Investors shouldn't underestimate the upside potential at United Parcel Service (UPS -0.25%). If CEO Carol Tome can achieve her goal of expanding profit margin, then the package delivery giant could be set for a significant increase in earnings and free cash flow in the coming years. It all makes for an attractive investment. Here are a few charts to help outline the investment case for the stock.
How UPS makes money
The following chart breaks out adjusted operating income by segment. Within the segments, two activities dominate UPS' earnings. In the U.S. domestic package segment, 73% of revenue came from ground-based deliveries.
Key profit drivers
As you might imagine, UPS makes more revenue per piece from next-day air deliveries ($16.82 in 2020) and deferred deliveries ($12.46) than it does from its ground-based business ($8.87). Still, the extra volume of ground deliveries dragged the total U.S. domestic package revenue per piece down to $9.92 in 2020.
Export deliveries generate around 76% of revenue within the international package, and its high revenue per piece ($28.52) drags up the total international segment revenue per piece to $16.99.
The two key drivers of profitability at UPS are U.S. domestic ground deliveries and international export deliveries. The latter tends to be dictated by international trade conditions and the global economy. Still, the U.S. domestic ground revenue and margin have been moved around a lot in recent years because of burgeoning growth in e-commerce revenue.
Given the relatively low margin of the U.S. domestic package business, any significant movement in that same margin will greatly impact UPS' overall profit margin. Therefore, the biggest key to profit growth in the future will be to improve U.S. domestic ground, and notably e-commerce-related, delivery margin.
U.S. domestic package margin and free cash flow
Raising U.S. domestic package margin and free cash flow (FCF) generation has not been an easy task in recent years. Burgeoning e-commerce deliveries are fine, but they have also created profit margin and FCF pressures. This is because e-commerce deliveries and, in particular, business-to-consumer (B2C) deliveries, are often inefficiently packaged, bulky, and delivered to multiple, difficult-to-reach addresses. Also, surging volumes during peak delivery periods in the holiday season can create margin pressures.
Investors can see the pressure on the business in the following chart of performance over the last decade. Operating profit margins have been under pressure, while capital spending as a revenue share has increased and eaten into FCF generation. The result is a drift downward in FCF generation from sales. Sales grew from $53.1 billion in 2011 to $84.6 billion in 2020, but FCF was the same in 2020 as it was in 2011.
The challenge and the opportunity
Putting all of this together, the questions most investors have had around the transportation giant in recent years are: What can UPS do to increase ground margin in the U.S. domestic package segment, and what can management do to improve FCF generation?
The answers to these questions are a combination of applying the company's ongoing transformation strategy (outlined in 2018) and new CEO Carol Tome's focus on a "better, not bigger" approach.
The transformation strategy involves focusing on key end markets such as high-growth international business, global e-commerce deliveries, and in particular, key industry verticals such as healthcare and the small and medium-sized business (SMB) market. Meanwhile, "better, not bigger" can be taken as a cue to focus on the most profitable business rather than just chasing e-commerce volume growth. There's plenty of e-commerce growth to go around; the key is finding ways to maximize profit from it.
The good news is the strategic plans appear to be working. Also, the COVID-19 pandemic has probably helped UPS expand in healthcare and develop relationships with SMBs needing to grow online sales due to stay-at-home measures.
As such, UPS has increased U.S. domestic package revenue per piece while benefiting from volume growth. Meanwhile, the focus on extracting value from the existing network capability means capital expenditures as a share of revenue can decline, so more revenue drops down into FCF generation.
Management's actions are winning favor with the investment community. Wall Street analysts have the operating margin improving while capital spending as a revenue share is set to drop, and FCF will increase markedly.
If Wall Street is right, UPS will trade on a price-to-FCF multiple of below 20 times FCF at the end of 2021 -- a good multiple for a business set to expand sales and earnings at a healthy clip.
Meanwhile, Tome is due to present the company's updated plans at the investor day event on June 9. That could lead to more estimate revisions. Investors should keep their eyes on what management presents.