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Investing, Stocks  | January 30, 2019


I really enjoy this comparison because it provides, in my opinion, great insights into the age old question: how should a company's management return shareholder capital? For new investors and for seasoned investors alike, the answer is pretty much never cut and dry. Many variables must be factored into deciding whether to pay a dividend, or to plow the free cash flow back into growth initiatives, or to buyback shares so as to engineer earnings gains.

Whether you're familiar with UPS and FedEx or considering buying or simply looking for a fantastic case study into return of capital to shareholders, I believe understanding the differences between these two companies can teach us a great deal about a management team's most prudent and judicious use of shareholder capital.

Overview Of The Two Titans Of Logistics

For the past few decades, FedEx (FDX) and UPS (UPS) have dominated the shipping and logistics business in the United States and abroad. Although new entrants, such as XPO Logistics (XPO), Amazon (AMZN) and numerous start ups, have recently made inroads, UPS and FedEx remain the incumbent leaders in the industry.

Though the companies operate in the same industry, their business models are distinct. Whereas UPS generates most of its revenues from business in the U.S., notably from its Ground Segment (to which Amazon is becoming a competitor), FedEx generates nearly half of its revenues from its international operations via "...FedEx’s fleet of more than 650 aircraft, which includes more than 100 Boeing widebodies."

To put it concisely, UPS operates primarily domestically; whereas, FedEx has a more international orientation. Each company has its pros and cons, but with the Amazon Death Star on the horizon in the U.S., UPS may be in grave danger. But we'll explore that in greater detail later.

For now, let's get the comparison underway.

In determining which company investors should buy, I plan to take an objective approach via a series of comparisons; at the end of which, I will tally the scores and provide my recommendation as to which logistics company is the best bet.

Here are the points of evaluation I will use to determine a winner:

  1. Valuation
  2. Revenue Growth
  3. Operating Margins
  4. Cash Flows
  5. Management's Return of Shareholder Capital

Let the games begin!

UPS Vs. FedEx: Valuation

UPS currently trades at a premium relative to FedEx. Why is that the case? Well, for several reasons, not least of which is UPS's larger dividend, secured by strong margins and predictable cash flows. However, to value the company solely on its present cash flows and generous dividend is to misunderstand the purpose of a valuation or share price.

The value of any asset is the present value of its future cash flows. Therefore, we must be forward looking to an extent in determining what we should pay for these companies. With this in mind, let's look at their current valuations and attempt to determine what the future might hold.

As the graph illustrates, both companies currently trade at substantial discounts relative to their historic valuations. That can partially be attributed to the poor guidance given on the FedEx's last conference call, in which management stated that due to Europeanzone weakness and softening Asian business, earnings growth would not be as good as expected.

Hence, both of their valuations have cratered as of late, creating fantastic opportunities for long term investors. But which of the two is the right way to play the temporary headwinds?

Now if you follow me, you know I like to analyze companies on their price to levered free cash flow ratio (Share Price/(Cash From Ops - Capex - Any Lease Obligations)), so as to ascertain what price I'm paying for cash generated by the core business that can be returned to me, the shareholder, in whatever form or fashion.

Due to recent financial irregularities for both companies, which I will delve into in greater detail later in the article, their price to free cash flow multiples currently don't offer a very reliable assessment, as free cash flow has become negative or negligible for both companies.

So with that in mind, I chose to look at other variables surrounding UPS's premium valuation in comparison to FedEx. Here are a few reasons I believe UPS current holds this premium to FedEx.

  • UPS pays a larger dividend.

UPS does pay a larger dividend, as the above chart illustrates; however, FedEx has been gaining ground, and the actual amount doesn't tell the whole story.

FedEx maintains a very low payout ratio in large part due to the way they manage their cash flows. Instead of returning capital entirely via dividends and buybacks, FedEx aggressively spends on capex. Although it seems FedEx has greater runway to grow its dividend, it actually currently maintains a negative Cash Payout Ratio (defined as Dividend Payment/Levered Free Cash Flow).

As I said, this is the result of management's use of capital and the accounting peculiarities that arise when companies report their financials on a GAAP basis. Regardless, investors don't like the low dividend and don't like the negative free cash flow; therefore, they place a premium valuation on UPS.

  • UPS has a stronger cash flow profile with higher operating margins.

UPS has historically had a stronger cash flow profile, boasting slightly higher margins and lower capex. The combination of higher margins and lower capex have allowed UPS to pay a large dividend, which is extremely secure, at least in the near term. As a result, the company has historically traded at a premium to FedEx.

  • There have been concerns regarding FedEx's free cash flow and margins.

