As for competition, FedEx ( FDX ) is a key player that also offers a broad range of shipping and logistics services. Amazon ( AMZN ) is an emerging competitor, particularly as it builds its own logistics network to support its e-commerce operations. Both pose challenges to UPS in different aspects of the logistics and delivery market.
UPS Global Scale and Duopoly in Logistics
In my opinion, UPS's extensive global network and scale are crucial assets that give it a competitive edge in the logistics and package delivery industry. With operations in over 220 countries and a robust infrastructure that includes a diverse fleet of vehicles and aircraft, UPS is well-positioned to capitalize on economies of scale. This is particularly beneficial for improving cost efficiency and boosting profit margins. By spreading its fixed costs over a large volume of shipments, UPS can effectively lower its average cost per package, thereby increasing its profitability.
I also believe that the economies of scale create a significant barrier to entry for new competitors. The initial investment required to achieve a similar level of operational efficiency as UPS would be extremely high, making it difficult for new entrants to compete effectively.
Furthermore, despite the emergence of Amazon Logistics, the logistics industry remains a near-duopoly between UPS and FedEx as of Q2 2023. UPS holds a commanding 50.97% market share in the Transport & Logistics Industry , closely followed by FedEx with a 47.78% share. Together, they control almost 99% of the market, leaving only 1% for smaller competitors who find it difficult to match their scale and efficiency. In my view, this concentration of market power not only limits price competition but also allows for more predictable operational planning for both UPS and FedEx. The economies of scale enjoyed by UPS further strengthen its competitive position, enabling it to meet a diverse range of customer needs while solidifying its cost advantages and barriers to entry. This market dominance underscores the formidable competitive landscape of the logistics sector and highlights the significant advantages that come with UPS's large-scale operations.
Focus on Customer Loyalty and Technological Investments
In my view, UPS's brand strength is a critical factor in its market leadership, but it's not just about marketing or name recognition. The company has earned trust through consistent reliability and customer service. For example, UPS has seen a steady increase in its engagement with small and medium-sized businesses. As of the most recent quarter of 2023, SMBs accounted for 29.6% of UPS's total U.S. volume, marking the 11th consecutive quarter of growth in this segment. This suggests a strong customer loyalty that has been built over years.
Furthermore, UPS is investing in technology to improve customer experience. The company plans to roll out 1,000 self-service kiosks in its stores by the end of October 2023, making it easier for customers to manage shipments and returns. I believe these aren't just cosmetic changes; they're strategic moves aimed at enhancing customer loyalty. This customer-centric approach not only helps to retain a loyal customer base but also acts as a competitive shield in a market where even minor lapses can send customers to competitors. Overall, UPS's brand and customer service are key assets that reinforce its competitive position.
Navigating Short-Term Financial Headwinds
In my opinion, UPS is facing a challenging financial landscape for the next twelve months, given the recent downturn in its key performance indicators. As of Q2 2023, the company's revenues have declined by 10.9% YoY, adjusted EPS has dropped by 22.8% YoY, and adjusted operating margins have contracted from 14.4% to 13.2%. I believe one of the main drivers behind this decline is the macro-economic slowdown, exacerbated by higher interest rates and inflation, which has led to a decrease in overall economic activity.
UPS Q2 2023 Earnings Presentation
Furthermore, I think the record-high gas prices are putting additional pressure on operating margins, a situation that doesn't seem likely to improve soon. Adding to these financial headwinds, UPS's operating margins are expected to be further impacted by a new labor contract. Under this agreement, the average full-time driver will earn approximately $170,000 annually in pay and benefits, while part-timers will make at least $25.75 per hour and receive full healthcare and pension benefits.
UPS Q2 2023 Earnings Presentation
Given these labor costs, along with the economic challenges and rising operational expenses, I feel the outlook for UPS's earnings over the next year is quite challenging. The company will need to tread carefully to maintain profitability, while also staying true to its commitments to customer service and employee well-being.
