UPS: What Brown Can't Do For You

Summary

• Amazon's potential delivery service is not a significant threat to UPS.
• The real problem they face is a slowdown in the economy.
• The faltering economy along with lower oil prices and a stronger dollar are tanking UPS' stock price.

When it comes to the United Parcel Service (NYSE:UPS), investors love talking about the threat of Amazon (AMZN). There's constant chatter that Amazon is creating a delivery network to crush UPS. And that's why you should sell.

Yes, it's true. You should sell UPS. But not because of Amazon. Amazon may be a long-term threat, but investors are blowing it out of proportion. The real reason you should sell is because of massive macroeconomic headwinds. These macro drivers trump any problems Amazon may cause.

UPS is in the business of making deliveries. They're the busiest and most profitable when the economy is booming. But that's not what's currently happening in the US. Our economy is slowing.

The faltering economy along with lower oil prices and a stronger dollar are killing UPS.

But before we get into that, let's first clear up the confusion about Amazon.

Amazon Is Not The Threat Here

As the story goes, the relationship between UPS and Amazon has been on the rocks lately. Costs became too much and forced UPS to raise their prices. Amazon was not pleased. You don't raise prices on King Bezos. You only lower them. Bezos was famously quoted as saying:

Your margin is my opportunity.

With this kind of attitude, higher prices won't work. Especially when Bezos' entire business centers around undercutting everyone.

Rumors have now surfaced that Amazon is in talks with Boeing to lease jets for an air-cargo business. There are also reports that they purchased a large amount of trailers for their own trucking business. Add this to their drone plans and Uber)-style metro delivery system, and you can see a strategy forming. This is what scares investors. They worry that Amazon will grow to become self-sufficient for deliveries. They won't need UPS anymore. Investors not only think that the resulting lack of e-commerce demand will kill UPS' profits, but also that Amazon could also start taking over other delivery segments too. But as we've said, this sentiment is blown out of proportion.

First, UPS does not make much money from Amazon. Losing them would not be a large problem. It is true that Amazon is UPS' biggest customer and provides them over $1 billion in revenue. But that's only a tiny amount of their total expected revenues of $60 billion in 2016. Amazon is a large customer, but UPS is sufficiently diversified.

The margins on delivering Amazon's packages are also razor thin. The company makes almost nothing on those deliveries. This is largely due to the huge discount Amazon negotiates. King Bezos usually gets what he wants. In 2005, the year Amazon launched their Prime 2-day shipping service, UPS gave them delivery discounts of up to 70% percent. Discounts like that don't help the bottom line.

Accommodating Amazon has recently become even harder due to a rise in delivery costs. These higher per-package costs place significant pressure on margins. And when you combine them with the Amazon discount, the economics start to look terrible. So while the general increase in e-commerce would seem to be good for UPS, it's actually more of a burden. More e-commerce leads to more packages delivered to sprawling residential areas. And these are the types of deliveries UPS barely breaks even on.

So no, losing Amazon's business would not be the end of the world.

And as far as Amazon building a transportation network that'll overtake every delivery segment? To that we say investors need to slow down. We agree it's usually not wise to bet against Amazon. It's a capable company that's able to produce results in many different sectors. But even so, we shouldn't assume that they will dominate the delivery business. UPS has been making deliveries for 108 years. In that time, they've become pretty good at what they do. Amazon may be able to enter the market, but dominating it is a different story. There are many logistical and cost issues that UPS has been solving for over a century. It will take Amazon a good amount of time to cross those hurdles. There's no need to worry about their small scale operations at this point.

As we've explained, the growth in e-commerce deliveries is not profitable for UPS. But if that's true, then where does UPS make its money? The answer is bulk shipping. UPS makes the most money when they deliver a large volume of items to a single place. The main customers for this type of shipping are businesses. For an example, just think of bulk deliveries to corporate headquarters or business parks. Business-to-business (B2B) deliveries are the key to profits for UPS.

