There's a good case for buying UPS (UPS -1.61%) stock, and an even better one for buying the stock if it cuts its dividend. It's not just about ensuring that the dividend is adequately supported by cash flow generation in the short term; it's also essential to guarantee that management can fully capitalize on the growth opportunities created by its current actions.
Not just a near-term consideration
In a previous article on UPS, I outlined how management's pre-Liberation Day guidance for 2025 called for $5.7 billion in free cash flow (FCF) when its dividend payment is $5.5 billion, and management plans $1 billion in share buybacks. However, since then, the tariff escalation has undoubtedly impacted the global economy, and UPS declined to update its full-year guidance on its first-quarter earnings call in late April.
As such, it's not difficult to see that UPS might be unable to cover its dividend with FCF if it misses its FCF estimate. As for the share buybacks, management has considered debt-financing them as the dividend on the stocks repurchased could be higher than the after-tax debt cost.
But here's the thing. Following the same logic, it's not going to make sense to debt-finance a dividend (which UPS may have to do if its FCF falls short of guidance) if the dividend yield is more than the after-tax debt cost.
Moreover, there's another major reason to cut the dividend, and it doesn't stem from sustainability considerations. Instead, it comes from the argument that it's in the best interests of shareholders because it frees up resources for management to generate value for them.
Image source: Getty Images.
UPS and generating returns from its assets
Fellow writer Sean Williams believes UPS might be a stock Warren Buffett is buying, and in one aspect, UPS is the kind of stock he might buy. Buffett is known for buying stocks that can improve their return on equity, or assets, but not necessarily their revenue or earnings.
It's doing so as part of its plan to repurpose its network to handle more selected and higher-margin deliveries. This plan has a few key parts.
- A conscious decision to reduce low or negative-margin deliveries for Amazon.com by 50% from the start of 2025 to the second half of 2026 -- Amazon made up 11.8% of total company revenue in 2024.
- Investments in automation and smart facilities will increase productivity, allow UPS to consolidate less-productive facilities, and lower the cost per package.
- Management plans to grow its small and medium-sized business (SMBs) and healthcare revenue and shift to higher-margin deliveries.
- On the investor day presentation in March 2024, management outlined plans to double its healthcare revenue from $10 billion in 2023 to $20 billion in 2026 , partly by making acquisitions.
These plans sacrifice revenue for increased profitability while consolidating facilities to improve productivity. This all points to increased returns on equity (RoE) and capital employed, as UPS will earn more for less.
Image source: Getty Images.
Why UPS should cut its dividend, part II
That's fine and worthy, but there are a couple of key considerations here.
First, UPS is making acquisitions in healthcare to achieve its aims. They include the acquisition of European complex healthcare logistics solution provider Frigo-Trans and BPL for an undisclosed sum in January , and an agreement to buy Andlauer Healthcare (logistics and cold chain transportation) for $1.6 billion in April.
That said, UPS could be more aggressive in acquisitions to hit its $20 billion target in 2026 if it didn't pay such a large dividend.
Second, assuming UPS achieves its aim of generating more from less and improves its potential (RoE) by having a more productive network in place, at this point, it would make sense to start plowing back investment into the business to benefit from an improved ability to generate returns. That's more challenging to do if the company continues paying such a large amount of its earnings and FCF in dividends. Arguably, cutting the dividend would free up resources to invest more in doing things like increasing SMB and healthcare exposure.
Image source: Getty Images.
Investing for growth
Ultimately, investors buy equities because they believe management can generate better returns with the money than they can. Suppose UPS is going to achieve its aim of improving profitability and return on equity or assets. In that case, investing more makes sense rather than paying a high percentage of its earnings or cash flow out in dividends.
As such, cutting the dividend might encourage the market to reset expectations and feel more positively about UPS' long-term growth prospects rather than stress over its dividend sustainability.
