Warren Buffett's UPS Has an Enviable, Durable Market Position
However as I read up on UPS I can see why Buffett may have been attracted to it. The UPS culture, much like Walmart (WMT)'s, has been one of frugality and “penny pinching” as noted by the author of "Driving Change: The UPS Approach to Business." The company had been privately held until 1999 and conducted much of its growth organically rather than by acquisition. However, that strategy changed with the IPO as UPS could more easily acquire companies with stock.
Most recently it successfully bid for European logistics company TNT. Many of UPS’s international forays have been with the help of a foreign partner rather than outright acquisitions as the local partner would be advantageous in navigating the foreign culture. UPS already competes against TNT so the gains to cultural understanding will not be as large as gains to market share. UPS noted that the TNT purchase would reduce its return on invested capital to below their 25% target for at least the next four years. Still it will be a long-term investment and given the lull in the European economy the price may not be so high after all.
UPS is a true beneficiary of network effects. The more cities the company connects, the more valuable their entire system. When the cost of distribution centers and airplanes are considered, the moat around the business grows even more. Unfortunately these advantages haven’t necessarily shown up in the net margin as it has varied from 7% to 10% over the past decade with high oil prices weighing on UPS earnings of late. These advantages do show up in market share where UPS holds some 61% of U.S. ground shipping and 30% of overnight shipping.
Ground Shipping Market Share (2007):
Source: MergeGlobal (2007) The New Supply Chain, American Shipper, November, http://www.mergeglobal.com/articles/2007-11_New-Supply-Chain.pdf
Note: Involves shipments of less than 150 pounds.
(Unfortunately only 2007 statistics were available.)
But if UPS can't notch high margins, it produces in the category that matters – return on equity. This past year the company logged a return on equity of 53%. This figure is up from the mid 20s earlier in the decade largely because of higher debt proportions, but also higher turnover. UPS produces $1.5 in sales for every dollar in assets, up from $1.2 in 2002. Assets have been held relatively flat over the last couple years despite gains in revenues. FedEx (FDX) has been consistently pushing $1.4 in sales per dollar in assets for the last decade so UPS may be able to sustain these high turnover numbers. If UPS can put a dent in fuel costs with its natural gas plan, margins may start to pick up as well as push higher that already lofty return on equity.
The company does have a much higher debt load than FedEx, but it should have no problem servicing that debt with its large free cash flows. UPS produced some $16 billion in operating cash flow in the past three years and invested some $4.9 billion capital expenditures. FedEx, by contrast, produced just under $10 billion in operating cash flows while investing just under $9 billion in capex for the period. UPS expects its capital expenditures to grow about 10% to $2.2 billion in 2012.
UPS has seen its operating cash flows vacillate over the years with pension contributions debiting the figure. Pension contributions were $924 million, $3.2 billion and $1.4 billion for the years 2009, 2010 and 2011. UPS noted that a $2 billion “discretionary contribution” was made in 2010 towards the UPS Retirement and Pension plans. These numbers are significant because free cash flow per share rose 90% from 2010 to 2011, but earnings per share only grew 11% during the period. UPS noted that additional discretionary contributions may be made in the future, but 2012 pension contributions are expected to be about $930 million.
The least attractive feature of UPS is the price — it sells for a price to earnings of 18. The reasons surely lie in the company’s economics. One of its main competitors, the US Postal System, has been on a steady retreat as it feels the pain of lower sales and high operating leverage. Eliminating Saturday service has been mentioned as one of the solutions and should that happen UPS will surely pick up some of those customers.
Unless the price comes down you're likely to find similarly high-quality businesses selling for less (IBM, Wells Fargo). Still the company is definitely worth keeping an eye on. It has an enviable market position and one that may likely hold for many more years if not decades.