These types of deliveries increase when the economy is buzzing. When businesses are doing well, they're making more deals. They send more product back and forth to each other. And this is where UPS comes in and makes their money -- in delivering that product. A strong economy equals a strong UPS.

So how is the economy doing? Well, not too good….

A Bad Economy Is Tanking UPS

Based on a variety of indicators, it's clear the US economy is hurting. This is a big problem for UPS when almost 75% of their revenue comes straight from the US.

The graph below depicts US Industrial Production growth. It measures the output of a variety of industrial businesses such as manufacturers. As you can see, industrial production decreased 1.8% in December year-over-year. This follows the 1.2% drop in November, which was the first decrease since December 2009. The trend has been down for the entirety of 2015 and will continue to do the same in 2016. Lesser production means fewer deliveries. This does not bode well for UPS.

Another way to look at the health of the economy is through the ISM Index. This index (shown below) has been dropping since the end of 2014 and is now at 48.2. Any reading below 50 signifies a contraction in the manufacturing economy.

As we explained in our "death of the bull market" article, contracting production has a history of preceding recessions. The ISM and Industrial Production numbers above are not reassuring in this regard. We're also in the middle of a expansion cycle that's longer than 29 of the 33 expansions since 1854. To say we're due for a contraction at this point would be an understatement….

Another great signal for recessions is viewing the combination of order backlogs and inventory levels. Stanford PhD John Hussman explained this concept in this article. He's recently seen companies' order backlogs dry up while their inventories have grown. Recessions usually occur when inventory levels become too high, forcing companies to scale back their production. The resultant decrease in private investment has a large negative effect on GDP, helping to cause a recession.

A dull economy leads to less business activity and fewer deliveries. If UPS gets less business, their profits will decrease. We can already see this decline happening with the Cass Freight Index.

The Cass Freight Index is useful to measure the health of transport companies. The index measures monthly freight activity. Freight activity includes goods transported by truck, train, ship, or plane. You can view the 2015 results below.

2015 was a disappointment. Monthly freight activity dropped significantly from 2014. Also, much of the second half of the year's activity was the lowest in 4 years. The deteriorating economy is having a large effect on transports.

For a more anecdotal example of how the economy is doing, just look at the office furniture industry. When the economy is doing well, business booms and companies expand. To expand and hire workers, these companies need more office equipment. Office furniture companies perform well in this environment. But when the economy is struggling and companies stop expanding, office equipment companies suffer.

Steelcase (SCS) is a company that makes many different types of office furniture. Their latest earnings report was a disaster. Their stock dropped over 20% as a result. Steelcase drastically lowered their sales forecast and stressed many difficulties going into 2016. As CEO Jim Keane explained:

The thing that was most pronounced was … a decline in orders from large customers and a decline in large projects. At the same time, order growth in the US furniture industry has slowed, as has overall US business capital spending. Our orders and pipeline at the end of the quarter showed fewer large projects than last year.

The Business and Institutional Furniture Manufacturers Association, or BIFMA, is the premier club for many different office equipment manufactures. According to them, office furniture growth has plummeted. It dropped from 10% in the beginning of the year to 3% at the end.

The office furniture industry is a good example of the type of B2B transactions that transports like UPS depend on. If they run into trouble, the effects carry over to UPS.

The transport sector in general has been in a steep decline. Check out the Transport ETF (IYT) below. All the transports, including UPS, have been struggling with the slowdown in the economy.

Not only do you have a significant downtrend since the end of 2014, but now the transports are falling off a cliff. They violated a major, multi-year support line and are plunging lower.

As Steve Cohen said in Market Wizards,

....40 percent of a stock's price movement [is] due to the market, 30 percent to the sector, and only 30 percent to the stock itself…

Much of the weakness in UPS comes from weakness in the general transports sector.

The bad economy is tanking everything. And it will only get worse from here. A look at UPS' earnings shows that they're already feeling the effects.

Revenue has not grown for the past 2 years and margins have stayed around 16% for the past 5 years. At best, UPS is stalling.

Their latest third quarter revenues came in at $14.2 billion, which was a 0.4% decrease from a year ago.

