By The Valuentum Team
United Parcel Service's Investment Considerations
• United Parcel Service (NYSE:UPS) "shrinks the globe." The firm is the world's largest package delivery company, a leader in the US less-than-truckload industry and the premier provider of global supply chain management solutions. Its history dates back to 1907. UPS is headquartered in Atlanta, Georgia.
• We're huge fans of UPS's worldwide integrated network, respected brand and consistent free cash flow generation. It has superior scale and efficiencies. Emerging markets represent the firm's largest growth opportunities.
• UPS boasts an industry-leading adjusted operating margin in small packages. In the mid-teens, it is nearly double the average of DHL (~9%), FedEx (NYSE:FDX) (~8%), and TNT (OTCPK:TNTEF) (~3%). The company benefits from over 100 years of improvement and investment. Its culture is one of continual reinvention. The firm reported record international operating profit in 2015.
• UPS reported its highest-ever fourth-quarter earnings per share of $1.57 in 2015, an increase of 26% from the year-ago period, as well as record annual earnings per share of $5.43 in 2015. Record international operating profit of $2.2 billion was led by the Europe region, where disciplined pricing, favorable customer and product mix combined with improved operational performance to drive profitability higher.
• Revenue management initiatives, including pricing, will be key drivers behind expected profit expansion. International shipment growth will also offer a nice tailwind to performance. Management is targeting 5-9% EPS growth in 2016 over the adjusted 2015 mark of $5.43, to the range of $5.70-5.90.
• UPS is truly an amazing free cash flow generator. During 2015, for example, the company hauled in $5.1 billion in free cash flow, helping to pay a growing dividend and buy back stock.
Economic Profit Analysis
In our view, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. United Parcel Service's three-year historical return on invested capital (without goodwill) is 38.2%, which is above the estimate of its cost of capital of 10%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Companies that have strong economic profit spreads are often also solid free cash flow generators, which also lends itself to dividend strength. United Parcel Service's Dividend Cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is 1.6 (anything above 1 is considered strong). Click here to learn more about the Dividend Cushion ratio.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. United Parcel Service's free cash flow margin has averaged about 8.2% during the past three years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At United Parcel Service, cash flow from operations decreased about 21% from levels registered two years ago while capital expenditures expanded about 8% over the same time period.
In 2015, UPS reported cash from operations of ~$7.4 billion and capital expenditures of nearly $2.4 billion, resulting in free cash flow of more than $5 billion. This represents an increase of nearly 50% from 2014.
This is the most important portion of our analysis. Below we package our valuation assumptions and ship them off in a fair value estimate for shares.
Our discounted cash flow model indicates that United Parcel Service's shares are worth between $77 and $115 each. Shares are currently trading at ~$105, in the upper half of our fair value range. This indicates that we feel there is more downside risk than upside potential associated with shares at the moment.
The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $96 per share represents a price-to-earnings (P/E) ratio of about 29.3 times last year's earnings and an implied EV/EBITDA multiple of about 7.8 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of 3.5% during the next five years, a pace that is higher than the firm's three-year historical compound annual growth rate of 3.1%. Our model reflects a five-year projected average operating margin of 14.8%, which is above United Parcel Service's trailing three-year average.
Beyond year five, we assume free cash flow will grow at an annual rate of 2.4% for the next 15 years and 3% in perpetuity. For United Parcel Service, we use a 10% weighted average cost of capital to discount future free cash flows.
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $96 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for United Parcel Service. We think the firm is attractive below $77 per share (the green line), but quite expensive above $115 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate United Parcel Service's fair value at this point in time to be about $96 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of United Parcel Service's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $120 per share in Year 3 represents our existing fair value per share of $96 increased at an annual rate of the firm's cost of equity, less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Wrapping Things Up
We think there is plenty to like about United Parcel Service. Its worldwide integrated network, respected brand, and consistent free cash flow generation are complemented nicely by its superior scale and efficiencies. An industry-leading operating margin is yet another attribute that sets the company apart from competitors. 2015 was a strong example of the strength of UPS's operating prowess, as it reported record profitability in the year. We're also fans of the firm's dividend, which appears poised for continued growth with a Dividend Cushion ratio of 1.6. Despite the fundamental business strengths of United Parcel Service, we think there are currently better investment opportunities elsewhere in the market. Even though we find its relative valuation and technical indicators to be attractive, we're waiting patiently for a better entry point as our DCF process implies. The company currently registers a 7 on the Valuentum Buying Index, however.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.