2023-04-24 11:45:38 ET
Summary
- Volume and revenue growth to remain under pressure from macroeconomic slowdown and lower B2C and B2B demand.
- Near-term margins should also get adversely impacted by operating deleveraging as volume declines more than offset productivity gains.
- Upcoming Teamsters union negotiation adds uncertainty.
Investment Thesis
UPS ( UPS ) is scheduled to release its Q1 FY23 earnings on Tuesday. There are concerns regarding the company's declining volume in the near term, attributable to both domestic and international macroeconomic slowdowns, which significantly impact the UPS parcel service business. Moreover, the company's strategic decision to reduce its shipments from Amazon ( AMZN ) is expected to have an adverse effect on volume growth for the quarter. Additionally, FedEx ( FDX ), the company's largest peer, reported a sequential and year-over-year decline in revenue and volume for its Q3FY23, which ended in February. I expect UPS’ revenue to remain under pressure in the near term.
Margins are also expected to be subdued in Q1 as operating deleverage is expected to offset the company's productivity gain initiatives. Further, upcoming Teamsters union negotiations will add uncertainty. UPS is trading above its historical averages based on the FY23 consensus P/E multiple as some investors are betting on an eventual recovery. However, I would suggest a wait-and-see approach and prefer to remain on the sidelines.
Revenue Outlook
During the pandemic, UPS experienced good demand in e-commerce and consumer channels, buoyed by stimulus checks. However, as the company emerged from the pandemic in 2022, it faced tougher comparisons and weakening consumer demand, leading to volume declines.
Even in the fourth quarter of 2022, changing consumer behavior in an inflationary environment and UPS's strategic decision to reduce its revenue share generated from Amazon (as it shifts to more profitable SMB customers) had a negative impact on volumes. The volume decline in Q4 was also more than anticipated due to continued weakness in Asia, resulting from tighter restrictions in China. The volume declines more than offset the company's price increases, leading to a negative impact on revenue growth. Consequently, there was a 2.7% year-over-year decline in revenue to ~$27 billion.
UPS’ Historical Revenue (Company Data, GS Analytics Research)
Looking ahead, Q1 2023 is expected to be another tough quarter for UPS as macroeconomic conditions continue to be tough, and inflationary pressure weighs on price-sensitive consumers, leading to a softer demand environment. The worsening macroeconomic conditions in the U.S. and internationally, combined with continued weakness in Asia, are expected to negatively impact the B2C and B2B channels, resulting in volume decline.
In addition, Europe is also expected to face recessionary pressure due to rising interest rates, energy costs, and inflation, and weak demand in China is expected to persist in Q1 due to COVID-related disruptions. Furthermore, UPS' decision to reduce its Amazon shipment volume is also expected to be a headwind for revenue growth in the quarter. The company’s peer FedEx also reported a 5.9% Y/Y decline in revenues for its Q3 FY23 which ended in February. With things getting even worse in March thanks to the banking crisis which resulted in tightening lending and weaker consumer sentiments, I am expecting a weak first quarter for UPS.
Looking beyond Q1, UPS is focused on growing its volume share from SMB customers for longer-term profitable growth. However, in 2023, when economies around the globe are expected to move into a potential recession, these small and medium-sized businesses tend to get affected harder than large businesses, which should impact UPS's efforts to maximize the SMB customer mix in the near term.
The company's Digital Access Program (DAP) is expected to be rolled out globally to attract SMB customers, but it may not be able to quickly replace lower Amazon shipments in 2023. However, the DAP's international rollout is expected to produce results in 2024 and help in revenue recovery. Additionally, China's economic reopening should support medium to long-term revenue growth as the country fully opens cross-border trade.
In summary, volume decline is expected to continue for the next couple of quarters, and the near-term outlook for UPS's revenue growth seems unfavorable due to broader market uncertainty. However, there is the potential for recovery in FY24 and beyond. I believe, in addition to Q1 results on Tuesday, investors will closely watch management’s commentary around how they are thinking about the macroeconomic cycle and when the volumes are likely to bottom to get a sense of the company’s future prospects. While some investors have started betting on the eventual recovery, I am taking a wait-and-see approach for now.
Margin Outlook
Over the past few years, UPS has focused on improving its operational productivity by increasing efficiency in day-to-day services. This has helped the company improve margins in the first three quarters of 2022, with initiatives referred to as the Total Service Plan ((TSP)). The TSP has enabled the company to improve its on-time network, with total productivity increasing by 1.6% in the fourth quarter as measured by pieces per hour. However, the operational deleveraging resulting from a greater-than-expected volume decline more than offset the productivity gains, leading to a 10 basis point year-over-year decline in adjusted operating margin to 14.1%.
UPS’ Historical Adjusted Operating Margin (Company Data, GS Analytics Research)
Moving forward, I expect operational deleveraging to continue to impact Q1 2023's adjusted operating margin as volumes further decline, muting the benefits gained from productivity initiatives. Moreover, management expects operating expenses to be elevated in the first half of the year as UPS invests in accelerating its Smart packages and Smart Facilities RFID initiatives in its remaining buildings, with some payouts expected in the second half. The company launched these initiatives in 2022 in approximately 100 of its buildings, which has enabled it to reduce missed loads of packages in the package car from one in 400 to one in 800. Now UPS is accelerating the rollout of RFID labeling in approximately 900 remaining buildings by the end of 2023 to further improve efficiencies. So, in addition to operating deleveraging due to lower volume, I expect elevated operating investments to also pressure margins in the coming quarters and more than offset the productivity gains.
In addition, labor inflation is at an all-time high, and there is still much uncertainty regarding the Teamsters Union contract negotiation, under which the company employs approximately 327,000 workers. The contract is expected to be renegotiated by the end of July 2023, and until then, it creates a lot of uncertainty around the cost structure in an inflationary environment and future margin growth prospects.
Valuation and Conclusion
UPS is currently trading at a 17.10x FY23 consensus EPS of $11.42 which is above its historical 5-year average forward P/E of 16.50x. If we look at consensus estimates for the quarter, sell-side analysts are expecting the company to post a ~5.75% Y/Y decline in revenues and a ~27.58% decline in EPS for the first quarter. Some bullish investors are counting on already low expectations for Q1 and a potential positive guidance commentary to build an upside scenario for the stock. However, I would prefer a more cautious wait-and-see approach. The uncertainty around the macroeconomic environment, reduction in Amazon volume, and the upcoming Teamsters negotiation keep me on the sidelines and I have a neutral rating on the stock.
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UPS: Near-Term Headwinds Keep Me On Sidelines