Profitable Parcels And Passive Income: Why 4.6%-Yielding UPS Is A Bullish Bet (NYSE:UPS)

Introduction

Earnings season is about to heat up, which includes one segment I always cover very extensively: transportation.

One transportation company I have increasingly covered since last year is the United Parcel Service, Inc. (NYSE:UPS). My most recent article on this company was written on March 28, when I went with the title “UPSwing: Why This Delivery Giant May Be Poised For Takeoff.”

In that article, we discussed the company’s long-term growth plans after it held its Analyst/Investor Day. This included a bigger focus on markets with secular growth, as the company needs to diversify in an increasingly challenging market. This includes healthcare, an addressable market of more than $150 billion.

As we slowly head into transportation earnings season, I’ll use this article to update my thesis, explain how UPS is changing, and what this may mean for the risk/reward.

So, as we have a lot to discuss, let’s get to it!

Finding Growth In A Challenging Market

On July 9, Reuters reported the news of a new CFO at UPS.

This transition is quite interesting, as Reuters noted that it comes at a time of significant challenges, including labor issues and the fight for major contracts.

Supply Chain Dive highlighted why this environment is so challenging for UPS, as it is “forced” to find growth in other areas, pressured by Amazon (AMZN) in its core business.

Competition in the shipping and freight industries has continued to erode shipping volumes at UPS as players like Amazon bring shipping to their own fleets, Tancredi, who leads the supply chain group for the Chicago-based consultancy said in an interview with CFO Dive.

With UPS facing increased costs of labor — last year, UPS inked a five-year contract with the Teamsters Union that included significant wage increases — “the only way they can recoup some of these additional costs is by increasing that sales volume, so I was expecting them to go outside with someone who has a history of growth oriented companies,” Tancredi said. – Supply Chain Dive.

Although the chart below is a bit “old,” it indicates that Amazon started to overtake UPS parcel volumes at the end of 2022. In fact, both UPS and FedEx (FDX) started to see slower volumes in 2020 when Amazon shifted more freight to its network.

As such, UPS needs to find growth in other areas and streamline its business.

This included the announcement on June 23 to sell its Coyote Logistics business to RXO (RXO) in a $1.03 billion deal.

While Coyote is a fantastic business in the third-party logistics industry with 100 thousand network carriers that manage roughly 10 thousand loads per day, the sale makes sense, as it allows UPS to free up cash and focus on its core business.

“As UPS positions itself to become the premium small package provider and logistics partner in the world, the decision to sell our Coyote Logistics business allows an even greater focus on our core business,” said UPS Chief Executive Officer Carol B. Tomé. – UPS.

Moreover, the company got a key tailwind from the partnership with the United States Postal Service (“USPS”) to become the primary air cargo provider.

This partnership is expected to drive top-line growth and improve operating margins in both the consolidated and U.S. domestic markets.

Why is this a big deal?

To use the company’s own words (and numbers):

With this deal, we’re on the way to our goal of growing faster than the market and hitting our financial target. Coupled with our 1+2 Strategy that will boost volume, increase revenue and fuel operating profit dollar growth throughout 2024, and also expand margin in 2025 and 2026 … we’re confident we will achieve our declarations and reach our goals. – UPS (emphasis added).

Additionally, the company’s investment in advanced technologies, including the Smart Packaged Smart Facility RFID solution and the deployment of more than 40,000 RFID readers in U.S. package cars, are good steps to improve efficiencies and lower costs.

These measures are important, especially because the current environment is vicious.

In the first quarter, revenues were down 5.3% year-over-year to $21.7 billion, and operating profit decreased by 31.5% to $1.7 billion. The U.S. Domestic segment saw a significant decline in operating profit by 43.6%.

The main source of weakness is lower volumes, as UPS was hit by the full force of weaker global economic growth in the first quarter.

As we can see below, the U.S. Domestic segment saw a 3.2% year-over-year drop in average daily volume, with business-to-business volumes declining by 5.5%. Internationally, the total average daily volume fell by 5.8%, which was driven by weaknesses in Europe and Asia.

Unsurprisingly, during its last earnings call, the company noted the global macroeconomic environment remains challenging.

Factors like weak manufacturing activity in Europe, excess market capacity in international air and ocean freight, and soft demand in the truckload brokerage unit have pressured demand.

The reason I’m making the case these comments are unsurprising is that UPS is highly cyclical. Because of its size, there is no way for this company to escape cyclical downtrends.

Looking at the chart below, we find two lines:

• Red: The distance (in %) UPS shares are trading below their all-time high.
• Black: The leading ISM Manufacturing Index.

We can clearly see that once economic growth conditions deteriorate, investors start to sell UPS stock.

There’s Good News

There’s also good news.

Despite current challenges, UPS has reaffirmed its 2024 financial targets, expecting revenues between $92.0 billion and $94.5 billion and an operating margin of 10.0% to 10.6%.

Moreover, the company expects volume and revenue growth to accelerate in the second half of the year as it laps the Teamsters contracts.

Additionally, UPS expects labor cost growth rates to drop and to realize significant savings from its “Fit to Serve” program, which aims to save $1 billion.

