2023-10-06 12:20:58 ET
Summary
- UPS stock has corrected 15% since my previous article due to lower demand and Teamster contract headwinds, but volume declines should become less bad in the coming quarters.
- Margins will remain under pressure in the next year due to high wages and benefits, but cost-cutting initiatives and volume recovery should help in the second half of 2024.
- UPS is currently trading below historical averages, and the company's long-term growth prospects are favorable, making it a buy.
Investment Thesis
I have recommended following a wait-and-watch approach on United Parcel Service, Inc.'s ( UPS ) stock and remaining on the sidelines in my last few articles as the company faced headwinds from lower demand and the Teamster's new contract and related wage increases. The stock has corrected ~15% since my previous article and looking forward, the volume declines should become less bad in the coming quarters and there is a potential for the company to return to sales growth by Q2 2024.
While the margins are expected to remain under pressure over the next year due to high wages and benefits increase in Year 1 of the new contract, the sell-side estimates on stock price have already come down and are reflecting these headwinds. Further, the company is working on cost-cutting related to non-driver jobs which along with volume recovery should help margins in 2H 2024. UPS is currently trading below its historical averages. The company's long-term growth prospects are favorable, and I believe the near-term concerns are already priced in at current levels. I believe UPS returning to revenue growth in 2024 coupled with management commentary on cost savings on the March 2024 Investors Day should act as a catalyst for the stock. Hence, I am moving to a buy rating on the stock.
Revenue Analysis and Outlook
In my previous article, I discussed the headwinds UPS was facing due to tough macroeconomic conditions which were expected to adversely impact the company's results. The company has reported its Q2 results since then and a similar trend was seen.
In the second quarter of 2023, the company saw reductions in both residential and commercial shipments due to challenging external conditions, including persistent inflation, declines in U.S. manufacturing production, and a reduction in discretionary consumer spending, which contributed to overall volume declines. This resulted in a 10.9% Y/Y decrease in revenue to $22.1 billion with a 9.3% decline in average shipment volume.
UPS' Historical Revenue Growth (Company Data, GS Analytics Research)
Looking forward, I believe the worst is behind us in terms of volume declines and Y/Y volume decline should moderate in the coming quarters. In addition to the tough macroeconomic environment, the Teamsters contract negotiations also had an adverse impact on the company's volumes until the agreement was finalized in July as the customers looked to move their freight to alternative carriers to prevent a potential disruption in case of a strike. If we look at the monthly cadence, UPS saw a Y/Y volume decline of ~7% in March and April which worsened to ~12% in June and, according to management, July was also down low double-digit though slightly better than June.
Post the new contract negotiation ending with Teamsters, the company is focusing on winning back those customers as well as acquiring new customers by highlighting its superior service and capabilities. The company won't win back all the lost volume immediately, but I expect sequential improvement as the company's third quarter progresses and into the fourth quarter. So, the pace of decline should reduce moving forward, and we should see a return to growth sometime next year (most likely Q2 2024 due to easier comparisons).
The company is also focused on growth initiatives like the Digital Access Program, growth in the healthcare business, and international expansion to drive growth.
The company continues to gain good traction with its Digital Access Program (DAP) and introduced plug-and-play technology last quarter to make it even easier for e-commerce platforms to connect. In the second quarter, the company added 7 new e-commerce platforms including 4 international platforms to DAP. The company is well-positioned to achieve its ~$3 bn revenue target from DAP this year.
Another important long-term growth driver for the company is its focus on growing its healthcare logistics business. The company is focusing on both organic and inorganic growth routes to become the leading provider of complex healthcare logistics solutions and is continuing to expand its globally connected, tech-enabled cold chain network to provide the best service to its clients. The company recently acquired MNX Global Logistics, a global provider of time-critical logistics services that should bring more precision and capabilities to UPS' existing solutions. Global healthcare logistics is a ~$130 bn market and emerging competitors like Amazon's ( AMZN ) third-party logistics have limited advantages in this market. So, this should be a defensive, high-growth, and profitable niche for UPS in the long run.
UPS' Healthcare Revenue and Global Healthcare Logistics Market (Company's Investors Presentation)
The company is also doing a good job in terms of international expansion and, after launching its asset-light joint venture MOVIN in India last May, the company has quickly expanded it to the 49 largest cities covering ~90% of the B2B marketing opportunity in the country.
Overall, I believe the company has good long-term opportunities and the near-term revenues also appear to be bottoming with a potential of the company returning to growth by Q2 next year as the company sees easier comparisons.
Margin Analysis and Outlook
In Q2 2023, the adjusted operating margin declined 120 bps Y/Y to 13.2% driven by volume deleverage across all segments which more than offset lower purchased transportation costs in Supply Chain Solutions, lower fuel expenses, and the impact of our ongoing productivity initiatives.
UPS' Adjusted Operating margin (Company Data, GS Analytics Research)
Looking forward, the company's margin should be under pressure from the recently ratified Teamsters contract at least till August next year when the first year wage and benefit increase under this contract anniversaries. The recent 5-year Teamsters contract includes the highest wage and benefit in the first year and a relatively normal pace of increase after that from Year 2 to Year 4. Since benefits and wages are the largest expense for the company, I don't see the company's productivity and cost-cutting initiatives offsetting it in the near term.
UPS' Teamsters Contract Annual Cost Growth Rates (Company's Investors Presentation)
This was also my concern when I recommended being on the sidelines in my last article.
However, the good news is that the sell-side expectations on margins have come down since my last article and the stock has also corrected meaningfully indicating buy-siders are also already pricing in this headwind.
The company has indicated that it plans to undertake significant headcount reductions among its ~140K non-driver employees through automation and sort consolidation and plans to give more details about these initiatives on its March 2024 Investor Day. Management has not given much clarity on it as of now and I will be watching out for management's commentary on it moving forward, but I expect these initiatives to offset labor inflation to a good extent starting Year 2 of the new Teamsters contract. As discussed earlier, the volume should also return to Y/Y growth sometime next year. So, these two factors should help improve margins towards the FY24 year-end and in FY25.
Valuation and Conclusion
UPS is currently trading at 16.43x FY23 consensus EPS estimates of $9.34 and 14.78x FY24 consensus estimates of $10.38. This is a discount versus its 5-year historical average forward P/E of 16.57.
I believe the current year EPS will likely mark the bottom-of-the-cycle earnings in the current downturn and valuation on this bottom-of-the-cycle EPS looks attractive. The company also has an attractive 4.21% forward dividend yield.
With the stock declining over 15% since my last article, I believe most of the negatives are already priced in at these levels and the return to growth in 2024 along with management commentary about cost-cutting among non-driver jobs on the March 2024 Investor Day may improve investor sentiments and serve as a catalyst for the stock. Hence, I am upgrading my rating to buy.
For further details see:
UPS: Moving To A Buy On This 4% Yield Stock As Fundamentals Bottom