Is UPS Undervalued Right Now?

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The United Parcel Service (NYSE:UPS) investor day presentation provided stockholders with a key insight on what to expect from the company in the coming years. However, with the stock now up 27% in 2021 alone, was the presentation enough to make the stock look a good value? Let’s take a closer look at the matter.

UPS management guidance

Put succinctly, management believes that successful growth initiatives with small and medium-sized businesses (SMB) and healthcare, combined with productivity initiatives, will help to produce significant margin expansion and revenue growth in the key U.S. domestic package segment. Meanwhile, expansionary investment in the international segment is expected to lead to market share gains and operating profit growth.

Packages outside a door

Image source: Getty Images.

A summation of the 2023 targets given by the transportation stock’s management is in the table below. The key takeaways from the financial targets are:

  • The bulk of margin expansion will come from the U.S. domestic package segment.
  • International package adjusted operating margin is forecast to be stable (around 21.5% in 2023 compared to 22.2% in 2020), so it’s primarily a revenue growth story in the segment.
  • Free cash flow (FCF) should expand significantly.

Data source: UPS presentations. *Three-year cumulative.

Turning to valuation matters, UPS has a stock price of $214 and a market cap of $186.5 billion and trades at 26.2 times its trailing-12-month FCF. Based on the midpoint of the three-year FCF target, UPS will generate $8.5 billion worth of FCF a year until 2023. That puts the stock at a valuation of slightly less than 22 times FCF.

Is UPS a good value?

Given that a mature industrial company often trades at a valuation of 20 times FCF, the company’s valuation appears a little rich. However, the numbers that UPS management is projecting it will hit are not those associated with a slow-growing, mature company.

For example, the targets to 2023 imply a 5% to 6% compound annual growth rate (CAGR) in revenue, while adjusted operating profit is expected to grow at a 12.5% to 17.2% CAGR over the same period. As such, UPS’ profile is closer to a growth company, meaning that investors should be willing to tolerate higher valuations to reflect the growth prospects.

The real question is, what are UPS’ growth prospects beyond 2023, and would they justify a stock trading at 22 times FCF? In my opinion, on balance, UPS is slightly undervalued, but not much.

Three reasons why UPS is only slightly undervalued

The first reason comes down to risk. Specifically, the chance that UPS doesn’t hit its targets. That risk partly comes down to the usual headline risk most companies face, namely the economy and the success of its growth initiatives. While the risk of the former is always there, the latter doesn’t seem significant.

The COVID-19 pandemic has given e-commerce a boost, and in particular, UPS is making great progress in the SMB market. In addition, the pandemic has helped its healthcare growth, and management expects double-digit growth in healthcare-related revenue to 2023. So, on balance, UPS looks well placed for the next few years, but investors still need to price in some risk.

The second reason is that the international segment margin is expected to be stable. This implies that profit growth is contingent on revenue growth, and it’s hard to predict what will be in the post-2023 environment.

Small packages on a keyboard.

Image source: Getty Images.

The third consideration is that it’s far from clear what UPS’ overall revenue growth rate will be after 2023. In a sense, the 5% to 6.4% revenue CAGR to 2023 is partly due to the boost provided by the stay-at-home measures accelerating the growth of e-commerce deliveries. The newly committed online purchasers should stay — great news for package delivery companies — but the growth rate might slow in the future. As such, it might be a stretch to pencil in 5% to 6.4% revenue growth after 2023. Meanwhile, there’s no guarantee that UPS will expand margin as quickly in the future.

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UPS is slightly undervalued

All told, UPS is an attractive company, but it’s hard to make the case it’s a screaming value right now. The company still has to meet its 2023 targets, and even then, there’s no guarantee its growth trajectory will justify a valuation of 22 times FCF. The stock will suit income-seeking investors enticed by a near-2% dividend yield, and a policy of “buying on the dips” makes sense, but UPS is no more than just undervalued right now.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.



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