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UPS Is Undervalued Based on Its Above-Average Yield

Aside from reviewing a company's most recent earnings report, one item I like to consider before making an investment is how the current dividend yield compares to the long-term historical average. I often use both the five and 10-year averages to see if shares are over- or undervalued based on the yield. If the company can't provide earnings per share guidance, then using the dividend yield can be another way to value a stock.


One company that is trading with a dividend yield above both its five and 10-year averages is United Parcel Services Inc. (NYSE:UPS).

Quarterly highlights

On April 28, UPS, which is the largest integrated air and ground package delivery carrier in the world and trades with a market capitalization of nearly $93 billion, reported mixed first-quarter earnings results. Revenue grew 5.1% to $18 billion, beating estimates by $865 million. Earnings per share, however, declined 17% to $1.15, 8 cents below what analysts were looking for.

Adjusted net income declined by $200 million, with $140 million of this related to the disruption to customers related to the Covid-19 pandemic. Casualty self-insurance accruals were a $110 million drag on results. These were partially offset by an additional operating day, which added $50 million to net income totals.

Digging deeper into results, the U.S. Domestic segment had revenue growth of 9.3%, driven by average daily volume growth of 8.5%. This segment contributed nearly 64% of all revenues. Revenue per piece was down less than 1% on account of changes in customer and product mix. Each product category was higher. Volumes for Next Day Air increased nearly 21%, marking the fourth quarter in a row of double-digit growth. Business to customer deliveries represented 70% of total volumes in March. Despite the uptick in volumes and headwinds from the Covid-19 pandemic, UPS had near-record performance for on-time delivery at all service levels.

While the domestic segment performed well during the quarter, the International segment faced headwinds. A decline in commercial delivers led to a 1.8% decrease in average daily volumes. Revenue was lower by 2.2% and cost per piece decreased 0.5% due to currency exchange rates. International was responsible for 19% of revenues. Europe average daily volumes declined 8% in March following solid growth in January and February. On the plus side, after declining in both January and February, volumes in China rose significantly and wiped out losses in the prior two months. The health care and e-commerce sectors contributed to this rebound with an acceleration in volumes seen as the coronavirus spread.

Revenue for the Supply Chain & Freight segment dropped 0.8% due to headwinds from the Covid-19 virus and difficult year-over-year comparisons. International Air Freight tonnage grew more than 15% in March, primarily due to packages leaving Asia.

Like many companies that have reported results, UPS pulled its earnings guidance for the remainder of the year. The company had expected adjusted earnings of $7.76 to $8.06 per share for the year. Analysts now expect earnings per share will decline 28% to $5.45. This would mark the first time since 2009 that UPS has suffered an annual decrease in earnings per share.

Overall, UPS's first quarter was solid. Revenue was up on strength in the U.S. segment as consumers stayed home and ordered more products online. UPS proved more than capable of handling this increase in shipments. International and Supply Chain & Freight were weaker compared to the prior year, but there were still pockets of growth within these businesses. Much of the weakness was due to the Covid-19 pandemic. UPS saw a rebound in volume growth in China in March, which coincided with the reopening of portions of the country. Were the virus to recede and the number of new cases declined or a vaccine was discovered, UPS stands a very strong chance of returning to growth in its two underperforming segments.

Dividend analysis

Quarterly results aside, the reason UPS looks like a solid investment is the stock's dividend yield. Based off of an annualized dividend of $4.04 and current share price of $107.50, UPS has a 3.8% dividend yield. This compares quite favorably to the five and 10-year average dividend yields of 3.1% and 3%, respectively. For comparison purposes, the S&P 500 yields 1.9%.

According to Value Line, were UPS to average the current yield for 2020, then this would be the highest average yield since at least 2004 for the stock.

UPS raised its dividend by 5.2% for the payment distributed on March 10. The company has now increased its dividend for the past 11 years. It has raised its dividend by an average of:

  • 7.2% per year over the past three years.
  • 7.5% per year over the past five years.
  • 7.9% per year over the past 10 years.



