UPS reports solid 3rd quarter earnings

UPS has reported solid third quarter growth, with revenues rising 7.7% and net income increasing 20.4%.

(10/22/2004)

Total worldwide average daily volume increased by 3.4% to 13.7 million packages per day. Total international export package volume grew 13.2%, while UPS Supply Chain Solutions posted strong growth with revenue up 10.1%.

For the three months ended September 30th, consolidated revenue totalled US$8.95 billion, up 7.7% (Q3 2003: US$8.31bn). Consolidated operating profit rose 9.7% to US$1.26 billion, and net income for the quarter was US$890 million (Q3 2003: US$739m).

The Q3 2003 results included a US$24 million gain on the sale of UPS Aviation Technologies and a US$22 million tax benefit due to a favourable tax ruling. The most recent quarter includes a US$99 million reduction to income taxes due to the resolution of various tax matters. Excluding these items, third quarter operating profit increased by 12% to US$1.26 billion, and adjusted net income totalled US$791 million, up 12.7% (Q3 2003: US$702m).

For the nine months ended September 30th, consolidated revenues at US$26.74 billion were up 8.9%, and operating profit at US$3.79 billion was up 19.3% compared to the same period last year. Net income increased to US$2.47 billion, a gain of 20.8% compared to the period in 2003.

Third quarter highlights included:

International package revenue increased 21.6% to US$1.67 billion on a 13.2% gain in export package volume and a 4.1% increase in international domestic package volume. Asia export volume increased 29% as export volume out of China more than doubled. US export volume led the industry with its fourth consecutive quarter of double-digit growth. Operating profit jumped 49% to US$262 million. International operating margin increased 290 basis points to 15.7%.
US package revenue increased 4.4% to US$6.49 billion while operating profit climbed 3.9% to US$857 million. Both were impacted by a difficult September during which multiple hurricanes and tropical storms disrupted commerce across the US and UPS operations in the Southeast and East. Average daily ground volume in the US grew 4.5%. Total Next Day Air® volume was down due to the large amount of letters associated with mortgage refinancing activity last year. Excluding letters, Next Day package volume increased.
Revenue for the non-package segment climbed 9.5% to US$792 million. Excluding last year’s gain on the sale of UPS Aviation Technologies, operating profit increased 13.9% to US$139 million. Revenue for UPS Supply Chain Solutions, the largest unit in the non-package segment, increased 10.1% to US$591 million. The UPS SCS unit, with the pending acquisition of Menlo Worldwide Forwarding, will add guaranteed heavy airfreight to its portfolio across the globe.
Earlier in the period, UPS added air capabilities to its Trade DirectSM line of services, helping customers eliminate the need for warehousing after importing.
Last month, UPS added three additional flights to its “around-the-world” network to accommodate expanding package flows between Asia and Europe.
This week, the US Dept. of Transport finalised the awarding of aviation rights, allowing UPS to triple its direct access to the fast-growing China market.
Scott Davis, UPS’s chief financial officer, said: “We’re seeing double-digit export growth in every region of the world with strong profit increases to match.” He added that UPS continues to generate substantial positive cash flow and the Board of Directors has increased the company’s share repurchase authorisation to US$2 billion.

For the fourth quarter, Davis said the company is expecting a solid holiday shipping season in the United States and stellar growth outside the US. UPS is projecting fourth quarter diluted EPS to increase to a range of US$0.83 to US$0.87, and to grow by 13 – 17% in 2005.

