UPS: A Value Opportunity

Summary

• Evaluating qualitative aspects surrounding UPS' business that will drive cash flow growth in the future.
• Running a discounted cash flow analysis on UPS evaluating their potential 1Q21 intrinsic value per share.
• Evaluating UPS' current dividend and their potential dividend value by 1Q21.

Introduction

United Parcel Service (NYSE:UPS) has had a rough quarter with its share price tumbling nearly 25%. The price decline associated with UPS was a result of an Amazon (AMZN) announcement to launch their own package delivery service. While Amazon clearly caters to a massive customer base, I still believe UPS has a handful of qualitative aspects, as well as a relatively attractive quantitative evaluation and dividend to make them worthy of taking a second look at.

Qualitative Analysis

A key factor of whether or not a company is investment worthy is, of course, their financial stability. UPS has reduced their unfunded liability by $6,000 (in millions). This reduction is particularly attractive for investors, as that is $6,000 (in millions) worth of liabilities that won’t be taken out of earnings and/or shareholder equity. Any reduction of unfunded liabilities is something to take note of, especially those that amount to $6,000 (in millions).

While UPS has a long-term debt to total asset ratio of .45, they have been investing heavily in their airline segment and global expansion initiatives. This can clearly be seen in their increase in capital expenditures from FY16 to FY17. Their FY16 year-end capital expenditures came to $2,965 (in millions) compared to their FY17 year-end capital expenditures of $5,227 (in millions). Generally, UPS has demonstrated a consistent long-term debt to total asset ratio of .30. UPS also realized a $1,750 (in millions) cash benefit in FY17 at the 35% tax rate. I will discuss the potential of the corporate tax cuts below, however, if UPS can realize a $1,750 (in millions) cash benefit at the 35% tax rate, it will be interesting to see what they can do when paying significantly less in taxes.

UPS is forecasting a significant increase in their FY18 free cash flow in comparison to their FY17 free cash flow. UPS had $3,573 (in millions) in free cash flow at the end of FY17 and they’re forecasting $4,500-$5,000 (in millions) in free cash flow by the end of FY18. Clearly free cash flow is an imperative metric to evaluate from an investor stand point. If UPS achieves their free cash flow target, it would represent a 26% and/or 40% increase, respectively, in a matter of only one year. This forecast can primarily be attributed to the anticipated tax cuts, and is one of the two primary catalysts behind this article next to UPS’ growth initiatives in correspondence to growing market demand.

(Source-Raymond James 03/06/18 Presentation Page 11.)

UPS also has incredible potential in terms of global growth. The 2017 global air freight industry saw its greatest growth since 2010. The air freight industry saw a 9% demand growth last year. This is great qualitative aspect to UPS’ business, especially when you look at UPS’ initiative to grow their air freight segment and the success they’ve already had doing so. UPS has shown a 10-year CAGR of 7.1% in their daily export volume via aircraft. In comparison, FedEx (FDX) demonstrated a CAGR of 4.9% during the same period.

(Source-Raymond James 03/06/18 Presentation Page 6.)

The combination of the global air freight demand growth in correlation to UPS’ strong initiative to grow their air freight and global business is very attractive in my opinion. UPS has already invested heavily in their air segment and global growth, and I believe they are poised to reap the benefits of their initiative and market demand growth.

UPS will also see a generous amount of freed up cash flow from the GOP corporate tax cuts. While the market has already seen an uptick in anticipation of these tax breaks, UPS’ recent price fall, as well as their $1,750 (in millions) cash benefit at the 35% tax rate makes me believe they still have much to benefit when the new tax plan hits their bottom line. According to csimarket, UPS has an average effective tax rate of 31%-34%. With corporate taxes anticipated to drop to roughly 20%, UPS’ earnings and valuation will look handsome, especially when looking at the average P/E ratio that UPS has traded at over the last five years.

