UPS held an investor day in New York City on February 22, three weeks after reporting disappointing fourth quarter results. Its stock fell sharply on the earnings news, giving back all of its Trump rally gains. So far this year, UPS is down 7.4%, much worse than the gains of 5.7% on the S&P 500 and 4.2% on the Dow Jones Transports, of which it is a member. Following management’s comprehensive strategy review and outlook, this is a good time to assess the company’s recent performance and consider the investment potential in its stock.
Fourth quarter results. For the 2016 fourth quarter, UPS reported a loss of $0.27 per share, compared with a profit of $1.48 per share in 2015. All of the loss was due to an after-tax, “mark-to-market” pension charge of $1.67 billion ($1.90 per share). Excluding that charge and a similar but smaller pension charge of $0.09 in the 2015 fourth quarter, the company’s adjusted 2016 fourth quarter EPS was $1.63, up 3.8% from $1.57 in 2015.
Accounting rules require that actuarial gains and losses be recognized if they exceed 10% of the greater of the pension benefit obligation (PBO) or fair value of plan assets. $2.0 billion of this year’s $2.65 billion pre-tax charge was due to a decline in the discount rate from 4.81% to 4.34%. A lower discount rate increases the present value of future expected obligations. Most of the remaining $0.65 billion pre-tax charge was due to lower-than-expected returns on pension plan assets.
Excluding the pension charge, UPS generated adjusted operating profit of $2.2 billion in the fourth quarter, up 2.5% from last year. Adjusted operating profit in the U.S. Domestic Package business declined 0.6% to $1.34 billion, despite a 6.3% jump in package volume to a new record. All of the increase in volume came from business-to-consumer (B-to-C) shipments, which are less profitable. UPS’s SurePost service, a lower margin service that hands smaller packages off to the U.S. Postal Service for final delivery to residential customers, saw volume surge 25% in the quarter. B-to-C accounted for 55% of U.S. Domestic Package volume in the fourth quarter and 63% in December.
Business-to-business (B-to-B) package volume in the U.S. Domestic Package business was down slightly in the quarter. Commercial volumes were solid, except for bricks-and-mortar retail; but the shipping of packages for export still faces strong dollar headwinds.
Despite the decline in U.S. Domestic Package’s operating profit, UPS handled the surge in package volume well, with few delivery glitches. The company shipped packages to 2.5 million new addresses in the quarter. Nevertheless, both UPS and investors were disappointed with the segment’s performance. The company was unable to translate higher shipping volumes and revenues into higher operating profits. Although UPS is delivering a higher volume of packages with great efficiency, it has not been able as yet to adjust pricing to compensate for the higher cost per delivery in the B-to-C business.
Improving pricing in B-to-C is not UPS’s only challenge. Average revenues per piece in next day air declined 2.3% in 2016. That followed a 3.7% decline in 2015. Next day air has a mix of B-to-B and B-to-C customers. The steady drop in pricing suggests tough competitive conditions in this segment of the U.S. domestic package market.
Supply Chain & Freight also reported lower adjusted operating profit, down 10% vs. the prior year. The segment has been stymied by soft global trade; but shipping volumes are beginning to pick-up. However, bid-ask spreads in air freight narrowed again in the quarter, hurting profitability.
International Package continues to deliver solid results. Adjusted operating profit increased 13.1% in the quarter, which marked its eighth consecutive quarter of double-digit gains. Revenues were up 5.0%, the strongest quarterly year-over-year gain this year. Package volume increased 7.3%, more than offsetting a 2.9% decline in the average revenue per piece. The business is seeing solid volume gains in China and intra-Europe.
The 2.5% increase in fourth quarter consolidated adjusted operating profit matched the third quarter increase, but it also reinforced concerns about a slowdown in profit growth, following operating profit increases of 6.3% in the first half of 2016 and 9.2% in 2015. If the slowdown continues, it may eventually call into question whether UPS is getting adequate returns on the significant investments that it has made to expand and modernize its delivery network.
Invest. Grow. Deliver. Despite the slowdown in profit growth in the 2016 second half, UPS has a solid record of growing its operations, improving its operating efficiency and generating good returns on invested capital. “Invest. Grow. Deliver.” was the theme of this year’s investor conference. This theme emphasizes the recurring pattern of investment, growth and performance that has enabled UPS to remain the world’s largest package delivery company.
