August 18, 2022

UPS: New CEO, New Strategy To Deliver Sustainable Alpha (NYSE:UPS)

Introduction – following a tried and true playbook

Not following its usual practice, UPS (UPS) appointed a board member as CEO as of June 1: Carol Tome, the long-serving CFO of Home Depot (HD). This former banker helped lead HD through the aftermath of the housing bust. From a Great Recession low below $20, HD has soared above $275, while paying steadily rising dividends. The strategy there was to more or less freeze the store count, not expand into Europe, Asia or South America, and focus on optimizing operations. Operating margins rose, and HD was relatively early in emulating Amazon (AMZN) in utilizing technology in the service of selling “stuff.” I discussed this point two years ago in How Home Depot Is Moving Toward Tech To Drive Alpha.

HD’s recovery from the Great Recession and entry into a strong bull phase stemmed from optimizing its assets; becoming better rather than focusing on expansion first.

Operational improvement is now the theme at UPS.

I expect a similar outcome as at HD, and am overweight UPS not because of its strong ‘beat’ in Q2 but because I expect UPS to both grow revenues and expand profit margins, while raising dividends annually, in line with HD’s stellar performance since 2009.

This article walks the reader through my rationale for having gone from no exposure to UPS to an overweight position following its jump to around $140 after earnings were released.

Some readers will be aware that post-COVID, much of my investing has been in very high P/E, fast-growing companies, such as Tesla (TSLA) and Zoom (ZM), as well as expensive tech names such as NVIDIA (NVDA), Amazon (AMZN) and Microsoft (MSFT). Note I have been and out of AMZN and have once again taken profits (but I’m looking for a re-entry based on evolving technicals as well as fundamentals).

UPS, with an emphasis on dividend increases, may appeal to a wider and different group of investors than the above stocks.

In this article, in addition to the Q2 earnings, I will refer to the conference call and associated presentation.

Before getting to management’s remarks, I want to show why UPS fits my criteria for a stock to buy when the economy is coming out of recession, but burdened by unresolved issues.

Earnings estimates are rising

How much of the ongoing increase in consensus EPS is related to the company’s plans to focus on total shareholder return may be an open question. In any case, per Yahoo! Finance, EPS estimates have been trending up for both Q4 2020 and all of 2021. This trend has remained in force even in September, even though the earnings report came in late July. Current consensus EPS are $7.03 and $7.95 for 2020 and 2021, respectively.

Consensus revenue estimates are for $80.7 billion and $84.6 billion for 2020 and 2021, respectively.

Coming out of a global economic shock, any company with this sort of positive earnings revision trend gets my interest. As a member of the Dow Jones Transports, with a commitment to the dividend, UPS therefore gets my special interest.

The next sections presents my core reason to own UPS.

Efficiency expertise can win the day

From the earnings presentation, Slide 9 begins in an anodyne way:

5 Core UPS Principles Underpin Our Actions

  • Our values
  • UPS dividend
  • Strong investment grade credit rating
  • Brand relevance
  • Employee ownership.

So far, that’s boilerplate, and vague. But, the slide ends by emphasizing that everything else is under review.

Clearly, the board, and the CEO, see room to improve.

Next, Slide 10 states that UPS plans to innovate and thereby improve its net promoter score and related metrics. This would allow faster growth with limited capital expenditure.

All this is easy to say, hard to do.

As the new regime has not put out a lot of details, I will refer to the conference call for hints as to why I expect the years ahead for UPS shareholders to look something like the years following the Great Recession for HD shareholders, i.e. a strong uptrend that beats the S&P 500 (SPY), with an above-average and rising dividend as a nice bonus.

UPS plans to be better, not bigger

Remember the HD article I reference in the first section of this article, that HD was using information technology to drive profitability. Now consider this important statement from Ms. Tome’s prepared remarks:

As we evaluate new market realities, we will be making decisions faster based on data and analytics…

My inference from this sentence fragment alone: UPS is going to follow the HD model, namely work smarter.

The rest of the sentence supports this view, saying that UPS will have:

… an emphasis on optimizing our existing network and the investments we’ve made.

How will shareholders benefit? The paragraph ends by making the focus clear; UPS will have:

… the goal of increasing the rates of return on the capital we invest. It’s all about becoming better, not bigger.

Better, not bigger. That’s the theme.

The next section shows where the company is going, remembering that almost every aspect of the company’s operations is under review.

A culture of continual efficiency gains is being introduced

From Ms. Tome’s prepared remarks, we learn that:

… we have accelerated our plans to improve time and transit, making the U.S. ground networks faster…

We also learned that weekend operations are being expanded further, which drives revenue enhancements and ultimately greater efficiency by utilizing assets more frequently.

Those details were also a bit pro forma, but in the Q&A, I sense that the new CEO almost explicitly criticized the prior management team. A few quotes from her response to the second questioner will suffice:

… depending on how you define products, we have between 400 and 500 products… we looked at it… last year, there were over 100 of those products that we didn’t even sell. So we’re going to rationalize our product offering to make it simpler for our customers and reduce expense here.

The implication that point, made early and voluntarily in the Q&A, is that prior management was asleep at the wheel.

