We See An Opportunity In United Parcel Service

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About: United Parcel Service, Inc. (UPS), Includes: AMZN
by: Quad 7 Capital
Summary

UPS has seen shares fall over 20%, and we believe short-term traders and longer-term value investors should be looking at UPS.

Chart suggests support is being approached, but we like the fundamentals.

We do need to watch for the impact of Amazon Air longer term; but in the near term, any negative hit is priced into the stock.

Across the board segment improvement in revenues with widening profit in the supply chain.

United Parcel Service (UPS) stock has been under a lot of pressure in recent weeks. Transportation names have felt the pinch of late and fears of competition are growing. However, we believe that there is opportunity to scoop up shares of UPS on this most recent selloff. The company has had a strong start to the busy holiday shipping season, a critical time for this important quarter. When the name recently reported its earnings, it raised its full-year cash flow guidance. The Street has had a mixed reaction to company and sector news over the last two months or so, but we believe both short-term traders and longer-term investors have an opportunity to enter UPS here at $106 per share for upside. The chart looks strong, but more importantly, the fundamentals continue to be solid. Performance is stellar, and we discuss our outlook for future performance and how to play the stock.

Price action

The recent price action in the last year has the name approaching what our chartist sees as a support area around $104-105:

Source: BAD BEAT Investing

Based on what we are seeing here, the name is in an attractive target area under the $110 level, and we think support is a point or two below current levels. Short-term traders who enter here may wish to consider a stop-loss order on a downside level of $99.50, whereas $113.50 and above is a short-term upside target. Longer term we believe the fundamentals continue to support upside, despite competitive risks.

Fundamental discussion

While we often trade, UPS as a stock has rewarded long-term investors over the years with slow but steady share price growth and a growing dividend. That is a winning combination. We continue to think that many longer-term investors are ignoring this name given the relatively low volume on shares traded compared to comparable market cap companies. We think after this large pullback that this stock offers a capital appreciation opportunity. Why? Well, with more and more shopping being done online every year and a record amount of online shopping on Black Friday this year, the demand for shipping services is clear.

Other fundamentals to consider are that moderating oil and fuel prices are a bit of a tailwind as we enter 2019 from a spending standpoint. In addition, UPS has effectively priced its services variably to offset much of the impact of higher oil prices in recent years. This has been effective in helping maintain margins and boost the bottom line. We think the stock is buy, and any noise around competition fears are overblown in the near term.

Revenues ramp up

There is no question that UPS continues to be strong and generally exceeds expectations. Revenue has grown both domestically and internationally each year. We project this trend will continue on the back of volume and pricing power. Although we expected revenues would rise year-over-year based on the trajectory of the company's performance, we had no prior projections for the most recent quarter on this or other key metrics. However, we want to discuss the performance and what it means going forward. The company reported another year of growth which was essentially in line with the consensus analyst revenue expectation:

Source: SEC filings, graphics by BAD BEAT Investing

This continues a clear trend of Q3 revenue growth. In the most recent quarter, revenue came in at $17.44 billion. Revenue was up 7.9% year-over-year on an absolute basis from the $15.75 billion last year. It was a small (and rare) miss of $50 million versus total consensus, though in line with general projections for high single-digit growth. What is key here is that all segments contributed to the top-line growth once again. Investors should be aware that there really isn't a 'weak' segment.

What do we mean? Well, sales were once again higher across each and every segment in Q3. Taking into account the growth and trajectory of the company's performance, we anticipate this will continue. There are key strengths to be aware of which lead us to project continued segment growth across the board.

Higher sales stem from volume and pricing

Like any other company offering a service, to increase revenue, the company can adjust its pricing over and over. However, this is risky since UPS faces competition from other shippers. If pricing gets too out of line, then many large customers will opt for another shipper. This is an ongoing risk of owning the stock and a continued challenge for UPS management.

Increased shipping volume is a metric we look for each and every quarter with this company. While shipping rates and pricing are adjusted all the time and the company can control exactly what it is charging, it can only do so much. Too high a price will hurt volume. And volume is really the name of the game here. The company (and its competitors) engage in an ongoing, multi-factor balancing act to maximize volumes with attractive pricing that keeps margins strong. Generally, the company has outperformed. This quarter was a touch slower than consensus, but there is no doubt that it was another quarter of industry-leading margins and strong free cash flow.

