Analysis: UPS

United Parcel Service (UPS) reported a top- and bottom-line beat with its second quarter results Tuesday morning. Revenue of $23.424 billion (+10.2% YoY) exceeded estimates of $23.187 billion, while adjusted earnings per share of $3.06 (+43.7% YoY) strongly beat estimates of $2.81 per share.

"I want to thank all UPSers for executing our strategy and delivering high service levels, which fueled record financial results in the second quarter," CEO Carol Tomé said in the earnings release. "Through our better not bigger framework, we are moving our world forward by delivering what matters."

Although the headline numbers were, in fact, better than expected, today's severely negative action in the stock price suggests anything but that. Let's first walk through the quarter, and later on, we'll try to explain why shares are getting pummeled today.

Before getting into the individual operating segments results, on a consolidated basis, adjusted operating profit of $3.273 billion was ahead of $3.033 billion consensus as the adjusted operating margin expanded 160 bps to 14.0%, up from 11.4% in the year ago period. As members will recall, margin expansion is a key focus of Tomé's "Better, Not Bigger" strategy and we love to see the execution here. Average daily package volume decreased 0.8% to 24.236 million and average revenue per piece advanced 15.3% to $12.26, up from $10.63 in the year ago period.

One thing we didn't like was how U.S. domestic revenue came in at $14.402 billion (+10.2% YoY), missing estimates of $14.756 billion. UPS saw a 2.9% decrease in average daily package volumes to a total of 20.508 million packages per day. Average revenue per piece increased 13.4% to $10.97, up from $9.67 in the year ago period. Importantly, average revenue piece far outpaced the associated cost as cost per piece, resulting in positive operating leverage - as we can see in the operating margin. Taking a look at those costs, we saw a 220 bps increase attributable to the higher cost of fuel, another ~200 bps increase attributable to due to enhancements to speed up the network and expand weekend operations, and another 210 bps increase attributable to an increase in employee benefit expenses as more employees became eligible for health, welfare and retirement benefits and from the reinstatement of the federal excise tax.

Customer mix continued to improve as small and medium-sized business (SMB) volumes, including platforms grew 21.6%, bringing SMB share of volume to 27.2% in the quarter. As a reminder, the mix of SMBs is important because they represent a higher margin opportunity for UPS.

Overall, B2C volume decreased 15.8% year-over-year. On the other hand, B2B average daily volume was strong, increasing 25.7% annually, with CFO Brian Newman commenting on the call, "All industry sectors grew B2B volume, led by retail as more foot traffic returned to the brick-and-mortar locations." Healthcare, which Tome called one of UPS' "wildly important customer-first initiatives," was a notable bright spot with volume up 28.6% in the quarter.

Operating profit was $1.675 billion on an adjusted basis (+37.9% YoY), a slight miss versus expectations of $1.689 billion. Adjusted operating margin was 11.6%, a solid improvement from the 9.3% margin reported in the year ago period.

International revenues were $4.817 billion (+30.0% YoY), topping estimates of $4.572 billion with all major regions showing double-digit percentage revenue growth. UPS saw a 12.7% increase in average daily package volumes with export growth increasing 14% YoY and all regions except Asia posting double-digit growth. Speaking to the dynamic in Asia, Newman noted that "Asia export volume faced difficult comps and was down 5.8% compared to the remarkable growth rate of 46.8% in the second quarter of last year, driven by the surge of PPE."

B2C average daily volume was down 4.1% while B2B average daily volumes were up 25% "with growth across all industries and customer segments." On the call, Newman noted, "these year-over-year comparisons reflect the unique pandemic effects from last year as B2C volume doubled in the second quarter of 2020."

Average revenue per piece also saw a nice increase to $19.32, a 15.5% annual increase. Importantly, the rise in average revenue per piece was above the 12.4% increase in cost per piece - with 570 bps of the expense increase attributable to higher fuel costs - though this was nearly entirely offset by a 530bps increase in fuel surcharge. So, once again, management was able to generate positive operating leverage in this segment as well for the quarter. Operating profit grew to $1.19 billion on an adjusted basis (+41.3% YoY), representing a beat against expectations of $1.025 billion as adjusted margins improved to 24.7%, up from 22.7% in the year ago period.