In its upcoming earnings, all eyes will be on this guidance. If it can reaffirm these numbers again, I would not bet against a relief rally — all else excluded.

The company also reaffirmed its 3-year outlook, expecting to generate at least $108 billion in revenue by 2026.

Additionally, the company targets expanding its consolidated operating margin to over 13% and its domestic operating margin to at least 12% by 2026.

A big driver of this is expected to be healthcare. Last, the company opened LabPort at Worldport, which is a state-of-the-art facility for lab customers.

The point of managing specific facilities is to accelerate the process of key operations like diagnostics. Healthcare providers rely on specific transportation conditions, which provides UPS with better margins.

Through a number of acquisitions, UPS has built a $10 billion healthcare business, which – as I already briefly mentioned – is focused on an addressable market of more than $150 billion.

It is also expanding in the APAC region, offering next-day flights between Shenzen, China, and Sydney, Australia.

According to the company, this supports faster imports and exports between two key hubs and allows shipments to Europe to benefit as well.

Even better, many of its customers are high-tech, manufacturing, and healthcare customers — a growing market in the region.

This is the latest in a series of recent network and facility enhancements UPS has made across Asia Pacific – including in Singapore, Japan, mainland China, Vietnam, South Korea, Hong Kong and the Philippines – as the company continues to make significant investments in the region to strengthen its portfolio of integrated express, supply chain and healthcare logistics services. – PR Newswire.

Shareholder Returns & Valuation

While we wait for macroeconomic conditions to improve, investors are benefitting from the company’s well-covered dividend.

In 1Q24, the company generated $2.3 billion in free cash flow — a $510 million year-over-year improvement. It used this to distribute $1.3 billion in dividends.

After hiking its dividend by a penny to $1.63 earlier this year, it now yields 4.6%.

This dividend has a payout ratio in the low 80% range and comes with a five-year CAGR of 11.7%. However, the latest one-penny hike clearly shows that elevated dividend growth will not return until the company sees an upswing in its earnings, which makes sense.

In general, I would not bet on a return to double-digit annual dividend growth anytime soon, as the five-year CAGR was massively skewed by the post-pandemic bull market.

With that said, as I already briefly mentioned, UPS, which has an A-rated balance sheet, is expected to see a growth bottom.

Analysts agree with the company, as they project the company to grow EPS by 19% in 2025 after a potential 9% decline in 2024. In 2026, EPS is expected to rise by 16%. These numbers are from FactSet and can be seen in the chart below (although they are tiny – sorry).

While all of these numbers are subject to adjustments, it makes for a good risk/reward, as UPS trades at a blended P/E ratio of 16.8x, a few points below its long-term normalized P/E ratio of 19.5x.

Purely theoretical, the next economic upswing could push UPS to a fair price target of at least $220 (+50%), which excludes potential positive outlook revisions.

Although UPS is not out of the woods yet, the risk/reward remains good at current levels. Hence, I leave my Buy rating in place.

That said, I need to mention a few things.

• UPS has returned just 5.1% per year since 2004. That is a poor return. It also includes dividends!
• UPS operates in a highly competitive industry. Its long-term turnaround isn’t just “nice to have” but critical for long-term survival.

While I am bullish and expecting a strong rally during the next upswing, UPS is not a “perfect” long-term investment. I prefer lower-risk transportation companies with wider moats, including railroads.

I believe this is important to mention, as it’s part of the long-term risk/reward.

One last thing. When UPS reports earnings on July 23, I will be watching for remarks regarding economic demand (can it confirm the expected 2H24 growth bottom?) and hope we get plenty of details regarding its expansions in APAC and healthcare.

Takeaway

As we head into the transportation earnings season, UPS faces significant challenges but also promising opportunities.

While competition and labor costs pressure its core business, the company is strategically diversifying into high-growth areas like healthcare and expanding its international footprint.

Recent moves, including the sale of Coyote Logistics and a key partnership with USPS, are aimed at improving its focus and operational efficiency.

Furthermore, while near-term earnings may be negatively impacted by macroeconomic headwinds, the company remains confident in its ability to achieve its financial targets, which makes it a compelling investment with a good risk/reward.

Pros & Cons

Pros:

• Diversification: UPS is expanding into high-growth markets like healthcare, which has an addressable market of more than $150 billion. This diversification is crucial in an increasingly competitive environment.
• Operational Efficiency: The sale of Coyote Logistics and the USPS partnership are steps towards streamlining operations.
• Long-Term Guidance: Despite current challenges, UPS has reaffirmed its 2024 financial targets and expects significant growth in the second half of the year.
• Attractive Valuation: Trading below its long-term P/E ratio, UPS offers a good risk/reward profile.

Cons:

• Competitive Pressure: UPS faces intense competition, especially from Amazon, which continues to erode its shipping volumes.
• Labor Costs: Rising labor costs, including significant wage increases, put pressure on margins.
• Economic Sensitivity: UPS is highly cyclical and vulnerable to economic downturns, which impact volumes and profitability.
• Poor Historical Returns: UPS has returned just 5.1% annually since 2004, including dividends, which is underwhelming and caused by a no-moat business environment.
• Risk of Turnaround: While I’m bullish on a strong rally, the long-term turnaround is critical for survival.