Can UPS Deliver in a Downturn?


By Amy Tsao It makes perfect sense that an economic slowdown should hurt a company like United Parcel Service Inc. (UPS). After all, the package delivery giant is exposed to just about every segment of the worldwide economy -- from lawyers to retailers to pharmaceutical companies. Fewer shipments and reduced spending on high-cost premium delivery services could spell trouble for UPS.

Hurt, it will, but the world's No. 1 package mover seems to have figured out how to weather the downturn better than its competitors through a combination of old-fashioned cost cutting and tightening of operations. The company met lowered expectations for the second quarter, when earnings fell 9% to $630 million, or $0.55 per share, on revenues that edged up 3.9%, to $7.57 billion. Things could have been much worse. Rival Federal Express (FDX) proved as much when its most recent quarterly net profit came in 54% short of last year's level.

Indeed, investors looking for strong cyclical plays should give UPS top priority. If the U.S. economy starts to turn around sometime later this year or early next, as economists are predicting, UPS should be one of the first companies to come roaring back in 2002. "We need to see a domestic recovery take hold. Once you see the bottom -- that we're starting to move up -- the stock should break out of [its] range," says Steve Raineri, an analyst with Dresdner Kleinwort Wasserstein. For one, AG Edwards analyst Donald Broughton expects the company's earnings per share to rebound to $2.53 next year.

RELATIVE STABILITY. To be sure, UPS' results this year will be lackluster. That's mainly because of the broad economic slowdown worldwide, though the falloff in e-commerce shipping in the U.S. isn't helping, either. Broughton, who has the most conservative earnings expectations on the Street for UPS, expects the company to post 2001 earnings per share of $2.06, down 13.7% from last year. Both companies are expected to be hit hard. Analysts, on average, forecast that Fedex's earnings for fiscal 2002, which ends next May 31, will slump to around $2.05, down 9% from fiscal 2001.

UPS shares aren't cheap. At around $58 apiece, UPS shares trade at a price-to-earnings ratio of 25. That's well above FedEx, which is trading around $41 a share and a price-earnings ratio of 20. Investors have put a premium on UPS for its ability to keep results from falling off a cliff.

UPS does have a lot going for it. For one thing, it is less exposed to the high-tech bust than FedEx, partly because its customer base is broader. Long considered the cheaper alternative to FedEx, UPS could even benefit as companies pare costs by shifting to slower and less costly shipping methods. "FedEx is more vulnerable to an economic slowdown as it is the market leader in express shipments and has total overnight volumes that are nearly double in size to UPS," writes Morgan Stanley Dean Witter analyst James Valentine in a recent report.

So far, UPS also is holding its own in heavy competitive warfare with FedEx. FedEx has been chipping away at UPS in the ground shipment business, where UPS' $3.9 billion in sales are nearly seven times FedEx' $580 million. In that segment, UPS' ground revenues edged up only 2.6%, well behind the 6.2% increase at FedEx. On the other hand, in the express air delivery business, which is FedEx' forte, UPS held up better than its rival in the second quarter.

SPENDING AND SAVING. Moreover, cost-cutting measures taken at the end of the first quarter have already started to help results at UPS. A 200-point program, including a hiring freeze and cuts in business travel, has kept the company from having to resort to layoffs. "They've done a good job of quickly reducing the cost structure," says Bill Fisher, an analyst with Raymond James & Associates Inc. He notes that in the latest quarter, UPS' domestic revenues were up 5% while overhead costs fell $120 million.

Additional savings will be booked in the second half. Capital spending on things such as information technology, trucks, buildings, and package-sorting will be cut by about $300 million, to a total of around $2.5 billion. The easing of fuel prices, if it continues, also should help. Last summer, UPS responded to the higher costs by tacking on a fuel surcharge of 1.25%. Norman Black, a spokesperson for UPS, says the fee is the lowest in the industry and is temporary. "We'll remove it as soon as we can," Black says. "We historically hold our fuel expenses to 3% of revenue. No competitor is even close to that." Among UPS' fuel-saving measures, Black points to hedging, strict operating procedures for pilots and drivers, and use of satellite technology to review driving routes.

In the meantime, UPS is beefing up its non-package business, which primarily consists of logistics. It recently paid $450 million for freight-forwarder Fritz Companies as part of its push to expand in the logistics segment. It also acquired Uni-Data, a global logistics company based in Germany.

With $1.5 billion free cash flow generated in the first six months of 2001 alone, UPS probably will continue to scoop up strategic acquisitions in non-core businesses, such as logistics, analysts say. For instance, it also recently bought private mail outfit Mail Boxes Etc. UPS' goal is to boost non-package businesses from about 7% of its $30 billion in annual revenue now, to 15% to 20% of revenue by 2007. Even without additional acquisitions, UPS' non-package revenue is expected to increase by around 40% this year.

HIGH HOPES. UPS also continues to expand overseas. About 15% of the company's total revenues come from international shipping, though overseas revenue growth in the second quarter fell to about 6%, which is down two-thirds from the rate in the first quarter. The good news is that volume in Europe is still growing around 21%. UPS also has put significant resources into building infrastructure in China and other parts of Asia, even while Asian economies are slowing.

The cost of these initiatives has been pinching operating margins. "They made some big investments during bad economic times and it has exacerbated the situation," Fisher says. But analysts expect a payoff as early as next year. For instance, the logistics operation, which includes Fritz, is expected to show a profit in the fourth quarter. And Raineri expects the China operation to contribute only a small loss on some $50 million to $60 million in revenues in 2001.

UPS insiders seem to have confidence in the company's long-term prospects. The company first went public less than two years ago, when it pulled off a wildly successful initial public offering. It continues to buy back shares in a show of management's confidence in the strategy. Employees, who own around 45% of the company, also are well motivated. "They all have their skin in the deal. That certainly helps. It keeps everyone focused on the right thing," Raineri says.

And the right thing for UPS is to batten down the hatches while continuing investing for the future. It may hurt now, but when the economy turns up again, the payoff could be big. By Amy Tsao in New York


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