It's an age-old investing conundrum. Do you buy a stock and potentially suffer the slings and arrows of near-term risk even if you think it's an excellent long-term buy? That's the question facing many potential investors in United Parcel Service (UPS -1.25%) right now.
I'd argue that the answer is to buy the stock. Here's why.
UPS stock looks like a good value
I'll start with the bad news.
The package delivery giant had to work through several headwinds this year, including a decline in package delivery volumes due to a weakening economy and the cost associated with some disruptive labor negotiations. As such, 2023 is set to be a rough year for earnings and cash flow for the company. In addition, Wall Street analysts don't expect its earnings to start growing again on a year-over-year basis until the third quarter of 2024.
In other words, while the market believes UPS will improve earnings and cash flow in 2024 on a year-over-year basis, it will be a year before UPS starts to report quarterly earnings growth. Furthermore, there's no guarantee the company will hit analyst estimates.
End demand for package delivery is cyclical and influenced by the economy. Less economic activity means less demand for deliveries, and it also usually leads to customers shifting from premium deliveries (such as next-day air to ground, which generates half as much revenue per package for UPS in the U.S.) to less-expensive delivery options.
These negative pressures caused UPS to lower its revenue and margin guidance through 2023. The table below (which includes my calculations for implied adjusted operating profit guidance) shows just how much UPS has lowered its guidance through the year.
Full-Year |
Guidance |
Guidance |
Guidance |
Guidance |
---|---|---|---|---|
Revenue |
$97 billion-$99.4 billion |
$97 billion |
$93 billion |
$91.3 billion-$92.3 billion |
Adj. operating margin |
12.8%-13.6% |
12.8% |
11.8% |
10.8%-11.3% |
Implied adj. operating profit* |
$13 billion |
$12.4 billion |
$11 billion |
$10.1 billion |
Three more reasons why UPS is a good value
First, just as you can't predict what the downside to the company's outlook could be from the economy, it's equally challenging to know what the upside could be. For example, there is no doubt that the yield on the 10-year Treasury note of 4.85% is constraining economic activity, but it's tough to predict where it will be next year or when the Federal Reserve might start reversing rate hikes.
Second, and closely connected with the first argument, based on market estimates, UPS looks like a good value. I don't want to get into the weeds here, but suffice to note the following:
- UPS trades on a trailing price-to-free-cash-flow (FCF) multiple of 20 times and 18.6 times analyst estimates for FCF in 2023 -- an excellent multiple of a company having a rough year.
- Based on analyst estimates, UPS will generate a trailing-12-month low of $12.7 billion in earnings before interest, taxes, depreciation, and amortization (EBITDA) just before earnings growth turns positive in the third quarter of 2024, putting the stock on an enterprise value-to-EBITDA multiple of 10.5 at its low point, based in the current price. That's an excellent valuation for a company in the low end of its economic cycle.
Third, the protracted labor negotiations had a distortive impact on UPS' earnings and cash flow in 2023 in two ways. The fear of strikes caused customers to divert deliveries to other delivery networks, but now the Teamsters contract is ratified, and UPS is winning volume back.
For example, year-over-year U.S. delivery volume was down 12.2% in June and then down 15.2% in August, with the latter figure contributing to the 11.5% decline overall in the third quarter. However, UPS is winning volume back, and its U.S. average daily volume was down just 7.4% in September.
The contract negotiations also meant that "we had $500 million of expense related to our Teamster contract in the third quarter," CEO Carol Tome said on the earnings call. She went on to note that the five-year contract was front-end loaded with 46% of the cost in the first year.
The following table shows how much the issue negatively impacted UPS' expenses. Despite a significant drop in revenue, UPS compensation and benefits rose in the quarter.
Metric |
Q3 2022 |
Q3 2023 |
First 9 Months |
First 9 Months |
---|---|---|---|---|
Revenue |
$24.2 billion |
$21.1 billion |
$73.3 billion |
$66 billion |
Operating expenses |
$21 billion |
$19.7 billion |
$63.4 billion |
$59.4 billion |
% of revenue |
87.1% |
93.6% |
86.5% |
89.9% |
Compensation and benefits |
$11.49 billion |
$11.53 billion |
$34.43 billion |
$34.19 billion |
% of revenue |
47.6% |
54.7% |
47% |
51.8% |
A stock to buy
All told, UPS has been hit by a combination of headwinds this year, which are unlikely to repeat next year. While it's difficult to know where the economy is heading, the stock's valuation makes it look like a favorable investment on a risk/reward basis. Throw in the stock's 4.8% dividend yield, and UPS is an excellent stock to buy for value investors with the patience to ride out some potential volatility.