Will United Parcel Service, Inc. Continue To Deliver The Dividends? (NYSE:UPS) (2024)

United Parcel Service (NYSE:UPS) is a dividend contender with 6 consecutive years of dividend growth. The company generate revenues through both delivery of goods and supply chain management. Its vast network gives it an advantage for companies looking to expand their own product lines within new markets. United Parcel Service closed trading on Thursday, July 2nd at $97.20, making for a current yield of 3.00%.

The following tables/graphs are taken from my personal stock analysis spreadsheet. Data for the stock analysis was sourced from United Parcel Service's investor relations page, Morningstar, and Yahoo Finance.

Historical Growth Rates:

Historically, owners of United Parcel Service stock have earned decent returns. According to longrundata.com, UPS has delivered investors a total return of 84.6%, or 6.3% annualized returns, over the last 10 years. Those numbers are market returns at specific snapshots in time, and aren't necessarily indicative of the business results over the same time period. Looking at the historical growth rates for per share dividends, earnings, revenue, and free cash flow gives a better idea of the operational results that United Parcel Service has delivered.

The 10-year annualized growth across most metrics mirrors the growth seen in the stock market. Of course, past results are no guarantee of future returns, so let's look at what the future could potentially have in store.

Discounted Earnings:

Analysts followed by Yahoo Finance expect United Parcel Service to grow earnings 9.4% per year over the next 5 years. I then assumed that UPS could grow earnings at 8.0% (85% of 9.4%) for 3 years and at 5% per year thereafter. Running these numbers through a discounted earnings analysis with a 10% discount rate and summing over 30 years yields a fair value price of $119.75.

Gordon Growth Model:

As a dividend growth investor, I'm primarily concerned with the growth of the dividend, since capital appreciation is too volatile in the short term. Using a simple Gordon Growth Model calculation starting with the current annual dividend of $2.92, a required rate of return of 10%, and a dividend growth rate of 7%, UPS's fair value is calculated to be $104.15.

You can also rearrange the formula to solve for the required growth rate based on the current price. Using the current annual dividend of $2.92 and the current price of $97.20, UPS would need to grow the dividend by 6.79% per year to provide a 10% rate of return.

United Parcel Service has a 6 consecutive year history of annual dividend increases, after holding the dividend steady between 2008-2009. While I prefer the companies I own to increase the dividend like clockwork, for companies such as United Parcel Service that are tied to the fluctuations in the economy, I'm much more forgiving of dividends being held constant so long as there are valid reasons and increases resume in the near term. The required growth rates used in the Gordon Growth Model calculations are lower than the historical growth rates that UPS has provided. This suggests that shares of United Parcel Service are undervalued.

Dividend Discount Model:

For the DDM, I assumed that United Parcel Service will grow dividends at the lowest rate of the 1-year, 3-year, 5-year, or 10-year growth rates or 15% for the next 5 years. In the case of UPS, the 10-year growth rate of 8.3% was used. I then assumed that UPS could increase the dividends by 7.4% (90% of 8.3%) per year for the next 3 years and at 5.00% in perpetuity. To calculate the value, I used a discount rate of 9.00%. Based on the DDM, the shares of United Parcel Service are worth $94.13.

Dividend Safety:

Of course, we all want dividend growth from the companies we own, because in general, that means there's growth of the underlying business. However, dividend growth at all costs is not sustainable. Over the last 10 years, the payout based on earnings has ranged from a low of 38.0% to a high of 466.7%, while the free cash flow payout ratio has ranged from 31.8% to 103.8%. The payout ratio sits at 80% for the TTM. Neither payout ratio inspires a lot of confidence in the consistency of UPS's dividend coverage; however, the FCF payout ratio has been much steadier than the traditional payout ratio.

Free cash flow after paying the dividend (operating cash flow - capital expenditures - dividend payments) has averaged $2.13 B per year since FY 2010. On average, United Parcel Service has been able to retain 31.9% of its operating cash flow - after paying for capital expenditures and dividends - for growth of the company and share buybacks. The dividend is well covered by cash flow at this time. However, total shareholder return, i.e. dividends plus buybacks, is just barely in the positive territory over the last 5 years, with a net surplus of $116 M. Either cash flow needs to expand, or dividends, buybacks, cash, or debt levels will have to suffer.

It's also important to analyze the balance sheet to determine the safety of the dividend. United Parcel Service is rather aggressively capitalized. Its debt-to-equity ratio has averaged 2.3 over the last 5 years, while the debt-to-total capitalization ratio has averaged 66.6%. Both metrics have deteriorated noticeably over the last 5 years.

As of the end of FY 2014, United Parcel Service's debt level was $9.86 B. Based on the average net income of the last 3 years, $2.74 B, UPS could use its cash stockpile of $2.29 B and repay all of its debt with 2.77 years worth of net income if it desired. I consider anything less than 5 years to be safe, and United Parcel Service is well under that mark. Given the capital-intensive nature of the business, I'm not surprised to see a more leveraged balance sheet compared to other industries. However, the increasing debt levels with declining equity levels has me a bit concerned about UPS.

Relative Historical Valuations:

Another thing I like to look at before investing in a company is where it currently sits compared to some common valuation ratios. Companies tend to stay within certain ranges as long as nothing has fundamentally changed with them. The following table shows the low end of the 5- and 10-year historical averages for dividend yield, P/E ratio, P/S ratio, and EBITDA per share, as well as the FY 2015 estimate for each metric, with the corresponding price targets. The reason for using the low end of the common ratios is because we are targeting to buy shares of the company at the cheapest valuation.

