When you decide to buy or sell stock in a company like United Parcel Service, Inc. (UPS -0.45%), there are two key questions you should ask yourself. The first is whether its earnings projections and financial numbers make the stock a good value. The second is whether you believe in the company's ability to hit the numbers. This article will deal with these considerations in turn so you can better decide whether UPS stock is a buy for you.
Forecasts and historical numbers
UPS recently hosted an investor conference in which it laid out its long-term financial targets. For now, let's look at what management expects from the business in the 2015-2019 time frame.
| Metric | Management Forecast for 2015-2019 |
|---|---|
| Revenue Growth | 5%-7% |
| Operating Profit Growth | 8%-11% |
| EPS Growth | 9%-13% |
| Return on Invested Capital | 25%-30% |
| Capital Expenditure % of Sales | 4.5%-5% |
Source: United Parcel Service, Inc Presentations.
It's a pretty impressive set of figures. Let's use these numbers to demonstrate what to expect going forward, starting with a look at historical income and cash flow conversion.
Source: Morningstar Research.
There are two key points to understand in this chart.
First, free cash flow conversion from sales (red line) has increased notably as a result of the reduction in capital expenditures as a share of sales (green line). Moreover, going back to the forecast above, UPS management is expecting capital expenditures as a share of sales to be in the 4.5%-5% range for 2015-2019.
Second, UPS has a strong record of converting net income (light blue line) into operating cash flow (dark blue line). In fact, adjusting for unusual items in 2012 would give an average ratio of operating cash flow/net income of around 1.9 times for the last 10 years. Of course, net income divided by the diluted number of shares gives earnings per share, or EPS.
In short, UPS is clearly a company with a high return on invested capital, or ROIC, that converts a large amount of net income into operating cash flow and appears to be entering a period of relatively low capital expenditures.
Why UPS' valuation is a good value
In the following table, I've used analyst forecasts for revenue and EPS for the next two years, and then the midpoint of the company's guidance given above. Operating cash flow is tabulated using the historical figure over the last five years of 1.7 times net income (or EPS) rather than the 1.9 times outlined above -- mainly for conservativeness' sake.
Capex per share is calculated using the midpoint of company guidance. The number of shares used is the most recent diluted figure of 922 million, and enterprise value, or EV (market cap plus net debt), is currently at $114 per share.
| Metrics |
2014 |
2015 |
2016 |
2017 |
2018 |
2019 |
|---|---|---|---|---|---|---|
|
Revenue ($bn) |
58.15 |
61.35 |
65.03 |
68.93 |
73.07 |
77.45 |
|
EPS ($) |
4.96 |
5.66 |
6.28 |
6.97 |
7.74 |
8.59 |
|
Operating Cash Flow Per Share ($) |
8.43 |
9.62 |
10.68 |
11.86 |
13.16 |
14.61 |
|
Capex Per Share ($) |
2.76 |
2.91 |
3.09 |
3.27 |
3.47 |
3.68 |
|
Free Cash Flow Per Share |
6.30 |
6.71 |
7.59 |
8.58 |
9.69 |
10.93 |
|
FCF/EV |
5.53% |
5.88% |
6.66% |
7.53% |
8.50% |
9.59% |
Source: Yahoo! Finance, author's analysis, United Parcel Service guidance.
The key to valuing the company is in the last row of the table. Free cash flow from enterprise value represents the actual cash an owner can pull out of the business that he invested in. In theory, a company could pay out all of its free cash flow to shareholders in the form of a dividend. The figures indicate that UPS -- provided it hits its targets -- could see some significant dividend increases in the future. In addition, its valuation looks significantly more attractive than buying a 10-year U.S. Treasury note yielding just 2.4%.
Will UPS hit its targets?
The table above is intended for indicatory purposes. With that said, it demonstrates the potential value in the stock. However, the key question is whether UPS can hit these targets or not. The answer lies in the evolution of the e-commerce market and how UPS deals with it.
The bullish case for UPS sees the company implementing its planned price increases and successfully increasing yield per package via the transition to dimensional weight pricing for all of its U.S. domestic packages. It's notable that its main rival, FedEx Corporation, is taking very similar measures, so the two companies are unlikely to lose significant business to each other as a consequence of raising pricing. Meanwhile, global trade growth will help UPS' international operations, and also its higher-yielding business-to-business deliveries.
The bearish case sees the inexorable growth in e-commerce deliveries, particularly business-to-consumer, as putting ongoing pressure on its operating margins. In addition, UPS and FedEx face potential competition from the United States Postal Service as well as Amazon.com and Google. In addition, it's not clear how customers will react to the pricing increases.
Is United Parcel Service a good value?
There is no doubt that growth in e-commerce deliveries is creating challenges as well as opportunities, but its valuation looks attractive, and there appears to be enough of a margin of safety baked in. Every business faces competitive and operational risks, but UPS looks attractively priced on a risk/reward basis. Carrying a near-2.5% dividend yield, and with significant cash flow generation ahead, UPS looks like a good value.
