Published March 2nd, 2017 by Nick McCullum
Warren Buffett has become a billionaire from investing in high-quality companies with strong competitive advantages and world-class management teams.
Investors can gain valuable insight into Buffett’s investment strategy by reading his annual reports and looking through his 13F filings – which list the holdings in Berkshire Hathaway’s investment portfolio.
One of Buffett’s smaller investments is United Parcel Services (UPS).
Through his conglomerate Berkshire Hathaway (BRK.A) (BRK.B), Buffett owns 59,400 shares of UPS that are worth approximately $6 million. $6 million might seem like a large stake for individual investors like you and I, but Berkshire’s UPS investment is dwarfed by some of its larger bets:
- Kraft Heinz (KHC): $30.8 billion
- Wells Fargo (WFC): $27.9 billion
- The Coca-Cola Company (KO): $16.6 billion
- International Business Machine (IBM): $14.6 billion
As you can see from the company’s above, Buffett’s portfolio is filled with dividend stocks.
Looking at Berkshire’s stake in UPS, Buffett seems content to sit on his investment. He reported no buying or selling of UPS shares for the quarter ending December 31, 2016. Moreover, the Oracle of Omaha has held shares of UPS since 1Q2006 – a holding period of nearly 11 years.
This article will discuss the investment prospects of UPS in detail.
UPS is the world’s largest logistics company with a focus on package delivery.
The company was founded in 1907 as a private messenger and delivery service in Seattle. After decades of sustained growth, UPS is an industry leader with a $92 billion market capitalization.
UPS divides their operations into three segments for reporting purposes:
- U.S. Domestic Package (62.9% of 2016 revenues)
- International Package (20.3% of 2016 revenues)
- Supply Chain & Freight (16.8% of 2016 revenues)
UPS will benefit from a variety of growth drivers moving forward.
The first, and perhaps most obvious, is the continued growth in the global economy. As trade volumes increase between globalized countries, the logistics market will grow as well. UPS will benefit from this trend.
Investors should be pleased to see that UPS has consistently taken a larger share of this market growth than their main competitor FedEx.
UPS has also recognized that efficiency will be a major driver of growth moving forward. One of the main ways this focus on efficiency has appeared in UPS’ operations is through their On-Road Integrated Optimization and Navigation [ORION] system.
ORION combines syndicated data from UPS’ delivery fleet to find the quickest, most fuel-efficient routes for their drivers.
Some of ORION’s major benefits can be seen in the following diagram.
It appears the best is yet to come for ORION. UPS believes that by 2019, the system will be able to integrate real-time data. The company expects annual cost savings in the range of $150 to $200 million.
UPS is also investing extensively in new fulfillment locations. Two notable examples are in Atlanta and Salt Lake City.
The Atlanta location was announced in November of last year and will be the third largest processing facility for UPS’ domestic operations. The project is expected to be at full operating capacity by the end of calendar 2018 and will house 1,250 new employees.
The Salt Lake City project, expected to be completed in late 2018, will process 69,000 packages per hour and complement UPS’ existing 200,000 square foot location in the city.
Beyond these two flagship projects, UPS is planning for 50-70 more development project in the medium term (3-5 years).
UPS is also focusing on technology (outside of the ORION project) to improve their operational efficacy. The company has recently tested the possibility of executing deliveries with drones sent from the roof of package cars. Other examples of UPS’ integration of technology include the possibility of UPS integrating self-driving trucks and the company’s constantly improving tracking technology.
Some of the company’s other forward-looking initiatives can be seen in the following diagram.
Will a growing global economy, an ever-strengthening distribution network, more robust fulfillment centers, and a focus on technology, UPS’ growth prospects for the foreseeable future appear very attractive.
Competitive Advantage & Recession Performance
UPS’ competitive advantage comes from their well-entrenched distribution network.
They are the largest logistics company in the world, which allows them to create many economies of scale. By passing these savings onto their customers, UPS generates customer loyalty which contributes to their future business pipeline.
UPS is not the most recession-resistant business. As a global logistics company, UPS will likely experience negative earnings growth during periods of economic recession.
This is because the company’s revenues are dependent on the movements of goods from one place to another. This type of activity naturally slows during recessions.
UPS’ earnings-per-share performance during the global financial crisis can be seen below.
- 2007: $4.11
- 2008: $3.50 (14.8% decrease)
- 2009: $2.31 (34.0% decrease)
- 2010: $3.56 (54.1% increase)
- 2011: $4.23 (18.8% increase)
From peak-to-trough, UPS’ earnings-per-share were nearly cut in half during the last major recession. However, the company recovered and posted record earnings after only two years.
Valuation & Expected Returns
For fiscal year 2016, UPS reported adjusted earnings per share of $5.75. At their current price of $107.13, UPS is trading at an adjusted price-to-earnings ratio of 18.6.
Looking ahead, Value Line estimates that UPS will report $5.90 of adjusted earnings-per-share in fiscal 2017. This equates to a forward price-to-earnings ratio of 18.2.
The following diagram displays how these two valuations compare to UPS’ long-term historical averages.
Source: Value Line
UPS is trading below their long-term historical average, but the company’s current valuation is actually quite in line with their price-to-earnings ratio since 2013. I do not expect valuation expansion/contraction to be a significant factor in the company’s expected total returns.
Looking next to earnings growth, UPS has compounded adjusted earnings-per-share from $2.10 in 2001 to $5.75 2016, which is good for a CAGR of 6.9%. The company’s long-term earnings trend can be seen in the following diagram.
Source: Value Line
I believe that UPS will succeed in growing their bottom line at a rate of 5%-7% over the long-term, with much of this growth being triggered by technology-driven cost savings and broad-based economic growth.
The last contributor to UPS’ total returns is the company’s dividend yield. Their last dividend payment, declared on February 8, was to be paid on March 8 in the amount of $0.83. This represented a 6.4% increase over UPS’ previous quarterly dividend payment of $0.78.
These $0.83 quarterly dividend payments represent an annual payout of $3.32, good for a 3.1% dividend yield. UPS’ dividend yield is significantly higher than the S&P 500’s dividend yield of 1.9%.
To summarize, UPS’ expected total returns will be composed of:
- 5%-7% earnings-per-share growth
- 3.1% dividend yield
For total returns in the range of 8.1%-10.1%.
UPS is a high-quality company that holds a leadership position in the logistics and transportation industry.
This market leadership provides the company with a durable competitive advantage, which might be why Warren Buffett is such a fan of the stock.
With the company trading around its historical price-to-earnings ratio in a market that some call overvalued, UPS appears to be a good choice for exposure to the logistics and transportation industry at current prices.