UPS has been remarkably consistent with its average dividend increases over the listed periods of time until the most recent increase. This is likely due to the dividend payout ratios becoming somewhat stretched.

According to Yahoo Finance, UPS is expected to earn $5.45 per share in 2020, which results in an earnings payout ratio of 74% when using the annualized dividend. UPS has been quite consistent in its payout ratios, with a payout range of 49% to 56% for the time period of 2010 to 2019. This year's expected payout ratio is considerably above the high end of this range. I give the company something of a pass here because the decrease in expected earnings per share isn't due to flaws in UPS's business, but the headwinds related to the ongoing pandemic.

Now let's look at free cash flow payout ratio, which isn't as pretty as the long-term earnings payout ratio.

UPS paid out $840 million in dividends in the first quarter of 2020 while generating $1.6 billion in free cash flow, for a payout ratio of 53%. This is a solid payout ratio, one that makes it likely that the dividend is safe from a cut.

The story changes looking back further. UPS distributed $3.2 billion in free cash flow in 2019 while generating $2.3 billion in free cash flow, for a payout ratio of 142%. It goes without saying that this payout ratio is unsustainable.

One reason that free cash flow hasn't covered dividend payments over the last four years is UPS's penchant for capital expenses. The company spent more than $21 billion on capital expenditures from 2015 through 2019. One positive development in this area is that UPS only had $933 million of capital expenditures during the first quarter, compared to $1.5 billion year-over-year and $2 billion quarter-over-quarter. UPS announced on the conference call that it would be reducing its expected capital expenditures by $1 billion for 2020. If capex is declining, then free cash flow should improve and the dividend will look much more secure from this angle.

UPS also suspended share buybacks for the remainder of the year, freeing up $800 million worth of capital. In addition, the company issued $3.5 billion of debt in order to cover its refinancing needs. These actions will likely allow for an increased cash flow as well.

The company not being able to cover its dividend with free cash flow for the previous four years is a concern, but UPS still managed to raise its dividend during this time. The most recent quarter showed much improvement on this metric and the free cash flow payout ratio was very reasonable. If UPS can string together consecutive quarters where the dividend is well covered by free cash flow, then the dividend can be considered much more secure. This would make it a much more attractive investment option to income investors.

Using the current share price and expected earnings per share for the year, UPS trades with a price-earnings ratio of 19.7. This compares unfavorably to the five and 10-year average price-earnings ratios of 17.2 and 17.8.

Normally, I would find the stock to be overvalued based on these numbers, but these are not normal times. UPS's business was expected to grow profitability by 5% before the onset of a global pandemic.

In the absence of any clear guidance from the company, I believe that using the current dividend yield compared to the long-term average yield may provide a much clearer image of how undervalued shares of UPS are at the moment. Using the stock's current yield and 10-year average yield, I find that UPS is 27% undervalued.

Final thoughts

Reviewing results for UPS's first quarter shows strong growth in its largest and most important segment (the U.S. business) with slight weakness in its smaller businesses. Much of this weakness was due to items largely outside of UPS's control, namely the coronavirus.

UPS's EPS payout ratio is much higher than its normally tight range, but this is due to lack of clarity in the upcoming quarters. Historically, UPS has a very solid payout ratio. The free cash flow payout ratio is more concerning, but was at a very healthy level in the most recent quarter. With no more share buybacks for the rest of 2020 and a decrease in capex, this payout ratio should improve relative to the last few years.

The company's dividend yield is 70 basis points above its five-year average yield and 80 basis points higher than its 10-year average yield. The stock's yield has traded around virtually the same level for much of the last decade. Assuming that the dividend isn't cut and the yield returns to the 3% level, it would result in a share price gain of 27%. This is a strong return possibility, and that's before you factor in the dividend. With a much higher-than-average yield and the possibility of a return to the mean, I find that UPS shares are undervalued today.

Disclosure: The author has no positions in any stocks mentioned.

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This article first appeared on GuruFocus.