Over the past year, we have had our eye on starting a small position in United Parcel Service (NYSE:UPS) shares and missed our chance. The company's shares dipped below $90 earlier in 2016 and we should have initiated a position for a long-term hold. We have not given up, but have changed our expectations as far as an entry price for our potential position price goes. We are now waiting for the company's shares to dip to the $95 to $100 range before we initiate our position. We believe the company's shares are likely to fall within our desired price range during the next overall strong market sell off. The current problem for many investors wishing to purchase shares of a company such as UPS at a more value-oriented price is the global low interest rate environment. With interest rates at historical lows and with no signaled end to such low interest rate environment, investors are flocking to dividend paying stocks. In this scenario, dividend growth stocks such as UPS are trading at premium prices. In other words, shares of companies such as UPS are "expensive." In a more normal interest rate environment, investors would be able to purchase UPS shares in the $85 to $95 price range and receive a dividend yield ranging from 3.25 percent to 3.75 percent. We believe, as noted above, that investors will likely have a chance to pick up UPS shares at the upper end of this range in the next year during the next strong overall market sell off.
In UPS' most recent quarter, the company noted that a weak global economy is adversely affecting the company's businesses even though it is profiting from a substantial increase in online commerce business and beneficial trends in automation. The company also noted during its most recent earnings announcement that it lowered its outlook for global economic growth even though it also noted that U.S. consumer spending remains healthy. The company noted further that "Delayed inventory draw-downs and soft export demand" would likely adversely affect its results though the end of 2016. Although the company's results can be adversely affected by global economic trends, it has exhibited strong performance in recent quarters in overseas markets. In the U.S., increasing online purchases has caused rising demand for the company's shipping services. To date, UPS has been able to partially offset adverse effects from weak global economic growth and decreasing U.S. inventories through package deliveries to consumers, which have been growing at several times the rate of deliveries to businesses. The company has also become more efficient through increased automation at large warehouses and installing software in its delivery vehicles to determine the best delivery routes in real time. Be aware, however, as we wrote earlier in 2016, that UPS' shares will continue to be pressured due to potential concerns (whether significantly real or minor) regarding competition from Amazon (NASDAQ:AMZN) in the consumer package delivery space.
UPS acknowledges that its investments and strategies have allowed it to offset some of the economic shifts it has experienced in recent years. As the company has attempted to benefit from trends of increased Internet shopping, the company faces real stumbling blocks such as the fact that the company generally only delivers a single package to a consumer's home, while it typically delivers multiple packages to a business during any single delivery. As such, the company recognizes increased costs when making deliveries to individual consumers rather than businesses. With this in mind, it is important that UPS lower its costs to service individual consumers to increase margins in consumer package delivery space as more and more of the company's business becomes consumer package deliveries. We have no doubt that UPS will solve the lower profit margin problem of package deliveries to consumers as the company is one of the most ingenious and technologically savvy global companies today. After all, UPS is the company that had its engineers determine that left-hand turns by its delivery vehicles were a major drag on efficiency that resulted in long waits in left-hand turn lanes that wasted time and fuel, and also led to a disproportionate number of accidents. To solve "the left hand turn" problem, the company mapped out routes that involved "a series of right-hand loops" that improved profits and safety while also being more environmentally friendly of saving gas and reduced emissions. Any company that can focus and solve even the smallest of problems such as the inefficiency of "left-hand turns" is a company we want to own shares in.
While UPS faces near-term obstacles, we believe this innovative world-class leader in package delivery and logistics will thrive and continue to reward investors with annual dividend increases and opportunistic share buybacks. Further, despite the company facing near-term pressures, it is continuously making acquisitions and innovating to sustain revenue and earnings growth. For example, in recent years the company has sought to change its image and focus more of its efforts on more profitable markets, where it can offer additional services; such as in the healthcare market, where a shipment must arrive expeditiously and at an appropriate temperature. To accomplish its goals of expanding its services, the company has built warehouse complexes with refrigeration. It has also become more active with respect to e-commerce package returns, an expensive logistical problem for e-retailers. UPS also assists brick-and-mortar retailers with tasks such as shipping packages from retail stores. We believe that over the long term, the company's package delivery expertise will serve it well in its established and new markets, and UPS as well as shareholders will be rewarded by the company's efforts. With the company's shares sitting closer to its 52-week high, however, potential investors should sit on the sidelines and wait to purchase the company's shares during the next overall market sell off.
