Prolonged bear markets can be challenging to endure. Sometimes it's the little things that can help investors resist the urge to sell stocks at bargain-bin prices. One uplifting feeling is to collect quarterly dividends from businesses that are worth owning for decades to come.
Few companies have 3%-plus dividend yields, excellent business models, rock-solid balance sheets, strong leadership, and high operating margins, and are leaders in their industries to boot. United Parcel Service (UPS 0.53%) is a rare passive income powerhouse dividend stock. Despite some impending headwinds, here's what makes UPS a great stock to buy in June.
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The elephant in the room
The short-term outlook for UPS isn't great. Transportation stocks like UPS thrive when consumer spending is high so residential package deliveries increase. Strong consumer spending also drives businesses to order more supplies to produce more products. Inflation is straining the pocketbook of the American consumer, which could mean less discretionary spending. If consumer spending falls, that could impact UPS' business-to-consumer segment.
A similar narrative applies to UPS' business-to-business segment. Low interest rates encourage growth, while rising interest rates dampen growth. A common theme we've seen across multiple sectors of the economy this earnings season is rising raw material, fuel, freight, and shipping and logistics costs.
Companies may have been willing to bite the bullet on higher shipping costs when demand outpaced supply. But if demand is catching up with supply, that could lead to less appetite for premium shipping costs, and even standard shipping costs. After all, UPS raised its prices by 5.9% to combat inflation. That hasn't been an issue so far, but the question now is whether UPS can continue growing and meet its full-year guidance if labor costs continue to rise and business slows.
UPS' performance over the next few quarters is going to be heavily dependent on the U.S. inflation rate and the state of the U.S. economy. If the situation worsens, it wouldn't be surprising to see UPS stock take a hit. So being aware of that risk is essential before jumping into UPS stock now.
However, the big picture for UPS is as impressive as ever.
UPS' strong profitability
If UPS' growth slows, then its margins would undoubtedly take a hit. But UPS' trailing-12-month operating margin is at a 10-year high, and is significantly higher than that of its fiercest competitor, FedEx (FDX -0.21%).
UPS Operating Margin (TTM) data by YCharts
An operating margin of 13.5% indicates that UPS is earning a little over 13 cents in operating income for every dollar it generates in revenue. This is impressive considering package delivery companies have incredibly high fixed costs, including labor, vehicle and equipment leases, building costs, and the cost of servicing routes and logistics. There are also high variable costs, like fuel and added labor during peak times like the holiday season.
UPS is an inherently bulky business, so having an operating margin above 10% would be a win. However, UPS' long-term goal is to have an operating margin that consistently exceeds 12%.
In its Q1 2022 earnings call, UPS said that it is guiding for full-year operating margin of 13.7%. Granted, that guidance was given in late April, and the inflation situation, along with consumer spending, has worsened since then. So I would expect UPS to miss this guidance or lower its full-year estimate soon.
However, the good news is that because UPS' operating margin is already so high (and its existing guidance was generous), the company has a large margin of safety for its operating margin to come down and still be quite good. This is a luxury that many other businesses simply do not have.
For example, companies like Walmart and Target have lower operating margins and are greatly affected by customers shifting away from discretionary goods toward staples.
In sum, UPS' growth should slow, and its profitability will likely come down. But its business is arguably in its best shape ever. So now is as good a time as any for UPS to handle an economic downturn.
Gobs of free cash flow
Just as UPS can afford for its margins to come down, so too can it handle lower free cash flow (FCF) and still have plenty of cash to pay and raise its dividend. UPS announced a historic 49% dividend increase in February, bringing its quarterly dividend to $1.52 per share. Even with that raise, UPS is generating plenty of FCF per share to afford its current dividend and future raises as well.
UPS Free Cash Flow Per Share (Quarterly) data by YCharts
UPS' goal is to distribute around half of its adjusted earnings per share via its dividend. Record annual earnings in 2021 led UPS to keep its promise, and it raised the dividend accordingly. While UPS isn't known to routinely raise its dividend every year, the monster raise kicks its dividend yield up to 3.4% as of Thursday's closing price.
Aside from being able to afford the dividend increase with FCF, what's exciting about UPS' dividend increase is that it provides a much higher base for the ordinary dividend. It's common to see companies issue special dividends as means to reward shareholders when times are good. Costco Wholesale is known to do this. And ConocoPhillips, one of the largest exploration and production oil and gas companies, recently launched a dividend program with a fluctuating payout that is meant to pass along outsized returns to shareholders directly through the dividend.
UPS did something that companies almost never do, especially companies of its size. It essentially committed to raising the dividend and keeping it high. In this vein, UPS could issue no dividend raises for a few years and it would still be a huge win for UPS shareholders given the magnitude of this last raise. Bumping up the ordinary dividend by 49% and keeping it high is a sign that UPS is confident in its ability to support that dividend over the long term.
UPS is the complete package when it comes to dividend stocks
UPS remains one of the best dividend stocks on the market. The company benefits from the long-term growth of e-commerce and package delivery. Given the capital-intensive nature of shipping and logistics, UPS has a wide moat and a shortlist of competitors. Carol Tomé is one of the best CEOs in the Fortune 500, and has done an impeccable job expanding routes and driving profitability.
UPS generates a lot of FCF, has an attractive dividend yield, and has been growing at a pace well above the industry average. To cap it all off, after falling almost 21% from the all-time high it set earlier this year, UPS has a price-to-earnings ratio of just 15.
For investors looking for a quality company with a generous yield that isn't overpriced, UPS stands out as the single best passive income play to buy in June and hold for years to come.