Inside Freight/Bear Stearns 22/10/04
UPS missed EPS expectations. UPS missed Consensus EPS by $0.02 and our estimate by $0.04 prior to a one time
gain. Continuing EPS of $0.70 included EBIT growth of 12% on 7.5% rev. growth and 60bp of OR improvement
compared to our expectation for 19% EBIT growth on 8.5% rev. growth and 80bp of OR improvement.
• No turn yet in domestic operating ratio? We had expected to see some evidence of the turn in domestic package
OR this quarter despite increased expensing of Package Flow Technology costs. However, instead of an 80bp y-o-y
margin improvement, UPS reported a 10bp deterioration in Domestic Package OR.
• …the stock has begun to anticipate the turn. The stock was up yesterday despite the miss we believe in a large
part because UPS’ mid point guidance of $0.85 for 4Q implies a significant y-o-y turn in its domestic package
operating ratio (about 70-130bp). We believe domestic operating leverage is the key to drive the stock’s upside
during C05.
• Management indicated it is ready to utilize cash flow. UPS should receive roughly $700M ($0.62/hsare) in cash
from the IRS in the near term in addition to its already strong cash balance and cash generation. The announced
$2B stock repurchase was 2x as much as past buybacks and management noted it would buy more aggressively.
• Reiterate Outperform rating. Despite the hiccup this quarter our high end out year EPS estimates wanted to move
modestly upward. We have left them unchanged with greater conviction that C05 and C06 are lining up as strong
years and that the domestic margin turn will take place in the current quarter, with lots of upside potential still in
front of UPS.
INVESTMENT CONCLUSION: UPS was up 0.3% (compared to the S&P 500 up modestly) yesterday despite missing
Consensus earnings by 3% in an environment where the vast majority of freight companies are beating estimates. UPS is
currently trading at 23.6x and 11.6x our forward rolling 12 month (2 months C04 / 10 months C05) P/E and EV/EBITDA
estimates. Our $88 year end C05 target price assumes a 23x forward target P/E out fourteen months from now on our than
forward unchanged C06 EPS estimate of $3.85.
From the stock’s perspective we think many positive things have resulted coming out of UPS’ report. (1) First of all the
stock held up much better than we expected into missed earnings, which tells us there remains pent up demand to own this
name. Investors waiting for a pullback were recently disappointed when the S&P determined that for its purposes all of
UPS stock floats and it would not be negatively re-weighted next year when the index was rebalanced. We suspect those
waiting to own the stock in anticipation of the much expected inflection in UPS’ Domestic Package operating ratio are
beginning to realize they are running out of time. (2) Second, UPS implied within its relatively strong 4Q:04 and C05 EPS
guidance and also directly noted on its conference call its expectation to see Domestic Package’s operating ratio inflect
during 4Q:04 when among other things start-up expenses for the roll out of its Package Flow Technology swing to modest
net cost savings. (3) Expectations for UPS Air Express volumes going down have been decreased which we believe gives
UPS some upside potential. Domestic Air Express volumes were down 4.6% but we believe are tracking closer to +2%-
3% in October. We are not concerned that UPS is losing market share domestically in the air as we believe both FDX and
DHL were also negative in their most recent reported domestic air volume reports and we expect the express business to
pick up later in the economy; (4) UPS announced it will become more aggressive in opportunistically repurchasing stock
including utilizing an expected $700M in cash due over the next six months from the IRS for the reversal of an earlier
decision against UPS; and (5) the company has started to see modest diversion of ocean freight shipments to the air during
4Q:04 to circumvent current congestion at the West Coast ports. We believe UPS could see some modest benefit from
this action although not as drastic as 4Q:02 (the West Coast port lockout quarter) when the company benefited by roughly
$35M (or $0.02/share). We reiterate our Outperform rating.
QUARTERLY HIGHLIGHTS:
�� Modest downside 3Q:04 EPS report. UPS reported 3Q:04 continuing EPS of $0.70 (prior to a $0.08/share one time
tax gain) compared to our estimate of $0.74, Consensus $0.72 and $0.62 continuing EPS a year ago. Downside
resulted from lower than expected Domestic Package revenue (predominantly weaker than expected Air Express
volume) and worse than expected operating margins across all three divisions particularly Domestic Package.
�� Management introduced 4Q:04 and C05 EPS guidance above current Consensus. In its release management
provided initial 4Q:04 EPS guidance of $0.83-$0.87, the mid point a penny above Consensus and our in-line estimate
prior to 3Q:04 results. Management also guided towards 13%-17% y-o-y EPS growth in C05 implying EPS in a
range of $3.31 to $3.43 which at the mid-point is a penny above Consensus $3.36 but below our high-end $3.40
estimate prior to 3Q:04 earnings. We have retained our $3.40 EPS estimate which wanted to move up a few pennies
based on better than expected cash flow.
�� Hurricanes negatively impacted 3Q:04 volumes. Management indicated hurricanes in FL and related weather
negatively impacted Domestic package volume y-o-y growth during September by an estimated 150bp (or 50bp
during the quarter). Assuming 50bp additional growth at Domestic Package and utilizing the average yield during
3Q:04 implies roughly $5M pre-tax (or less than half a penny per share) of negative impact. We note this does not
factor in modest cost pressures from facility closures due to this weather.
�� UPS expects $700M ($0.62/share) of tax reimbursements over the next six months. Aside from the $99M
($0.08/share) tax reimbursement received during 3Q:04 UPS indicated it had settled tax issues with the IRS for 1991- 1998 time period. The company anticipates an additional $750M ($0.42/share) in tax refunds likely to be received
over the next six months.
�� International segment strong once again. Revenue increased 21.6% y-o-y during 3Q:04 which was above our
18.7% estimate. More importantly International’s 84.3% OR improved by 290bp but below our call for 340bp of
improvement as margin comparisons are more difficult due to drastic improvement in the year ago quarter and