Since 2015, FedEx has experienced margin compression as a result of the acquisition of TNT Express, the dutch based shipping and logistics company, and the expenses thereof. Many bemoaned the lack of synergies between the two companies when the acquisition occurred, and the financials have further borne out that story via operating margin compression. In addition, changes in working capital (read: heavy spend on pension contributions), have decreased FedEx's operating cash flows. The combination of both factors, along with heavy capex spend, has caused FedEx's cash flows to decline to such an extent that they were negative for 2018.

Are cash flows the reason UPS trades at a premium? Most likely not as institutional investors, which make up around 73% of all shares held by the public, see these temporary financial headwinds and do not waiver in maintaining their holdings. There's no grave concern for survival FedEx's business despite their negative FCF.

Instead, the premium is likely solely attributable to the dividend disparities between the two companies.

Final Verdict On Valuation: FedEx Takes The Victory

Up until now, you're probably thinking, "UPS has a solid cash flow profile and a strong, growing dividend. No wonder it trades at a premium to FedEx." And you'd be right. What isn't reflected in what I've shared so far are the nuances of capital management that have led to FedEx actually being undervalued today relative to UPS; and therefore, the better valued company for those looking to buy or add to their logistics holdings.

Valuations are mechanisms for determining what investors must pay for future cash flows; therefore, it's important to not look entirely at what was but also what will be.

For evidence of what will be, let's look at some statistics.

Take for example dividend growth over the last five years:

UPS Dividend Growth (2013-2018)46.77%
FedEx Dividend Growth (2013-2018)257%

Or perhaps revenue growth over the last 10 years:

Seen from the vantage point of these statistics, it becomes apparent that Wall Street currently has it wrong.

What appear to be positives for UPS could actually be seen as negatives, and what appear to be negatives for FedEx could actually be quite positive. FedEx has been running itself as a growth company; whereas, UPS has been running itself with complacence and certainty (never good qualities for business longevity).

Furthermore, the strong cash flow profile that UPS has boasted is the result of management's decision to play it safe, or to be overly conservative, through suppressing capex and returning to shareholders via buybacks and dividends what should've been creatively reinvested into the business.

Therefore, FedEx currently offers greater prospects for growth of its dividend, its revenues, and by extension, its share price, yet it trades at a discount to UPS, simply because Wall Street and investors are hooked on the immediacy of capital return by UPS.

UPS Vs. FedEx: Revenue Growth

In the coming years, FedEx will likely surpass UPS in total revenues. This is the result of a management that has always taken a long term approach at FedEx. Whereas, UPS has lavished money on dividends and buybacks, while keeping capex well below operating cash flow, FedEx has consistently found routes for spending on growth and efficiency initiatives, forgoing large dividends and buybacks in the process (not entirely however). As a result, it seems highly possible that UPS will be dethroned as the world's number one shipping and logistics business by revenues.

But don't just take my word for it. Check out the revenue growth of the two companies during the past decade.

FedEx has been quietly closing gap between the two companies. The chart below pretty much seals the deal with this comparison: FedEx consistently grows its revenues faster than UPS, yet, as we've seen the company trades at a discount. Unbelievable.

Admittedly, a fortuitous event fell into the lap of FedEx in 2015, when they were granted permission to acquire TNT Express, which added $7.4 billion to total revenue, as is reflected in the above chart when revenue growth spikes around 2016-2017.

However, even if we back out the addition of that $7.4 billion to their revenues, FedEx closed the revenue gap by 12.56% over the last 8 years. With the acquisition of TNT Express, the gap between the two has nearly disappeared.

Final Verdict On Revenue Growth: FedEx Takes The Victory

Aside from my comments regarding each companies' management of their cash flows, the numbers do not lie (they did for valuation) with respect to revenue growth. FedEx has grown its revenues faster than UPS, especially so with the acquisition of TNT, and with its enormous capex spend, it is further positioned to capitalize on the growing e-commerce trend.

UPS Vs. FedEx: Operating Margins

Especially in the last two years, UPS has had the far superior operating margins, as defined by operating income/revenue. As a result of FedEx's acquisition of TNT Express, FedEx has experienced margin compression, making UPS's margins much stronger by comparison.

UPS has been able to maintain such strong margins through consistent price increases in its Ground Segment while controlling expenses to a greater degree than has FedEx.

Until proven otherwise, it seems UPS will be able command higher and higher prices on their Ground Segment, from which they derive a large portion of their profits in the U.S.

Final Verdict On Valuation: UPS Wins The Margin Battle But Beware

Although FedEx concedes defeat to UPS with respect to their margins, one must consider that Amazon is primarily targeting the core of UPS's business model through Amazon's own shipping offering.

