UPS(NYSE:UPS) is still struggling through a difficult period. The small package delivery market is overcapacity, putting pressure on pricing power at a time when a weak economy is encouraging customers to switch to cheaper delivery options. It all adds up to a rough patch for UPS, and the company will end 2024 with significantly lower profits than management expected at the start of the year. UPS will likely be a big winner if interest rates fall. This is why.
Interest rates not only affect UPS’s end markets, but also its business model. CEO Carol Tome’s tenure was marked by her admonition for the “better, not bigger” operating framework.
Do you miss the morning spoon?Breakfast news delivers it all in one fast, silly and free daily newsletter. Register for free »
In plain English, this means focusing on targeted deliveries rather than chasing volume growth. This approach colors the structure and competitiveness of the company in its end markets. The latter is key to understanding why UPS needs lower interest rates. I will come back to that point later. First, a few words about the cyclical benefit of lower interest rates.
Parcel delivery has also been cyclical, and always will be. When the economy is doing well, more physical goods are shipped, and vice versa. As such, the weakness of the economy in recent years has had a negative impact on delivery volumes. Unfortunately, the delivery delay came after parcel delivery companies ramped up capacity to meet growing demand created by pandemic lockdown measures.
As management explained during the investor day in March, the US small package market will have an excess capacity of approximately €12 million in average daily volume by 2024.
Image source: Getty Images.
It will take some time for the sector to eliminate this overcapacity, and UPS, among others, is reducing capacity where necessary. Lower rates will stimulate business activity and consumer spending, leading to growth in package delivery volumes, and customers will return to more expensive and timely delivery options in response.
Getting back to the point about the UPS business model, it’s fair to say that the “better not bigger” framework has been called into question this year. The company continued to focus on driving growth in select end markets, such as higher-margin markets such as small and medium-sized businesses (SMBs) and healthcare. However, in 2024 there will also be a significantly lower turnover volume per unit of deliveries. You can see this in the chart below, where unit sales continue to decline, but volumes are growing again, leading to revenue growth.
While this is not UPS’s ideal scenario and seems inconsistent with “better, not bigger,” market conditions dictate it.
Data source: UPS Presentations. Chart by author.
A lower interest rate environment will improve overall demand for package delivery and allow UPS to better align its operations with its long-term strategy. Management can do little about the end markets, and the pragmatic approach taken in 2024 – by assuming lower yields per piece delivery – is on balance positive given the circumstances.
With lower interest rates in 2025, UPS should be able to return to its core philosophy of growing in its target markets and hopefully improving unit revenue growth.
That would be a positive development, as the good news from the third quarter came from the 4.1% annualized unit cost reduction. Not only is UPS doing a great job of cutting costs (the company is cutting 12,000 jobs this year to reduce costs by $1 billion), it is also outpacing the cost increases associated with the enhanced labor contract agreed to in 2023.
The mid-term plan outlined in March calls for continued investments in automation and smart facilities to improve network productivity, allowing UPS to consolidate its facilities and reduce unit costs.
Image source: Getty Images.
UPS has a lot to gain from a lower rate environment: better pricing power, potential improvement in unit revenue while per unit costs are likely to remain in check, and UPS can return to focus on higher margin deliveries. It all speaks to a combination of revenue growth and margin expansion next year as the company recovers from a tough few years.
UPS is far from perfect and there’s no guarantee it will meet its full-year earnings expectations. But on balance, the stock appears to be a good value, as it trades at 15.6 times estimated 2025 earnings.
Before purchasing shares in United Parcel Service, please consider the following:
The Motley Fool stock advisor The analyst team has just identified what they think is the 10 best stocks for investors to buy now… and United Parcel Service wasn’t one of them. The ten stocks that survived the cut could deliver monster returns in the coming years.
Think about when Nvidia created this list on April 15, 2005… if you had $1,000 invested at the time of our recommendation, you would have $829,378!*
Stock Advisor provides investors with an easy-to-follow blueprint for success, including portfolio building guidance, regular analyst updates, and two new stock picks per month. TheStock Advisoris on duty more than quadrupled the return of the S&P 500 since 2002*.
View the 10 stocks »
*Stock Advisor returns November 25, 2024
Lee Samaha has no positions in the stocks mentioned. The Motley Fool recommends United Parcel Service. The Motley Fool has a disclosure policy.
If the Fed Keeps Cutting Rates, This Stock Could Be a Winner Originally published by The Motley Fool