declined FX comparisons. Total international volume improved 7.6% y-o-y, led by +30% growth in Asia as well as
+10% growth in U.S. and European export volumes. We note UPS saw double digit volume growth in every region
of the world. Additional flight frequencies awarded by the DOT into China (six currently being utilized and six more
to begin in March C05) should enable UPS to continue strong international volume growth rates.
�� Domestic Package results slightly below our expectations. U.S. Domestic Package revenue was up 4.4% y-o-y
which was below our 6.0% estimate as total Air Express volume growth fell short of our projection (albeit off a tough
comp). Domestic Package’s OR deteriorated by roughly 10bp y-o-y at 86.8% which was worse than our 85.9%
estimate. Management stated that similar to 2Q:04 the rollout of new Package Flow technology worked against the
domestic margin by roughly 75bp (or $50M of total cost in the quarter) although it felt like a bigger impact.
Inclement weather related to hurricanes during September also likely had a modest negative cost impact during the
quarter although difficult to quantify. Management indicated Package Flow costs will be minimal during 4Q:04 and
we should start to see modest net productivity benefits in the quarter. We have modeled for roughly 60bp of y-o-y
margin improvement within Domestic Package during 4Q:04 and 150bp of y-o-y Domestic Package OR improvement
during C05. Sensitivity: each 100bp change in Domestic Package’s OR during C05 equates to roughly
$0.16/share in full-year earnings.
9.5% y-o-y (70bp below our expectations) representing acceleration from y-o-y revenue growth of 6.4% recorded
during 2Q:04. Our sense is SCS’ y-o-y revenue (roughly 70% of Non Package’s total) growth should strengthen
during 4Q:04 nearing double digit growth for C04 which is in line with management estimates. Non Package’s OR of
82.4% represented 70bp of y-o-y expansion but was below our 81.5% estimate. Management indicated its pending
acquisition of Menlo (former Emery) should be complete towards the end of 4Q:04 and be mildly accretive to
earnings in the coming year. We estimate this acquisition stands to add roughly $0.03-$0.05/share of incremental
EPS to our C05 estimate (or 1%-2% upside).
�� Weak Air Express volume growth off of a difficult comp. UPS reported a 4.6% y-o-y decline in total Air Express
volumes during 3Q:04, 490bp below our estimated 0.3% y-o-y increase, off of a difficult 9.5% y-o-y growth rate
recorded during 3Q:03 as mortgage refinancing activities peaked. Next Day Air’s y-o-y volume decline of 4.1%
during 3Q:04 was below our 2.0% estimate. However, management indicated removing one time in nature mortgage
refinancing volumes from a year ago Next Day package and letter volumes (which were up 18% last year) were up
3.5% and roughly 1.0% y-o-y, respectively. This compares to FDX whose total Overnight volume declined 2.1% y-oy
during F1Q:05 (quarter ending August) and did not materially benefit from mortgage refinancing activities in the
year ago quarter Continued strength in y-o-y Ground volumes. Ground volumes grew 4.5% on a y-o-y basis during 3Q:04 in line
with our estimate. Including the volume loss from hurricanes and related weather we estimate Ground volume growth
was closer to 5.0% y-o-y. We believe this is critical as sustained volume growth into its fixed network is essential for
UPS to leverage labor costs and package density. Going forward we have modeled for y-o-y growth of 4.2% for
4Q:04, slightly above management’s guidance for 4.0% total Domestic Package volume growth, into sustained
economic growth. Management noted that Ground volumes were up 5% y-o-y in both July and August but only 2.5%
in September in which UPS believes it lost 150bp of growth to the hurricanes. October Ground volumes to date are
up 4% y-o-y.
�� Domestic yields firm; International yields higher than expected. Yield growth across all products remained firm
as total U.S. Daily Package yields grew 1.4% y-o-y although this was 70bp lower than our expectations of 2.1% y-o-y
growth. Total Air Express yield growth of 8.5% y-o-y was 150bp better than our expectations due to product mix,
increased weight per shipment, and the y-o-y benefit of Air Express’ higher fuel surcharge (see more below). Ground
yield growth of 0.4% was slightly below our call for 0.7% y-o-y growth. We would anticipate continued relatively
stronger y-o-y yield growth for Total Air Express volumes and less so for Ground during 4Q:04 as UPS introduced a
sliding fuel surcharge indexed to jet fuel for all air products and eliminated its Ground fuel surcharge at the beginning of the year. International yields were better than expected in 3Q:04 up 13.5% y-o-y (280bp above our estimate for
10.7% y-o-y growth) with both Domestic and Export yield growth better than anticipated – likely a function of a
currency benefit.
�� Pilot negation update. On the call management indicated they will meet once again with the IPA for mediated talks
next week with additional sessions scheduled for November and December at this point. It is our sense that UPS and
the IPA will eventually work out a new contract over the next 12-18 months.
�� Cash flow. During 3Q:04, UPS generated roughly $449M ($0.40/share) in free cash flow, comprised of
approximately $960M from operating sources less $511M in capex (and prior to an estimated $355M of stock
repurchases and $280M of dividends paid out in the quarter). This compares to 3Q:03 when UPS generated roughly
$1.1B ($0.99/share) in free cash flow, comprised of approximately $1.6B from operating sources less $464M in capex
(and prior to $282M of dividends paid and $158M in share repurchases). Recently UPS’ Board of Directors
authorized a share repurchase program for up to $2.0B of common stock. This is typically more than the company
has historically allocated for share repurchases and we believe UPS could be more active in buying back shares going
forward mitigating a rising share count for option exercises.
�� Balance sheet. At the end of the 3Q:04, UPS reported roughly $4.5B ($3.96/share) in cash and marketable securities,
$3.1B in long-term debt (short-term debt not broken out separately in the release), our estimate of roughly $1.0B of
off-balance sheet debt, and $15.5B in shareholders’ equity, for a net cash position of roughly $450M at the end of
3Q:04 (including off-balance sheet debt) which compares to a net cash position of $700M at the end of 2Q:04.