2023-08-02 13:15:47 ET
Summary
- UPS is set to report Q2 FY23 earnings next Tuesday, with concerns about lower consumer demand, a shift in consumer behavior, and reduced shipments from Amazon.
- Margins are expected to remain suppressed due to operating deleveraging.
- The cost increases from the new Teamsters contract don't help either.
- Valuations are not attractive enough to look beyond these near term headwinds.
Investment Thesis
United Parcel Service, Inc (UPS) is scheduled to release its Q2 FY23 earnings on Tuesday. The parcel services of UPS have been impacted by lower consumer demand in an inflationary environment and a post-pandemic shift in consumer demand behavior toward service and away from goods. Moreover, the reduced shipments from Amazon ( AMZN ) are also a concern. In mid-June, the company's peer FedEx ( FDX ), reported a sequential and year-over-year decline in revenue and volume for its Q4FY23 (ended May) and guided for a weaker demand environment for a couple of quarters ahead. I expect similar commentary from UPS as well.
Margins are also expected to remain suppressed in Q2 as operating deleveraging is expected to offset the company's productivity benefits. Furthermore, UPS is trading above its historical averages based on the FY23 consensus P/E multiple. Given the higher than historical valuation, I would suggest a “wait and watch” approach and prefer to remain on the sidelines to see some signs of volume recovery and margin expansion before turning more positive on the stock. Hence, I continue to have a neutral rating on the stock.
Revenue Outlook
In my previous preview article for UPS first quarter of 2023, I anticipated weaker consumer demand in an inflationary environment and tough macroeconomic conditions in Europe and China to adversely impact volume levels for the company. I also preferred to wait on the sidelines due to higher than historical valuation and declining volumes. The company reported its earnings for the first quarter of 2023 shortly after that where similar dynamics were seen and the stock price has corrected ~5.2% since then underperform ing the S&P 500’s ( SPY ) 10% gain.
In the first quarter of 2023, the company’s volume growth continued to suffer from lower consumer demand in an inflationary environment and UPS’ strategic decision to reduce its shipments generated from Amazon. In addition, weaker demand in Asia due to the slower reopening of China and tough macroeconomic conditions in Europe also impacted the volume levels. Furthermore, the banking crisis in March also lowered consumer sentiment and further softened end-market demand. The volume declines more than offset the price increases, leading to a negative impact on revenue growth. This resulted in a 6% YoY decline in revenue to $22.9 billion, with average volume declining 5.6% YoY.
UPS’ Historical Revenue (Company Data, GS Analytics Research)
UPS’ Historical Shipment Volume and Average Revenue Per Piece (Company Data, GS Analytics Research)
Looking forward to the second quarter earnings, I believe the company is going to see similar trends to what we saw in Q1 2023. The overall economic conditions continue to remain tough, and the inflationary environment continues to pressure consumer demand. Moreover, a shift towards services from goods post-pandemic is also affecting consumer demand globally. These factors along with reduced shipments from Amazon should continue to pressure volume levels in Q2 2023, negatively impacting revenue growth.
In an inflationary environment, consumers prioritize purchasing essential goods over discretionary items. Usually, essential and staple categories are typically bought in-store, which reduces the demand for parcel services, impacting the company's shipment volume. Additionally, a decline in consumer confidence due to the persistent pressure from rising interest rates and inflation should also negatively impact demand. So due to this weaker consumer environment, I anticipate that shipment volumes in the second quarter should also remain suppressed.
Moreover, the COVID-19 pandemic led to a significant shift in people's lifestyles as they were confined to their homes. This led to a surge in demand for general merchandise like kitchen appliances, and home improvement items, as individuals focused on enhancing their living spaces, while demand for services was put on hold due to travel and mobility restrictions. As the pandemic situation improved and restrictions were lifted, there was pent-up demand for services that people had been unable to access during the lockdowns like hotel stays, vacations, dining out, movie theaters, etc.