Long-Term Margin Expansion Amid Economic Challenges
In my view, UPS is making strategic moves to counterbalance its financial challenges by leveraging technology to reduce expenses, thanks in part to the implementation of its Total Service Plan . This plan aims to lower operational hours by approximately 10%. Additionally, UPS has utilized Network Planning Tools to reduce volume in non-automated buildings by 18%, allowing the company to close sorts and decrease its operations headcount by 7% YoY. Another noteworthy effort is the reduction of airline block hours by 6.5%. UPS achieved this by consolidating more activity into its Worldport hub and cutting back on 2nd Day Air flights. I believe that once the current economic headwinds subside, operating margins will likely expand past previous levels which should translate into substantially higher earnings.
UPS Q2 2023 Earnings Presentation
Financial Analysis
Over the past 5 years, the company has demonstrated solid financial performance. Its revenue has shown a consistent and strong growth, increasing from $71,861.00 million in 2018 to $96,174.00 million in the last 12 months in 2023, representing a compound annual growth rate ((CAGR)) of approximately 6%. The earnings per share ((EPS)) have been equally solid, growing steadily from $5.51 in 2018 to $11.55 in the last 12 months, reflecting the company's ability to translate revenue growth into bottom-line success.
As of the most recent quarter, the company reported cash and cash equivalents of $7,883.00 million . The company's total debt stands at $19,024.00 million, a manageable amount that could be paid off entirely with about 3 years' worth of last twelve months free cash flow. The company's current ratio, a measure of its ability to cover short-term liabilities with short-term assets, is 1.32, which is generally considered healthy as it is above 1.
As previously mentioned, I expect the upcoming few quarterly earnings results to be tough due to reduce overall package volume as a result of macro-economic headwinds dampening economic activity and higher labor costs and fuel costs.
Looking beyond the next 12 months, assuming a return to favorable macroeconomic conditions, the company, in my view should be able to expand margins as a result of the implementation of the Total Services Plan.
Valuation
When considering valuation, I always consider what we are paying for the business (the market capitalisation) versus what we are getting (the underlying business fundamentals and future earnings). I believe a reliable way of measuring what you get versus what you pay is by conducting a discounted cashflow analysis of the business as seen below.
UPS' current TTM Cashflow per Share as of Q2, 2023 is $7.14. Once a favourable macro environment returns, as cash flows normalise and margins expand from the Total Services Plan, I believe that UPS should grow conservatively at 12% annually for the next five years. Therefore, once factoring in the growth rate by Q2 2028 UPS's Cashflow per Share is expected to be $12.58. If we then apply an exit multiple of 16, this infers a price target in five years of $229.29. Therefore, based on these estimations, if you were to buy UPS at today's share price of $168, this would result in a CAGR of 6% over the next five years.
While UPS has a strong business model and is a market leader, I think investor expectations are currently too elevated for the company to offer any sort of margin of safety. A projected 6% CAGR over the next five years doesn't seem sufficient, particularly when the U.S. 5-year treasury bond is yielding over 4%. Given these factors, UPS will stay on my watchlist, as I hope the market will offer a more favorable investment opportunity in the future.
Conclusion
In my opinion, UPS stands as a formidable force in the logistics industry, capitalizing on its global scale and near-duopoly with FedEx to achieve cost efficiencies and ward off new competition. I believe the company's focus on customer service and technological advancements has further strengthened its brand, making it a preferred choice for a wide range of clients. However, UPS is currently facing short-term financial headwinds due to an economic slowdown, elevated labor costs, and high fuel costs. While the company is strategically using technology to improve efficiency, this improvement will be felt once the economy recovers. I think the projected 6% CAGR over the next five years doesn't offer a sufficient margin of safety, particularly when the U.S. 5-year treasury bond is yielding over 4%. Given these factors, UPS will remain on my watchlist as I await a more favorable investment opportunity.
For further details see:
UPS: Good Business But No Margin Of Safety