UPS: Delivering Alpha For Your Dividend Growth Portfolio

About: United Parcel Service, Inc. (UPS)
by: Kody's Dividends

Having raised its dividend for the past 9 years, UPS is a Dividend Challenger and has paid a dividend dating back to 1999.

Despite the risks, UPS possesses the prerequisites to deliver on what should be an industry with continued growth on its horizon.

UPS is currently 5% undervalued, which indicates there is a reasonable margin of safety built into a high-quality company such as UPS.

When all of this is factored together, I arrive at the conclusion that UPS offers market-beating returns in the coming years, with likely annual returns of 10.1-11.1%.

As we've seen in recent years with the rise of the likes of companies such as eBay (NASDAQ:EBAY) and Amazon (NASDAQ:AMZN), not only is the world becoming increasingly digital, but it's also relying on small transactions or micro-transactions much more often than in years past.

When we consider that 96% of Americans conduct at least some shopping online and more Americans are relying on the convenience of online shopping in recent years, it seems evident that this growth in online shopping and micro-transactions in recent years is more than just a fad, but an undeniable trend set to continue over the long term.

With that said, there is a tremendous need for the infrastructure to deliver these goods in a wide variety of ways, including from business to customer, customer back to business (textbook rentals from Amazon being a great example), and so forth.

Image Source: imgflip

This leads me into the point that at the right price, an investment in United Parcel Service (UPS) is poised to deliver market-beating returns over the next 5 years and beyond.

We'll delve into the specific reasons for my above investment thesis, which include the safe and growing dividend of UPS, the growth catalysts of UPS in the coming years, the current stock price in relation to my estimated fair value, and the total return potential of an investment in UPS at the current price.

Reason #1: A Strong, Safe, And Growing Dividend

While it's largely the fundamentals that I'll discuss a bit later in this section that I consider, I do also like to look at the past of a company and extrapolate if anything has significantly changed or will significantly change going forward that could negatively impact the ability of a company to continue its dividend history into the future.

Image Source: Simply Safe Dividends

As we can see above, UPS has paid a dividend for the past 20 years with periods of rapid dividend growth, in addition to periods of dividend freezes such as during the Great Recession. The company has increased its dividend each year since 2010.

Overall, the 5-year DGR of 8% probably won't be far off of what UPS will deliver in terms of dividend growth in the next 5-10 years, plus or minus 2%. I'd expect dividend growth to roughly mirror whatever earnings growth is going forward, and with earnings growth set to taper off a bit from the 10% in the past 5 years to 6% annually over the next 5 years, UPS is well-positioned to deliver mid to high single-digit increases during that time.

In the context of examining the safety of a dividend, I rely on several key metrics. I will typically examine the safety of a dividend by delving into the company's financials and ascertaining the company's EPS against its dividend obligation to arrive at the EPS payout ratio, as well as comparing the company's free cash flow or FCF in relation to its dividend obligation to arrive at the FCF payout ratio.

It's these two metrics that I examine before I check the dividend safety score from Simply Safe Dividends. I believe independently examining the safety of a company's dividend before referring to Simply Safe Dividends helps me to be a less biased investor and to feel out the safety of a dividend before I rely on a source like Simply Safe Dividends. I find Simply Safe Dividends to be a great source that can either confirm or potentially refute my findings. I don't simply resort to confirmation bias as that can be a recipe for disaster in investing.

With that said, we'll now examine the dividend in the context of its EPS payout ratio.

Image Source: UPS Q4 2018 Earnings Presentation

As shown above, UPS generated $7.24 in adjusted EPS during 2018. This is compared against the $3.64 in dividends per share that were paid out in 2018, for a trailing twelve months EPS payout ratio of 50.3%.

Looking ahead to 2019, the company is forecasting an adjusted EPS midpoint of $7.60, which would place the current annualized dividend of $3.84 at a 50.5% payout ratio.

In looking at these payout ratios, UPS offers that sweet spot of dividend growth investing that allows the company to retain enough cash to fund growth projects going forward, thereby continuing the dividend growth streak, while also adequately rewarding shareholders in the process.