This resulted in a swift transition in purchasing patterns from goods to services as the economy reopened and travel became more feasible. According to FRED, since the beginning of 2022 till June 2023, personal consumption expenditure for services has increased by ~4.7% whereas personal consumption expenditure for goods has only increased by ~0.5% during the same time period. So, we should see the general shift of consumer demand from goods to services also impacting volume levels and sales growth in the second quarter.
Furthermore, UPS’s biggest rival FedEx reported its earnings for the fourth quarter of its fiscal 2023 (ending May). FDX’s revenue in the quarter declined by 10% YoY. FedEx not only saw a year-over-year decline but also saw a sequential worsening of revenue decline, as the 10% YoY decline in Q4FY23 followed a 5.9% YoY decline in Q3FY23. Moreover, management at FedEx commented that they are expecting a weaker consumer environment to persist for a couple of quarters ahead as well, which could continue to negatively impact shipment levels. Now the quarter end for FDX and UPS doesn’t exactly overlap, but I anticipate hearing a similar commentary about the weakening trend from UPS given the current macro environment. So, I expect not only Q2 2023 but a couple of quarters ahead should also see depressed volume levels, negatively impacting revenue growth in the second half of 2023.
Margin Outlook
On the margin front, in my Q1 2023 preview, I anticipated continued pressure from volume deleveraging to adversely impact margin growth and in the first quarter of 2023 earnings, results came in as I expected. The company saw sales deleverage as volume levels declined. This more than offset productivity benefits realized from the company’s Total Service Plan (TSP enabled the company to improve its on-time network). This led to a 250 bps YoY decline in adjusted operating margin to 11.1%.
UPS’ Historical Adjusted Operating Margin (Company Data, GS Analytics Research)
Looking forward to the second quarter earnings, I expect margins to further decline due to continued headwinds from volume deleveraging. Moreover, management has accelerated the rollout of its Smart packages and Smart Facilities RFID initiatives in its remaining buildings. The company launched these initiatives in 2022 in approximately 100 of its buildings, which has helped in reducing missed loads of packages in the package cars.
Previously management anticipated the rollout of these initiatives in its remaining 900 buildings to be completed by the end of 2023. However, management estimates to complete the rollout by the end of October 2023. This implies that operating expenses incurred in rolling out these initiatives should increase further in the coming quarters. So headwinds from operating deleveraging and elevated investments should continue to impact margins in the coming quarters, and that will more than offset productivity gains.
In addition, the company also completed the Teamsters contract renewal negotiation, under which the company employs approximately 340,000 workers, and closed the agreement last week. According to the new contract, the company will incur $30 billion of additional costs over the next five years in order to fulfill the new terms and conditions of the contract. The wage rates under the new contract agreement have also increased for both existing full-time and part-time workers. This wage rate increase came in line with all-time high labor inflation as I anticipated and should pressure the margins by elevating payroll costs over coming years.
While management is taking cost control measures like reducing work hours and aligning them with lower shipments, eliminating headcounts, and reducing air package flows to optimize the network, I believe volume deleveraging, elevated investments, and an increase in labor wage rates, should negatively impact margin expansion in the coming quarters.
Valuation and Conclusion
UPS is currently trading at a 17.4x FY23 consensus EPS of $10.66 which is above its historical 5-year average forward P/E of 16.55x. If we look at consensus estimates for the quarter, sell-side analysts are expecting the company to post a ~6.6% YoY decline in revenues and a ~24% decline in EPS for the second quarter. I expect the company’s earnings and margins to remain pressured in the coming quarters as well due to the soft demand environment.
Hence, I would continue to prefer a more cautious wait-and-watch approach. The uncertainty around the macroeconomic environment, reduction in Amazon volume, and additional cost headwinds from the Teamster contract renewal keep me on the sidelines. I need to see some signs of volume recovery and success of management productivity initiatives to improve margins before turning positive on the company.
For further details see:
UPS: Still Not Appealing Enough