United Parcel Service, Inc. (UPS): An Exceptional Business for an Unexceptional Price

Investment Write-ups

Business Description

United Parcel Service, Inc. (UPS) was founded in 1907 and has grown to be the world’s largest package delivery company, the leader in ‘less than truckload’ shipments and a global supplier of supply chain management solutions. The company facilitates deliveries to over 9 million receivers, across over 220 countries, each and every day. In 2017, the company delivered an average of 20 million packages per day. In logistics, the company offers transportation, contract logistics, ground/air/ocean freight, customs brokerage, insurance and financing.

Together with FedEx, they dominate the US package delivery industry.

Why do we own it?

1. Returns on Capital

UPS has not only generated stable returns over its history, but very high and stable returns. These returns are significantly above those of their main competitor, FedEx:

Why is this? The answer is simple: UPS has a completely integrated network which allows continual optimization and efficiency improvements, whereas FedEx operates its business units as individual silos. Although this strategy has enabled FedEx to grow their business much more quickly, through franchisees who ‘own’ individual routes, it has also meant that they can’t optimize their route network. Additionally, by running a Ground and Express route on top of one another, they often must duplicate drops and overlap routes, creating further inefficiencies.

UPS does not have this issue- they own all their routes, totally integrate the different segments (air, express, ground) and as such are much more able to efficiently plan and optimize routes. It is also likely that the newcomer to the space, Amazon delivery services, will encounter the same issue– they are also growing through a franchising model. It’s a great way to grow quickly, but not a great way to earn the best returns over the long term.

This a structural advantage for UPS– so we expect them to continue to earn higher returns than peers, meaning more cash available to return to us as investors (4% dividend yield), as well as to reinvest in new technology, automation, drones etc., that will further enhance those returns relative to peers.

2. Long term growth opportunity

Package delivery continues to grow consistently each year and will likely continue to do so for many more years to come. There are several key drivers here:

Ecommerce: one of the biggest impacts is going to be the continued growth of online shopping- currently only 10% of US retail is online and this number continues to grow rapidly each year.
International: Growth rates outside of the US are even higher, particularly in Asia where consumers have embraced Ecommerce much more quickly.
Healthcare: while not a market many people typically think about, the healthcare package delivery market is expected to grow to $105 billion by 2021. UPS have made acquisitions in this space and are well positioned to benefit from this trend.

3. Valuation

By most metrics, UPS’s stock looks cheap- it is trading at a 23% discount to the market as a whole. This discount offers an attractive buying opportunity for investors that can take a long-term view. This chart shows UPS’s valuation relative to the market:

For decades UPS has earned much higher returns than the average stock, they have a defensible position and they are seeing growth in their end markets. Using what we believe is an appropriate market multiple, as well as our own discounted cash flow valuation, we think UPS should be trading closer to $150, yet the market is currently pricing the stock below $100.

So why is it so cheap? The main reason is the threat from Amazon. Many commentators see that Amazon is moving into the delivery business and expect that they will take market share from UPS.

To put this risk into context, Amazon currently makes up about 8% of UPS earnings. That number is not huge, and even if it went to zero, the implication for UPS would not be substantial. The greater risk is that Amazon takes an increasing portion of UPS’s non-Amazon business as they grow their competing service.

For us to own UPS, we need be confident that the market is overreacting to this threat. The reasons we are confident are:

Capital/ Logistics: The capital and logistics required to re-create UPS’s network scale are staggering. Yes, Amazon effectively operates with zero cost of capital, but even so the spend and time required is enormous, which is why UPS’s returns have been so well defended historically.
Inefficient model: There is a chance that Amazon is already going down the wrong path with the franchise model- similar to what FedEx did. It allows fast growth, but it leaves these businesses with an inefficient network that can’t be optimized. UPS’s advantage in owning all its routes is substantial.
Customer risk: There are many customers (Walmart, Target, retailers in general) who will likely be reluctant to use an Amazon delivery service as it would give their main competitor a huge amount of information about their sales. This could limit Amazon’s ability to compete in some retail focused markets.
Last mile is not highly profitable: Amazon may expand sufficiently to take the attractive high drop city routes while leaving a lot of the less desirable rural routes to UPS and FedEx. Obviously, this isn’t great if it means UPS get left with just the less profitable routes- but it does place a cap on how far Amazon might go in this market.
Amazon is being forced to expand, whether they want to or not: Amazon have run into problems previously as a lot of their volume occurs at peak times, and a lot of it is small unprofitable packages. Both UPS and FedEx have refused to build out certain elements of capacity when asked by Amazon, as they don’t see them as profitable. As both have pulled back, this has meant Amazon has been forced to build out some capacity themselves in order to maintain their customer service, whether that was their long-term goal or not.

We should not completely brush aside the Amazon threat given their scale and lack of normal capital discipline requirements. However, in this situation we believe UPS is well protected. It is very easy for pundits, analysts, etc to construct a negative view on UPS, but lucky for us that is what has driven down the valuation to such an attractive level.

Another point to consider is that UPS has greatly increased their capital spending over the last few years. This is a cash cost, so short-term analysts don’t like to see it. For us, we take a longer-term view- this CapEx is predominantly going into depot automation and efficiency improvements. The company has said they are already earning 20%+ returns on their capital spend- so this will likely drive significant cash flow growth over the long term.

What can we expect?

As shareholders, we should expect 6%+ top-line growth, a 4% dividend and an appreciation in market multiple. Combined, this gets us comfortably into double digit returns over the medium term.

UPS is a great example of the market miss-pricing a long-term defensible asset due to short term headwinds in the news.

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United Parcel Service, Inc. (UPS): An Exceptional Business for an Unexceptional Price