In the past, I have looked at a few companies which are operating in the logistics and distribution market, but mostly in highly specialized segments. These are companies like Owens & Minor (NYSE: OMI) or McKesson Corporation (NYSE: MCK) – two medical supply distribution companies. In the following article, we are analyzing a non-specialized distribution company which is also known to the general public and one of the biggest logistic companies in the world: United Parcel Service (NYSE: UPS).
We will describe why UPS is a great company: it is investor-friendly (increasing dividend and share buybacks), has a wide moat and can mostly present solid numbers. However, we will also address negative points like the high debt levels. Additionally, we will look at the growth perspective and finally, we will calculate the intrinsic value; for the moment, we come to the conclusion that UPS is a great company, but no investment is merited at current prices.
One of the first and elementary steps of every analysis should be the focus on understanding the business model of a company. United States Parcel service operates in many different segments of the global logistics market – including ground freight, air freight, ocean freight, distribution, transportation and insurance. The company owns a dense logistics network with about 435,000 employees, over 2,500 operating facilities, over 27,500 UPS access points and a delivery fleet consisting of 116,000 different vehicles. Although most of its revenue is still generated in the United States, UPS is also operating in other countries around the world and managed for example, in Germany, to gain a market share of already 13% (having to compete against the local top dog Deutsche Post AG (OTCPK: OTCPK:DPSTF)).
Horrible Balance Sheet And Debt Levels
We begin our financial analysis by taking a closer look at the SEC filings and start with some horrible numbers for UPS. The company has a frightening D/E ratio of 9.51 and such a high debt/equity ratio usually implies trouble, and should be reason enough not to invest in the company. But we have to look a bit closer at the numbers and see UPS’ long-term debt being $14,355 million plus an additional $4,555 million short-term debt on the balance sheet. If we compare the outstanding debt not to the shareholder’s equity, but to the company’s operating income (in order to get a feeling of how long it would take to pay back the debt), we see at least $5 billion in operating income which UPS is generating annually in the recent past. Subtracting the $4.5 billion in cash and cash equivalents, it would take about three years’ operating income to pay back the outstanding debt – and that number is acceptable.
If the debt-to-operating income ratio is acceptable, why is the D/E ratio so high? The reason for that horrible ratio is not to be found in the high debt levels, but in the low shareholder’s equity. In the fourth quarter of 2016, shareholder’s equity was only $405 million (extremely low for a company generating $65 billion in annual revenue) and could since then be increased to about $1 billion. A price to book value ratio of 60.8 is reflective of the low shareholder’s equity. The number is way above the industry average and astronomically high for a company that is dependent on physical assets like trucks and distribution centers. The declining shareholder’s equity also led to an extremely high return on equity – 210% in 2015, 239% in 2016 and 698% in 2017.
For the debt level, we can conclude that an investor should pay close attention to that number and although UPS is not the ideal investment from that perspective, it is not reason enough to abstain from an investment.
Not Just Negative Numbers
When examining the SEC filings further, we are not just finding concerning numbers, but also very positive ones like the astronomic RoE mentioned above. I think we can all agree not to pay too much attention to the RoE as it is meaningless (or at least, doesn’t reflect real profitability of UPS). However, return on invested capital was also extremely high over the last decade – in the last five years we see numbers between 21.56% and 34.10%. And when looking at the different margins, we see a company that is able to keep them constant. Gross margin is steady at about 75% over the years (in some years it came even close to 80%). The operating margin is fluctuating between 8% and 12% over the last decade and net income margin was about 7-8% in recent years. While margins were stable, revenue could be increased over the years, but only slightly – similar to long-term GDP growth, which is a typical sign for mature companies. UPS’ own target (at least for the next two years) is revenue growth of 4-6% annually. Earnings per share however grew much more than revenue in the past years and as margins stayed steady (more or less), we have to find the reason somewhere else.
Share Buyback Program And Dividend
One of the reasons for the fact, that earnings per share grew more than revenue, is the share buyback program of the company. In the past, the number of outstanding shares has been constantly decreased - in the last decade from 1,022 million in 2008 to 875 million right now.
Aside from buying back shares, UPS is also rewarding its investors with a quarterly dividend and since the IPO the dividend was increased every year (except 2002 and 2009 in which the dividend stayed the same as the year before). The annual dividend is $3.32 right now, which leads to a payout ratio of 59% and results in a dividend yield of about 2.9%. In a presentation, UPS claims that dividends are a priority. Considering the low cash reserves and low shareholder’s equity mentioned above, maybe UPS should reduce its share buyback program and focus more on repaying the debt. But once again, I am not worried as UPS usually generates about $6-7 billion in net cash provided by operations and only needs $2-3 billion for capital expenditures.
