The market was left unimpressed by the second-quarter earnings from UPS (UPS -1.51%) and the stock is now down around 10% from its all-time peak in early May. So is now the time to take advantage of a dip and buy into a long-term growth story? Here's what you need to know before buying UPS stock.
Image source: Getty Images.
Why UPS stock sold off
It comes down to one key metric that investors have been focusing on in recent years: the company's U.S. domestic package operating margin. Unfortunately, investors were left disappointed by management's guidance for it to be lower (around 9.2%) in the second half than the 11% reported in the first half.
Why the U.S. domestic package operating margin matters
It's the key metric for investors for the following reasons:
First, it's the largest revenue and profit generator for the transportation company.
Data source: UPS presentations. Chart by author.
Second, U.S. domestic package operating profit margin expansion is the key to meeting the 2023 targets laid out during the investor day presentation in June. The international package operating profit margin is expected to be stable from 2020 to 2023, with profit growth in the segment coming from revenue expansion.
The overall company margin is forecast to expand to 12.7%-13.7% in 2023, driven by an improvement in U.S. domestic package margin from 7.7% in 2020 to 10.5%-12% in 2023.
|
Metric |
2023 Target |
2020 |
|---|---|---|
|
Revenue |
$98 billion to $102 billion |
$84.6 billion |
|
U.S. domestic package adjusted operating profit margin |
10.5% to 12% |
7.7% |
|
Total company adjusted operating margin |
12.7% to 13.7% |
10.3% |
|
Total company adjusted operating profit |
$12.4 billion to $14 billion |
$8.7 billion |
Data source: UPS presentations.
Third, the question of the domestic segment's margin has been front and center in the battle between bulls and bears over the stock. The bears argue that surging e-commerce volumes, particularly more costly business-to-consumer (B2C) deliveries, will lead to ongoing margin pressure and continued investment in the network to service demand. Indeed, there's a reason FedEx severed contracts with Amazon.
In opposition, the bulls believe that UPS (and FedEx) can be more selective over e-commerce deliveries and focus on more profitable deliveries. As such, the bulls took heart in hearing UPS CEO Carol Tomé (appointed in 2020) outline a "better, not bigger" framework -- an approach that encompasses focusing on profitable deliveries. Moreover, UPS is already focused on growing its small and medium-sized business (SMB) and healthcare end markets. It all adds up to UPS being able to expand the segment's margin.
What happened
Given the metric's importance to the investment case, it was no surprise to see the stock sold off after management gave the disappointing guidance referred to earlier.
During the earnings call, CFO Brian Newman put it down to a combination of factors:
- Higher compensation expense from contractual labor increases, which come "into effect each year in August."
- "Targeted hourly rate adjustments in certain geographies to remain competitive in the market"
- The natural shift toward lower-margin revenue as B2C volumes surge during the holiday season.
He and Tomé also pointed out that the second quarter traditionally represents the peak margin quarter for UPS. Moreover, both highlighted that management's guidance calls for a full-year U.S. domestic package operating margin to hit 10.1%. As you can see in the table of 2023 guidance above, that figure implies that UPS is more than halfway to reaching the high end of the targeted range (10.5% to 12%) for 2023.
Image source: Getty Images.
In this context, UPS remains on track for its medium-term goals, even if its progress on margin progression isn't quite as fast as what analysts had penciled in for 2021.
What it means to investors
It looks like investors got too excited over UPS' margin progression in 2021 and priced in too much optimism on the matter. That's fair enough, but it doesn't mean that UPS is behind its objectives. For example, Tomé argued that UPS was "well on our way to achieving the high end of our 2023 financial targets" during the earnings call. In addition, it's worth noting that UPS is, after all, in uncharted territory in raising margin in this manner.
Going back to the 2023 targets, the high end of the free cash flow (FCF) guidance calls for $27 billion over the next three years, or an average of $9 billion a year. Slapping a 20 times FCF multiple on the stock would result in a price target of $206 with the current stock price at $195.
As such, UPS continues to look undervalued, but not by much. The stock will probably need to dip a bit more to look like a good value, or the company will need to outperform its internal expectations.
