United Parcel Service (UPS +2.29%) has a huge 7.5% dividend yield. For reference, the S&P 500 (SNPINDEX: ^GSPC) is only offering a yield of around 1.2%. The company's dividend has been increased annually for 16 consecutive years.
Investors probably shouldn't view UPS, as the stock is more commonly known, as a dividend stock. Here's what you need to know if you're thinking about buying this delivery giant right now.
The problem with UPS' dividend
United Parcel Service's trailing-12-month dividend payout ratio is close to 100%. Dividends aren't paid out of earnings, however, so the dividend as a percentage of earnings (the payout ratio) can be elevated for a little while, and nothing bad may happen. Dividends come out of cash flow, but that's actually worse in this case, because the cash dividend payout ratio is 150% over the trailing 12 months. The cash dividend payout ratio looks at dividends as a percentage of free cash flow.
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There's a very real risk that the board of directors will decide to cut the dividend here. To be fair, the board could also decide to find other ways to support the dividend, such as taking on additional debt. But the dividend discussion at UPS isn't happening in a vacuum. It has to be couched in the corporate reset that's taking place right now.
UPS is positioning itself for a brighter future
Following the coronavirus pandemic demand spike, package delivery quickly fell back to more normal levels. The spike led to a rally in UPS' shares. The reversion to the mean led to UPS' shares plunging, since Wall Street had extrapolated higher demand way too far into the future.
Along the way, management decided it needed to take a good look at the business. The decision was to make big changes.
UPS has been working to slim down its operations. That's included selling divisions off to exit less desirable business lines. It has included capital investments in technology to increase speed, accuracy, and efficiency. It has included closing older facilities and trimming staff, to reduce costs and better align with its new streamlined operations. This has also included refocusing around its most profitable business, while selectively choosing to limit the packages it handles for lower-margin customers.
NYSE: UPS
Key Data Points
This should all position the company for a brighter, more profitable future. But, in the near term, the end result of all this work on the income statement is less revenue and higher costs. This is a transition period, and investors are understandably worried. However, UPS is likely to come out the other side a better company. Yet, the shares are now below where they were prior to the pandemic.
Essentially, this is a turnaround story. If you view UPS that way, it could be worth buying right now and holding for the long term. Holding is important because this business reset is going to play out over years, not days.
However, when a company resets its business like this, the dividend can sometimes be reset, too. Given the high yield and elevated payout ratios, it wouldn't be shocking to see the board make just such a change at UPS.
Buy for the turnaround, not the dividend
Dividend investors have a habit of reaching too far for yield, letting a huge yield distract them from the deeper story of a business. In the case of UPS, that could set you up for disappointment.
The company provides a valuable service. It would be nearly impossible to replicate or replace UPS in the market. But the real story here is the business overhaul that's taking place, not the dividend. UPS should come out of this effort a better company, which is why you would want to buy it. If the dividend makes it through this period unscathed, look at it as icing on the cake, not the main event.