(Source: UPS Overview Presentation)
The company itself expects online retail to be the growth engine for the future. While a few decades ago, people could order some items for example via telephone and these items had already involved delivery, many products where bought in stores and taken home by the customers themselves. However, the growth of online retail will lead to more and more items that need to be delivered by companies like UPS. Although I don’t share the often cited “death of retail” story, traditional brick-and-mortar businesses are of course shifting towards e-commerce as the market share of e-commerce will grow in the years to come (currently about 10%). Not surprisingly, logistics and delivery companies will profit from such trends and therefore UPS is expecting 14% revenue CAGR for the years until 2021.
But a growing market doesn’t have to be advantageous for every single company operating in that market. Above average growth and return rates attract new competitors that also like to enter the market and profit from the expected revenue streams. A recent example was the announcement that Amazon is looking to launch its own delivery service, which sent shockwaves through the sector and sent the stocks of UPS and FedEx down. The omnipresent risk of new companies entering the market makes it extremely important for UPS to protect its business – an aspect we analyze further in the next section of this article.
UPS has several competitive advantages over its rivals (and especially over companies that might enter the market in the future). UPS claims that it has built a leading and trusted brand that stands for quality service, reliability and product innovation. According to Interbrand, UPS takes the 29th spot of the most valuable company brands in the world, and it is therefore safe to claim UPS is a valuable and trusted brand. Although there are 28 companies in the world more valuable, UPS is at least the most valuable distributor – FedEx takes the 72nd spot, DHL is 76th on the list. Usually, a recognizable brand has a positive and long-lasting effect on revenue because it serves as kind of short cut in the decision-making process of a customer. Having to decide which service I want to use, I often take the brand I already know and only seldom will start a little research on which company offers perhaps the best service or cheapest price.
Aside from the valuable brand, we have to mention the distribution network, which is at least similarly important and valuable as the brand. Like a brand, a distribution network is expensive and it takes a lot of time to build it. I have written so much about distribution networks in past articles and the arguments are quite similar for all these companies, therefore I only present two bullet points. Distribution networks are an immense competitive advantage as it takes a long time and incredible amounts of money to build them. And even with an already existing distribution network, new competitors won’t be able to match the prices of long-established companies like UPS as every additional item these companies deliver will add further revenue but almost no costs (because the dense distribution network is already in place). For further information on why a distribution network is such a valuable asset and a competitive advantage, see my article about four undervalued picks with a distribution network.
UPS is also trying to improve its logistics network and across many different aspects – it is essentially investing in the entire logistics chain. On one hand, UPS has its routing software ORION (On-Road Integration Optimization and Navigation). The completed phase I in 2016 led to 210 million fewer miles driven and more than $400 million in annual savings. For the future, UPS is expecting another $150-200 million in cost avoidance and savings with a targeted completion date in 2019. UPS is also investing in facility automation and has over 70 new package and hub projects around the world. The company is targeting between $300 and $400 million in annual savings with a targeted completion data in 2021.
(Source: UPS Overview Presentation)
Intrinsic Value Calculation
We mentioned above that UPS itself is expecting online retail to grow about 14% in the United States and globally. But to expect a similar free cash flow growth for UPS would be wrong at least for two different reasons. First of all, while online retail is helping UPS to grow its business, the business model is not just delivering items that people ordered online. And a second important point is that UPS is a bit too optimistic, as the company is also expecting US GDP to grow 4.6% annually for the next few years – a number that is, in my opinion, way too high. Plus, we have to watch out and examine very carefully if 14% growth for online retail is not too optimistic as well.
(Source: UPS Overview Presentation)
We mentioned above that UPS could increase its revenue about 3% annually for the last decade, but the EPS growth was higher due to share buyback programs. But in the end, we look at the free cash flow a company can generate in future years in order to determine its fair value. In the last year, the free cash flow was negative for the first time in over ten years. Last year, the net cash from operating activities was only $1.4 billion (while in other years it was about $6-7 billion). On one hand, the reasons for this are the $7.8 billion for pension and post-retirement benefit contributions. On the other hand, capital expenditures were $5.2 billion last year and twice as high as in the years before ($3 billion at most). In 2016, the free cash flow was about $3.5 billion, over the last few years, the average free cash flow was about $5 billion annually.
For a conservative calculation, we can use the average free cash flow of the last decade - $3,549 million. If we take that number as a basis and assume an annual growth rate of 4.5% in perpetuity (a realistic number thanks to the wide moat), the intrinsic value of UPS would be $74.76. Now we can point out that the average free cash flow of the last decade is probably a bit too conservative and we should use a higher number – about $5 billion as realistic number. If we use $5 billion as basis and assume a 4.5% growth in perpetuity, we get an intrinsic value of $105.56 for UPS. Even when taking the higher free cash flow, UPS is still a bit overvalued and we wouldn’t have included any margin of safety. We also have to point out, that UPS has only been able to increase the free cash flow slightly over the years – and especially in the last two times of recession, the free cash flow dropped significantly.
UPS is definitely a good company worth investing in, but not at current prices. Not only does the company have a wide moat but also a stable business, and these factors make it a good investment. However, UPS is not fairly valued right now and can definitely not be called a bargain. As a consequence, I would advise adding UPS to your personal watchlist and wait for better prices to buy.
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.