In 2016, UPS initiated three major projects: the construction of a $400 million, 1.2 million sq. ft. regional processing facility in Atlanta, a $196 million expansion of its hub in Jacksonville, FL and a $175 expansion to double the processing capacity of its Columbus, OH hub. In 2017, it will add 840,000 sq. ft. to its Salt Lake City hub. These expansions coincide with the company’s ongoing deployment of automation technology in all of its sorting facilities to increase throughput and reduce errors and handling costs. In 2017, UPS will expand its fleet of aircraft by taking delivery of the first three of 14 planned Boeing 747-8 air freighters. In all, the company has 70 projects on tap to expand existing facilities, build new facilities and deploy new technologies.
In 2016, UPS completed the rollout of Phase 1 of ORION (its On-Road Integration and Optimization Navigation system) that uses advanced algorithms to optimize delivery routes. The system tells distribution center personnel how to load each truck and prepares daily routes for its delivery trucks that maximize productivity. With ORION, UPS was able to limit the growth in miles driven in 2016 to just 0.2%, even though average daily package volume increased 4.1% and the number of delivery stops rose 4.4%. That translates into a savings of 210 million miles (or 6-8 miles per driver per day) and 9% more stops per delivery mile. Management estimates that the company has already achieved $400 million in annual savings with ORION. By 2019, UPS will complete a rollout of a real-time version of ORION, which will change routes on the fly, for example, to optimize package pick-up routes. Management estimates that Phase 2 of ORION will be quicker and cheaper and yield $150-$200 million of annual cost savings.
UPS is also in the process of rolling out Saturday delivery service to cities across the U.S. The move will help the company to increase capacity by spreading its sorting, delivery and pick-up volumes over six days with no additional capital investment. It plans to launch Saturday service in 50% of its U.S. markets in 2017 and complete the rollout in 2018. Saturday service will help UPS win more B-to-C business; but many B-to-B customers will use the expanded service, as well. Management says that the rollout of the service will be a headwind for profitability in 2017, at least early on, but UPS will adjust its operations to minimize the cost drain and may even begin to turn a profit on the move by the end of the year. FedEx already offers Saturday delivery, which may add a competitive dimension to UPS’s rollout.
UPS uses its technology both to optimize its network operations and interface with customers. Some of the features of ORION will be incorporated into its Enhanced Dynamic Global Execution (EDGE) system, which will allow global network operators to share real-time data, locate operating assets and use mobile tools to communicate with delivery personnel, all in an effort to optimize operating plans. EDGE was launched in 2016 and will be fully deployed by 2019. Management believes that it will generate $200-$300 million in annual savings and cost avoidance.
The company continues to explore new network planning tools, such as advanced analytics, artificial intelligence and operations research to improve performance and operating efficiency. With projects already in process, UPS hopes to achieve an additional $100-$200 million in savings or cost avoidance from this effort over the next few years.
UPS has made its network information available to consumers, giving them the ability through its MyChoice web-based interface to track and manage their deliveries. MyChoice customers get a text message notifying them a day ahead of a delivery. If they do not plan to be home on the expected delivery date, they can for a small fee reroute the package to a UPS Access Point (often a UPS Store) or reschedule. Alternatively, consumers can authorize a shipment release for the package at no additional cost.
UPS is also stepping up its investment in smart logistics that will enable its supply chain shippers to respond more quickly and precisely to changes in their customers’ work flows. In its Supply Chain & Freight businesses, UPS helps customers maximize speed and minimize the cost of shipping their goods around the world. UPS itself is using these technologies to scale and flex its own operations automatically for changes package delivery volumes.
The company aims to continue to expand its international presence. Over the past thirty years, UPS has expanded its operating footprint to 240 countries and territories. The company usually establishes itself in a new country by offering air delivery services for packages bound for the U.S. and other countries. Over time, it often broadens and deepens its footprint by adding local ground package delivery services and expanding its service to nearby cities. In China, for example, UPS plans to offer delivery services to 21 new cities in 2017, each with a population of more than one million people. Achieving greater density in individual international markets helps drive down delivery costs.
As the global network expands, so does the potential for add-on services. In 2016, UPS launched AM Express delivery service in 52 countries and AM Express Plus delivery service in 26 countries. These services offer next day or two-day cross border 9:00 AM delivery service. The company plans to offer these services in 37 additional countries in 2017.
Going forward, UPS is using its technology budget to explore new delivery vehicle alternatives, such as autonomous and hybrid vehicles and, in selected cases, the use of drones, all in an effort to continue reducing per piece delivery costs.
