Buying United Parcel Service (UPS -0.73%) stock currently offers investors an opportunity to get a 3.5% dividend yield with the promise of increased dividends for many years. As a result, it's an excellent option for passive income-seeking investors, not least because the company is demonstrating its ability to increase its long-term profitability, meaning its ability to raise dividends should increase. Here's why UPS is an outstanding stock to buy for 2023.

UPS' strategic challenges

UPS and its rival FedEx (FDX -0.29%) had an opportunity and a challenge to face up to a few years ago. In a nutshell, burgeoning e-commerce deliveries, not least from Amazon.com (AMZN 0.23%) (formerly a major customer of both companies), create significant revenue growth opportunities. At the same time, e-commerce deliveries, particularly business-to-consumer (B2C) deliveries, also bring margin and free cash flow challenges. 

The last statement may seem counterintuitive, but consider that B2C deliveries are often bulky (think mattresses, trampolines, etc.), inefficiently packaged (weight alone doesn't account for mass), and involve multiple deliveries to costly hard-to-deliver addresses. Contrast this with e-commerce business-to-business (B2B) deliveries involving well-packaged parcels consistently sent to a familiar address. 

In addition, delivering B2C parcels often creates enormous pressures on networks (particularly during peak days in the holiday season), where UPS and FedEx literally have to guess when to expand their "network" temporarily through hiring more workers or costly third-party transportation. 

These pressures led to declining operating margins in the middle of the last decade.

UPS Operating Margin (TTM) Chart

Data by YCharts

In addition, both companies were forced to ramp absolute capital expenditures in 2014-2020 (see middle chart below) and also capital expenditures as a share of revenue (see lower chart below), leading to a decline in free cash flow (FCF) at both companies (see upper chart below). 

UPS Free Cash Flow Chart

Data by YCharts

Declining operating profit margins and FCF is not a recipe for success in investing. Moreover, if there were any truth in the much-discussed idea that Amazon's expansion into deliveries would result in it eating the lunch of UPS and FedEx, then the traditional delivery giants' stocks would look like strong sells. 

Don't worry about Amazon

Fortunately, the "Amazon threat" is a red herring. There are more than enough e-commerce deliveries to go around. In fact, FedEx was happy not to renew contracts with Amazon in 2019. UPS has been happy to forego lower-margin Amazon shipments giving UPS "room to grow in the parts of the market that we want to grow, like SMB and B2B and healthcare and others," according to UPS CEO Carol Tomé on an earnings call.

Tomé's comments encapsulate the company's response to the margin/FCF challenges discussed above. 

UPS responds to challenges

Management launched its transformation program in 2018, targeting expansion in four areas:

  • High-growth international markets
  • Profitable and selective expansion in B2C and B2B e-commerce deliveries
  • Healthcare and life sciences
  • Small and medium-sized businesses (SMB), including offering its digital access program (DAP) to help SMBs reduce complexity in their shipping and obtain discounts for high-volume shippers.

Meanwhile, Tomé's "better, not bigger" strategy focused UPS on sweating its existing assets (capital spending was cut back, helping FCF generation) and focusing on higher-margin deliveries.

It worked.

UPS now expects to grow its healthcare revenue by 12.3% a year from 2020 to 2023, reaching $10 billion in revenue. International segment profit is forecast to grow from $3.5 billion in 2020 to $4.3 billion-$4.6 billion by 2023. DAP-based revenue is tracking ahead of plan with $1.6 billion in the first nine months of 2022 compared to a target of $2 billion for the full year. The share of U.S. volume coming from SMBs is up from the low 20%s in 2019/2020 to 28.3% in the third quarter of 2022, and management aims to hit 30% by 2023.

It's resulted in UPS being on track to hit its 2023 targets a year ahead of schedule in 2022. Moreover, as you can see below, UPS is growing its revenue even as volumes decline – "better, not bigger" in action. As a result, the segment's profit margins are expanding, and so are its profits. In addition, as shown in the first chart above, UPS is winning the war on margin and FCF generation.

UPS U.S. domestic package segment metrics.

Data source: UPS presentations

A passive income stock to buy

All told, UPS' strategy is working, and even though it faces some challenges from weaker economic growth in 2023, management is set on continuing to improve its underlying fundamentals. As such, investors can expect earnings and dividend growth over the long term, and starting by buying a stock on a 3.5% yield is a pretty good entry point.