UPS - Higher Costs Creates Little Current Appeal In This Long-Term Growth Story

| About: United Parcel (UPS)


UPS is spending more to improve its peak capacity to avoid last year's holiday shipping delays.

This hurts this year's earnings, but is a positive development for the future.

The strong growth profile remains attractive, shares offer appeal on dips.

United Parcel Service (NYSE:UPS) saw its shares being under a bit of pressure after the global transportation giant warned about higher costs of the preparation for the peak holiday season.

These incremental investments will take a hit on this year's earnings, which tempered enthusiasm among investors, as 2014 will be an "investment" year.

I like the long-term growth prospects of the firm, the efficiency and 2.7% dividend yield. Despite this, shares already trade at a 15% premium or so versus the wider market, limiting the immediate appeal at this moment in my eyes.

Highlights For The Second Quarter

UPS posted second quarter sales of $14.27 billion, a 5.6% improvement versus last year. Reported revenues were better than consensus estimates which called for revenues of $14.11 billion.

The company posted net earnings of $454 million for the quarter, down 57.6% from the reported $1.07 billion last year. The fall in earnings results from the transfer of post-retirement liabilities for some of its Teamster employees to defined contribution healthcare plans.

This move costs the company about $665 million on an after tax basis. Without this charge, earnings would have come in around $1.12 billion for the period.

Reported GAAP earnings came in at $0.49 per share. Adjusted non-GAAP earnings, which exclude the charge related to post-retirement liabilities, improved by eight cents to $1.21 per share. Despite the increase in adjusted earnings, they missed consensus estimates by four cents.

Looking At The Business Segments

Revenues at UPS' most important domestic business rose by 5.2% to $8.67 billion. Topline sales results were driven by the ground subsegment which saw revenues advance by 6.1% to $6.21 billion. Growth at the next day air business as well as deferred unit came in at just 2.7% and 3.4%, respectively.

The company did see some pressure on rates as the domestic business delivered 7.4% more packages, or about 14.3 million packages a day. The blended revenue per package was down 2.0% to $9.47. Lighter and smaller packages are the result of the growth in e-commerce shipments which pressures average revenues per package.

Reported operating earnings were down by 82% to $209 million due to the healthcare and post-retirement charge as discussed above. Adjusting for this earnings improved by 3% to $1.2 billion.

Revenues from international packages improved by 6.2% to $3.25 billion. A portion of the retirement charges was borne by the unit as well, with reported operating earnings being down by $7 million to $444 million. Adjusted earnings improved by 4.4% to $471 million, resulting in very healthy operating margins of 14.5%. On average UPS shipped 2.55 million packages overseas a day, a 6.6% improvement from last year. Consolidated revenues per package fell by 1.5% to $10.91.

Revenues from the supply chain and freight business were up by 6.5% to $2.35 billion. Operating earnings were down by 41% to $94 million, again on the aforementioned issues. Adjusted earnings were up by 10.7% to $176 million.

Updating The Full-Year Outlook

UPS sees its operating expenses increase by an additional $175 million for this year. These additional expenses or investments relate to the increase in the peak capacity of the firm, while it allows UPS to operate more efficiently during the off-peak season as well.

Due to these investments, UPS has lowered the full-year adjusted earnings guidance to $4.90-$5.00 per share, still representing a 7-9% increase in earnings on an adjusted basis.

Previously the company guided for adjusted earnings of $5.05-$5.30 per share. It had warned that the earnings would come in at the low end of the range given the harsh winter weather which impacted the business in the first quarter.

Valuing The Business

I did not see a balance sheet being provided within the earnings report. At the end of the first quarter, UPS held little over $7.0 billion in cash and equivalents, while operating with $12.1 billion in total debt.

On a trailing basis, UPS has now posted sales just above $56 billion. Reported trailing earnings came in at $3.6 billion on a GAAP basis, as adjusting for the post-retirement items, earnings would have come in around $4.3 billion.

With 927 million shares outstanding at the moment, and shares trading at $99 per share, equity in the business is valued at about $92 billion. This values equity in UPS at 1.6 times annual sales and around 20 times adjusted earnings as forecast for this year.

Strong Recent Growth, Positioned For Future Growth

UPS was always well-positioned to benefit from globalization, worldwide trade and e-commerce growth.

Between 2004 and the current moment, the company has increased sales by more than 50% on a cumulative basis to about $56 billion. Earnings have improved as well, but have not completely kept track with topline sales growth.

Sizable repurchases have however added significantly to reported earnings per share, with the total outstanding share base declining by about a fifth. All of this has been achieved while maintaining a solid balance sheet, although the net debt position has inched up in recent years amidst the sizable share repurchases.

At its recent investor presentation, UPS outlined its competitive advantage to grow in the future. The worldwide integrated network should allow for further growth while the company has focused on certain areas like emerging markets, B2C solutions and technology. Notably the continued evolution to omni-channel and e-commerce will drive further growth going forwards.

The leverage of the network, technology driven efficiency gains and strong pricing, allows for superior margins versus its competitors. Sophisticated routing under the ORION tool, activity based costing and focus on smaller and lower weight packages, should also allow for lower fuel surcharge volatility.

All of this should be achieved while maintaining the superior strong free cash flows, aided by low capital expenditures and record returns on investment.

Final Takeaway

UPS has learned its lesson from the past year when peak e-commerce deliveries coincided with harsh winter weather, causing many unwelcome delays for holiday gifts.

As such the company is upping the incremental investments to improve the peak handling capacity. While UPS previously anticipated these investments to result in $100 million in additional operating expenses, it has now upped this guidance to $175 million. More capacity and smarter usage of existing capacity through ORION, for example, should make sure that last year's troubles won't repeat themselves this holiday season.

Of course the growing trend towards e-commerce is a long-term opportunity, although the peak demands result in some additional costs which are taken upfront by the company. This makes 2014 not so much a great year, but the underlying growth profile and market domination create an appealing long-term investment story.

Unfortunately UPS already trades at a roughly 15% premium versus the wider markets, which is warranted given the growth profile, but does not leave much appeal. I am a buyer if the company's shares sell off significantly, that is some 10-15%, creating an opportunity to buy a great business at a valuation at par with the wider equity markets.

At the same time, shares will yield over 3% in such a scenario. Until that moment in time I will watch the action from the sidelines.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.