UPS (UPS 1.72%) stock has posted gains recently that could make some investors faint. Its stock is up 28% on a year-to-date basis and 131% on a year-over-year basis. It's a remarkable move, and it comes as the company is demonstrating real progress on its long-term goals. The coronavirus pandemic has definitely distorted matters, but the underlying evidence is clear. UPS is demonstrating that it has the ability to significantly grow earnings and free cash flow (FCF) for many years to come. That's a major plus and suggests there's more upside potential for the stock. Here's why.
Margin and free cash flow pressure
The bull and bear debate around UPS, and FedEx (FDX 0.07%) for that matter, has centered around their ability to grow earnings margin and FCF even with burgeoning business-to-consumer (B2C) e-commerce volumes. That's not an easy thing to do, as B2C deliveries are often inefficiently packaged, and sent to myriad, hard-to-deliver-to addresses. Moreover, surging B2C deliveries create challenges during peak delivery periods in the Christmas season.
The fear is that earnings margin will forever be under pressure as B2C volumes grow, and capital spending (something that reduces FCF) will have to continue to ramp as UPS and FedEx are pressured to build out network capacity in order to service B2C growth. Indeed, the evidence before 2020 was that both FCF and earnings margin were under pressure. (For reference, EBITDA is earnings before interest, taxation, depreciation, and amortization.)
While the margin and FCF pressures are real, UPS also has a significant opportunity to turn things around. There's plenty of e-commerce growth to go around, and management could opt to be more selective in how it generates revenue. Indeed, that principle is behind UPS CEO Carol Tome's thinking.
A key part of the company's plans involves expanding into the U.S. small and medium-sized business (SMB) market with its digital access program (DAP). Through DAP, SMB customers are offered discounted shipping rates in order to embed UPS as part of their e-commerce platforms. As the SMBs expand their e-commerce activity, UPS will benefit too.
The evidence is that it's working. On the recent earnings call, Tome noted that UPS added "150,000 new DAP accounts" in the quarter and was well placed to hit $1 billion in DAP-based revenue by the end of 2021. Tome also said that "total average daily volume growth for SMBs, including our platform businesses, reached an all-time high of 35.6%, outpacing the growth rate of our larger customers for the third consecutive quarter."
The transportation stock's more targeted revenue growth actions led to an expansion in U.S. domestic revenue per piece by 10.2% year over year in the first quarter. As you can see below, UPS is also now achieving significant volume growth and revenue per piece growth at the same time.
The improvement in revenue per piece means that more volume growth is translating into revenue growth, and revenue has grown more than volume growth for the last three quarters.
All of it is leading to an increase in the U.S. domestic segment's profits and profit margin. While it's easy to dismiss this improvement as a special set of conditions only existing in the COVID-19 pandemic, there's also evidence to suggest that it's probably going to be a lasting effect. For example, margins are expanding even though higher-margin business-to-business (B2B) volumes were only 40% of total U.S. domestic volume in the first quarter, compared to closer to 50% in 2019.
The change in e-commerce relationships with SMBs and DAP and consumer willingness to use online shopping is highly likely to last.
All told, there's enough about UPS's recent earnings to suggest the war on U.S. domestic margin is starting to be won. Moreover, the international package segment continues to generate 20% plus operating profit margins while revenue surges as a result of ongoing lockdown measures. Meanwhile, the supply chain and freight segment should enjoy a bounce as the economy recovers in 2021.
If the improvements in profitability are lasting, then investors can start pricing in higher profit numbers for UPS over the long term, and that's usually something very bullish for the stock price. UPS's stock price run looks like it's far from over, and it continues to look like an attractive option for investors.