Operating and Financial Risks. Despite continued success in expanding and upgrading its delivery network, UPS delivered somewhat disappointing financial performance in 2016. Excluding the fourth quarter pension charge, adjusted operating profit increased $332 million or 4.3%, but this was less than the reported $400 million in annual savings from the ORION deployment. (The growth in U.S. Domestic Package’s adjusted operating profit, where ORION is primarily used, was only $96 million.) Average daily package delivery volume was up a solid 4.2%, but average revenue per piece was down 0.7%. A higher proportion of B-to-C business pressured per piece delivery prices. B-to-C shipping volume was also lackluster.
Management acknowledged that it needs to do a better job of matching revenue with the higher delivery cost associated with the B-to-C business. It said that it has been reluctant to push pricing, for fear that it could facilitate the growth of competitors. While no company, except perhaps FedEx, can come approach the efficiency of the UPS network in the U.S., smaller local delivery companies could conceivably win some business from shippers, especially in B-to-C, if UPS sets its rates too high.
At the same time, Amazon has established its own delivery service in selected cities and is now delivering an estimated 1.5 billion packages annually, according to UPS. Much of that volume, however, is directed to the U.S. Post Office for the final leg of the delivery to the customer. UPS still gets a significant amount of volume from Amazon and thus still sees Amazon as a key customer; but it probably does not want to encourage additional expansion of Amazon’s delivery network. Yet, it is also hard to imagine that Amazon can operate its delivery network as efficiently as UPS.
Over the past couple of years, UPS’s B-to-B business has been soft, mostly because of lackluster industrial production and weakness in U.S. exports due the sharp rise in the dollar. The company has been able to sustain the growth in its international business by expanding its geographic footprint and eventually offering local delivery services in those new markets. Yet, slow global economic growth and the slowdown in global trade, unless reversed, is bound to catch up with the company. Recently, there have been signs that economic activity is picking up in the U.S., Europe and other parts of the world; but the possible imposition of border controls that could hurt global trade is a new risk that has surfaced with the rise of populism in the U.S. and Europe.
Financial Projections and Outlook. Management remains upbeat in its long-term outlook, but has set a fairly wide range in its financial guidance for 2017. It expects to deliver 2017 earnings per share of $5.80-$6.10, up 0.9%-6.1% from 2016 adjusted EPS of $5.75. (All non-GAAP adjustments for UPS from 2014 to 2016 were due to pension and healthcare (mark-to-market) charges.)
During its fourth quarter earnings conference call, management said that its earnings guidance was based upon expected revenue growth of 5%-7% in 2017, which would be the strongest since 2012. It anticipates revenue growth of 5%-7% in U.S. Domestic Package, 2%-4% in International Package and 8%-10% in Supply Chain & Freight.
That guidance implies a decline in 2017 consolidated adjusted operating margin from 13.3% to 12.9%. Management expects that adjusted operating profit will decline 4%-8% in International Package, but grow by 7% or so (i.e. less than revenues) in Supply Chain & Freight. It gave no specific operating profit growth target for U.S. Domestic Package, but did say that it expects less margin improvement there because of stepped-up capital spending. My 2017 EPS estimate of $5.95 implies adjusted operating profit growth of 6% for U.S. Domestic Package, which represents a slight decline in its adjusted operating margin from 12.9% to 12.8%.
The slower growth in U.S. Domestic’s adjusted operating profit suggests that its operating cost per piece will rise 3.0% in 2017 from $8.06 to $8.30. That compares with an average cost per piece that has fluctuated between $8.06 and $8.12 for the past five years.
At the investor conference, management said that U.S. Domestic’s operating costs will rise by about $200 million next year because of the Saturday delivery launch and “other factors.” Yet, the $200 million of additional costs represents only about one-fifth of the implied increase in U.S. Domestic’s adjusted operating costs according to my projections (and management’s previous guidance).
Management’s revenue guidance for U.S. Domestic seems aggressive, given the division’s recent historical performance and its acknowledgement that it needs to do a better job of aligning pricing with costs in B-to-C. However, its implied cost guidance also seems overstated; so perhaps there will be opportunities to achieve an average cost per piece below $8.30 and more in line with the five-year range of $8.06-$8.12. For example, management in U.S. Domestic believes that it can implement Saturday delivery without much of a hit to earnings.
In International Package, management anticipates that average daily volume will rise 4%-6%, but revenues will increase only 2%-4%. The slower increase in revenues is presumably due to projected foreign currency headwinds of $400 million. Since that expected currency loss drops straight to the bottom line, management projects that International’s adjusted operating profit will decline 4%-8% in 2017. If so, that would break two consecutive years of double-digit operating profit increases.
In Supply Chain & Freight, management anticipates that 2017 adjusted operating margins will be slightly below 2016’s, despite expected revenue growth of 8%-10%. Thus, I have assumed that its adjusted operating profit will grow 7%.
