UPS: Transformation Program Not Yet Priced In

Last year United Parcel Service (NYSE:UPS) management announced their vision for the company, as part of the 2018 Transformation program

- Q2 earnings showed signs the Transformation Program was gaining traction, but this was not enough to compensate for a disappointing Q1

- CEO remains confident in reiterating a full year 2019 adjusted EPS guidance of $7.45 and $7.75 a share

- Investors remain unconvinced and stock price reflects this.

- Conservative estimates put today's stock price at 11% undervalued, and carries the benefit of a decent 3.4% dividend.

On September 13th UPS senior management presented their vision for the company’s future. A press release entitled “UPS transformation and enhanced business strategy to boost future earnings” outlined the main points of the strategy as follows:

- Continued expansion of high-growth international markets where the company efficiently connects domestic and export customers to its global network;

- Profitable expansion of e-commerce (B2B and B2C), as U.S. industry package revenue is expected to grow by 40% from 2017 to 2022, and crossborder e-commerce volume is expected to grow by 28% over the next three years;

- Further penetration of Healthcare and Life Science logistics markets, with increasing shift toward home healthcare, where UPS’s residential delivery network will provide new value for healthcare companies and consumers;

- Enhanced services and value for Small and Medium-sized Businesses, as the company repositions its commercial and service strategies to help this growing economic segment reduce logistics complexity and costs

With new and renovated facilities, aircraft and fleet assets coming online at record levels during the next four years, UPS will add 350,000-400,000 pieces per hour of sortation capacity in the U.S. each year.

David Abney, chairman and chief executive officer asserted “The savings we achieve will be reinvested in the company … and will be used to reward shareowners.” The company expects these actions to collectively result in an incremental increase to adjusted earnings per share in the range of $1.00 to $1.20 by 2022.

First-quarter earnings, excluding one-time items, fell to $1.39 per share from $1.55 per share in the corresponding period of last year, largely attributed to the winter storms which hobbled operations. Analysts were looking for a slower decline, however Abney remained confident in reiterating a full year 2019 adjusted EPS guidance of $7.45 and $7.75 a share. Investors were unconvinced by this assertion and lack of investor confidence pulled the stock price down 8% as a result.

If we move onto Q2, earnings came in better than expected and management pointed to benefits from the Transformation Program taking traction. Highlights as follows:

- 2Q19 EPS of $1.94; 2Q19 Adjusted EPS of $1.96

- 3.4% consolidated revenue growth.

- 20.9% operating profit growth or 6.3% growth in adjusted operating profit.

- Profit grew in all three business segments.

- Most profitable quarter in the history of the company.

Notably, results for Q2 were bolstered by a 30%+ increase in Next Day Air volume, which the company attributed to a structural change in e-commerce creating opportunities. Some analysts pointed towards Amazon (NASDAQ:AMZN) business as a potential source of this incremental Next Day Air volume and overall the lack of clarity for the year kept investors on the sideline. The fact that Amazon are currently building out their own transportation network will logically mean that the company will be less reliant on UPS for shipping needs going forward. This being said, accounts such as Amazon do tend to be very low in margin. If UPS (in keeping with the new strategy) is able to replace Amazon volume with higher yield Small and Medium-sized business volume then this would be positive to EBIT - providing they can gain the sufficient volume.

Given these factors of a disappointing Q1 result, coupled with lack of clarity following the Q2 earnings release, the critical question here is whether we believe UPS can achieve the EPS full year guidance given by CEO, Abney and team. With Q1 adjusted EPS coming in at $1.39 and Q2 coming in at $1.96, the H1 EPS amounts to only $3.35. This would require adjusted H2 EPS to be in the region of $4.10 to $4.40 if the target of $7.45 and $7.75 is to be achieved.

Let's approach this from another angle and take a conservative assumption that H2 earnings will come in at approximately the same level as H1 earnings. In this case, we would use the unadjusted numbers of $1.28 for Q1 and $1.94 for Q2 to give us an unadjusted EPS H1 sum of $3.22 and assume the same for H2, to give us a full year unadjusted EPS of $6.44. For the PE ratio we would apply a conservative value of 20, given that the average for trailing five years is 22.99 and 21.03 TTM. Using this highly simplified and rather conservative approach, and based on unadjusted numbers, we could project a share price of $128.80 ( (H1 $3.22 + H2 $3.22) x 20 PE ) which would amount to a 11.8% increase over today’s share price of $115.25. Subsequently, I see the UPS stock at a current of $115.25 as being potentially 11.8% undervalued.

If, following these calculations, we still don’t believe in Abney’s EPS commitment for a full year adjusted EPS of between $7.45 and $7.75, we can also play this stock purely for the dividend. Today the yield on UPS sits at 3.4%. Furthermore, if we truly really don’t believe this stock will appreciate by any value at all, we could always sell a $115 Jan 2020 call option and profit from both the call premium as well as the dividend.

We could make this an even more risk averse deal by using this call option premium to purchase a $110 put option, which would limit our overall risk (excluding transaction costs) to 4.5% of the share price, which just so happens to be covered by the dividend payment we would receive across the 16 months period of the options.

In summary, UPS is at a pivotal point of its 116 year history. Management are bullish and have set aggressive targets for 2019 EPS. These targets are being scrutinized by investors, who look at the results from H1 and see substantial challenges in achieving the necessary growth in H2 to achieve the full year adjusted EPS of between $7.45 and $7.75.

I have shown that even with a repeat of H1 results, where Q1 disappointed and Q2 overdelivered, H2 could provide a full year unadjusted EPS sufficient to achieve a share price 11.8% higher than where we stand today, based upon a very conservative PE ratio of 20.

Finally, I have also shown, through use of selling a covered call, with the premium being used to purchase a corresponding protective put, that we could benefit from the dividend yield of 3.4%, making this a sufficiently attractive stock to make UPS a calculated buy.