Why I Expect UPS To Deliver In The Upcoming Years (NYSE:UPS)

Summary

UPS will without doubt benefit from the rise of eCommerce.
The company's financials are solid, and its strategy in line with industry trends.
The recent price drop creates a buying opportunity for dividend growth investors.

United Parcel Service (NYSE:UPS) has underperformed the market since early 2014. There are multiple fears in the industry, namely the idea that Amazon (AMZN) will hurt their business. However, when you run the numbers, it seems that Amazon’s impact will be minimal given the increased business UPS should derive from increasing eCommerce sales in upcoming years. The valuation is attractive at this point, and I would recommend dividend growth investors to consider purchasing UPS.

Source: Mashable

4th quarter earnings increased by over $1.5/share compared to Q4 2016, reaching $1.27/share on revenues which were 11% stronger. Since then, the company’s stock price is exactly where it was this time last year at $106 after tumbling more than 20% since January, when the market didn’t react well to below consensus guidance for 2018. UPS increased its dividend by 9% giving the company a 3.4% dividend yield, thus introducing it into my screener.

The S.A.F.E. dividend stock screener is designed to find stocks which have attractive yields, a history of dividend increases, room to grow the dividend, and whose financial condition ensure dividend stability.

It screens on 5 criteria:

Dividend yield greater than 3%.
Payout ratio less than 70%.
Current ratio greater than 1x.
At least 5 years of consecutive dividend payments.
A positive PE Ratio.

The first two elements are the most important ratios in the screener. They ensure that I'm getting a yield which I am content with, without horrifying payout ratios. The dividend streak shows some commitment from management to return cash to investors. Positive PE means the company generated positive net income in the last year, so I know we are not looking at companies that are losing money. The current ratio is a sanity check to only include companies which can cover their short-term liabilities.

This method only gives you a handful of results at any point in time. I like this because I can focus my efforts on a handful of stocks. The obvious shortfall is that some very good dividend growers will be excluded. You can still apply the rest of the framework to any dividend paying stock, this screener gives you a starting point.

UPS fits the bill in every single respect, as the table below suggests.

Source: uuptick

The S.A.F.E. Dividend Method is a framework developed by my son Sam and myself to uncover undervalued dividend growth stocks.

Within our framework, I analyze in detail any stock which makes it into our screener. I monitor the screener weekly for new entrants as well as exits.

REVENUES AND NET INCOME

UPS's revenues have grown at a 5-year compound annual growth rate (CAGR) of 4% vs. 3% for the S&P 500; and earnings grew even faster at a 44% CAGR vs. 3.4% for the S&P 500.

Source: uuptick

UPS’s revenues have been growing every year as it has been the beneficiary of growth in eCommerce domestically and abroad. Its margins have been mostly stable between 6% and 8%.

Looking forward, there are some conflicting trends.

Starting with the good, in the US, eCommerce is expected to grow more than 50% in the upcoming 5 years. This provides UPS with a unique opportunity to position itself between the consumer and online businesses.

On the other hand, Amazon is moving into the delivery space. Amazon represents about 7% of UPS’s business.

Amazon’s share of online sales is also growing. In 2017, it gained another 4 points, creeping up to 44% of online sales.

There are a couple of questions which we must ask ourselves.

The first is to what extent will Amazon’s delivery service impact UPS?

It is most likely that Amazon’s service will focus on low margin, local deliveries, since the cost of developing a worldwide delivery network would likely not be profitable, given that an extra global player would cause margins to go down to extremely low levels.

Nonetheless, we must expect some of UPS’s business to be cut, maybe 2-3% of UPS's total sales at most. The more worrisome part, which is hard to estimate, is that Amazon will be able to use its service as leverage to drive UPS and FedEx’s (FDX) prices down. Let’s assume 1-2% less in net margins.

The total impact would be somewhere between $150M-$250M on UPS’s net income.

The second question is: of the 8% annual growth we expect to see every year in eCommerce, which carriers are going to get the lion’s share?

Amazon will likely continue to dominate. However, UPS will still have its fair share, with huge clients such as Nike (NKE), to name only one.

UPS has properly anticipated this and is investing massively to expand the network. These high levels of CAPEX have been seen in the past when it developed its fleet. This has paid off tremendously in the past generating massive shareholder value.

Proper execution will ensure UPS receives its fair share of market growth.

If you add to that the fact that the company’s tax rate will go from 35% to 23-24% in 2018, the earnings potential is extremely attractive.

HISTORICAL PAYOUT RATIO & OUTLOOK

The next thing I do is look at the company's payout ratio relative to its historical value. I also look at the evolution of the two underlying line items: net income and dividends.

