Macroeconomic headwinds are gathering, but the underlying quality of UPS (UPS -1.35%) earnings is improving. That's the key takeaway from the package delivery giant's recent third-quarter earnings report. So does it add up to make the stock a buy? Let's take a look.
Headwinds coming for UPS
A breakout of UPS' adjusted operating income by segment quickly gets to the point. As you can see below, international package segment income fell in the quarter as a low single-digit increase in revenue was more than offset by rising costs. During the earnings call, CFO Brian Newman conceded that average daily volume "did not improve as much as we anticipated due to continued macro[economic] softening." In fact, the international package average daily volume declined by 5.2% year over year in Q3.
The disappointing performance speaks to the uncertain economic environment in parts of the world. China's growth, for example, faces challenges due to the government's zero-COVID policies. Meanwhile, the European economy faces a tough winter due to soaring energy costs caused by sanctions applied on Russian energy.
It all adds up to an uncertain environment, and the bull and bear debate around the stock continues. It doesn't help UPS that the international package segment is its highest margin business, with an adjusted operating margin of 20.9% in the quarter compared to the U.S. domestic package segment adjusted operating profit margin of 11%. Consequently, investors should brace themselves for some potential disappointment in Q4.
|
UPS Third Quarter |
Adj. Operating Income |
YOY Change |
Revenue |
YOY Change |
|---|---|---|---|---|
|
U.S. Domestic Package |
$1.69 billion |
19.2% |
$15.37 billion |
8.2% |
|
International Package |
$1 billion |
(9.4%) |
$4.8 billion |
1.7% |
|
Supply Chain Solutions |
$0.46 billion |
2.5% |
$3.99 billion |
(6.3%) |
|
Total |
$3.15 billion |
6% |
$24.16 billion |
4.2% |
Data source: UPS presentations. YOY = Year-over-year.
The improving quality of UPS earnings
The international segment has the highest margin, but the U.S. domestic package segment has, by far, the largest revenue. For example, the U.S. segment's revenue was $60.3 billion in 2021 compared to $19.5 billion for the international package segment.
As such, moving the needle on profit margins matters more to UPS if it comes in the U.S. domestic package segment. Indeed, the segment's adjusted operating income margin expanded to 11% in the quarter from 10% in the same quarter a year ago.
It's essential to understand why because the underlying improvement in the margin at UPS is the key to its investment case. In a nutshell, UPS is undertaking an ongoing series of initiatives resulting in margin improvement. The guiding principle is CEO Carol Tome's "better, not bigger" framework. As such, UPS is focused on sweating its existing assets and making its network run more productively while demonstrating a willingness to be more selective over deliveries. As a result, UPS isn't chasing volume for volume's sake. Instead, it's focusing its business more on profitable deliveries.
The following chart of the U.S. domestic package segment metrics helps illustrate matters. Once again, UPS reported a decline in average daily package growth. Yet, a 9.8% increase in average revenue per piece resulted in an 8.2% increase in revenue and, as noted above, considerable margin expansion.
Data source: UPS presentations. U.S. domestic package segment.
UPS is improving its margin by refocusing its business on key end markets, including healthcare. (Tome confirmed UPS was on track for $10 billion in healthcare revenue in 2023.) Small and medium-sized businesses (SMB) are another focus; SMB average daily volume increased by 1.9% in the quarter and was responsible for 28.3% of total U.S. volume in the quarter compared to 27.4% a year ago. UPS' digital access program (DAP) provides SMBs with a suite of services to enable their e-commerce operations, and management believes it will succeed in beating its target of $2 billion in DAP-related revenue in 2022.
Tome plans to continue driving the company forward by "moving faster to grow in our targeted market segment" and improving productivity by using initiatives such as digital technology to enhance delivery density and using smart RFID labeling to reduce misloaded packages.
A stock to buy
UPS is improving its underlying earnings quality, and the margin progression in the U.S. domestic package segment is impressive. That said, there's little the company can do about the economy, and the international package segment will face challenges. Nevertheless, if you're willing to ride out some potentially bad news, UPS is an attractive stock to buy, and that's likely to remain the case as long as the company demonstrates success with its transformational strategies.
