A Quality Dividend Growth Stock Held by Bill Gates

History has taught us that often boring but steadily growing businesses can make the best long-term investments, especially if those companies have a strong commitment to rewarding investors with strong, consistent dividend growth.

United Parcel Service (UPS) is just such a company, slowly but steadily growing into a globe-spanning behemoth that has proven itself excellent at generating growing income and wealth for shareholders over time.

In fact, the company is one of the largest dividend stocks in Bill Gates’ concentrated stock portfolio (see analysis of all of Bill Gates’ dividend stocks here).

Let’s take a closer look at just what makes UPS so special and, more importantly, if this delivery master is likely to continue to do well for dividend growth investors in the coming years and decades.

Business Description
United Parcel Service is the world’s largest delivery service with 444,000 employees operating in over 220 countries and territories.

Thanks to a global fleet of 104,000 vehicles and 543 aircraft, UPS delivers 18.3 million packages and documents each day to around 10 million customers.

UPS’s business can be broken up into three business units: domestic package, international package, and supply chain & freight (the industrial logistics arm of the company), or SC&F.

captureWhile the domestic business continues to generate the majority of revenue and operating profits, the company continues to expand overseas and diversify into SC&F in order to become less dependent on just the U.S. economy.

As seen below, total revenue mix from U.S. domestic operations has decreased from 81% in 2000 to 63% in 2015.

Source: UPS Investor Presentation

Business Analysis
While the company’s sales and earnings growth is lumpy due to the variable nature of the package delivery business, UPS has the classic signs of a wide moat company, which bodes well for its long-term prospects.

Source: Simply Safe Dividends
Source: Simply Safe Dividends

Specifically, note how long-term EPS growth has outpaced sales growth, and free cash flow (FCF) growth has outpaced EPS growth.

This shows that UPS is able to achieve ongoing efficiency improvements via its massive economies of scale that allow it to consistently grow its profits over time and achieve the industry’s best margins.

Few companies can afford to invest in all of the hard assets required to efficiently run a global delivery service business. Furthermore, new or smaller rivals lack the brand recognition enjoyed by UPS, which is important because customers expect their packages to be reliably delivered in a time-sensitive manner.

These are all reasons why the industry is heavily concentrated with a small handful of operators dominating the space.

Another key to UPS’ success is excellent management, courtesy of current CEO David Abney, who before taking top spot served as COO and president of UPS International.

Abney has literally spent his entire professional life with UPS, starting at age 18, and has been climbing the corporate ladder for 40 years.

Along the way he’s developed a finely honed skill at learning how to optimize efficiency at the company’s vast network of distribution centers and beat rivals like FedEx in terms of international expansion.

Take a look at both companies’ export volume growth over the last decade.

Today UPS continues to invest heavily into cost optimization through projects as ORION, or On-Road Integration & Navigation, which utilizes route optimization to reduce delivery time, improve reliability, and cut fuel waste.

UPS estimates that ORION alone will help cut $300 million to $400 million in annual operating expenses, and that’s just one major efficiency initiative the company is working on.

In addition, the company is pouring billions into hub automation (especially in Europe) to maximize the efficiency of its workforce. For example, by 2019 UPS expects 50% to 60% of its packages to be handled by robots, which should boost hub productivity by 20% to 25%.

Further efficiency gains come from computerization of delivery times to help minimize missed deliveries and improve customer satisfaction, further building up brand equity and improving pricing power.

This allows UPS, despite the monstrously capital intensive nature of its industry, to generate truly amazing returns on shareholder capital, including a return on invested capital north of 30%.

captureBest of all, thanks to management’s excellent capital allocation (including strong, consistent share buybacks of 2.4% CAGR over the past five years), management expects adjusted EPS to grow strongly in the coming years.

As seen below, adjusted earnings per share are expected to increase 9% to 13% annually from 2016 through 2019. Strong earnings growth bodes very well for the company’s dividend growth prospects.

Key Risks
No company, not even a blue chip like UPS, is without risks. There are three risks in particular that potential investors need to be aware of.

The first is that UPS’ business is cyclical, meaning sales, earnings, and cash flow will fluctuate based on the health of the U.S. and global economies. That’s especially true given the capital intensive nature of the business which can play havoc with short-term results (and result in share price volatility).

For example, UPS just announced that it was purchasing 14 Boeing (BA) 747-8 Freighter jets with an option to buy 14 more between 2017 and 2020. Each plane costs $357.5 million, meaning that just these 28 planes alone would end up costing UPS over $10 billion.

Depending on the exact delivery date of these planes, quarterly or annual EPS and FCF could take a substantial hit that could disappoint Wall Street and make the dividend appear less safe than it really is.

And speaking of capital intensity, we can’t forget that delivery companies carry a lot of debt on their balance sheets.

While UPS’ debt load (more on this later) isn’t anywhere close to dangerous levels, investors will want to watch it over time to make sure that management doesn’t get so enthusiastic about returning cash to shareholders that it creates dangerous amounts of unmanageable debt.

And finally, we can’t forget about competition, both from other delivery companies such as Fedex (FDX) but also from Amazon (AMZN), which has recently launched its own delivery company.

While the immense scope of Amazon’s delivery needs, and online retail delivery in general, are so vast that this isn’t likely to prove an existential threat, investors will want to make sure that UPS stays on top of the situation.