Image Source: UPS Q4 2018 Earnings Presentation

Next, we'll examine the company's FCF payout ratio.

As shown above, UPS generated $6.1 billion of free cash flow in 2018 while paying out dividends of $3.2 billion, for a TTM FCF payout ratio of 52.5%.

Using both the EPS and FCF payout ratio, it is clear that the dividend of UPS is in no immediate danger of any kind.

Image Source: Simply Safe Dividends

It is the above fundamental reasons that led Simply Safe Dividends to rate the dividend of UPS safe, with a dividend safety score of 72. It seems as though Simply Safe Dividends and I have both arrived at the conclusion that the dividend of UPS is safe.

According to Simply Safe Dividends, 98% of 232 of the 236 of dividend cuts since the inception of Simply Safe Dividends in 2015 would have been avoided had investors stuck with companies that possessed a dividend safety score of greater than 60, which are safe and very safe ratings.

It's unlikely that UPS will cut its dividend because as a massive company, the capital allocation policy of UPS doesn't seem likely to suddenly change overnight as was the case some dividend cuts or suspensions by smaller companies. The only major danger to the dividend would be a catastrophic regulatory change or a similar event that would drastically alter the fundamentals of the company going forward. Although anything is possible, I don't view an event of that magnitude as probable enough for it to negatively impact my opinion toward UPS.

Reason #2: The Ability To Deliver On Growth Catalysts In The Years Ahead

UPS is a behemoth within the logistics and delivery sector, operating in the following business segments:

1. U.S. Domestic

2. International

3. Supply Chain and Freight

Its delivery services are offered in 220 countries and territories in the world. With a fleet of over 119,000 cars, motorcycles, and vans, in addition to owning 248 jet aircraft and leasing another 316, UPS has the capacity to deliver like nobody else.

As such, the company's 2018 daily global delivery volume was a whopping 20.7 million packages and documents. For context, FedEx (NYSE:FDX) delivered about two thirds of the volume that UPS did in 2018, at 14 million packages daily.

What's more, the barriers to entry are incredibly high in the capital-intensive logistics and delivery industry. This means that not just anyone can up and compete with industry giants UPS and FedEx. Building out delivery infrastructure to service millions of customers daily takes billions of dollars of capital that virtually nobody is able to access and the expertise to appropriately do so. This allows UPS to benefit from a so-called "wide moat" and has enabled it to achieve its massive success.

Image Source: eMarketer via Statista

As we alluded to earlier, the trend of rising e-commerce sales and the micro-transactions that accompany that trend will continue strongly in the years ahead. E-commerce sales as a percent of total retail sales are expected to increase from the 10% last year to nearly 14% in 2021. This type of annual low double-digit growth in e-commerce sales as a percent of total retail sales will be a strong growth catalyst for companies such as UPS going forward.

Image Source: Statista

This increased market share of the retail market for e-commerce sales suggests that sales will increase at a rate of about 8% a year, from the $504.6 billion in 2018 to over $735 billion in 2023.

There will be an ever-increasing need to ship packages and UPS is well-positioned to deliver upon that need, due to it being the low-cost player with extra automated sorting capacity soon coming online.

Image Source: Logistics Management

In addition to the 22 new or retrofitted automated facilities (including 5 superhubs such as the Atlanta superhub illustrated above) that opened worldwide in 2018, UPS will also be opening another 18 of these facilities in 2019. It's facilities like that superhub in Atlanta that have the capacity to sort 100,000 parcels per hour on the 321 acres site.

As such, UPS expects its strategy of automation to continue, with 50% of packages being processed at automated facilities in 2017, 70% in 2018, and UPS is expecting to increase that number to 80% in 2019.

Image Source: UPS Q4 2018 Earnings Presentation

In addition to business to consumer, UPS is also partnering with businesses such as Inxeption and Shoprunner. This partnership is expected to provide simplified pricing to small and medium-sized businesses, and the 3% B2B growth in Q4 2018 is expected to continue into 2019 and beyond as a result of the aforementioned simplified pricing structure for small and medium-sized businesses.

