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UPS Needs to Do These 3 Things

By Lee Samaha – Updated Apr 11, 2019 at 11:29AM

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The package delivery giant appears to be making progress on its strategic goals.

After a few years of underperforming FedEx (FDX 1.02%), UPS's (UPS 0.67%) stock has outperformed its rival's by 33 percentage points over the last year. Moreover, both stocks are up by the low double-digits in 2019. What's going on with UPS, and has the company turned the corner? Let's try to answer these questions in the context of UPS's latest fourth-quarter earnings report.

Three challenges and opportunities for UPS

UPS and FedEx obviously face similar industry dynamics, but their investing propositions differ significantly. The key to FedEx's near-term future is the successful integration of TNT Express in the face of slowing growth in Europe and the lingering effects of the NotPetya cyberattack in 2017. 

Small packages on top of a keyboard.

Image source: Getty Images.

For UPS, the keys that investors are looking for in the immediate future are as follows:

  • A return to generating strong free cash flow (FCF) after going through a period of relatively high capital expenditures.
  • Demonstrating it has the appropriate network and structure to deal with peak demand during the holiday season.
  • Growth in volume and margin in the key U.S. Domestic Package segment.

Check out the latest earnings call transcript for UPS.

Free cash flow will remain constrained

The first two issues are related in the sense that UPS has faced criticism for underinvesting in its network. This has arguably meant it's had a harder time dealing with peak demand during the holiday season than FedEx has. In addition, UPS has had to invest in its network in order to improve productivity and better serve demand for e-commerce deliveries at all times of the year. 

As a consequence, the company shocked investors earlier in the year when it revealed it would be significantly ramping up capital expenditures in the coming years -- which means that FCF will come under pressure

As you can see below, UPS has traditionally used a smaller share of its revenue on capital spending than FedEx has.

UPS CAPEX to Revenue (Annual) Chart

UPS CAPEX to Revenue (Annual) data by YCharts.

However, on last year's fourth-quarter earnings call, CFO Richard Peretz told investors UPS would be ramping up capital expenditures to between 8.5% and 10% of revenue in the next few years. Fast-forward to 2019, and he guided toward the same range for the full year. He declined to give specifics when asked during the call when it would come down again.

In a nutshell, Peretz argued that "we know for the next few years, the advantages from the investments are getting the return." That's fine, but it means FCF is likely to be constrained due to relatively high capital expenditures. As such, Peretz guided toward adjusted FCF of $3.5 billion to $4 billion for the full year, putting the company on a forward market-cap-to-FCF multiple of nearly 26.  

Productivity improvements and peak performance

That's not a cheap valuation, but investors will be hoping that the productivity improvements generated by spending on its network will lead to increased earnings and cash flow in the future.

On this note, COO Jim Barber outlined how UPS had opened 22 new or retrofit facilities globally, including five new superhubs, which use the latest automation and productivity tools, and that "as we start 2019, 18 additional new and retrofit facility projects are under way, with completion dates ahead of peak of this year."

Barber sees the investments in facilities as "key to success at peak as well," and it should be noted that UPS had a relatively good performance during peak demand periods in the 2018-2019 winter.

Volume and margin growth?

E-commerce is obviously a key long-term growth driver for UPS and FedEx, but it won't be all smooth sailing. For example, delivering bulky and inefficiently packaged items to residential addresses tends to imply a shift toward lower-margin activity.

It's clear that FedEx and UPS have faced margin pressure due to e-commerce growth, and the question of whether the U.S. Domestic Package segment can grow volume and margin at the same time came up on the earnings call.

Peretz responded by pointing out that the company's guidance called for margin expansion in the segment, with 2019 marking a "pivot point." Moreover, a look at yield vs. volume shows that both are now growing at the same time -- a very good sign.

UPS U.S. Domestic Package yields vs. volume

Data source: UPS presentations. Chart by author.

What it means to investors

All told, there's clear evidence that UPS is starting to gain traction in its aim of expanding margins, and its investments appear to be paying off in terms of helping the company deal with peak demand periods.

However, one question is far from being resolved: Just what kind of level of capital spending as a share of its revenue will the company need over the long term? In the near term, its damage on FCF is making the stock look expensive -- at least on an FCF basis. On the other hand, long-term investors will look beyond the near-term impact if adjusted operating profit growth can reach the low teens, as management is expecting for 2019.

It's too early for hard conclusions, but UPS appears to be making good progress on its plans, as the fourth-quarter results and guidance showed.

Lee Samaha has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends FedEx. The Motley Fool has a disclosure policy.

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