Tuesday, October 2, 2018

An Income Opportunity in UPS

Shielded Dividend Stream?

Analysis Origin & Methodology


We created this analysis on request.  Analyses of this sort are general -we don't know the requester's circumstances and we don't know what kind of an opportunity, if any, the stock presents.

Therefore, we look broadly at the stock including quality, value, growth and income.  In this analysis, we looked at UPS with a group of peers.

Some areas will have additional notes.  This will be indicated at the conclusion of the section and can be found at the end of the report.

Company Overview


United Parcel Service, Inc. is a logistics and package delivery company, which provides supply chain management services. Its logistics services include transportation, distribution, contract logistics, ground freight, ocean freight, air freight, customs brokerage, insurance, and financing.

The company operates through the following segments: U.S. Domestic Package, International Package, and Supply Chain and Freight. The U.S. Domestic Package segment offers a full spectrum of U.S. domestic guaranteed ground and air package transportation services. The International Package segment includes small package operations in Europe, Asia-Pacific, Canada and Latin America, Indian sub-continent, and the Middle East and Africa. The Supply Chain and Freight segment offers transportation, distribution, and international trade and brokerage services.

The company was founded by James E. Casey and Claude Ryan on August 28, 1907 and is headquartered in Atlanta, GA.

Number of Employees: 280,000

CEO: David P. Abney

Peer Group

Stock Name (Symbol)Last Price (as at Sep 17, 2018)Market Cap
FedEx Corporation(FDX:XNYS)$255.8965.4095B
Brink's Company(BCO:XNYS)$70.403.6746B
Hub Group, Inc. Class A(HUBG:XNAS)$47.551.6519B
Forward Air Corporation(FWRD:XNAS)$68.121.9052B
Expeditors International of Washington, Inc.(EXPD:XNAS)$73.7812.9853B
C.H. Robinson Worldwide, Inc.(CHRW:XNAS)$96.7113.3805B
Air Transport Services Group, Inc.(ATSG:XNAS)$22.321.2123B
Atlas Air Worldwide Holdings, Inc.(AAWW:XNAS)$63.551.5793B
ZTO Express (Cayman) Inc. Sponsored ADR Class A(ZTO:XNYS)$17.1410.4481B
United Parcel Service, Inc. Class B(UPS:XNYS)$119.09105.7714B


Earnings Quality


It is a fact that earnings can be manipulated and they can be changed by accounting-driven decisions.  We want earnings that are persistent and grow and that aren't the result of management tinkering.

I use an eight part quality of earnings framework based off the work of two academics, Lev & Thiagarajan.  You can read their original paper here.  You can read my adaptation here.

The framework looks at eight (or nine) areas in the financial statements: inventories, receivables, capital expenditures (and/or research & development which is not used in this analysis), gross income, selling-general-administrative expenses, sales per employees, tax rate and audit opinion.

The first two, the fourth, fifth and six are compared to sales levels, capex and/or r&d are compared to industry averages (I use the peer group average as a proxy), the tax rate measures seeks to remove the effect of an earnings bump from a reduction in the tax rate and the a last one looks for a clean audit opinion.

When any of these measures give a favourable signal, I give it a score of one.  All the scores are summed to get a total out of eight, the higher the better.

Here are the results:


UPS's score of four is mediocre. Brinks and Air Transport Services are quite good. See analysis notes for more details.

Earnings Growth


This measure looks at the number of years the companies have been able to achieve year over year growth.  I'm looking at a six year time period so the maximum occurrence is five.

UPS is not a growth story with a score of three.

How about HUBG with a perfect score of five?  I am skeptical of their results given they achieved the worst score of all the companies in the quality of earnings category.  I wouldn't consider a long position in a company with a score of two.

There are notes to this section.

Earnings Growth Relative to Price Change


This measure is similar to the earnings yield (which is the inverse of the PE ratio), but I tweaked it to compare growth rates in earnings and price, rather than values at a single point in time.

The growth period is over three years and the calculation for the numerator is the earnings for the current period (Y) divided by earnings for the for the period three years ago (Y-3), minus one.  The calculation for the denominator is current price divided by price 36 months ago, minus one.

A value greater than one indicates that earnings have grown more than the price has grown, a favourable signal, especially if it is coupled with high quality of earnings.

Here are the results:
Great numbers for FDX and UPS, their earnings growth has outstripped the growth in their price (on a percentage basis.  As mentioned, HUBG is no longer a consideration.

See the Analysis Notes section for more details.

Valuation


I like to look at multiple valuation measures in order to confirm a consistent valuation message.  We'll look at PE ratio, enterprise value over EBITDA and Ohlson's Clean Surplus (OSC).