Second quarter 2016 earnings
In late July 2016, UPS announced earnings of $1.43 per share, a 6 percent increase from the year-ago quarter. The company's revenues increased 3.8 percent from the year-ago quarter to $14.63 billion as the company recorded growth across all of its divisions. Adverse currency effects and lower fuel surcharges did pressure revenues during the quarter. UPS' U.S. domestic package division revenues increased 2.4 percent to $9 billion while operating profits for the division increased 2.7 percent to $1.2 billion. Operating margins for the division were 13.7 percent as results for such division improved due to a decrease in cost per unit and productivity improvements.
UPS' international package division revenues increased 1.1 percent to $3.1 billion despite adverse currency effects depressing revenue results. Revenues for the division were also adversely affected due to decrease in fuel surcharges. Operating profits for the division increased by more than 11 percent to $613 million due to disciplined pricing, network efficiency improvements and volume expansion. The company's supply chain and freight division revenues increased more than 13 percent to $2.5 billion as revenues results were boosted by the company's acquisition of Coyote Logistics. Operating profits for the division decreased 7.2 percent to $192 million.
UPS retained its 2016 adjusted earnings per share estimates to be in the range of $5.70 to $5.90, which represents a 5 percent to 9 percent growth rate over 2015.
We are hoping to have the opportunity to purchase UPS shares below $100 and recommend new investors wait as well. Remember that earlier in 2016, the company's shares even traded below $90. So, our purchase price target is not out of the question if the overall market sentiment turns sufficiently negative. The company does face several negative issues that are likely to pressure UPS shares in the near term including: 1) potential competition from AMZN in the e-commerce delivery space; 2) ongoing labor issues/costs regarding the company's pilots and other employees; and 3) employee pension issues. UPS, however, is likely to negotiate past each of these issues. In regard to AMZN package-delivery activities, we believe that AMZN competing with UPS is not a simple task given the logistics complexities and capital intensiveness of the package delivery industry. Further, any loss of AMZN's package deliveries would have a minimal effect given that AMZN's low-margin business to UPS is less than $1 billion dollars out of almost $60 billion dollars UPS expects in 2016 revenue. As for the labor and pension issues, UPS will resolve these issues near term in the most cost effective manner possible.
Near-term adversities notwithstanding, over the long term UPS will likely experience increased package volumes. Investors typically recognize increased package volumes as a positive for UPS if it minimize costs and preserve margins. Although UPS has been battling rising per-package costs in recent years as package volumes increased, the company has the expertise to control costs as it is engaging in shipment and productivity improvements to drive growth and preserve margins. In addition, its strategic investments, technology-supported operations and enhanced global network will strengthen its market position and protect the company against adverse market dynamics. Despite the competitiveness of the markets UPS competes in, we want to own the company's shares given its clear shareholder friendly policy of dividend increases and share buybacks. For example, in the most recent quarter, UPS generated free cash flow of $3.7 billion and paid out about $1.3 billion in dividend payments bought back 13.3 million shares for $1.3 billion.
The current price-to-earnings ratio for UPS shares is about 19.65, and the shares yield about 2.85 percent. UPS's forward price-to-earnings ratio is about 18.55, based on 2016 earnings estimates of $5.82 and about 17.35 based on 2017 earnings estimates of $6.23. The price-to-earnings ratio for the company is at the upper-end of its 10-year historical price-to-earnings range in the mid-to-upper teens. We believe potential investors should wait for the UPS share price to drop to the $93.45 to 99.65 price range before establishing a full position (a forward price-to-earnings ratio in the range of about 15.00 to about 16.00, based on 2016 price-to-earnings estimates). While our purchase range for UPS shares may seem aggressive, as noted above the company's shares did trade as low as about $88 earlier in 2016. Ultimately, we believe that UPS will overcome any potential threats from AMZN and any labor or pension issues, and that a well-timed investment in UPS shares will allow an investor to be rewarded with an outsized dividend yield, substantial share buybacks and share price appreciation over the long term.
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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.