Monday, May 08, 2006

United Parcel Service -- SELL

I originally started analyzing United Parcel Service [UPS] for last weeks “stocks on the edge” column, but it started looking good and I had to dig into it even more. Unfortunately I realized I had to rate this company a SELL when I reached the pension section and did some background research.

UPS has a price to cash flow ratio of about 16, which is high, but acceptable for a high growth rate in a growth industry. My favorite analysis of growth and earnings is to calculate the present value of a stock’s earnings stream while applying a conservative 15% discount rate. A stock that passes this harsh test still has some value even if a few things go wrong. Applying a 15% discount rate to future earnings at UPS would require a 13.1% growth rate for the next ten years, above analyst projections for a good-case 5-year growth. Fortunately there is a huge demand for more shipping (see article on the Baltic Dry Index).

Some shipping and logistics articles have been calling for a threefold increase in shipping volumes over the next ten years, which works out to an 11.6% cumulative growth rate in the core market UPS serves. Recent actual shipping data, however, has pointed toward 6-7% growth per year for the near future and these numbers (from the World Trade Organization) are even the ones cited in the UPS annual report. There is always the logistics business to try to pick up the slack, but the point of all this data is to show UPS is already priced for the rosiest growth picture and it doesn’t look likely to meet my stringent demand for a 15% discount rate.

Much of the cash from the significant cash flow is spent exactly where you would want it : UPS has distributed $5.4 billion in dividends in the last five years and last year alone they bought back 2.6% of outstanding shares. That’s a sign of good management.

UPS has also faced a number of scary business transitions in recent years. The acquisition and integration of chain stores went as well as one could hope for. In 2003 UPS started a total re-engineering of their sorting, tracking, and routing system (which is enough to scare any investor) and now with the new system deployed over 61% of their network it seems like the change is turning out to be a non-event for investors. More signs of good management.

Unfortunately even the good management at UPS has run into a nasty challenge in the form of the Teamster’s Union. The Teamsters union has tied UPS to a hideous liability: a multi-employer pension plan. Basically this is a pension set up by the Teamsters where each of the companies who are part of the plan are liable for the benefits of all Teamsters. Anytime some poorly run shipping company goes out of business and can’t pay for its pension obligations the healthier companies like UPS have to make up the difference. As the biggest Teamster employer in the pension plan cash-healthy UPS has to make up most of the gap created by cost-cutting competitors who don’t fund their pensions. Newer shipping companies, meanwhile, refuse to get captured by this plan, which means that UPS is slowly coming to support huge piles of retired Teamsters who never had any relationship with UPS. At this point the Teamsters have more retirees collecting checks from the program than they have workers in the field.

In 2006 UPS expects to pay $322 million in conventional retirement benefits for employees not covered by this nasty union loophole, last year alone they paid over $2 billion for pension and health care to the union multi-employer plans – that’s about 6x more per teamster employee than per non-teamster. UPS doesn’t estimate the union payments because they freely admit they have no control over how high their liabilities are. Don't believe this amazine statement? See page F-23 of their annual report for 2005 under "Other Plans". This liability is not controlled by UPS or even limited to UPS employees. Using current projections for the next ten years for the internal plan and current trends (8.5% annual growth) for the union multi-employer trend I get a projected pension burden of an astounding $38.6 billion over the next ten years. If I apply a 6% predicted return rate (which is more generous than the UPS assumption in the annual financials for anyone keeping score) this is the equivalent of a $30 billion current liability and equals a third of the market capitalization of the company. UPS tried to face down the union in 1996 on this topic and instead faced a strike that led to a cost increase and increased shipping prices. In 2002 Congress tried to untie such pension plans, but the reform was defeated. This is a problem that does not appear to be going away anytime soon. In fact my projections are highly generous to the company as management sees an uptick in pension expenses in about five years. Revenue could meet the growth numbers needed to grow the company 13% a year and net income would still fall far behind values needed to support the current price due to pension obligations.

If anything bad happens to the shipping industry, such as a slowdown in global shipping growth, UPS will get hammered on both the growth front and on the pension front. It’s possible that in five years UPS may be in the high-cost union-impaired state that airlines were in a few years back. Although this is a cataclysmic scenario it is not completely unlikely, meanwhile the happy growth scenario has been priced into the stock. I like management and the dividends they pay, but I recommend you avoid this stock because of the ticking pension time bomb.

The stock has many good qualities but as with any SELL call I issue, I simply think you can do better.
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