United Parcel Service (NYSE:UPS) reported a strong set of Q3 results in October, aided by a recovery in the global logistics industry. The company reported a faster growth in its top line on a quarterly basis, boosted by increased shipments from its domestic operations. In addition to strong top line growth resulting from improving global conditions within the logistics industry, the company has been making efforts to further expand its margins by improving its natural gas footprint and optimizing routes for its ground fleet.
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We believe that these operational developments bode well for the company’s future earnings growth and considering the better global outlook, we have increased our price estimate for UPS from around $88 to about $108, which is at a premium of about 9% to the current market price. Below is a brief summary of the rationale behind the changes to our price estimate.
UPS Ground and International Segments To Lead Top Line Growth
A recovery in the global macroeconomic environment has significantly lifted top line results for logistics operators such as UPS and FedEx (NYSE:FDX) during the current fiscal year. Strengthening domestic markets and weak international currencies have increased volume shipments and revenues, albeit the lower prices. During the nine months so far in 2013, overall volume shipments increased 3.1%, almost in line with the growth between 2011-12. However, Q3 witnessed an acceleration in shipment volume growth at 4.6%, compared to 2.3% in Q2 and 2.4% in Q1. During the fourth quarter, UPS expects shipments to increase by 8% on a peak day. We believe this strong holiday season demand should drive higher shipment growth for fiscal 2013 on a y-o-y basis.
UPS’ strength in ground operations in comparison to FedEx has supported a much faster growth in top line for the company. Domestic revenues for the first nine months for UPS registered a 3.5% growth rate and stood at approximately $24.8 billion, supported by a 5% rise in ground segment revenues. On a similar basis, FedEx reported flat revenues from its U.S. package business, with gains in FedEx Ground nullified by declines in FedEx Express. Additionally, UPS seems to be sacrificing its revenue yield to take advantage of the shift in industry dynamics to cheaper transportation modes and increased average package volumes. For fiscal 2013, we expect approximately a 4% growth in revenues for UPS’ U.S. operations, primarily driven by a 5.6% rise in Ground revenues.
International shipments globally have been on the rise due to an increase in export industry activity following currency volatility in emerging markets. Traffic along the trade lanes connecting Europe, Asia and Latin America increased this fiscal year for UPS. Additionally, a recovery in the Euro-zone economies in 2013 supported an increase in manufacturing exports from the region to various emerging markets. For the nine months so far, international shipments increased 4.4% over 2012 shipments. Domestic shipments in international geographies, serviced though UPS’ subsidiaries and various acquired companies, had a volume increase rate of 3.9% while international export volumes grew 5.2%. Revenue yields for the international domestic business, however, continued to be pressurized by weak consumer spending, growing 0.6% so far in 2013. Growth in revenue yields for UPS’ international export business was pegged back by 4.6%, heavily impacted by weak currencies along major trade routes in emerging nations. On the whole, international business revenues for the 9 months were 1.5% higher compared to a similar period in 2012. Going forward, we expect a 2.5% growth rate for UPS’ international package business in 2013 due to a decline in yields as emerging market currencies continue to stay weak.
Margins To Improve With Increased Operational Efficiencies
Operating margins for UPS slumped from 11.4% in 2010 and 2011 to 2.5% in 2012 due to a $5 billion increase in mark-to-market charges associated with its compensation and pension payment plans. In the following 9 months, margins increased back to over 12% as the company incurred no additional one-time charges. Going forward, we expect margins to expand at a faster pace with concentrated efforts to save fuel expenses from the company’s management.
Recently, UPS announced its plan to add 9 more LNG plants to its earlier target of building 4 LNG fueling stations by the end of 2014. These 13 fueling stations are expected to service approximately 1,000 LNG tractors that UPS uses for its ground operations, and the transition from diesel to LNG is a result of a decade of rising crude prices. With efficient transition into LNG, UPS estimates an annual diesel displacement of about 24 million gallons beginning in 2014. .
Additionally, UPS aims to decrease operational and fuel expenses by increasing the roll-out of its On-Road Integrated Optimization and Navigation (ORION) software. The ORION software is a route optimization software that is intended to improve delivery times and decrease fuel expenses for its ground fleet. Upon successful integration into its operations, the software is expected to save close to $50 million for every mile of route shortened per driver.  By the end of this fiscal year, routes implemented with ORION are expected to account for 1.5 million gallons of fuel savings. The company expects complete integration of its proprietary ORION software within the 55,000 operational routes in the U.S. by 2017, and a global roll-out subsequently. We haven’t accounted for the impact of this software integration into its ground fleet, but we believe that UPS could gain significant expansions in its operating margins in the future.Notes:
- UPS to Expand Natural Gas Footprint, UPS Pressroom, October 2013 [↩]
- UPS Speeds ORION Deployment And Takes Routing Optimization To New Heights, UPS Pressroom, October 2013 [↩]