Nobody said this would be an easy year for Berkshire Hathaway holding United Parcel Service (UPS -0.02%). After all, when the economy slows, so does the transportation sector, particularly the demand for package deliveries. These cyclical headwinds came to the forefront in UPS's recent first-quarter earnings, and investors sold the stock aggressively in its aftermath. However, is it time to take advantage of the dip or avoid the store altogether? Here's the lowdown.

Why UPS stock slumped

In a nutshell, end demand isn't as strong as management thought. For example, in the international markets, export activity in Asia "gradually recovered through the quarter, but at a slower pace than we anticipated," according to CFO Brian Newman on the earnings call.

Meanwhile, conditions in the U.S. seemed to worsen throughout the quarter. For instance, CEO Carol Tome noted, "Relative to our base plan, volume was higher than we expected in January, close to our plan in February, and then moved significantly lower than our plan in March."

It's not only that retail sales are contracting, but Tome also spoke of an unfavorable shift in consumer spending, whereby items such as food (usually bought in-store) represent a larger share of spending, and consumers spend more on services than goods.

The result was a disappointing first quarter wherein revenue declined 6%, leading to a 21.8% decline in operating profit. In addition, management cut its full-year guidance:

  • Full-year revenue is now expected to be at the bottom end of the guidance range of $97 billion to $99.4 billion.
  • Adjusted operating margin is now expected to be at the bottom of the guidance range of 12.8% to 13.6%.
  • Management still expects capital spending of $5.3 billion, dividend payments of $5.4 billion, and share repurchases of $3 billion.

In accordance with the lowering of guidance, Wall Street analysts reduced their consensus estimates for earnings per share (EPS) to $10.87. As such, UPS now stands on a forward price-to-earnings ratio of 16.1 times earnings -- possibly a little rich for a company with declining earnings.

The underlying trend in UPS

That said, it's essential to keep some perspective here. The critical point is that this looks like the typical cyclical weakness that tends to correct when the economy picks up again. UPS is arguably continuing to lay the groundwork for substantial long-term growth.

The chart of its U.S. domestic package segment (below) can express the underlying dynamics in UPS's business. Due to management focusing on key end markets, like small and medium-sized businesses (SMB) and the healthcare sectors, and foregoing less profitable deliveries by being more selective over contracts, UPS managed to grow its revenue per piece to offset any loss of volume leading to revenue growth.

However, the 5.4% decline in U.S. domestic package volume was more significant than expected, and even though revenue per piece did rise again, it wasn't enough to fully offset weaker volume.

UPS U.S. domestic package segment.

Data source: UPS presentations.

If the weakness in U.S. domestic and international volumes (down 6.2%) is a function of a slowing economy, then when the economy picks up and volume growth returns, UPS should be able to drive margin expansion, provided it can control its cost per piece.

Reason to be optimistic

Here's the reason to be optimistic: Despite significant cost pressures from wage increases, Newman expects UPS's cost per piece to rise by only "low-single digits for the balance of the year." Meanwhile, the underlying growth in its key end markets looks assured. For example, the international expansion of the highly successful SMB-targeted digital access program (DAP) continues. Overall, DAP revenue increased by 51%, with management expecting $3 billion in DAP revenue this year. The success of the DAP in the U.S. helped SMB volume reach 29.6% of total U.S. volume, according to Tome.

Meanwhile, investment in the expansion into healthcare continues with the opening of an additional one million square feet of "dedicated healthcare space," including a facility in Germany. Management expects $10 billion of healthcare revenue in 2023.

Two workers carrying boxes.

Image source: Getty Images.

Time to buy UPS?

I think the answer is yes, provided you can stomach the possibility of more bad news. The reality is that UPS is a cyclical company, and this will be a down year and could even worsen. However, the expansion in SMB and healthcare revenues and the ongoing improvement in revenue per piece (while managing cost per piece) means UPS stands well placed for a pick-up in the economy -- and history suggests that will happen.

It's the kind of long-term thinking that characterizes Buffett's investing. Hence, it's no surprise to see UPS in Berkshire's portfolio, and with a 3.8% dividend yield, it will attract income-seeking investors, too.