A few months ago, I was attempting to identify undervalued stocks based on the current dividend yield compared to the average yield over a long period of time. One stock that I felt was extremely undervalued using this method was United Parcel Services UPS.
Shares were trading at $107.50 at that time and provided shareholders with a 3.8% dividend yield. This was 80 basis points higher than the 10-year average yield of 3%. If averaged for an entire year, this would be the highest since at least 2004. As a result, I estimated that UPS was undervalued by 27%.
Fast forward less than two months to today and the stock price has increased almost 35%, with 14% of this gain coming on the day following the most recent earnings release. I didn’t believe that the stock would return this much this quickly, but the company’s most recent quarter was stronger than expected.
Quarterly highlights
UPS reported second-quarter earnings results on July 30. Wall Street analysts had expected a decline on both the top and bottom lines, but the company massively outperformed expectations. Revenue increased $13.4% year-over-year to $20.5 billion, nearly $3 billion higher than expected. Earnings per share grew 17 cents, or 8.7%, to $2.13, which was $1.05 ahead of estimates.
The company faced additional costs related to the pandemic in the first-quarter, but UPS benefited from the pandemic during the second quarter as demand surged. Consumers weren’t able to purchase goods in person like normal so they turned to e-commerce as a way to acquire what they wanted. Healthcare shipments were especially strong during the quarter.
U.S. Domestic revenues increased 17.3% to $13.1 billion. The operating margin was 9% for the quarter. Average daily volumes were higher by 22.8% with the company delivering more than 21 million packages per day. Demand was heavy in residential areas as business-to-customer shipments increased 65.2%. Revenue per piece was down 4.4% due to lower fuel prices and expenses related to having too many packages to deliver and thus needing to entrust more to USPS for delivery through partnership services. Adjusted operating profit was down slightly.
International revenues increased 5.7% to $3.7 billion, with margins of 20.8%. Outbound demand from Asia was especially strong, and the company added 335 flights above normal schedules to address this need. Business-to customer volumes almost doubled, led by cross-border e-commerce in Europe. Average daily volumes improved almost 10% year-over-year. Adjusted operating profit was the best of the segments in the second-quarter as it was up 27%.
Revenues for the Supply Chain and Freight Segment climbed 8.5% to $3.7 billion while operating margins were 7%. An improvement in market rates out of Asia was the primary reason behind the increase. UPS added 300 charter flights out of the region to meet demand. This was offset by very weak demand in the beginning of the quarter. Adjusted operating profit declined 2.2%.
UPS ended the quarter with $17.1 billion in current assets, including $5.7 billion in cash, cash equivalents and short-term investments. This compares to total current liabilities of $15.4 billion, including short-term debt of $3.4 billion. UPS has long-term debt of $21.8 billion, but has a weighted average maturity of 11.8 years and an average weighted coupon on 2.8%.
The company generated $3.4 billion of cash from operations during the quarter and nearly $6 billion year-to-date. Free cash flow was almost $2.3 billion in the most recent quarter and $3.9 billion for the first half of 2020. Between cash on the balance sheet and free cash flow generation, UPS will likely be able to meet its debt obligations.
UPS hasn’t released updated guidance, but analysts expect the company to produce EPS of $7.01 for 2020. Using the current share price of $145, UPS has a forward price-earnings ratio of 20.7. UPS has traded with an average price-earnings ratio of 17.8 over the last decade, so shares are expensive using the traditional price-earnings method.
Following the increase in share price since my last article on the company, UPS has a dividend yield of 2.8%. If shares were to average the current yield for the entire year, it would tie 2013 and 2017 as the second-lowest dividend yield since 2008. I used dividend yield to determine that UPS was undervalued by the market two months ago. Using this method today, I find the stock to be overvalued.
Final thoughts
Overall, UPS had an excellent quarter as results easily beat what the market had expected. The company was able to meet a surge in demand as consumers turned to online shopping.
That said, my previous attraction to the stock was that it offered a much higher than usual dividend yield. The significant increase in share price since my last article on the stock has caused the yield to sink below the long-term average. As such, UPS looks to be overvalued at the current price.
Author disclosure: the author has no position in any stock mentioned in this article.
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