The mega-trend of increased micro-transactions and e-commerce, in addition to the capabilities of UPS to capitalize on these tailwinds by continuing to expand their logistics network and sorting capacity are the precise reasons that analysts are expecting the company's annual earnings growth rates to be around 6% over the next 5 years.

Risks To Consider:

One mild to moderate concern to UPS shareholders is the ballooning debt in order to fund the ambitious expansion plans of UPS in recent years, from $9.86 billion in long-term debt at year-end 2014 to $19.93 billion in year-end 2018.

With that increase in debt, the interest coverage ratio has decreased from just under 18 at year-end 2014 to just above 12 at year-end 2018. Along with what Moody's perceives to be excessive capex and share buybacks, this prompted Moody's to downgrade the outlook to negative while maintaining the mid-tier investment grade rating of UPS of A-1. While this weakening in the coverage ratio would be concerning if UPS wasn't expected to capitalize upon the growth that analysts are forecasting, that fortunately isn't the case.

However, it does also need to be considered that should the global economy enter a recession in the near future, this would have a negative impact on EBIT and therefore drag down the coverage ratio even further, potentially below the generally accepted ratio of 8.

While nothing outside of an economic meltdown rivaling the Great Depression would pose anything close to the level of a serious threat to the long-term prospects of UPS, it is still worth considering that revenues declined 12% from 2008 to 2009 in the last recession. While economic growth tends to prevail over longer periods of time, should this risk materialize in the near future, it could pose as a further detriment to a balance sheet that has weakened in recent years as the company would likely need to borrow a bit to maintain its dividend through such an event while also keeping up with capital expenditures.

Yet another concern is if UPS fails to meet or come close to the analyst expectations for growth in the next few years. While UPS has a history of delivering on analyst expectations in the past, we all know that past performance is no guarantee of future results. Any blunders on earnings in the next few years from simply a lack of execution (which does happen to even the best of management teams), poor economic conditions, or other factors would likely lead to UPS being an ugly duckling of the market for a period of time.

It's this type of cyclical nature of the business environment in which UPS operates, combined with the expectations of analysts, that could lead to a material drop in the stock price for investors. As such, it's important for potential investors to be aware of the risk of volatility and be able to tolerate those risks before making an investment in UPS (or any equity for that matter).

Another risk regarding UPS is that the nature of the capital-intensive business of the logistics and delivery industry is that it could mean the next couple dividend increases are close to the recent 5.5% raise, while the company continues to build out its network and sorting capabilities to meet the growing package volumes, as a result of the rise of e-commerce. While this will be a benefit in the long term, some shareholders may not be pleased with raises of this caliber from the company. I'd expect an acceleration from the most recent raise of 5.5% to at least 6-7% in 2021 and beyond.

The final risk is that the industry could become more competitive as Amazon enters into the delivery business. It has been well-documented that companies like UPS and FedEx have had difficulties handling peak capacity during the holidays and that it isn't feasible for them to build out their network just to accommodate deliveries for a few of the busiest days of the year. As such, I believe Amazon's intentions of entry into logistics is to simply deliver to customers whatever volume UPS and FedEx aren't able to handle during busy times of the year. I'll refer the interested reader to the following article for more details and insight into why it isn't likely Amazon will meaningfully enter the delivery business.

Even if Amazon does have intentions of undercutting UPS and FedEx, it's important to note that with the growth of micro-transactions and the fact that no one customer comprises a significant amount of revenue (Amazon is about 10% of revenue), Amazon likely wouldn't pose a major threat and the fears are a bit overblown.

Reason #3: A Wonderful Company Trading At A Fair Price

Having discussed the fundamentals of UPS from a dividend and growth standpoint, we now arrive at the final component of the case for an investment in UPS.

I'll discuss three metrics that I believe to be reliable in spotting any notable discrepancies between fair value and current price, which investors could potentially benefit from.

The first metric that I rely on is the current forward price to earnings ratio of a company in relation to its 5-year average. Assuming the fundamentals of a company remain intact, a forward PE ratio that is below the 5-year average would indicate a company is undervalued and could warrant further consideration as an investment.

