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UPS Is Looking Like a Good Value Again

By Lee Samaha - Updated Oct 25, 2019 at 12:31PM

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The package delivery giant's latest earnings report had a lot of positives to offset fears over global trade, and the stock is starting to look attractive.

The varying fortunes of UPS (UPS 0.48%) and FedEx (FDX 1.10%) continued into the current quarter's earnings. Whereas FedEx opened its first fiscal quarter of 2020 by promptly cutting full-year guidance and blaming the economy for the bulk of the reduction in its profit outlook, UPS reported another quarter of strong earnings growth. In short, FedEx has somewhat lost its way in the last year or so, while UPS's latest results are demonstrating good progress in its transformation.

For the first time in a while, UPS is starting to look like an attractive investment.

Small packages on a keyboard

Image source: Getty Images

The big questions facing FedEx and UPS

Burgeoning e-commerce deliveries are certainly creating opportunity for FedEx and UPS -- don't worry about the so-called Amazon.com (AMZN -0.26%) "threat" because there's no issue with business-to-consumer (B2C) volume growth at FedEx and UPS. But there are question marks around the following:

  • FedEx and UPS need to demonstrate they can expand margin with e-commerce deliveries, and in particular B2C deliveries, which can be bulky and inefficiently packaged.
  • Both companies have taken a hit to free cash flow (FCF) as a consequence, due to ramping up capital expenditures in order to expand capacity for e-commerce deliveries, and this could be an ongoing exercise.

The good news is that UPS has, for the second consecutive quarter, demonstrated progress on both points, and management also served notice that it's ready to take advantage with the upcoming peak season.

UPS margin expansion

As you can see below, UPS managed to grow margin across all three segments -- notably in the key U.S. domestic package segment.

UPS Segment

Q3 2019 Adjusted Profit 

Q3 2019 Margin

Q3 2018 Adjusted Profit 

Q3 2018 Margin

U.S. domestic package

$1.242 billion

10.8%

$988 million

9.5%

International package

$693 million

19.8%

$576 million

16.6%

Supply chain and freight

$256 million

7.6%

$260 million

7.4%

Total

$2.191 billion

12%

$1.824 billion

10.5%

Data source: UPS.

In the earnings release, CEO David Abney lauded "the investments we are making in new facilities and automation in our network, coupled with solid execution of our strategies," and the evidence suggests he has reason to be positive on the margin outlook for the segment.

UPS's plan is to invest heavily in its network in order to service volume growth while reducing its cost per piece thanks to the increase in productivity. The good news is that the cost per piece has now started to decline as volume starts to flow through the enhanced network.

U.S. Domestic Package 

2017

2018

Q1 2019

Q2 2019

Q3 2019

Total cost-per-piece increase (decline)

5.5%

6.6%

2.8%

0.5%

(2.50)%

Data source: UPS.

Meanwhile, volume growth remains strong and is driving revenue growth, even though revenue per piece declined in the third quarter.

UPS U.S. domestic package segment

Data source: UPS.

All told, UPS is seeing an impressive reduction in cost per piece, and that's helping margin expansion.

Free cash flow and capital expenditures

UPS shocked the market early in 2018 with a disappointing performance over the holiday season and the announcement that it would be ramping up capital expenditures to a range of 8.5% to 10% of revenue for the next few years -- a level that FedEx has traditionally been at.

The charts below show how the increase in capex has eaten into FCF in recent years.

UPS CAPEX to Revenue (Annual) Chart

UPS Capex to Revenue (Annual) data by YCharts. TTM = trailing 12 months.

There's nothing wrong in making capital expenditures to service growth in the future, but until the point when FCF starts improving again and capex moderates, investors will often fret.

The good news is that it appears that point may well have come. For example, UPS announced it would reduce its capital investments by $500 million in 2019 and 2020 while "network automation targets and other transformation goals remain unchanged."

As a consequence, UPS raised its forecast for FCF in 2019 to $4 billion from a previous range of $3.5 billion to $4 billion. The updated guidance puts UPS on a 2019 price-to-FCF multiple of 25 times. That's not particularly cheap, but hopefully capex can be cut in the next few years while earnings and cash flow will improve.

What it means to investors

UPS still has to negotiate the peak holiday season, but its network investments suggest it's in better shape to handle the sudden spikes in demand that can occur, while the domestic package volume growth in the quarter tells you all you need to know about the "Amazon threat."

The trade conflict continues to overhang its international package operations, as it does with FedEx. But otherwise UPS is making good operational progress with its initiatives, and FCF is set for marked improvement in the coming years. All told, UPS is starting to look like an attractive investment again. 

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Lee Samaha has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon and FedEx. The Motley Fool has a disclosure policy.

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Stocks Mentioned

United Parcel Service, Inc. Stock Quote
United Parcel Service, Inc.
UPS
$205.88 (0.48%) $0.99
Amazon.com, Inc. Stock Quote
Amazon.com, Inc.
AMZN
$143.18 (-0.26%) $0.37
FedEx Corporation Stock Quote
FedEx Corporation
FDX
$233.21 (1.10%) $2.53

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