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Summary

  • UPS aims to grow by increasing its coverage of global small package markets and developing its auxiliary businesses;
  • The company has shown a significant capital discipline over the past few years and the trend of strong free cash flows generation is expected to continue in the future;
  • The company is also utilizing its cutting edge technology and continuous network enhancements to increase density in its B2C business, which is a key to improving margins.

United Parcel Service Inc. (NYSE:UPS), the largest package delivery company in the world, provides transportation, logistics, and financial services in the United States and internationally. The company has three main operating segments: U.S. Domestic Package, International Package, and Supply Chain and Freight. The Atlanta, Georgia based company reportedly delivers more than 15 million packages a day to 6.1 million customers in more than 220 countries and territories worldwide.

UPS is the highest return generator among its global peers and is well positioned to benefit from the improving economic conditions. At current valuation UPS shares provide a compelling investment opportunity as accelerating economy should lead to greater earnings leverage. The company is also bolstering its capacity to process growing e-commerce business. UPS is also taking a number of technology initiatives such as ORION and network enhancements and expects to gain market share within the growing online retail pie.

Shipping Enters a New Dimension

Following the lead of its biggest competitor, FedEx (NYSE:FDX), UPS recently announced that effective December 29, it will also adopt dimensional pricing in the United States. This means that shipments will now be charged on the basis of both volume and weight and not weight alone. This should result in an increase in prices for bulky items.

Dimensional weight pricing is not an entirely new concept in the freight industry. UPS itself currently charges dimensional pricing for shipments of 3 cubic feet or larger while U.S. postal service adopted it a few years back calling it "Shape-Based Pricing". Together UPS, FDX, and USPS represent something of a monopoly and shippers have nowhere to turn now as there are no other alternatives. Following the decision by UPS, the shipping prices based on size will soon become a norm.

If UPS had decided not to charge dimensional weight pricing, the customers who ship light weight but large packages, such as pillow manufacturers, would have moved their business to UPS and away from FDX, and consequently consume a lot of capacity in the network at a low yield. From capital investment perspective, there are significant benefits from dimensional pricing. Smaller, denser packages put less strain on the network and allow for more goods to flow through the system. As a result, incremental capital requirements should slow. However, the new pricing strategy could be more costly to middle market and smaller customers who don't have multiple box sizes.

UPS Playing an Offensive Game in B2C

The package delivery companies are going through a permanent shift in their business because of the rapid growth in e-commerce, which is anticipated to grow 4 times faster than both domestic and global GDP. B2C market carries smaller margins compared to business-to-business [B2B] and is much more dynamic as compared to the static B2B market environment. Given that, the companies will need to optimize their structures and processes to have a competitive edge moving forward. B2C represents approx. 40% of the United Parcel's U.S. domestic small package volumes. This is compared to merely 20% share ten years ago, implying a relative growth of 2% every year. During the last few years, more than 100% of the growth in the U.S. came from B2C volumes.

Although the B2C margins are unlikely to reach B2B levels, the company has several major initiatives underway in order to drive more packages to its network. United Parcel in order to increase margins from B2C is leveraging its advances in technologies such as ORION (which I will discuss later), MyChoice, SurePost Redirect, hub modernization/automation and is accelerating its planned retrofit of approx. 30 major sorting facilities in the U.S. These initiatives will improve the profitability profile of B2C by allowing UPS to process and deliver packages more efficiently.

If the company is able to capture a bigger piece of the growing B2C market in the U.S. (around 50% of domestic volumes), it would significantly boost revenue and EBIT, which in turn would drive earnings growth. The continuation of B2C volume growth will benefit UPS as the low capital intensity of segment provides the company with attractive ROIC despite of lower margins. Moreover, from the capital efficiency perspective, B2C volumes require lower capital consumption given the fact that they don't require as much network capacity as the large package B2B volumes.

ORION - Software That Will Save UPS Millions

The world's biggest package shipping company is also introducing a new route guidance system, ORION. ORION, the company's biggest technological achievement in the past ten years, will save both time and money and reduce fuel burn as it enables driver to find the most efficient route to pursue. According to the company, if each UPS driver in the U.S. reduces miles driven by merely one mile per day, the company figures it can save $50 million every year.

It is pertinent to mention here that not all of the ORION benefits would translate into margin expansion, since part of the efficiency gains would be used to offset the effect of the mix shift towards B2C. However, as the network has the capacity to handle the increasing demand being created by rapid e-commerce growth, more revenue will be captured, which will flow through to operating profits and ultimately generate incremental EPS. Therefore, B2C business can deliver the same or better ROIC as compared to B2B business with less capital being spent. The company has accelerated the deployment of ORION and plans to deploy the technology on 45% of routes by the end of 2014.

Europe Showing Signs of Improvement

UPS has significant global operations with 25-30% of revenue coming from international operations. Europe, which accounts for over half of international revenue, is the biggest market out of the U.S. The company's European operations are expanding at a comparative growth rate to the regions GDP. With the region on mend, UPS is expected to experience decent growth in its European operations. Asia, on the other hand, remains a key long-term growth opportunity for the company but the region is not yielding consistent results due to choppy demand and excessive capacity.

