UPS: Valuation And Dividend Strength Too Compelling To Pass Up

Transportation Secretary Buttigieg Tours UPS Facility Distributing Vaccines

Alex Wong

It’s been about 20 months since I wrote my cautious piece on United Parcel Service Inc. (NYSE:UPS), shares have returned about 10.8% against a gain of about 6.25% for the S&P 500. The stock has come down in price recently, and they’ve obviously reported earnings since I last looked at them, so I thought I’d take another look to see if it makes sense to buy at current prices. I’ll make this determination by looking at the financials here, paying particular attention to most recent financial results. I’ll also look at the stock as a thing distinct from the business, because I’m of the view that the shares of a great company can be a terrible investment if you overpay for them. Finally, I feel like writing about put options here, so I’m going to write about put options here. I think these may offer a great, profitable alternative to the stock for some people. They may also give me the chance to brag about previous trades, and I never pass up that opportunity.

Welcome to the “thesis statement” portion of the article. It’s here where I give you the “gist” of my thinking. In particular, I’ll give you the highlights of my thesis (hence the name “thesis statement”) so you won’t be obliged to read the entirety of my screed. This is for people who want to glean my thoughts, but don’t want all of the self congratulation, cheesy jokes, or other nonsense that I might scatter throughout my articles. I’m of the view that UPS represents fairly good value at the moment. Revenue and net income are both up dramatically, and the capital structure is much better than it has been in years. For example, cash on hand represents about 3 ½ years of dividend payments, and long term debt and lease obligations are down dramatically over the year. In spite of this, the shares are trading near multi year lows, and the dividend yield is back to reasonable levels in my view. For this reason, I’ll be buying a few shares. All that written, I can understand why an investor would be nervous about buying stock at the moment. There isn’t a shortage of bad news. If I were talking to such people, I would say two things. First, the only way we can “buy low” is by doing so when other people are fearful, and for that reason, investing well is a bit emotionally uncomfortable. Second, if buying the stock at the current level is too much for you, consider selling put options, as the premia on offer for these is quite good at the moment. In particular, I would recommend the December puts with a strike of $150 for people who are afraid of the stock at the moment.

Financial Snapshot

I’ve written about UPS’ long financial history in my previous work, so I won’t go over old ground here. Rather, I’ll focus on the most recent quarter, relative to the same period a year ago, and relative to the same period in the pre-pandemic world. Although revenue during the most recent quarter was up about mid single digits (6.4%) relative to this time last year, net income has absolutely collapsed, down about $2.1 billion, or 44.5%. The chief culprits here is the 51.2% uptick in fuel costs, and the collapse in “investment and other income”, which was about 91% lower than it was in 2021. I’ve written previously about how investment income goosed returns previously, and the latest performance testifies to how volatile this source of income is.

When compared to the same period in 2019, though, things look rather better. Revenue for the first three months of 2022 was fully 42% higher than it was in 2019, and net income has more than doubled, up by just under 140%. The reason for this comes down to increased revenue over the past few years. Specifically, the $7.2 billion increase in revenue between the quarter end of March 2019 and the quarter end of March 2022 swamps the uptick in expenses. Said another way, in spite of the fact that expenses increased between 24.7% (compensation and benefits) on the low side, and 58.4% (fuel) on the high side, the company is far more profitable now than it was previously.

At the same time, the company has improved the capital structure dramatically over the past few years. Long term debt and lease obligations have dropped about 7.8% over the year, and cash and marketable securities are about 55% higher than they were this time last year.

Finally, at a payout ratio of just over 50%, I think the dividend is reasonably well covered here. I like the fact that cash on the balance sheet is currently the equivalent of ~3.5 years of dividend payments.

Given all of the above, I’d be very happy to buy this stock at the right price.

A financial history of UPS from 2014 to the present.

United Parcel Service Financials (UPS investor relations)

The Stock

My regulars know that the phrase “at the right price” has talked me out of more than my fair share of investments that went on to increase in price. I acknowledge that this can be frustrating, but I would prefer to give up on upside to taking undue risk.

Also, I’m about to tread over very old ground. If you subject yourself to my stuff regularly for some unknown reason, you know that I think the stock is distinct from the business in many ways. In addition, the stock is often a very poor proxy for the business that it supposedly represents. You must agree with me on some level on this point, otherwise you wouldn’t spend time on a site such as this.

To develop the point more fully, a business buys a number of inputs, adds value to them, and then sells the results at a profit. The stock, on the other hand, is a traded instrument that reflects the crowd’s aggregate belief about the long-term prospects for the company. The crowd changes its views about the company relatively frequently, which is what drives the share price up and down. Added to that is the volatility induced by the crowd’s views about stocks in general. “Stocks” become more or less attractive, and the shares of a given company get taken along for the ride. Although it’s tedious to see your favorite investment get buffeted because the asset class of “stock” goes in and out of favor, within this tedium, we have opportunity. If we can spot disconnect between the price the crowd dropped the shares to, and likely future results, we’ll do well over time. It’s typically the case that the lower the price paid for a given stock, the greater the investor’s future returns. In order to buy at these cheap prices, though, you need to buy when the crowd is feeling particularly down in the dumps about a given name. This is obviously easier said than done.