Quantitative Analysis

This quantitative evaluation will be run off a discounted cash flow analysis. I like to use the 10-year Treasury note as my discount rate. I am aware many investors believe that discount rate isn’t sufficient, but I don’t believe higher discount rates can truly account for risk associated with any given investment.

With that being said, the current 10-year Treasury note yield is 2.741%. I will use a 2.9% discount rate for my analysis and will be evaluating UPS’ 1Q21 intrinsic value. Currently, UPS has a trailing twelve month revenue of $65,872 (in millions). UPS has demonstrated 9.6% revenue growth over the last year and a revenue CAGR of 6.1% over the last three years. Due to UPS’ air segment growth along with corporate tax cuts, I believe UPS will be able to grow their revenue at a CAGR of 10% over the next three years. With our discount rate of 2.9%, our effective growth rate will be 7.1%. This would give us a trailing 1Q21 revenue of $80,922. UPS has an average net margin over the last three years of 7.13%. I believe this net margin is easily achievable and potentially modest, thus, I will use it for my forecast. A net margin of 7.13% would give us a trailing 1Q21 net income of $5,770 (in millions) and a trailing 1Q21 EPS of $6.69.

Keep in mind Nasdaq is forecasting $7+ EPS for FY18-FY20, so my forecast is more than reasonable if not modest. UPS has traded at an average P/E ratio of approximately 25 over the last five years. I believe 25 is an excessive earnings multiplier, but UPS has demonstrated its ability to consistently trade at those levels for five years straight. Even an earnings multiplier of 20 is high, but I will use that in this forecast, as I believe it isn’t over the top considering UPS has traded at an average of 25 for the last five years straight. With our EPS of $6.69, this would give us a trailing 1Q21 earning power intrinsic value of $133.80 per share. UPS’ book and tangible asset value is not significant enough for me to make adjustments to my intrinsic value figure, thus, I believe UPS’ trailing 1Q21 intrinsic value per share is around $133.80. With the current market price of UPS at $104.66 per share, that figure would represent a 27.84% increase in three years. This analysis represents an attractive opportunity in itself and is not inclusive of UPS’ attractive dividend.

Current Price	$104.66
1Q21 Intrinsic Value	$133.80

Click to enlarge

(Dalton H. 2018. MS Excel.)

Dividend Evaluation

UPS has demonstrated nothing short of excellence in terms of their ability to consistently provide a generous and growing dividend to its shareholders. UPS’ current dividend is $3.64. With their current market price of $104.66 per share, UPS’ dividend yield is currently 3.47%. UPS’ trailing twelve month EPS is $5.62, representing a payout ratio of 64.76%. Everything about UPS’ dividend is attractive, from the fact that it’s nearly $4 per share in annual payments, to the yield and payout ratio. If UPS were to achieve my forecast of trailing 1Q21 EPS of $6.69 per share and continued paying out 64.76% of their earnings in dividends, UPS would be paying $4.33 per share in annual dividends. If UPS were purchased at current market prices of $104.66 per share, an annual dividend of $4.33 per share would represent a 3-year forward dividend yield of 4.13%. UPS’ dividend is very attractive and something to take note of.

(Source.)

Current Dividend	$3.64
1Q21 Forecasted Dividend	$4.33

Click to enlarge

(Dalton H. 2018. MS Excel.)

Conclusion

Overall, UPS appears to be trading at attractive levels. Between their qualitative aspects, ranging from strong financial stability, their initiatives to grow their air freight and global business, the impressive global air freight demand growth, and generous corporate tax cuts, UPS is poised to start generating more cash flow and shareholder equity than ever before. With the discounted cash flow analysis above, UPS is also very attractive on a quantitative level. Between a potential 27.84% increase in share price and a 3-year forward dividend yield of 4.33%, I believe UPS is a worthy investment opportunity to keep an eye on. Based on my analysis, I believe UPS will achieve a 1Q21 price target around $133 per share with a forward dividend yield above 4% if purchased at current market prices.

Analyst’s 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.