5 Reasons the Market Is Being Harsh on UPS

The market took a dim view of United Parcel Service's (UPS 0.34%)first-quarter results, but there are reasons to believe Wall Street's judgment was unduly harsh. In fact, the company demonstrated progress on a number of initiatives, and little has changed with regard to the investment thesis. In other words, if you liked UPS stock before the earnings report, there wasn't much in the results that should have changed that view. Let's look at the recent developments, and why the market is beating up this stock unfairly.

UPS disappoints the market

The Q1 results delivered late last month were lighter than analysts expected in terms of revenue and earnings per share (EPS). But even worse was its guidance for Q2 EPS, which UPS expects to be flat compared to the same period last year. That raised questions as to whether management was wise to reiterate full-year guidance for adjusted EPS in the $7.45 to $7.75 range. 

Moreover, total adjusted operating profit declined in the first quarter, with only the smallest segment (supply chain & freight) reporting a significant increase in profit. Is it time to throw in the towel?

Data source: UPS. YOY=year over year.

Why the market is being harsh

UPS certainly has work to do to meet its earnings expectations -- missing first-quarter expectations and then guiding toward flat earnings for the second quarter is never a good start. But investors need to put matters into context. There are five considerations:

First, UPS took a hit from unexpectedly poor winter weather in the quarter. Management said the weather reduced operating profit by $80 million, operating margin by 70 basis points, and EPS by $0.07. Adding these figures back gives 5.1% growth in adjusted year-over-year operating profit, and would lead to adjusted EPS of $1.46, versus the figure of $1.39 in the quarter.

Second, the EPS guidance for the second quarter is hurt by planned pension financing costs. In fact, UPS management is guiding toward operating profit growth in the mid-single digits, but adjusted EPS is set to be flat due to the financing costs.

Third, as CFO Richard Peretz reminded investors, "2019 is a year of investments in our network and executing our strategies to improve operating cost and deliver higher quality revenue growth despite uncertain conditions." As such, UPS plans to open "30% of our new capacity for 2019 within the second quarter" according to Peretz. This will lead to extra expenses in the second quarter, which will constrain profit growth.

UPS is investing heavily in expanding and modernizing its network. Image source: Getty Images.

Fourth, Peretz's guidance for the third quarter -- for EPS around 28% of the full-year guidance midpoint -- implies earnings of $2.13 per share. That would represent year-over-year growth of 17%. In other words, UPS' growth is set to significantly improve in the coming quarters.

Fifth, management's full-year outlook continues to call for operating-profit growth in all three segments, up by low double digits, and free cash flow (FCF) in the range of $3.5 billion to $4 billion. The midpoint of that would put UPS on a forward price-to-FCF multiple of 23.4. That's not a bad multiple for a company in the middle of a period of heavy capital expenditures.

What it means to investors

There are question marks around UPS' guidance. After all, losing $0.07 of EPS from the weather in the first-quarter will put some pressure on full-year guidance for $7.45 to $7.75. In addition, UPS still has to demonstrate that it can expand margin and e-commerce related volumes. And investors and analysts are still waiting for management to indicate when the elevated levels of capital spending will fall, so they can price in estimates for long-term FCF generation.

That said, it's not rational to sell a stock based on poor weather in one quarter, or because the company is investing heavily to support future growth. Moreover, the long-term questions were known about before the last earnings report and were unlikely to be resolved in one quarter. 

Putting it all together, the market appears to have overreacted to the headline numbers and guidance. If you were bullish on UPS stock before the earnings report, then it's probably a good idea to see the post-earnings dip as a buying opportunity.