She continues on the efficiency theme with her next point:

We love our air fleet and in fact, about 11% of our air fleet are wide-body planes, these are 747 planes… we had an opportunity to buy more of those 747s…

But they did not take that opportunity, because, as Ms. Tome went on to say, in a phrase I like a lot:

… we’re going to really look to sweat the assets… to get more off of that investment that we’ve made over time.

In addition to the focus on sweating the assets – which is what HD did post-Great Recession – she again criticized prior management in the lead-in to the above comments, when she noted that:

What we have done in the past is built capacity or bought capacity, and the hope that demand would follow. And we would take demand at any cost or any price, if you will. Not necessarily nutritive demand.

That’s a very unusual criticism from an incoming CEO; and, note, the prior CEO, David Abney, is now Executive Chairman.

All this leads up to Ms. Tome talking about identifying areas where UPS has not been pricing its services as aggressively as its customers would be willing to pay, and then discussing that Transformation 2.0 and then 3.0 are going to take billions of dollars out of the cost structure.

There is much more in the Q&A that is relevant to the new management team’s plans to improve revenues while taking costs out of the business; please read it in its entirety if you are interested.

These points led me to jump on UPS, beginning around the $140 share price, and go from no position to overweight. (My personal definition of overweight in a stock is more than 1% of financial net worth. Since I am mostly in bonds (and some cash), this implies a 2.5% of greater share of our equity positions.)

The HD model suggests years of alpha ahead

HD bottomed at $17 in the Great Recession. Its stock price recovery was achieved with stable gross margins around 34%, but with SG&A reduced so that operating margin rose from the 10-12% range for several years before and after the Great Recession, to 15% in 2015.

EPS were further helped by aggressive, debt-fueled buybacks. All that was enough to push HD far into record territory, above $130, by 2015.

That’s as far as I want to go in thinking of UPS, as by comparison it would look out to 2025.

The HD store count was 2274 in 2008, and by 2015 it was… 2274.

Better, not bigger was the theme.

My bullish thesis is simple: UPS will be HD. Both are leaders in an oligopoly. Both companies are middlemen, not innovators. What they do, others do. The only moats are the established locations, including behind-the-scenes processes.

I also think that UPS can appeal to most investors, just as HD did. A commitment to the dividend and a focus on total shareholder return can work for income-oriented investors as well as those interested in performance.

Now to a discussion of risks.

How UPS can lose investors money

The COVID recession that I believe has ended was easy on UPS in that it coincided with a huge surge in B2C business. Future recessions may be more traditional, with B2B business dropping off as has occurred this year, but not rescued in any way by B2C business.

Just as is HD, UPS is sensitive to the economy. Its costs are somewhat fixed; and its revenues and margins are both susceptible to be harmed by a weak economy.

In addition to its pro-cyclical nature, UPS probably faces more top-tier competition than HD, for which only Lowe’s (LOW) is a large direct competitor. UPS has FedEx (FDX), ambitious AMZN, and of course the USPS. International competition is significant, as well. So, competition may be tougher for UPS than for HD.

General market risks join with the risk of weak execution of Transformation 2.0 and 3.0 as the main risks for investors I am highlighting today.

Please review the 10-K and 10-Q’s for the company’s much more complete recitation of risks.

Concluding comments – valuation matters, and UPS makes the grade

UPS closed Friday at $158.87. I am projecting a $200 stock price within two year, based on my expectation that UPS will tend to generate “beats” as it succeeds in improving operating efficiency and a certain amount of price increases where UPS has been behind the pricing curve in certain segments. Improved efficiency also implies market share gains, as the company offers superior performance to customers.

The times we are in should allow operating margins to increase. Labor is plentiful again, and the price of oil has been hammered both by the COVID hits to travel, and to the electric vehicle surge. Also, with interest rates so low, UPS can borrow as needed at very low rates. So, conditions look ideal for this particular company as it looks to improve its margin profile.

That leads me to look at consensus EPS of $7.95 for 2021, note that Ms. Tome is planning for cost savings in the billions of dollars, and use $9 for 2021 EPS.

Though it’s very early, I am thinking of EPS of $10+ for 2022.

With competing interest rates so low, and with years of margin improvement potentially ahead (as with HD), I am comfortable projecting a 20X P/E on projected 2022 EPS of $10, or a $200 stock price, two years from now.

I believe there is significant upside potential to that price target. The greatest reason is that if UPS is viewed as a blue chip with revenue growth ahead in a growing 2022 economy, with e-commerce continuing on its secular growth trend, I would be comfortable thinking of a 24-25X P/E in 2022 on projected 2022 EPS. So a $250 share price before 2023 strikes me as not unreasonable, though it may be unlikely.

In any case, a rise to $200 implies about a 30% total return in two years. Given today’s valuations, I find that attractive given the relatively ‘steady Eddie’ nature of this company’s business.

Thanks for reading and sharing any comments you wish to contribute.

Submitted Saturday morning.

Disclosure: I am/we are long UPS,AAPL,MSFT,NVDA,TSLA,ZM. 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.

Additional disclosure: Not investment advice. I am not an investment adviser.

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