As far as shipments are concerned, competitive pricing can increase volumes. On a larger scale, however, volumes depend on the economy and the company's ability to compete with other shippers. As we know, online shopping continues to grow each and every year. This is a tailwind but also why Amazon Air is scaring some investors as Amazon (AMZN) is a major customer. Further, the consumer is stronger than ever and has been helped domestically by the large U.S. tax cuts. Still, both volume and pricing drive revenue higher (or lower), but volumes are what matter most. We see strength globally.

Domestically, where Amazon Air is the current scare, we see continued strength. U.S. domestic shipments drove revenues up 8.1% to $10.4 billion. There was another increase in daily volumes, rising 3.3% in aggregate, with revenue per piece up across all products. However, expenses were an issue thanks to planned increases and costs for ongoing network expansion projects, which weighed. With these added costs, operating profit domestically narrowed, which contributed to the reaction. Operating profit narrowed to $989 million from $1.01 billion last year.

Internationally, shipments were strong as well, and on an absolute basis, revenues were up across all regions. They rose 5% overall on a currency neutral basis to $3.48 billion from $3.37 billion. This is solid growth. This rise was driven by a 4.2% spike in daily export shipments in Europe. Yield also jumped 5.1%. Despite solid cost controls, currency, and fuel, as well as some trade rules, led to operating profit for the first quarter in three years. It narrowed from $606 million to $576 million. This as a disappointment overall, but one weaker than normal quarter does not make a trend.

The company's supply chain and freighting segment showed real strength. In fact, revenue was positive, as it delivered another quarter of double-digit revenue growth. Revenue was up 12% to $3.53 billion from $3.14 billion last year. Revenue was up in large part due to effective strategies to increase business from small- and medium-sized businesses. Operating profit also impressed as it expanded 33% here, driven in part by efficiencies that led to widening margins.

Earnings growth solid

As revenues increased and shares were repurchased, the company saw widening earnings per share. Net income was up overall thanks to a better tax rate, despite slightly narrowing operating profit. We had no expectations for earnings but did see them as increasing from last year. It was another solid quarter of earnings per share growth:

Source: SEC filings, graphics by BAD BEAT Investing

Earnings came in at $1.82, a 26% increase over the same period last year. This was just below expectations, missing consensus by $0.06, mostly due to lower than expected revenues. Free cash flow was a star. This all-important metric rose to $4.9 billion this year. Longer term, transformation initiatives which are boosting working capital are paying off. What is more, the company remains shareholder-friendly.

Shareholder-friendly

There is no question that UPS continues to be incredibly shareholder-friendly. So far, in 2018, the company raised its dividend another 10% and currently pays $0.91 quarterly. In addition, it has paid dividends of over $1.6 billion this year. Further, it has repurchased over $750 million worth of shares this year, or approximately 6.6 million shares. With consistent dividend hikes and ongoing repurchases, shareholders are being rewarded with more value.

Amazon air impact

It is too soon to tell what the actual impact of Amazon helping self-ship packages will bring, but Morgan Stanley (MS) analysts see risk. We must acknowledge this. Because of this, the firm is bearish on UPS. This is in contrast to our call. Longer term (and we mean years from now), as Amazon Air is built out, there will be a hit to revenues. As it stands now, there could be a several hundred basis point impact on major shippers' domestic volume near term. That is an impact as Morgan Stanley estimates that "Amazon Air's lanes overlap with over 2/3rd of the volume flown by UPS (and its main competitor) combined". Amazon stands to save "$2-4 per package" this way. The overall impact to UPS is unclear in the near term, but this is something to watch in the next decade. Short term, we think any risk is priced in after a 20-point drop from the highs earlier this year.

Our 2018 earnings outlook

With 2018 entering the final stretch complete and the completion of transformation initiatives that improved working capital, we are bullish on the company. While consensus estimates were for $7.23, we are looking for $7.15 to $7.30. Management downplayed its outlook guiding for $7.03 to $7.37, but with consistent revenue growth and greater efficiencies, along with a huge Black Friday sales report and strength in this longer holiday shopping season (as Thanksgiving was earlier than average), we see earnings coming in higher. Given shares are at $106, the valuation is attractive at 14.5 times 2018 earnings.

Take home

The chart suggests a bounce, and earnings growth looks like it will be solid through the end of the decade. The impact of Amazon Air will be slight in the near term, but longer term, we will be watching closely. The stock as a whole is attractively valued and paying a yield of nearly 3.2%. We think a bounce is coming and are bullish after this major pullback.

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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.