UPS Vulnerable to Surging Fuel Prices

Earlier this week we wrote a recommendation for a put spread on Federal Express (FDX), aiming to profit from the downside in the overnight transport firm's stock that we saw on the horizon due to higher fuel costs. This trade is starting to work well; it's been an exciting few days as oil prices have continued to spike higher and we're now seeing some of the people-passenger (as opposed to cargo-passenger) firms cutting significant capacity due to these fuel prices. American Airlines (AMR) announced yesterday a 12% capacity reduction to cut costs, and has made it known that possible further cuts are coming.

We're restating our argument on FDX's potential downside due to these higher fuel costs - and we're also going to recommend today a put spread on another transport company, United Parcel (UPS). They're big, they're brown, but they're not running in the Belmont (as far as we know) and in our opinion they are also very, very vulnerable to surging fuel prices.

Technical Analysis

The above chart shows UPS stock for the last six months. The stock has been grinding sideways, and has come off its highs. Given last week's warning from Federal Express (FDX) on earnings, even UPS's technical indicators are starting to deteriorate. The Relative Strenght [RSI] and Moving Average Convergence / Divergence [MACD] stochastic lines are negative right now, and look like they could weaken further. We think the timing is right for a put spread on this name.

Fundamental Data

• Current Price: $69.90
• Shares Outstanding: 1.02 billion
• Market Cap: $71.4 billion
• Forward Price / Earnings (avg. Est): 15.1x
• PEG Ratio (5 Year Expected): 1.5x
• Price / Book: 6.2x

UPS hasn't made a public pronouncement yet about lower quarterly profit expectations (as opposed to FedEx, which did make an announcement like that on May 12th) and the average quarterly earnings estimate of analysts that follow the company is presently in the range of $0.96 to $1.05 per share this quarter. On an annual basis, UPS is expected to earn around $4.07 per share this year (2008 average estimate of 18 analysts) although this number has been reduced lately from a target of $4.44 per share ninety days ago. Next year's estimates (2009's) have also been cut from a level of nearly $5.00 per share to a standing $4.64 average expectation now. We think there's more downside to these estimates.

Y-O-Y growth in top line sales estimates appears to be around 6% to 7% on UPS current revenue run rate of approximately $52 billion in sales per year. Like FDX, we think that while showing an increase over 2008's fiscal year results, UPS will struggle to maintain its profits or even show profit growth in an environment of such sharply rising fuel costs. We are convinced that margins are going to be compressed in this industry, even if UPS or its competitors try to pass on the costs to consumers with fuel surcharges.

UPS's balance sheet has some strength to it, although it is more leveraged than its FDX competitors. The firm currenly holds $1.0 billion in cash offset by nearly $10 billion in debt. UPS also pays an annual dividend of $1.80 per share, or a yield of 2.5%. This is a relatively high payout rate for the company, actually, and this dividend may be in jeopardy.

Investment Recommendation

We recommend that investors create a put spread in the October 2008 expiration of UPS options. We would buy the October $70 put for $4.20, and sell the October $60 put for $1.30, for a net cost of $2.90. The maximum profitability of this trade is $10 per contract if UPS is trading below $60 at October's expiration. We would look to exit this trade if the spread could be unwound for anything greater than $8.50 between now and expiration. This "trigger" can be entered with your broker.

Investors will have just about five months (until expiration in October 2008) to realize these levels if purchase of the stock and sale of the call occurs on Wednesday, May 21, 2008.

Please note: Options trades all involve a high degree of risk and the potential to lose some or all of your investment. These recommendations are general in nature, and you should consult your own financial professional who is familiar with your situation as to the appropriateness of these trade ideas.

Disclosure: Analyst has no position in UPS stock or UPS options.

Comments

[John Pseudonym]

I own a business and we ship a lot of packages. With the recent Postal Service rate hike, UPS Ground is now cheaper the the USPS for nearly every package over 3 pounds.

We've shifted to UPS for those 3 pound+ shipments.

Any business with their eye on shipping costs will do the same. As long as UPS stay competitive with the Post Office, they're business will grow.

What about FedEx Ground? Forget it; they're not a serious player.

[Swamp Fox]

"The maximum profitability of this trade is $10 per contract . . . " Is it? Or, is it $7.10 after taking the net premium debit into account.

[Zenvestor]

I've looked at the last year's quarterly and annual reports to confirm UPS's quoted P/E ratio of about 160! Does anyone have an explanation for this high P/E ratio?