Description

Apologize for the brevity, but I think UPS is a good short relative to industrials/transports from here for a few reasons:

·         Disintermediation in process will impact volume and pricing

o   While Amazon is no longer really viewed as an existential threat, my work suggests that they are indeed aggressively moving into the logistics space, working to disintermediate the integrators in nearly every step, from Express to last mile

§  Amazon has contracted 40+ aircraft

·         Adding 10% of capacity to the US Express market

§  Amazon has been building Amazon Flex, which is a last mile delivery substitute that now covers over 30% of the US population

·         It is estimated that the USPS can deliver last mile for 10-20% of the cost of UPS/FDX and given our work on Amazon Flex, the delivery cost could approach similar cost as USPS

§  Some of this capacity has started coming online this year, ahead of the holidays and increasingly more will come online over the next year or two, which should lead to a slow bleed in pricing

·         UPS/FDX claim that Amazon’s network is built for extra capacity during peak season, but it seems foolish to think that they will then allow those assets to sit idle for the rest of the year…if anything, it turns UPS/FDX into their peaking capacity during the year

o   Other services such as Google, Uber, etc. are now providing local delivery as well as potential last mile competitors

·         Q4/2017 at risk

o   UPS is facing significant FX headwinds next year due to the roll-off of several hedges. 

§  This has been well telegraphed, but given recent growth trends, I believe that 2017 Street numbers are still too aggressive and I think they will have a difficult time actually growing earnings next year

§  Additionally, the company’s main internal cost initiative (ORION) is coming to an end this year and our work suggests diminishing returns for the latter portion of the rollout

·         ORION optimizes a driver’s route…this works well in densely populated areas (initial part of rollout), but as it has been moved into more rural areas, it has not helped drivers nearly as much with stop efficiency

§  Peak season seems to have gone reasonably well, but Q416 guidance midpoint (where Street is) suggests the strongest sequential earnings growth (+17%) we’ve seen since eCommerce really started disrupting peak season in 2013/14

·         Note: FDX missed their most recent quarter as margins came in light due to increased labor costs into peak (should also be a UPS problem), ground expansion (UPS competitive) and weather issues (hurricane Matthew…also a UPS problem)

·         Trump policies are mixed for UPS, almost unilaterally positive for other transports

o   Tax reform and repatriation in the US are definitely positive, but potentially less so relative to other transports given only 75% US revenue exposure (vs. 90-100% for most other mid-to-large cap US-based transports…think rails, truckers, LTL)

o   Tightening of global trade policies are potential negatives for UPS/FDX volumes

·         FDX’s acquisition of TNT poses some incremental competition in Europe

o   Our channel work suggests that FDX has already done a good job integrating TNT and has made some of their pricing more competitive

o   Note: UPS int’l segment rev/package growth showed incremental weakness last Q

·         The stock is sitting near to top end of its historical P/E band at over 19x 2017 earnings

·         Given the discussion above, we think it’s plausible that they could miss this quarter and FY17 guidance could come closer to $5.90-$6 (which wouldn’t be a layup, given the FX headwinds), which is LSD growth vs. 9-13% LT expectation

o   As we look into 2018, we think it’s likely that we start to see any fraying in volumes/pricing, which will make it difficult for the company to reach their HSD-LDD EPS growth target again.  We think they can generate $6.30 in EPS

o   In this scenario, we think the stock is worth more of a mid-cycle multiple of 17.5x $6.30 yields $110 PT in the short-term

§  Thought, if we do indeed start to see pricing fray, that multiple can contract even more

This excludes any sort of tax reform and/or significant economic recovery, but as I stated prior, other names will benefit more significantly from these positive events.  Don’t get me wrong, UPS is a great company with a great dividend yield, however it’s being proven that the assets are not irreplaceable and I believe we are at the beginning of secular concerns with potential earnings misses coming.

Catalyst

2017 guidance

Pricing/volume deterioration