Who says old traditional businesses can’t transform? UPS (NYSE:UPS) emerged from the pandemic with a revitalized free cash flow position and a changed investment story. Dramatic increase in shipping volumes allowed UPS to significantly increase available cash cash flow generation, which in turn reduced its debt position and gave it the ability to reward shareholders with a dramatic increase in dividend and share buybacks. After the recent dividend increase, the stock offers an attractive forward yield of 3.2%. The stock also offers a way to invest in global e-commerce growth at a valuation and with capital allocation policies that should appeal to value investors.
UPS stock price
After nearly a decade of sluggish stock prices, UPS saw its shares erupt during the pandemic and have held its gains ever since.
These gains are not necessarily short-lived. UPS has seen its free cash flow generation surpass the $4 billion annual level in recent years to finally show significant growth.
With the company guiding continued free cash flow generation, there’s little reason to think UPS hasn’t gained share price post-pandemic.
Benefits of UPS shares
In 2021, UPS grew revenue to $97.3 billion and operating profit to $13.1 billion. These reflect another year of accelerated growth as the company benefited from the growth of e-commerce.
In the fourth quarter, UPS was able to slightly increase operating income from its international operations as it offset year-over-year volume declines with price increases.
Instead, domestic operations drove the bulk of the margin gains as the company experienced some volume growth and significant price increases.
Overall, UPS generated $10.9 billion in free cash flow in 2021 and reduced its debt ratio to 1.9 times debt to EBITDA.
Looking ahead, UPS forecast modest revenue growth to $102 billion and an increase in operating profit to around $14 billion.
UPS has guided free cash flow to grow from $10.9 billion in 2021 to $9 billion in 2022. This is a function of the two expected headwinds as the company has pre-funded some service costs in 2020 (this which makes free cash flow in 2021 exceptionally higher) and also increased capital expenditure plans.
On the conference call, management hinted that the planned $1 billion share buyback was more of a “floor” because the company has $4.5 billion in its authorization.
UPS had previously slowed its dividend growth program due to stagnant free cash flow. However, with booming free cash flow in 2021, it decided to increase its dividend by 49% to $6.08 per share annualized.
This represents a dividend payout ratio of around 50%, leaving plenty of cash available for both share buybacks and capital expenditures. I don’t expect the company to have to repay its net debt as the current debt ratio is already well below historical levels.
Is the UPS action a buy, sell or hold?
Wall Street consensus estimates call for minimal earnings growth over the next few years.
This type of growth profile is not sexy although the estimates turn out to be conservative. Either way, with stocks trading at less than 15 times forward earnings, even modest growth is a decent investment thesis. I expect Wall Street to continue to view UPS as a low-risk proxy for investing in e-commerce growth, as UPS is not directly tied to the fate of any particular retailer, but rather stands to benefit as long as e-commerce continues to grow. Additionally, as the company continues to invest in growth capital expenditures, it may eventually realize efficiencies that could allow for greater free cash flow. As it stands, the company plans to return approximately $6.2 billion in cash to shareholders through dividends and share buybacks in 2022. At recent prices, that represents a shareholder return of 3.8%, but I note that based on management guidance, there is still $2.8 billion of unaccounted free cash flow. The company can use this excess cash flow to accelerate share buybacks or use it to reduce debt. Although UPS is not a tech stock, I still expect the stock to experience multiple expansion as it offers what appears to be a perfect package: an attractive secular growth story for e-commerce, a position balance sheet and a generous return to shareholders. I can see UPS trading up to at least 18 times earnings, which is a stock price of $232 per share. The stock is posting a total return of around 27% against this target.
What are the risks here? The reader might wonder if rising oil prices would hurt UPS negatively. UPS applies fuel surcharges that allow it to pass on the cost of rising fuel costs to its customers. That said, high fuel surcharges decrease profitability for e-commerce customers, which in turn can lead to higher e-commerce prices and ultimately lower end-consumer demand. UPS is working towards a carbon neutral strategy, but has set 2050 as the target year to achieve this goal. I wouldn’t be surprised if UPS sees some volatility in its short-term earnings trajectory, but as long as oil prices eventually normalize to historic levels, I still view UPS as a secular growth story.
Another risk is that the combination of modest growth and modest shareholder return (relative to total free cash flow generation) may mean the stock could experience some multiple compression. The 3.2% dividend yield arguably offers some downside protection, but if the company returns to its previous levels of dividend growth (or stagnation to be more precise), then a dividend yield of 5% wouldn’t be out of the question. It’s a name I can see going up directionally over the long term, but with some volatility along the way. I rate the stock as a buy with a total return of 27% upside my price target of $232 per share.