Source: uuptick

The company has maintained a payout ratio between 50% and 80% throughout the latest 7 years if we exclude an exceptionally bad year in 2012, while constantly increasing dividends. This is a definitive positive. The company is expected to remain within this range for 2017. I expect the yield to remain in a similar range, with high single-digit to low double-digit dividend growth throughout the next 5 years.

HISTORICAL DIVIDEND YIELD

I then look at the company's dividend yield compared to its historical value as well as the historical 1-year trailing average.

Source: uuptick

UPS has historically yielded between 2.3% and 3.3% on a TTM basis. With a $0.91 dividend per quarter, the forward yield is about 3.4%, among the highest it has been throughout the last 7 years.

PRICE ACTION

Throughout this bull market, UPS had underperformed the S&P 500. This underperformance started in early 2014, following the Christmas 2013 delivery fiasco the company has faced. It has recently tanked again, making it flat for the last 4 years.

Source: uuptick

UPS has been beaten down on fears which have not reflected themselves in the numbers. This is the sort of situation I look for as an investor.

SAFETY OF THE DIVIDEND

Next, I need to assess the safety of the dividend.

I will look at the degree of operating leverage (DOL) for our security, and how it evolved over the last business cycle. This allows me to estimate the decline in revenues required to wipe out operating income.

Source: uuptick

In the real world, you sometimes get a negative relationship between revenues and operating income, in which case the data isn't workable. You also get a high standard deviation with so few observations

This can give you interesting insights into the nature of the business.

As you can see with UPS, operating income has had very little correlation with revenues in the past few years, proving that costs can be hard to predict, and that if it gets its forecasting wrong, especially around the holiday season, that extra costs can eat into the margins. This is an unfortunate aspect of the delivery business.

I also want to know that the company has shown dedication to increase its dividend over time. UPS has been paying a dividend since 1969 and has more than quadrupled it since going public in 1999. This is extremely positive. The fact that management reiterates how important the dividend is to them also reassures me, as it show commitment to paying and increasing the dividend over time.

Source: uuptick

As you can see, the dividend has more than doubled in the last 7 years. This year, the dividend has increased 9.6%. I believe that over the next 5-7 years, the dividend could double again.

Overall, UPS is a sound company with great growth prospects

VALUE OF THE DIVIDEND STREAM

Next up is figuring out what I want to pay for a stock which pays $3.64 in dividends per year, which I will assume grows at 6% per year.

I run a simple DDM Model three times adjusting the dividend growth rate by +/- 1%. I then divide these values by the price to see what portion of the stock price can be attributed to the dividend stream, and what premium I must pay for exposure to potential stock appreciation.

I assume a constant 10% discount rate for every equity I analyse which allows me to compare the stocks within my screener’s theoretical value to their stock price.

For UPS this gives us a value between $77 and $129 with a midpoint of $96 or between 73% and 121% of the current share price. This is extremely encouraging, since it suggests that the value of the dividend stream alone is worth about the stock price today.

Source: uuptick

RELATIVE VALUATION

I then look at Peter Lynch PE lines over the last 5 years. A Peter Lynch PE line gives you the theoretical price at a point in time if the stock traded at a certain multiple of earnings. I look at the PE line for the average 5-year PE as well as the minimum and maximum PE over the same period.

Source: uuptick

As you can see, UPS is trading below its average multi-year PE multiple.

This is also extremely attractive when you consider the likeliness that earnings will most likely grow in 2018, making the valuation extremely attractive.

CONCLUSION

UPS has all the signs of a great pick. Its price has been somewhat displaced by the “Amazon effect”; its yield is juicy, has room to grow, and the valuation is at a more attractive place than it has been for years.

Opening a position at these prices makes sense to me. I never enter a full position in one order and will welcome additional purchases at lower price points if the opportunity arises.

I will be analyzing other stocks which are in my S.A.F.E. stock screener during the next few weeks, so if you enjoyed this article please follow me and don't hesitate to ask any questions you might have.

This article was written by

Robert & Sam Kovacs

41.7K Followers

Robert & Sam Kovac are a father & son team specializing in building diversifed dividend portfolios. Robert has 40 years of experience as a software engineer at investment and retail banks, insurance companies, clearing houses, and the European Commission. Sam has passed levels 1 of both the CFA & CAIA programs and he holds a Masters of Economics from Sciences Po Paris, one of France’s most selective schools.

Together they lead the investing group The Dividend Freedom Tribe where they help investors achieve their retirement goals with analysis of the 120 best dividend stocks. Features include: a training course, three model portfolios, weekly in depth analysis, buy/watch/sell lists, access to MAD Dividends Plus for free, as well as a community of lively dividend investors available via chat. Learn more.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in UPS over 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.

These views represent the opinion of the author and not those of his company, uuptick LTD.

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