Having said that, the current forward PE ratio for UPS is 14.51 against the 5-year average of 17.02. Even if we reasonably assume that the company won't be able to replicate the annual 10% earnings growth of the past 5 years, it seems reasonably conservative to assign a fair value forward PE ratio of 15 to the company.

A fair value forward PE of 15 would indicate that the current fair value of UPS is $110.30 against the current share price of $106.70 (as of March 8, 2019). This would imply UPS is trading at a 3.3% discount to fair value, offering 3.4% upside.

The second metric that I find helpful in determining the fair value yield of a company is in comparing the current dividend yield of a company against its 5-year average. All else equal and assuming there is no deterioration in a company's fundamentals, a dividend yield that is above the 5-year average would imply that a company is undervalued.

UPS currently offers a dividend yield of 3.60% in comparison to its 5-year average of 2.93%. An explanation for this discrepancy is that as interest rates have increased in the past 5 years, the risk-free rate of return has also increased. That is largely responsible for the increase in the dividend yield for taking on increased risk in the form of equity ownership.

However, I believe that a fair value yield of 3.25% against the current 30-year treasury yield of 3.016% adequately rewards investors for the risks they are accepting that accompany an equity investment.

Should the dividend yield of UPS revert to a fair value yield of 3.25%, this would imply a fair value of $118.15. This would indicate that UPS is trading at a discount to fair value of 9.7%, offering 10.7% upside.

One final metric that I find useful is my own estimation of the fair value of UPS shares using the dividend discount model or DDM.

Image Source: Investopedia

In the case of UPS, the expected annualized dividend per share is currently $3.84 with the most recent dividend increase of 5.5%.

The capital cost of equity, also referred to as the required rate of return, is highly subjective, but I tend to prefer using 10% as that should be well above the annual total returns of the broader market over the next few decades.

Finally, the long-term dividend growth rate is another subjective metric and can vary from one investor to another based on their assumptions. In this case, I'll assume 6.5% annual dividend growth. This is well below the 5-year average of 8% and the 20-year average of 12%, and this is because we obviously have seen a deceleration from the 12% over the past few years and will probably see a slight deceleration from the 5-year average of 8% over the long term.

When we input all these variables in the DDM equation, we arrive at a fair value of $109.71. This would indicate the company is trading at a 2.7% discount to fair value, offering 2.8% upside.

Image Source: izquotes

When we average the three fair values above, we arrive at an average fair value of $112.72. This would imply UPS is trading at a 5.3% discount to fair value, offering 5.6% upside.

While this isn't a massive bargain in terms of discount to fair value, it goes without saying that if Warren Buffett advocates buying a wonderful company at a fair or better price, I think that's sound advice from one of the most successful investors in history.

Summary: UPS Possesses The Traits Of A Future Market-Beating Investment

Typically, market-beating investments offer investors the ability to collect an attractive, safe, and growing dividend. Given the history of solid dividend growth from UPS and the fundamentals going forward, it doesn't seem unreasonable to extrapolate slightly decelerated but still strong dividend growth into the future.

As the increase in e-commerce and micro-transactions continues to materialize, UPS is positioning itself with investments in its future to quite deliver packages to customers, growing volumes and profits in the process, which will support continued dividend growth.

Despite the risks to the company which include its growing debt pile, its economic sensitivity, and the entry of Amazon into transportation and logistics services, I believe the risk to reward profile of an investment in UPS skews enough toward the reward side and less toward the risk side to justify an investment.

As such, UPS is currently trading at a 5% discount to fair value and is an excellent company, which makes UPS a buy.

It seems likely that an investment in UPS will return to shareholders an entry yield of 3.6%, conservatively speaking 6-7% earnings growth, and 0.5% valuation expansion over the next 10 years.

Those expected annual total returns of 10.1-11.1% over the next 10 years makes it quite probable that an investment in UPS will outperform the broader market during that time, thereby delivering alpha.

Disclosure: I am/we are long UPS. 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.