The company's European business continues to show organic growth because of the increased density in ground network. The company's efforts to increase the density, such as $200 million expansion of its facility in Cologne, Germany, are yielding results. The economic backdrop in Europe appears to be supportive of continued strength with European economy showing signs of recovery and faster growth. One factor that can somewhat mute the otherwise strong recovery is the Ukraine crisis.

Learning from Past Experience

The company's 2013 daily volumes were stronger than expected and grew 14% on average compared with the company's own guidance of approx. 8% growth. The increased sales due to the last minute promotions by online retailers created the latest peak day in company's history (6 days later than normal). The order volume was so huge that the company was left short of resources to make deliveries on time.

UPS took extraordinary measures and deployed additional staff and equipment to meet demand. While UPS admitted that it could not meet its own standards set for the holiday period, it also resolved to let this not happen again. CEO David Scott admitted that UPS was not happy with the peak season delays and, "will make the necessary investments and operational improvements to ensure it effectively manages peak demand in the future."

The company during its 4Q13 earnings conference call guided on the four primary initiatives it would undergo to ensure an efficient and profitable peak season in the future. The initiatives included increased investment in facilities and technology, working more closely with the biggest customers to anticipate the increase in demand beforehand (UPS has embedded its employees at the 25 largest customers in 2014), improving shipment visibility as the company didn't had visibility into loads until they showed up at the facility, and finally developing a better communication with both customers and shippers.

Capital Efficiency

Despite of the negative mix shift to B2C from B2B, the company has still managed to consistently deliver strong returns and hence free cash flows. UPS has shown strong capital discipline over the last five years. Before recession, the American company's reported capex as a percentage of revenues was in the range of 6-7% (Credit Suisse figures), as the company was going through a heavy investment cycle during which it built out its Asia network as well as Worldport hub in Louisville, KY.

However, capex levels have stabilized at approx. 4% of sales following the recession. The company plans to spend $2.5 billion in capex for 2014, around 4.3% of the revenue. The increased capex levels can be explained by the decision to accelerate the rollout of its ORION technology as well as its initiative to retrofit its legacy sorting facilities in the U.S.

Going forward, the company expects its capex to settle at approx. 4% of the revenue as compared to FedEx, which spends approximately 8%-9% of its sales annually. UPS has consistently generated strong free cash flows over the past several years. This is an important consideration within the context that the company is shifting its business model mix towards the lower margin B2C. The continued free cash flow generation is also supportive of the company's target to return 100% of net income to shareholders, both in form of share repurchases and dividends. Moreover, the expectations for the lower capex requirements in the future because of less capital intensive nature of the B2C business might result in even more cash returns to shareholders.

Healthcare Benefit-Restructuring Plan a Smart Move

UPS also recently announced that the Master Agreement with the International Brotherhood of Teamsters has been approved until 2018. According to the agreement, UPS sponsored health plans will be migrated to multi-employer health plans for Teamster employees. This move will shift the rising healthcare costs to Teamster plans as UPS will only bear a defined contribution rather than a defined benefit. As part of the agreement the company will be required to make cash payment of $2.3 billion and an upfront pre-tax charge of $1.1 billion.

The contract is not expected to materially impact the company's capital distribution policies (which include $2.7 billion of share purchases planned for 2014), as the company boasts a strong liquidity position with over $7 billion of cash and marketable securities on its balance sheet.

Financials & Valuation

UPS reported adjusted 1Q14 EPS of $0.98 compared to consensus estimates of $1.08. Although the company experienced strong package volumes in both domestic and international segments; the deterioration from the pricing mix weighed on results.

The unusually harsh weather, which resulted in increased expenses and slower revenue growth during the quarter, also negatively impacted the Domestic Package operating profits by approx. $200 million ($0.14 per share). The company's average daily shipments in the United States increased 4.2% during the first quarter primarily because of the underlying growth in e-commerce and large e-commerce shippers using lightweight deferred shipping solutions. Going forward, UPS expects to grow its profits by 12%-14% from its international operations during 2014.

UPS is down 1.3% year-to-date while the peer FDX gained 5.5% during the same period. The underperformance can be attributed to relatively poor sales volumes in the first quarter because of the harsh weather. UPS is trading at a discount compared to industry. UPS has a price/earnings ratio of 22.9 compared to industry average of 23.4 and company's own 5-year average of 35.6. UPS also offers healthy dividend yield of 2.6%, compared to 0.5% of FDX.

Conclusion

The largest U.S. package delivery company, both by revenue and volume, aims to grow by increasing its coverage of global small package markets and developing its auxiliary businesses. The company's one-size, one-price strategy has come to an end after its move towards the dimensional pricing. While the decision will result in higher prices for shippers, it will result in higher revenue and more controlled costs for UPS. The company has shown a significant capital discipline over the past few years and the trend of strong free cash flows generation is expected to continue. This is because of the company's efforts to make its operations more efficient and the e-commerce boom, which is a growth area for package delivery entities.

UPS offers upside potential and its stock is currently trading at a relative discount compared to its peers. The company's underperformance YTD presents an attractive entry point. Finally the company has a healthy dividend yield of 2.6% and targets to return its investors 100% of the net income, both in form of share buyback and dividends.

Source: UPS: Quality On Sale