Investors in United Parcel Service (UPS -1.51%) could be forgiven for wondering what has happened to their stock. The company, alongside key rival FedEx (FDX -2.09%), has long been known for being a play on global growth, but many of the underlying assumptions behind this view have changed in recent years. In short, UPS faces challenges and opportunities that make it a different investment proposition than you might think. It's time to look at the pros and cons of buying stock in UPS.
Source: United Parcel Service.
United Parcel Service faces changes
Recently, I've taken a look at the key fundamentals from UPS' earnings report and conference call, as well as the bullish and bearish cases for the stock. My key argument in this series is that, since 2008, the investment proposition behind buying UPS, and FedEx, has changed relative to previous recoveries. The three reasons are as follows:
- Global trade has grown more slowly than global GDP as a consequence of protectionist policies.
- E-commerce is growing strongly and certainly brings growth opportunities, but it also creates challenges, as it tends to lead to an increase in lighter-weight and lower-yielding packages.
- Since 2008, customers have become more cautious and are shifting toward lower-cost and slower delivery options, putting pressure on margins.
The first point tends to reduce overall revenue growth, while the last two points tend to pressure yields. Moreover, rising e-commerce demand -- particularly from business-to-consumer, or B2C, growth -- has a tendency to create very high peak demand spikes during the holiday season. Consequently, UPS has had to invest more, at the cost of earnings, to restructure its business for higher-than-expected volume growth from lower-margin e-commerce deliveries.
In addition, investment is needed to deal with peak demand challenges. If all of this wasn't enough, then the news that the U.S. Postal Service is cutting prices to attract e-commerce business from big companies will surely worry investors.
What you need to know before buying UPS
In essence, it boils down to two questions. Can UPS get back to double-digit earnings growth, or is something structural going on, which means it can only expect high-single-digit EPS growth in the future? Moreover, how do you value the company in this new environment?
On a positive note, there are some signs that global trade is likely to pick up in the next couple of years and e-commerce is surely going to increase volume growth. The issue comes down to margin growth, something that UPS has struggled to generate in recent years.
Source: United Parcel Service presentations.
Moreover, the pricing threat from the U.S. Postal Service in the e-commerce delivery marketplace, and the longer-term possibility that Amazon.com will take market share in last-mile delivery with its drone program, means that investors should be a little bit cautious on valuation matters with UPS. In other words, the increased risk needs to be priced in.
When asked on the conference call about margins and future long-term EPS growth, UPS CEO Scott Davis deferred more detailed discussion until later in the year: "We'll clearly talk about the long term and the future in November a little more."
Turning to valuation, a quick look at its EV/EBITDA multiple reveals that, like FedEx's, the stock is looking a bit more expensive than it has in recent years. Enterprise value (market cap plus debt), or EV, over earnings before interest, taxation, depreciation, and amortization, or EBITDA, is a useful valuation metric, because it gives investors an appreciation of how much cash flow the company is generating in relation to the price of the business.
The following chart plots the forward EV/EBITDA ratio. Although it looks expensive relative to FedEx's, a forward EV/EBITDA ratio of around 10 isn't too pricey on an absolute basis. Both stocks look like a good value.
UPS EV to EBITDA (Forward) data by YCharts.
Time to buy UPS?
All told, UPS is clearly experiencing some growing pains as it deals with e-commerce growth, and its margins could continue to be challenged in the future by pricing competition. On the other hand, the investments it's making now are to restructure the business to deal with a higher volume of package deliveries -- obviously a good thing.
Moreover, generating margin improvements from increased scale, which will come from e-commerce growth, is part and parcel of what UPS' management does. Don't be surprised if its management succeeds in leveraging e-commerce-led growth into margin improvements in the future. However, cautious investors might want to pay attention to the company's investor conference on Nov. 13, particularly for more color on how management sees its long-term growth rates and margins developing.