There's a certain dynamic in economics that unfolds when a market participant in a highly competitive industry commands high margins. New entrants arrive and begin to eat away at the profits the incumbent (UPS) has been generating. New entrants continue to appear and a price war ensues, as the new entrants lure away customers from the incumbent with lower prices. This continues until nobody is able to generate strong profits because the industry has too many competitors seeking a return. These business are called businesses with no moats.

I'm fairly confident this will unfold until UPS loses the revenues it generates from Amazon (which are alleged to be around 10% of total UPS revenues). And if UPS can't adapt to the new price competition, Amazon may begin exporting its in-house delivery services just as it has done with AWS. This would not bode well for UPS or FedEx to be sure, but the most damaged company will certainly be UPS.

As an aside (which actually may be central to the conversation around Amazon vs. UPS) there is an unfortunate phenomenon unfolding in the U.S. at present where workers are being stripped of their benefits, retirement plans, and competitive wages as corporations become wealthy and pay rock bottom prices for labor (Examples: Uber (UBER) or Amazon Flex). Ultimately, it's up to the citizens of a country to determine whether they stand for such treatment of workers by corporations, but companies such as Uber and Amazon, currently take advantage of their "independent contractors" through low wages and a lack of benefits.

UPS Vs. FedEx: Cash Flows

Presently, both UPS and FedEx struggle to generate positive free cash flow. This can be attributed to two factors:

  1. Operating cash flow for both companies has declined as they've made large pension contributions over the past two years, which is reflected in change in working capital when calculating cash from operations.
  2. Both companies have aggressive capex spend at present. However, it has not always been so for UPS.

As the above chart illustrates, UPS has only recently began aggressively devoting dollars to capex. Conversely, FedEx has been aggressively spending on capex for over a decade.

Final Verdict on Valuation: UPS's Cash Flows Trounce Those of FedEx

For the sake of deciding a winner for this comparison, I will take the cash flow profiles at face value. As such, it's no question that UPS is the winner. From their higher operating margins to the gulf between their operating cash flows and capital expenditures, it's easy to see that UPS walks away with the win, at least for now.

Momentary Intermission

If you haven't been keeping track, the companies are tied at 2-2. The final section should persuade you as to which company is worth buying for decades to come. Furthermore, the next and final section explores the most important aspect of this comparison: How Different Managements Return Shareholder Capital.

In response to the long held debate, I will provide an gleaming example of effective management, using capital in the most judicious way given the circumstances. In addition, I will illustrate an example of a management that has returned capital in a way, which on the surface seems positive, but is actually deleterious to its shareholders.

UPS Vs. FedEx: Management's Return of Shareholder Capital

The following two graphs could summarize the entirety of what anybody needs to know when approaching investment in either company in 2019. As some preliminary information, the major dips that occur in each company's cash from operations are the result of multi-billion dollar contributions to their pension funds, and as such, should be seen largely as irregularities. What is most crucial is the way in which management has used the free cash flow for creating shareholder value.

The above chart illustrates the level of levered free cash flow UPS has produced over the last 10 years. As can be seen, UPS has reserved significant portions of its FCF for activities such as dividends and share repurchase programs, while suppressing its capex, which could've been used for expansionary projects, automation, robotics, artificial intelligence, or otherwise gaining a leg up on the fierce competition that surrounds them.

Over the last ten years, management has retired approximately 130 million shares, resulting in a 13% reduction in share count. Furthermore, in the same period, UPS has raised its dividend another 57%.

Meanwhile, the U.S. and the rest of the world have been experiencing one of the most expansionary periods for shipping in recent history, and e-commerce's growth does not appear to be abating.

It's almost as if UPS management has been asleep at the wheel during one of the greatest periods of evolution for the shipping and logistics business the U.S. has ever seen.

Well... at least they financially engineered their earnings upward and kept their shareholders temporarily happy. And at least the dividend has grown nicely over the years.

Conversely, FedEx has been aggressively investing for the future through massive capex spend, the growth of which has been in lockstep with its operating cash flows.

In FedEx's most recent annual report, they stated that 30% of their 2017 fiscal year's capex was devoted to "growth initiatives".

As evidence of FedEx's commitment to returning shareholder capital through reinvestment, let's look at the growth rates of the two companies' total sales.

As the graph illustrates, FedEx consistently outperforms UPS in quarter over quarter revenue growth, a testament to the strategy of FedEx's management.