After all, if Amazon becomes a major rival to UPS and FedEx or merely takes its deliveries in-house, that could eliminate a major growth catalyst for UPS and hurt its dividend growth prospects going forward.

Dividend Safety Analysis: United Parcel Service
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

United Parcel Service has a Dividend Safety Score of 75, indicating a safe dividend that you don’t need to worry about.

This is thanks to the company’s moderate (if sometimes volatile) payout ratios, which mean that the dividend is almost always well covered by both earnings and free cash flow per share.

In fact, over the past 12 months, UPS’ dividend has consumed 55% and 71% of its EPS and FCF, respectively. These are reasonable levels that provide a healthy margin of safety.

The few years in which the payout ratio was over 100% was due to especially capital intensive periods in which UPS spent a lot on growth investments, such as taking deliveries of numerous aircraft.

During those years, the dividend was paid for out of cash on the balance sheet or taking on additional debt.

Source: Simply Safe Dividends
Source: Simply Safe Dividends

The company’s strong Dividend Safety Score is also supported by UPS’ excellent free cash flow generation. Free cash flow is the lifeblood of a company and represents the money available to be returned to shareholders after a business has reinvested to maintain and grow its operations.

As seen below, UPS has generated remarkably steady free cash flow over the last decade despite its capital intensive operations. The company’s free cash flow generated during the financial crisis was more than enough to easily cover its current dividend.

The third protective factor for the dividend is the company’s strong balance sheet. While UPS’ debt levels on an absolute level are high, the solid current ratio, low leverage ratio, and sky-high interest coverage ratio shows that, in fact, UPS isn’t overly leveraged.

Source: Simply Safe Dividends

The same holds true when we compare UPS’ balance sheet against its peers, where we see that the company’s leverage ratio (Debt/EBITDA), and interest coverage (EBITDA/Interest) ratio are very strong, which explains its excellent A+ credit rating from S&P.

captureThis allows UPS to borrow for 30 years for as little as 3.4% and keeps its cost of capital low. As a result, the company can generate greater profit margins and keep the dividend growing nicely.

Income investors don’t need to lose any sleep over the safety of UPS’ dividend. The company has paid cash dividends since 1969 and

Dividend Growth Analysis
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

United Parcel Service has a Dividend Growth Score of 63, indicating that dividend growth investors can expect above average payout growth from the company in the future.

UPS went public in 1999, and since then it’s had a very respectable record of growing its dividend nearly every year by nearly 10%.

Note that during recessions such as 2001-2002 and 2008-2009 the dividend didn’t grow, but the company has never been forced to cut the payout.

Source: Simply Safe Dividends

While UPS may never become a dividend aristocrat, nonetheless it can make a solid holding in many income growth portfolios. That’s especially true given management’s excellent track record of cutting costs, boosting margins, and returning capital to shareholders.

Combined with its strong track record of reducing its share count, which helps boost EPS and FCF per share and keep the payout ratio in a safe range, UPS has a very good chance of being able to continue growing its dividend at its historical 8% to 9% annual rate for the foreseeable future.

That’s especially true given the numerous large growth markets UPS can expand into, including medical deliveries, and of course the immense growth potential of e-commerce deliveries both in the U.S. and abroad (online retail is forecast to grow 3 times the rate of GDP, according to a UPS investor presentation).

Valuation
In terms of determining whether or not a company is trading at a reasonable price, there are two ways to look at it.

First, on an absolute basis, UPS is currently trading at a slight discount to the S&P 500’s P/E of 26.1.

However, the company’s current P/E multiple and dividend yield are roughly in line with its long-term averages.

captureThat being said, UPS’ historical yield has varied from 1.6% to 4.6% over the past 13 years, so the current valuation doesn’t represent an obvious bargain.

Not that you should wait for anything close to a 4.6% yield, which would represent a share price of $67.83, 42% below the current price. That’s because a 4.6% yield was only available during the lows of the financial crisis.

However, a 3% to 3.25% yield, representing a share price of $96 to $104, is more likely to become available during the market’s next inevitable, if unpredictable, correction.

Since long-term total returns typically follow a company’s dividend yield plus its earnings growth rate, at today’s share price UPS investors can expect annual total return potential around 10-12% (2.7% dividend yield plus 7-9% annual earnings growth) over the coming years. The stock appears to be reasonably priced, assuming management can deliver on their growth ambitions.

Closing Thoughts on United Parcel Service
While the company doesn’t look like an obvious bargain today, United Parcel Service still represents a best-in-breed delivery company with an excellent and very shareholder-friendly management team.

With plenty of growth opportunities both domestically and overseas, this is a solid core holding to keep an eye on for most dividend growth portfolios.

UPS is on my watch list, and I will wait for a more attractive opportunity before giving the company serious consideration for our Top 20 Dividend Stocks portfolio.

Brian Bollinger
Simply Safe Dividends

Simply Safe Dividends provides a monthly newsletter and a comprehensive, easy-to-use suite of online research tools to help dividend investors increase current income, make better investment decisions, and avoid risk. Whether you are looking to find safe dividend stocks for retirement, track your dividend portfolio’s income, or receive guidance on potential stocks to buy, Simply Safe Dividends has you covered. Our service is rooted in integrity and filled with objective analysis. We are your one-stop shop for safe dividend investing. Brian Bollinger, CPA, runs Simply Safe Dividends and previously worked as an equity research analyst at a multibillion-dollar investment firm. Check us out today, with your free 10-day trial (no credit card required).

Source: Simply Safe Dividends