I've included both the low and high end of the ranges that United Parcel Service has traded for over the last 5 and 10 years, as well as the estimate for FY 2015 across the metrics. The current share price is on the lower end of the historical valuation spectrum across all metrics, suggesting that the company is currently undervalued. For reference, the average of the 5- and 10-year valuations across all 4 metrics comes to $105.24.

Share Buybacks:

Since the end of FY 2009, United Parcel Service has decreased its share count by 8.0%. At the end of FY 2009, the diluted weighted shares outstanding were at 1.004 B, and by the end of FY 2014, they were 0.924 B. That's good for a 1.7% annual decrease.

While I enjoy share buybacks as a way to return capital to shareholders, it's also important to look at how effective those buybacks have been. UPS has spent $10.06 B on share buybacks since the end of FY 2009. That's an average share repurchase price of $125.78 over that period. Considering the highest share price over that time is below the average repurchase price, things don't bode well for the buybacks being very effective.

If United Parcel Service's share count remained the same as at the end of FY 2009, i.e., 1.004 B, the earnings per share for FY 2014 would have been $3.02. Since the company earned $3.28 per diluted share in FY 2014, the effect of the buyback has been $0.26 ($3.28-3.02) per share. Management used $10.02 per share worth of equity value for the repurchases, which represents just a 2.6% return ($0.26 / $10.02).

Overall, the share buyback program has been effective in reducing the share count. However, due to the low 2.6% return that management has earned with the equity value they used, I'm not sure this is the best use of shareholder capital. I would need to see a clearer plan to earn better returns via buybacks in the future to feel confident in management's use of equity value.

A negative number for the % change value means shares were bought back by the company, and a positive value means the shares outstanding increased.

Revenue and Net Income:

Since the basis of sustained dividend growth is revenue and net income growth, we'll now look at how United Parcel Service has fared on that front. Revenue growth between FY 2009 and FY 2014 has been solid, at 5.2% per year. Net income has been even better, growing 7.1% per year and leading to an increase in net income margin from 4.8% to 5.2%. Assuming that the net income margin is 5.8%, the average of the previous 5 years, net income would come in at $3.15 B based on FY 2015's estimate of $58.43 B in revenue. The problem with UPS's net income is that the margins are extremely tight, which means any dip in productivity or efficiency can quickly be lost. That's why you saw the net income margin dip to just 1.5% in FY 2012, despite revenue increasing compared to FY 2011.

Forecast:

The following chart represents the earnings per share forecast used in the discounted earnings valuation from above and the typical P/E ranges that shares of United Parcel Service have traded for. The shares appear to be undervalued currently, as the forward P/E ratio sits at 16.9. However, it's important to remember that these are just forecasts, and if the company is able to grow earnings at a faster or slower rate than my assumptions, the valuation could be very different. There's also the possibility that the market in general will change its normal P/E range for UPS, leading to P/E compression or expansion.

Conclusion:

The average of all the valuation models gives a target entry price of $94.26, which means that shares of United Parcel Service are trading at just a 3.1% premium. I've also calculated it with the highest and lowest valuation methods thrown out. In this case, the Gordon Growth Model and Graham Number valuations are removed, and the new average becomes $97.08. The shares are currently trading for just a 0.1% premium to this price. The average valuation price comes to $110.38, and the high valuation price is at $121.52.

According to Yahoo Finance, the 1-year target estimate is $109.18, suggesting that the share price is undervalued and has 12.3% upside. S&P Capital IQ has UPS as a 4-star buy and has a 1-year target price of $120.00, suggesting 23.5% upside. Morningstar has UPS rated as a 3-star stock meaning the company is trading at their fair value estimate.

United Parcel Service is a leader in delivery and supply chain management, thanks to its vast network capabilities. This allowed the company to deliver a record 4.6 billion packages throughout 2014, including 572 million in December alone, which is a make or break time for retail. Due to United Parcel Service's expertise in delivery of goods, companies look to it when they seek expansion into new markets - whether domestic or foreign - rather than setting up their own distribution networks.

United Parcel Service derives a majority of its revenue in the United States; however, the international segment is also growing rapidly. International growth is fueled through both expansion of existing delivery volumes, as well as by entering newer, faster-growing markets. Management has identified 13 countries that represent the best opportunities for growth, including 20 markets in China. With over 1 billion people in China alone, including a rising middle class, the country should continue to be a large driver of growth for UPS. Management is also tying its future to the faster-growing segments of the economy, specifically e-commerce and healthcare. Both of these should continue to expand at rates much faster than the economy as a whole, which should lead to continued growth for UPS with its vast distribution network and excellent supply chain management.

Overall, I'm very intrigued by United Parcel Service, as I feel the valuation is low and the company should continue to see solid growth by entering into new international markets, as well as by fully developing its e-commerce and healthcare footprint. While the current dividend growth streak sits at just 6 years, due to UPS holding its dividend steady during the Great Recession, the company has not decreased the dividend since initiating one back in FY 1999. That's a solid track record covering two major recessions. My biggest concerns with United Parcel Service are the tight cash flow and its less-than-stellar balance sheet. Personally, I would like to see the company's debt load decrease with extra cash flow, rather than going towards share buybacks that haven't been as effective as they could have been. Neither of these make UPS a no-go as an investment; however, they are the factors I would be watching most closely, should I invest in UPS. With a starting dividend yield of 3.00% and the valuation of shares being on the low end of historical norms, I'm tempted to initiate a starter position in UPS around the $96.50 mark. However, that is subject to availability of funds at the time and other opportunities.

A full list of my holdings can be found here.

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