Here's Why UPS Is a No-Brainer Transportation Stock

It's no secret that UPS (UPS 0.14%) is going through a difficult year. A combination of weakening end demand caused by a slowing economy and costly protracted labor contract negotiations have come together to mean the company's revenue and earnings will decline this year.

Still, its best days are yet to come, and the stock looks like an excellent buy for dividend-focused investors and value investors alike. Here's why.

UPS is improving the quality of its earnings

In a previous article, I highlighted the value case for UPS stock, and now it's time to include a more qualitative discussion. That's a key point for UPS because it's an integral part of management's "better, not bigger" approach.

In other words, the company is focused on improving the quality of its revenue rather than just chasing delivery volume growth for its own sake. One example of this comes from contractual agreements with Amazon.com that resulted in reducing the volume and revenue coming from its largest customer. It's a demonstration of UPS' willingness to forego lower-margin deliveries.

Another example of how UPS is aiming to improve its revenue quality comes from the "wildly important" initiatives in key end markets laid out at its investor day in 2021.

• In the small and medium-sized business (SMB) market, UPS aims to generate $3 billion in digital access program (DAP) related revenue in 2023 and significantly increase its share of revenue from SMBs over time.
• In the healthcare market, UPS aims to grow revenue at a 12.3% compound annual rate from 2020 to 2023, reaching $10 billion.
• In international markets, management aims to hit adjusted operating profit of $4.3 billion to $4.6 billion in 2023.

Image source: Getty Images.

UPS scorecard

The good news is that, despite significant headwinds this year, the transportation stock is on target to meet most of these metrics in 2023, and the only one it's highly unlikely to meet in 2023 (international adjusted operating profit) was already hit in 2022. In fact, UPS hit its headline 2023 targets in 2022.

The italicized statement should not take away from the fact that revenue and earnings are on the decline in 2023 but rather highlight that the company faced cyclical and labor-related headwinds unlikely to repeat in the near future. They combined to take the company off a course it was well ahead in.

The headline targets for 2023 called for revenue of $98 billion to $103 billion and an adjusted operating profit of $12.4 billion to $14 billion. UPS hit $100.3 billion in revenue in 2022 and an adjusted operating profit of $13.85 billion in 2022 -- one year ahead of its plan.

Turning to the three end markets referenced above, they aren't just numbers. They represent an improvement in the quality of UPS revenue, which should ultimately be seen in the numbers when the economy picks up, driving volumes higher.

• In the SMB market, management recently confirmed it's on target to reach $3 billion in DAP-related revenue in 2023 from just $1.3 billion in 2021. DAP is a set of solutions designed to help SMBs run e-commerce shipping operations more smoothly to better compete with larger companies.
• Management confirmed it was on track to hit $10 billion in healthcare revenue in 2023.
• The international segment operating profit target was hit in 2022, with the segment hitting $4.42 billion in adjusted operating profit.

Image source: Getty Images.

The improvement in the SMB market is focused on the U.S. domestic package segment. CEO Carol Tome lauded the improvement, noting that the company's third-quarter 2023 revenue was comparable to that of 2019, but "our SMB mix has moved from 23% to 29%, and our net revenue per piece has moved from $9.99 a to $12.54." By "SMB mix," she means the share of the segment's revenue.

As you can see in the following chart, she has a point. The segment's revenue per piece has increased at a steady rate (see the trend line), even though volume growth has been varied, "better, not bigger." Simply put, UPS has improved the quality of its revenue.

Data source: UPS presentations.

If you are wondering whether this has produced a corresponding increase in revenue, profits, and margin, here's a comparison between 2019 and 2022 full-year figures. Simply put, UPS is a better company with better underlying margin these days -- at least, it is in normalized conditions.

Data source: UPS presentations.

Is UPS stock a buy?

The growth in healthcare and SMB revenue is improving the quality of UPS' revenue and its revenue per piece, and that's flowed into its underlying margins. Meanwhile, the rollout of DAP to international markets will also help expand that segment's profitability. As such, when the economy improves and volumes start growing again, UPS will be ideally placed to benefit from growth in demand.