UPS reported slower growth in its US Domestic Package segment that accounts for over 60% of its revenue. Per package revenue decreased by 2.5% and ground product delivery struggled because of lower industrial production and fewer B2B shipments. As we've explained, this is a direct result of less business activity in a struggling economy.

The Supply Chain & Freight segment makes up over 15% of revenue. This segment includes logistics services provided to other companies and also larger trucking activities. The logistics side reported a drop in revenue. Less business activity meant fewer companies needing help to route their trucks. There was also a 8.6% drop in freight revenue due to a reduction in tonnage. The reason cited was soft market demand, meaning fewer customers needing products shipped. Of course that's again due to a slower economy.

As the economy continues to weaken, UPS will run into more trouble.

Lower Oil Prices Don't Help Either

On top of a struggling economy, UPS also has to deal with lower oil prices affecting their business. Most people would think that lower prices at the pump would help a delivery company like UPS. Cheaper gas should lead to lower costs and higher profits right?

Not necessarily.

Many transports actually benefit from higher fuel prices because of fuel surcharges. Fuel surcharges are costs passed on to customers based on fuel prices. Although these surcharges are only supposed to cover the gas bill, they usually cover a lot more too. And this is why transport companies love them. You see this phenomenon a lot in the long haul trucking industry, but it also happens with delivery companies like UPS.

Just take a look at third quarter earnings again. A decrease in fuel surcharges caused much of the disappointing results. Operating profits in the US Domestic Package segment dropped by 1.6% due to the lower charges. The International Package segment also suffered for the same reason. Package yield declined by 3.5%. Supply Chain & Freight were affected too.

Businesses have a difficult time adjusting to rapidly changing fuel prices. And the type of volatility that hurts them is exactly what we're experiencing now. As we've discussed in our oil article, the volatile price decline will not end anytime soon. UPS will continue to suffer.

Dollar Strength Is A Drag Too

A strong dollar has had an impact on most multinational companies. UPS is no exception. The revenue these companies make overseas are denominated in foreign currencies. Companies have to convert this revenue back into dollars. As the dollar grows stronger, the conversion rate becomes a big hurdle, and overseas revenues becomes worth less. This in turn affects the bottom line.

The International Package division accounts for over 20% of UPS' total revenue. And according to the latest earnings report, it has been struggling. Revenue in the segment dropped 7% from a year earlier in most part due dollar appreciation.

Unfortunately for UPS, the dollar will only grow stronger. The Fed is expected to keep raising rates throughout 2016, helping to strengthen it. And as we've explained before, the rest of the world will also continue to devalue their currencies. This sets up a lot of runway for further dollar appreciation.

This will continue to hurt UPS' profits.

Ship Your Shares Away

The way the economy is trending is not good for UPS. Its stock price will likely take a dive. This is especially true because of how overvalued it is compared to its competitors.

Take FedEx (FDX) for example. FedEx has been fast on the heels of UPS' business for years. Due to recent upgrades, FedEx can now offer faster deliveries on 30% of its routes. At the same time, UPS only has an advantage over FedEx on 3% of its routes. It's this type of hustle from FedEx that has allowed it to continuously gain market share for the past 16 years straight.

FedEx is catching up overseas too. With their recent acquisition of TNT, they now own 22% of the European express delivery market. UPS only owns a little more at 25% of the market.

FedEx's revenue is almost as large as UPS' revenue. It's also posting faster earnings growth. But even so, FedEx's market cap is less than half of UPS'.

UPS also trades near 16x forward earnings while FedEx only trades near 12x. It's clearly overvalued. It's true that FedEx suffers from the same macro headwinds, but due to its overvaluation, UPS' stock price has a lot more room to fall.

UPS recently broke a huge support line near $93.00. This is a multi-year support level going all the way back to October 2013. At Foundation Investing, we alerted our premium members to our short position on 1/7/2016. UPS should continue lower, and we look forward to disappointing earnings on February 2nd that will likely cause further pain.

Disclosure: I am/we are short UPS. 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.