United Parcel Service (UPS) 18Q1 Results

UPS reported 19Q1 EPS of $1.28, down from $1.55 a year ago. Non-GAAP EPS, which excludes the after tax impact of transformation strategy costs – i.e. costs that “will create efficiencies across the enterprise and produce higher-quality revenue growth” – were $1.39 per share, which was still well below both the prior year period and market expectations.

Management said that results were hurt by severe winter weather, which reduced EPS by an estimated $0.07 per share.  In addition, it noted that the 2019 first quarter had one less operating day. Volume in the quarter was also affected by the shift this year of the Easter holiday season to April.

At its analyst meeting in September 2018, UPS announced a commitment to continuously transform and modernize its business through the application of state-of-the-art technology.  The goal of the effort is to enhance the quality and efficiency of its network and expand operating capabilities to strengthen the company’s competitive position and capture new revenue opportunities. UPS is targeting several market segments, including small and medium-sized businesses, certain international markets, ecommerce and the healthcare and life sciences industries, for growth.

Yet, as long as I have been following UPS, the company has been committed improving its delivery network through the application of technology.  What seems to have changed is its continuous commitment: To win in the marketplace, UPS recognizes that it must continuously pursue opportunities to improve its operating efficiency and win new business.

While clearly an important initiative, the Transformation Strategy does not, in my view, qualify for non-GAAP treatment.  Non-GAAP adjustments are intended to highlight unusual expenses that are not likely to be repeated going forward (or at least not likely to be repeated indefinitely).  They provide investors with a view of what a company might be able to earn when those unusual expenses go away.  Consequently, they are best seen as an aid in forecasting future earnings.

UPS’s Transformation Strategy is an ongoing initiative that may very well be instrumental in helping it to achieve greater growth in revenues. It may also be true that the company’s profits may decline without it. It may therefore be indispensable part of the company’s overall strategy; but it does not appear to be different from other initiatives – that are not classified as non-GAAP – that are also necessary to sustain or grow its revenues and profits.

In its 19Q1 press release and on the conference call, management reaffirmed its 2019 adjusted EPS guidance of $7.45-$7.75, which does not include either transformation costs or mark-to-market pension adjustments.  It did note, however, that “onboarding” costs (which presumably are start-up costs) associated with the opening of 30% of its planned capacity additions will hurt expected 19Q2 earnings.

While 19Q2 operating earnings are expected to grow, EPS is expected to be comparable to the 18Q2 quarter.   Since that guidance was below current market expectations, the company’s reaffirmed guidance implies that it expects to make up for the 19Q2 shortfall with better-than-previously-anticipated earnings in the second half of the year.  In fact, management said that numerous factors, including an extra operating day and the non-repeating of commodity prices headwinds in its international business, should help boost third quarter results.

Still, investors were not pleased with weaker-than-expected 19Q1 results and the reduced 19Q2 outlook.  UPS’s stock gapped down at the open and barely recovered during the course of the trading session.  It finished the day at $105.13, down 8.1% from the previous close and has remained near this level over the past two trading sessions.

From a technical perspective, like many stocks, UPS had been in an uptrend since bottoming in December. However, it has lagged the broader market both in its recent recovery and over a much longer time horizon. In fact, the stock has been in a downtrend – i.e. a series of lower highs and lower lows – since it peaked at around $130 in early 2018.

That poor relative share price performance has also mirrored the company’s financial results. Over the past two years (2017 and 2018), UPS’s operating profit declined by 4.4% annually and its operating margin fell from 12.5% in 2016 to 9.8% in 2018. Transformation costs were only a small part of that decline. (They totaled $360 million in 2018; while operating profit was $7.0 billion.)

The company attributed most of the decline in profitability to higher operating costs in its U.S. Domestic Package business. While several factors were given, including higher wages, a greater number of hours worked, the increased use of outside contractors and others, it appear that the company’s overall operating efficiency has been declining over the period, which is surprising given the perceived efficiency with which UPS has operated over many years.

A WSJ article from June 2018 took aim at some of UPS’s problems; but at the time, I thought that the article was out of step with what I perceived to be the technologically advanced state of the company’s delivery network. I am less sure about that now.

The decline in operating profit occurred despite average annual revenue increases of 8% in both years, due to growth in volume (but at a declining rate) and increases in prices (especially fuel charges).

2019 first quarter results showed less of a decline in operating profit than in the annual results. Excluding $123 million of transformation costs, adjusted operating profit was essentially flat. But one quarter’s results are not enough to conclude that operating profits are stabilizing, especially with the reduced profit outlook for the second quarter.

My concerns have been heightened in part by management’s change in format for its quarterly conference calls. About two years ago, the company began fielding a high percentage of questions in the Q&A period from emails. That is quite unusual; in my experience, very few companies take questions from emails.

In its instructions for the submission of questions, management stresses that it will favor questions that are of a “long-term strategic nature” (presumably rather than pointed questions about why the company failed to meet or beat estimates). Such a step might be understandable if there was evidence that analysts were too focused on short-term issues, but I personally have not come across any evidence of that on UPS calls. On the contrary, it seems to me that the cause of the sharp decline in the company’s operating profitability over the past two years is an appropriate topic for this forum. In my view, UPS has not (as yet anyway) addressed this topic adequately in the MD&A section of its financial statements or in any of its other communications with the investment community. Since I have not participated in most of the company’s quarterly conference calls, however, I do not know whether these issues have been addressed by management on previous conference calls, either in its prepared remarks or in Q&A with the investment community.

I believe that the concerns that I have raised here are reflected in the poor relative performance of UPS’s stock since 2017 and in its only average valuation metrics vs. peers, despite its superior dividend yield. Although I believe that the company still has significant competitive advantages and the potential to fix its problems, there appear to be good reasons for investors to be cautious here.

April 29, 2019

Stephen P. Percoco
Lark Research
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Linden, New Jersey 07036
(908) 448-2246
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