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Here's How UPS CEO Carol Tome Plans to Make Shareholders Money

By Lee Samaha - Nov 20, 2020 at 8:17AM

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The package delivery giant's leadership left investors in no doubt as to how it's reshaping the business for profit.

UPS ( UPS 2.96% ) CEO Carol Tome left investors without a doubt that she understands the key things that investors want to see from the company going forward. While there's no guarantee that the highly regarded Tome will achieve these aims, it's very clear that she's committed to following a playbook designed to extract maximum value for shareholders. Let's take a look at what's going on and what investors can expect in the future from Tome and UPS.

Delivery packages on a conveyor belt.

Image source: Getty Images.

Two key factors

It's no secret that package delivery companies, like FedEx ( FDX 1.07% ) and UPS, are seeing strong growth in e-commerce-related volumes -- a fact even before the COVID-19 pandemic and stay-at-home measures boosted e-commerce. While booming e-commerce volumes are good for revenue, there are two key, and related, questions around the matter:

  • UPS and FedEx have both suffered margin pressure as a result of e-commerce deliveries, and in particular from relatively expensive business-to-consumer (B2C) deliveries to residential addresses.
  • The capital investments necessary to expand the network in order to service e-commerce growth have led to fears that UPS and FedEx are stuck in a cycle of ongoing capital spending increases that will eat into free cash flow (FCF) generation.

These dynamics can be seen in the chart below. Rising capital expenditures have constrained FCF growth, while total operating margin has been falling for both.

UPS Free Cash Flow Chart

Data by YCharts

UPS' future direction

All of this leads to a question that could almost be deemed philosophical. Is it better to pursue volume growth and grow earnings through revenue increases, even if operating margin and FCF margin will come under pressure? Alternatively, is it better to grow earnings by focusing on maximizing the profitability of deliveries rather than chasing volume?

The ultimate answer will lie somewhere in the middle of these two approaches. However, it's clear from UPS's recent earnings call that Tome is more inclined toward the latter approach. In what would become a familiar refrain, Tome talked of "better, not bigger," sweating assets more, and a renewed focus on growing in the most attractive areas such as healthcare and small and medium-sized businesses (SMB).

Tome would go on to talk of improving operating margin though improving revenue quality, and confirmed that UPS had "been controlling the volume since July" through working with customers to adjust their operations accordingly. She also declared she was "OK" with losing some sales and said that "it's not about volume share growth."

Underlying improvements

An example of the underlying improvement can be seen in the improvement in the trend of revenue per piece in the third quarter in the key U.S. domestic packages segment -- something cited by CFO Brian Newman on the earnings call. The opportunity for the transportation stock is to continue to improve revenue per piece while maintaining volume growth.

UPS domestic package yield versus volume growth.

Data source: UPS presentations. Year-over-year growth.

The key question then turns to when investors can expect to see revenue improvements turn into larger increases in operating income. Analysts asked a number of questions on the matter during the earnings call, and Tome promised she would "lay out tangible action plans that will also show improvement in the operating margin" as the company moved into 2021.

Meanwhile, Tome suggested that analysts should model in around $4 billion in capital expenditures for 2021, a figure that implies a large drop from the $5.6 billion expected in 2020, and the $6.4 billion reported in 2018. To put the 2021 estimate into perspective, Wall Street analysts are expecting $86.4 billion in revenue in 2021, so it implies only 4.6% of revenue will be used on capital expenditures. As you can see below, it's a big reduction in absolute and relative terms for UPS.

UPS Capital Expenditures (TTM) Chart

Data by YCharts

What it means to investors

Putting it all together, it's far too early to conclude that UPS is on track to improve operating profit and FCF margin over time. However, the ingredients for improvement are in place.

In the near term, UPS should see an improvement in higher-margin business-to-business deliveries as the economy opens up. Thinking longer-term, volume growth has been exceptional in 2020 and the pandemic has accelerated the shift toward e-commerce spending from traditional retail spending. Moreover, surging volume growth is creating an opportunity for UPS to be more selective in how it generates revenue.

To cap it all, Tome is explicitly telling investors UPS is committed to translating improved revenue into margin expansion. That's the first step in generating the improvements that investors want to see, and it should be welcomed as a positive development. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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Stocks Mentioned

United Parcel Service, Inc. Stock Quote
United Parcel Service, Inc.
UPS
$199.90 (2.96%) $5.75
FedEx Corporation Stock Quote
FedEx Corporation
FDX
$237.81 (1.07%) $2.51

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