As my regulars know, I measure the relative cheapness of a stock in a few ways ranging from the simple to the more complex. On the simple side, I like to look at the ratio of price to some measure of economic value, like earnings, sales, free cash, and the like. Once again, cheaper wins. I want to see a company trading at a discount to both the overall market, and the company’s own history. In my previous note on UPS, I lamented the fact that the shares were changing hands at a PE of ~31.3 times.

Fast forward to the present, and the ratio is much more attractive, per the following:

Chart
Data by YCharts

At the same time that investors are paying less than they have for a few years now, they’re getting more, per the following:

Chart
Data by YCharts

In my view, the company is much stronger now than it has been in a long while. In spite of this, the market is paying less for $1 of earnings than it has in a long while. Additionally, the dividend is reasonably well covered in my view. Given all of the above, I’ll take a (small) bite of UPS at the moment.

Options As Alternative

My regular readers know how much I love to brag, and my performance with short puts on this stock give me a couple of good reasons to do so. I don’t want to go over that again in this article, though, so if you really want to expose yourself to industrial scale bragging on my part, I would recommend my previous article, where I write about receiving decent premia, and/or having shares put to me at very attractive prices.

At the moment, I want to write about short puts as an alternative to buying the stock. I understand that buying stock can be difficult for people at the moment, given the enormous risks we can point to in the economy and the market overall. For people who like this business, and who would be willing to buy, but only at a lower price, I offer an alternative to simply waiting for shares to possibly drop further in price. I think selling put options makes the most sense for people who like UPS, but who are simultaneously nervous about the prospects of continued market weakness. Specifically, I think the December UPS put with a strike of $150 is very compelling at the moment. These are currently bid at $6.50, which I consider to be a reasonably good premium. So to walk through the mechanics, if these shares drop another 15% in price from current levels, the investor will likely be obliged to buy, but will do so at an even more attractive valuation and dividend yield obviously. If the shares don’t fall another 15%, the investor will collect the equivalent of ~4.3% on their risk capital ($6.50/$150) for a little over 5 months of, uh, “work.” Either outcome would be acceptable in my view, and I would recommend it to anyone nervous about taking a position in the stock at the moment. This “premium if the shares rise” and “premium plus great entry price if the shares fall” is one of the reasons why I characterize these as “win-win” trades in general, and why I recommend this trade in particular for people nervous about buying the stock at the moment.

Now that you’re hopefully excited by the prospect of a “win-win” trade, we come to the portion of the article where I get to indulge in my semi-sadistic tendency to ruin the mood by writing about risk. This trade, like all others, comes with risk. I consider the risks associated with put options the way I trade them to fall into two broad categories: the economic and the emotional.

Starting with the economic risks, I’d say that the short puts I advocate are a small subset of the total number of put options out there. I’m only ever willing to sell puts on companies I’d be willing to buy and at prices I’d be willing to pay. So, I would never advocate that people simply sell puts because they sport a high premium. This strategy leads to disastrous results. Take my word on this one, as it’s informed by some painful experience.

The two other risks associated with my short puts strategy are both emotional in nature. The first involves the emotional pain some people feel from missing out on upside. To use this trade as an example, let’s assume that UPS’ stock price goes parabolic and hits $200 per share between now and the third Friday of December. Obviously, these puts will expire worthless, which is a great outcome in some ways. Put sellers will not catch any of that upside in the stock price, though. So, short put returns are capped by the premium received. This is emotionally painful for some more hopeful souls than me.

Secondly, it can be emotionally painful when the shares crash below your strike price. As of this writing, there’s only one instance when this didn’t work out well for me, though. Things have generally worked out well over the long term, because I insist on only ever writing puts at “screaming buy” strike prices. That said, it has been emotionally stressful in the short term on occasion. If you’re going to sell puts, please be aware of the way that they can play with your emotions.

If you understand these risks and can tolerate them, I would recommend that you sell the December puts with a strike of $150 here. Whatever happens, you’ll collect a great premium and you may have the benefit of buying a very decent company at a great price.

You may consider it odd that I’m concluding a section on risk by writing about how short put options can enhance return and actually reduce risk. If this is the first time you’ve noticed that I can be odd, you’re obviously not paying attention.

Conclusion

There’s a good chance that UPS shares will continue to drop in price. If you have any experience at all investing in stocks, this shouldn’t be a problem for you. No one has ever consistently bought at absolute bottom prices. The point isn’t trying to buy at the absolute lowest price, the point is to buy when the shares are priced below their value. In my view, they are currently priced below their value, so I’m willing to buy a few shares. For those nervous about buying at the moment, I would recommend the short puts described above.

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