In response to one of the most expansive period for shipping and logistics America has seen since its birth, FedEx has devoted billions every year to automating its shipping hubs, investing in 3D printing technology, employing blockchain technology, and positioning itself well for the future of commerce; whereas, UPS has returned most of its cash flows to its shareholders in the form of dividends and share buybacks.

Final Verdict On Valuation: FedEx Wins For Its Focus on the Future

Although it cannot be officially determined that FedEx will prevail, it certainly appears at the moment that they are the more equipped team to navigate the rapidly evolving shipping and logistics landscape.

In 10 years, investors will be able to look back on what has transpired between these two companies and use this case study for future investment decisions. Although it appears UPS has been asleep at the wheel, they have recently rapidly accelerated their capex spend and taken on more debt; both of which lead me to believe the company is finally realizing that the industry is rapidly evolving, and they cannot remain on cruise control as demand for logistics services increases and new market entrants appear.

Is it too late for UPS? Only time will tell, but my greatest concern for UPS would be the threat of Amazon and the gig economy; both of which are notorious for low wages and disregard for workers' welfare. In contrast, UPS has been lauded for its high wages and regard for its unionized workers, a facet of its business that, unfortunately, may actually make it less competitive against the likes of Amazon and Uber.

Winner: Resoundingly FedEx With A 3-2 Victory

According to my analysis, FedEx will outperform UPS over the coming decade, especially with Fred Smith at the helm. Read on for some more information and my final comments!

The TNT Acquisition: What You Need To Know

In 2013, UPS attempted to acquire TNT Express, a Dutch based logistics business but couldn't due to antitrust regulators in Europe.

UPS dropped its $6.9 billion bid for TNT in 2013 after the European Commission, the European Union’s antitrust regulator, blocked the deal, concerned that it would limit choice for European shipping customers and lead to price increases.

Two years later, FedEx moved to acquire the Dutch company with its own bid. When FedEx made its offer of $4.8 billion, the value of the euro had declined more than 19% in value against the dollar, making the transaction especially appealing. The deal added $7.4 billion to FedEx's total revenues, further narrowing the gap between UPS' and FedEx's yearly sales.

Despite the apparent bargain price FedEx paid, many have bemoaned the pace with which the company has executed the merger. Although the merger has not gone as smooth as management and investors would have hoped, the TNT Express acquisition seems likely to be valuable for FedEx in the future.

Amazon Threat

The Amazon threat further strengthens my contention that FedEx is the vastly superior buy at this point. While UPS derives 10% of its revenues from Amazon, FedEx derives a mere 3%. From my perspective, it's inevitable that Amazon will eventually be self-sufficient in delivery of its online products, so long as they continue on their current trajectory.

The next question would be then, "Will Amazon export their delivery services to businesses outside of Amazon's ecosystem?"

If Amazon's strategy is anything like their AWS or Prime strategy, then it is highly likely that Amazon will use its spare capacity to begin poaching business outside of its own ecosystem, and it's made it apparent that it is prepared to underpay its workers dramatically.

Who stands to lose the most in the event Amazon executes this strategy years down the road?

The company that generates an enormous portion of its high margin revenues through their U.S. delivery business, i.e. UPS. Furthermore, FedEx has insulated itself from the Amazon threat because its business is more globally oriented.

Final Comments - Buy FedEx Or At Least Avoid UPS

Admittedly, FedEx did catch a break with their TNT acquisition as the EU competition commission prevented UPS from acquiring it; after which FedEx got it at a bargain price. That vaulted them even closer to surpassing UPS, and without the acquisition, UPS would still hold a commanding lead in total revenues.

Maybe one day FedEx will turn on the cash flow spigot, but that will likely be the day Fred is no longer CEO, and the new management cares more about dividends and financial engineering than aggressive reinvestment and growth. For now, investors in FedEx must understand that share price appreciation will be the primary means of ROI for shareholders, as FedEx's current level of capex spend, a large percentage of which goes to growth initiatives, just doesn't allow for substantially higher dividends and more aggressive share repurchase programs.

For those looking to buy, I've shared in previous articles that I believe the 160s to be a prime buying zone, and recently, I discovered that an insider noteworthily agrees.

Director David P. Steiner acquired 7,000 shares of FedEx, paying $162.92 per share for a total amount of $1.14 million. Mr. Steiner increased his stake by 36.85% to 25,994 shares with this purchase. Mr. Steiner has served on the board of FedEx since 2009 and it has been over six years since his last insider purchase of FedEx back in August 2012 when he purchased 5,000 shares at an average price of $87.65.

While each company has its merits, from my perspective, FedEx is the clear winner for investors with a multi-decade time horizon, looking to capitalize on the growth of e-commerce, logistics, and a globalizing economy (most of the time).

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