For more information on the OCS, please see this article.

PE Ratio


The average of 23 is fairly high.  UPS is below average at just under 20.

EV/EBITA


UPS is basically equivalent to the group average of 12. By traditional measures it is somewhat high.

OCS


The OCS is an interesting valuation model that calculates a theoretical stock value.  While I don't hold it out to be an exact value, it can give a decent ball park or at least an indication whether the stock is over, under or fairly valued.

Stock    Theoretical Price    Actual Price  (Premium)/Discount
FDX         182.60                255.89                 (29%)
BCO             6.15                  70.40                 (91%)
HUBG           41.81                  47.55                 (12%)
FWRD           31.56                  68.12                 (54%)
EXPD           29.27                  73.78                 (60%)
CHRW           37.89                   96.71                 (61%)
ATSG             5.91                   22.32                  (74%)
AAWW         100.45                   63.55                    58%
ZTO             8.77                   17.14                  (49%)
UPS       4171.26                   119.9               (3,403%)

Most of the group is over-valued with the exception of AAWW and UPS. 

In the case of UPS, the theoretical price and the indicated discount is rather ridiculous, but when I examine the model I can see it has a very high ROE.  One of the assumptions in the model is that it uses the most recent ROE and it will persist into the future (another similar assumption is used for the dividend payout ratio).

I examined UPS's ROE over the past few years - it's been consistently high.  Using the average ROE over five years reduces the theoretical price to $936.  Cutting the ROE in half turns the theoretical price to $246, still a 107% premium.

It's also possible the dividend payout ratio will increase.  UPS isn't a growth story and so returning money back to shareholders seems reasonable.

A higher dividend payout ratio brings the valuation down quite quickly.  Increasing the payout ratio by 52% brings the stock into fair valued territory (without adjusting for ROE).

Regardless, according to this valuation technique, UPS seems to be undervalued.

Bonus - Quick and Dirty Discounted Cash Flow (DCF)


I wanted to see the results of the DCF model.  I only put it together for UPS and I made a number of simplifying assumptions - I used dividends as the cash flow proxy, and I only used the most recent year's.

For the discount rate I used the firm's rate calculated in the OCS and I used a growth rate of 6%, which is lower than the past three years of dividend growth for UPS (7%, 9% and 8%).

The quick and dirty DCF calculation is 3.32/(.0635-.06) = $949.  This is very close the value arrived at using the OCS when the average ROE is used.

It's a bit of a mixed story on whether UPS is under or over-valued. There seems to be more indicators that it is undervalued, however.


Dividends


Not all the companies in this analysis offer a dividend.  The ones who do are FDX, BCO, FWRD, EXPD, CHRW and UPS.

We'll look at the current dividend yield, dividends per share and the dividend payout ratio.  We'll also look at the free cash flow trend.  Although this can't definitely say how secure the dividend is, it can give us a clue.

Dividend Yield


UPS has the highest yield and we can see that it keeps its dividend in a range, as do the other companies.

Dividends Per Share


Strong dividend growth for UPS.

Dividend Payout Payout Ratio


With the exception of one year, UPS pays out a consistent portion of its earnings as a dividend.  The other companies are similar in that respect as well.

Free Cash Flow


UPS's free cash flow had been terrific up to the most current year.  The reason's for the drop are several.  They paid almost $8.8 billion into their pension plan, a sizable increase over previous years'.  Capital expenditures were also up.  To pay for this, they took on debt and reduced their FCF.

Conclusion


Stocks have different stories - some are growth stories, some are value, some are income.  You won't find all three at once, but you can find a stock strong in one or two areas.  UPS may be undervalued and it certainly has an attractive dividend.  Although it's earnings quality is so-so, that could be cautiously overlooked.

Analysis Notes


Earnings Quality - HUBG, EXPD, CHRW and AAWW do not report inventories and FWRD and ATSG do not report SG & A expenses.  Therefore these six companies would actually have a score out of seven, rather than eight.

Earnings Growth - there is no EPS information for ZTO for the years prior to the fiscal year ending December 31, 2014, it's score is out of three.  It grew it's earnings three out three times (not four out of five).

Earnings Growth Relative to Price Change  - Price information for ZTO begins in 2016, so there is no value for this stock.

Disclaimer


We hope you've enjoyed this analysis.  Please let us know if you have any questions or require clarification on any of the points.

This report does not constitute an investment recommendation.  INVRS, it's parent company, the employees, directors and officers cannot be held responsible for any investment decision you make, how so ever made.

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