On the same day that United Parcel Service Inc (NYSE:UPS) released its first-quarter earnings, Moody's changed its outlook on the company's debt to negative. It's never a good sign when a credit rating agency lowers its outlook on a company's debt, and investors in the stock might be concerned that the bond market knows something that the equity market doesn't. With that said, what are investors to make of Moody's move?
Moody's lowers outlook on UPS
First, I want to be clear that Moody's actually affirmed an Aa3 rating on UPS' debt; the change was in the lowering of the outlook. According to Moody's Senior Credit Officer Jonathan Root in the press release, the agency believes UPS credit metrics won't be fully supportive of its current rating for a while due to a:
...combination of expected lower free cash flow generation because of a lengthy period of increased capital investment, a more aggressive financial policy of funding some of share repurchases with debt and the potential to continue to underperform its annual financial plans.
Moreover, Moody's suggested that the increased capital spending plans from UPS might be an indication that the company had underinvested in previous years. Also, the rating agency stressed the importance of the successful execution of UPS' hub modernization and technology investments -- largely being made to deal with burgeoning e-commerce demand.
Free cash flow generation
In summary, the fear is that some or all of the factors above could come together and cause UPS to fall short of the required cash flow generation to service its debt, or at least at the level required for the Aa3 rating. In this regard, UPS uses a measure called Funds From Operations, or FFO, to debt, and aims for a ratio of at least 50% -- a ratio that Moody's points out UPS hasn't met for "a number of years." FFO is a measure sometimes used as a proxy for cash flow, and companies and credit agencies can differ in their calculations on debt and FFO.
With this in mind, I've decided to make things clearer by calculating free cash flow (operating cash flow minus capital expenditures) compared to year-end debt levels for the last few years. As you can see in the chart, the ratio (green line) declined in 2014 and is likely to come under pressure should UPS increase its capital expenditures to $3 billion as outlined in its 10K filing. Similarly, operating cash flow took a hit in 2014 as profits were hit by poor execution during the Christmas period.
Putting all this together, it's not hard to see why Moody's lowered its outlook, but is it something to worry about?
Time to panic?
As ever in investing, it's not that simple. In reality, the need for extra capital investments has been necessitated partly by the changes in UPS end markets. Moreover, the disappointments with earnings and free cash flow generation in the last two years have been down to the issues in dealing with peak demand during the holiday season.
Of course, UPS and FedEx Corporation have taken operational measures (such as dimensional weight pricing) in order to better manage demand during peak season. If UPS successfully completes its capital investment plans and executes better during peak periods, then profits and operating cash flow should start to increase accordingly. Moreover, next year's planned capital expenditures of $3 billion represent 5% of forecast revenue, and are therefore within the 4.5%-5% band forecast at UPS' investor conference in November.
It's hard to argue with Moody's that risk isn't rising with UPS and that its credit metrics haven't deteriorated somewhat in recent years. However, on a more positive note, the reasons for the increased capital spending relate to strong e-commerce demand -- something which should turn out to be more of an opportunity than a challenge. In other words, investors should expect UPS to make these investments.
It would be more worrying if UPS were dealing with some sort of long-term decline in end markets, rather than increasing complexity in peak demand. UPS has to execute, that's for sure, but if the company has a good Thanksgiving/Christmas this year, then its credit metrics will start to improve sooner rather than later.
Lee Samaha has no position in any stocks mentioned. The Motley Fool recommends United Parcel Service. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.