Putting it all together, I project consolidated revenue growth of 6.1% to $64.6 billion, adjusted operating profit growth of 2.6% to $8.33 billion, adjusted net income growth of 1.4% to $5.17 billion and adjusted EPS growth of 3.4% to $5.95. I project that net income will grow at a slower rate than operating profits because of a slight increase in the company’s average interest rate on debt and income tax rate. I project that EPS will grow faster than net income because of share buybacks.
From a cash flow perspective, the company will step up its capital spending this year to $4 billion from just under $3 billion in 2016. It will also reduce its share buybacks from $2.7 billion to $1.8 billion. With the increase in the annual dividend from $3.12 to $3.32, I estimate that the company will pay out $2.9 billion in dividends, up about $250 million from 2016.
Yet, I project that UPS will generate $4.6 billion in free cash flow (i.e. cash flow from operating and investing activities), up from $3.9 billion in 2016, mostly as a result of a positive swing in working capital. Thus, my projections suggest that UPS’s debt will remain flat in 2017.
Valuation metrics. At Friday’s (2/24) closing price of $106.18, UPS’s stock is valued at 17.8 times projected 2017 earnings and 16.5 times the 2018 consensus estimate. By comparison, the stocks in the Dow Jones Transports have an average forward P/E multiple of 16.6 times projected 2017 earnings and 15.8 times projected 2018 earnings. My projections assume adjusted EPS growth of 3.5% in 2017, compared with an estimated average EPS increase of 0.9% for the Dow Transports. Consensus estimates anticipate 2018 EPS growth of 8.4% for UPS and 11.4% for the Transports. UPS’s book value per share is not comparable to its peers, primarily because of its significant share buyback activity.
At 3.1%, UPS offers the highest dividend yield among its peers. By comparison, the average dividend yield for the Dow Transports is 1.4%.
If economic activity strengthens, the market may begin to anticipate that UPS can meet its revenue guidance and perhaps even exceed its implicit cost guidance. That would drive expectations to the high end of management’s EPS guidance range, which would have a positive impact on UPS’s share price performance. Thus, at the current share price, I think that UPS can deliver a total return of at least 6.6% in 2017, equal to its dividend yield of 3.1% and my projected EPS growth of 3.5%. The stocks total return would rise as high as 9.2%, if the company achieves EPS growth at the high end of management’s guidance range. Total returns above 9.2% would require actual 2017 EPS growth above management’s guidance or a view that earnings growth will begin to accelerate in 2018 and beyond. Management is targeting EPS growth of 5%-10% in the 2018-2019 time frame which could produce low double-digit returns on the stock.
Technical Analysis. Since the market bottom in March 2009, UPS has delivered a solid total return to investors, but it has underperformed both its peer group and the broader market. Likewise, over the past three years, UPS has given investors a respectable total annualized return of 6.4%, but still less than the annualized returns of 8.6% for the Dow Transports and 10.7% for the S&P 500.
With the recent sell-off in late January, UPS’s stock is at a critical juncture, near medium-term price support and below both its 50-day and 200-day moving averages. If it can hold or bounce back from this level, it would be positioned to resume its upward advance. Alternatively, I would become more concerned if the stock were to move down towards its January 2016 low of $87.30. Without a negative change in sentiment on global economic growth, it seems unlikely that the stock will move back down toward that January 2016 low.
Concluding thoughts. I have little doubt that UPS will continue to make the investments necessary to sustain its worldwide leadership position. However, its future performance will also be driven largely by global (and especially U.S.) economics trends.
Recent data suggests a pick-up in global economic activity. In the U.S., for example, manufacturing activity has advanced in four out of the past five months, according to the Federal Reserve, reversing a decline earlier in 2016. There are also signs of an improving economic activity in Europe and much of Asia continues to grow at a solid pace.
A strengthening of global economic activity would likely drive higher package volumes in UPS’s B-to-B business and should help sustain the growth in B-to-C. Higher package volumes would also allow UPS to show tangible results from the network and technology upgrades that it has implemented over the past several years. It would therefore support the company’s revenue growth objectives and perhaps allow it to exceed expectations on delivery costs.
On the other hand, the company’s performance would suffer, if economic activity weakens and global trade activity shrinks. Any follow through on threats by the Trump administration to erect trade barriers would hurt UPS’s business. The same is true if other countries seek similar protections for their economies.
Given recent gains in global stock markets and the signs of strengthening economic activity, however, it seems more likely that UPS will be able to deliver on (and perhaps even exceed) its revenue and profit guidance for 2017.
February 25, 2017
Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
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