At Supply Chain Solutions, revenues of $4.205 billion (+14.3% YoY) topped estimates of $3.85 billion. As a reminder, the divestiture of UPS Freight was competed on April 30, 2021. Operating profit was also strong, coming in at a record $408 million on an adjusted basis (+52.8% YoY), above expectations of $370 million as adjusted margins also expanded to a record 9.7%, up from 7.25% in the year ago period. Speaking to the operating profit dynamic, Newman commented, "Looking at operating profit. In forwarding, our Ocean Freight product more than doubled its operating profit on a year-over-year basis, driven by strong inventory replenishment demand. And in health care, our clinical trials, along with cell and gene solutions, again delivered record top and bottom line results."

As for the outlook management once again withheld revenue and diluted earnings per share guidance. But what the team did provide is a reaffirmation of their full year 2021 capital allocation plans. As a reminder, capital expenditure is expected to be about $4.0 billion, in-line with estimates. The long-term debt repayment of $2.55 billion has now been completed. On the topic of share repurchases, which is something the UPS investor has wanted to see, management said in their prepared remarks that they have no plans to repurchase stock in 2021 at this time. But interestingly enough, it sounded like to us that management changed their tune as the conference call went on and UPS stock continued to sell off. During the Q&A, Tome stated, "We are looking at reentering the share repurchases market" and noted that it will be a topic at the Board meeting next week. Given today's sharp selloff and the significant amount of cash flow UPS is generating, we would be very surprised if UPS did not announce a share repurchase program sometime in the near future.

Now before we get into what we didn't like, first we want to discuss some of the initiatives Tome has in place because it helps explain the benefits of Tome's better not bigger strategy. First, the company commented that Saturday ground delivery volume grew 13% in the second quarter as they continued expanding our weekend coverage. This is an example of expanding services with little upfront capital spending. The Saturday expansion story is expected to continue through the end of October, which is when UPS expects to be able to cover about 90% of the U.S. population.

Another great example is how UPS is improving customer churn. Tome also noted that the company is working diligently to address its claims procedure, a pain point that impacts churn. Specifically, Tome said that in a recently completed pilot, the team was able to reduce claim processing time from 20 days to just five and with this noticed a 1.9% reduction in churn among pilot participants. To quantify that impact, Tome noted that every one percentage point improvement amounts to $170 million in annual revenue. The team plans to roll out the new claims process to all U.S. SMB customers over the next 12 months. There are many more examples we could get into, but we wanted to highlight these two as ways UPS is transforming into better business without the need of chasing volume growth or spending heavily on capital expenditures.

Now let's try to figure out why the stock is selling off so hard this afternoon. We saw the stock start to move heavily to the downside after management provided its second half 2021 outlook for the domestic business. Management said revenues are expected to grow 8.2% over the next two quarters, which is a clear deceleration from the first half. Investors never like to see growth slow down, especially when the concern right now with some of the pandemic beneficiaries is that are we in a as good as it gets environment. But in the case of UPS, we think management's domestic outlook should not be a complete surprise given the tough comps the company is up against from last year.

Additionally, we think margins were of focus after management said they expect operating margins in the back half of the year to be lower than the first half. The factors driving this decline are higher compensation expense, targeted hourly rate adjustment in certain locations to stay competitive in the market, and lower margin enterprise and B2C volumes becoming a larger part of total volumes. For the full year 2021, management expects 2021 U.S. operating margins to be 10.1%, which would be nicely up from 7.7% in 2020, and put the company well on its way towar.ds their 12% goal in 2023. But it looks a little lower than estimates and we think there were some investors here that were expecting a more aggressive forecast.

So where do we come away? We think today's ~8% selloff is an overreaction. Investors may be disappointed with the outlook over the next two quarters, but we think the fundamental story is intact here with management working hard to create a better, more efficient company amid positive industry trends in the parcel industry.

Plus, we think there is an underappreciated capital return story here. The current dividend isn't much with a yield of 2.11%, but management's new dividend payout is 50% of earnings, and with earnings expected to significantly grow in 2021, we are anticipating a material bump the next time management increases the payment. And to repeat ourselves from earlier, we would be shocked if share repurchases did not enter the picture here given the cash flow and today's selloff.

We also believe there was a hint of conservatism in management's guidance because that is simply who they are. But this has become both a good and bad thing for UPS. We always appreciate management teams who under promise and over deliver but owning shares in a company whose management team frequently talks down the stock can become tiresome. We aren't adjusting a long-term view here, but this is something we must contemplate going forward.

So what would we do with the stock? Having trimmed 150 shares at about $220 in May here and bought back 50 shares just under $200 in June here, we are looking to buy back more of the stock we previously sold at a higher price at these now lower prices. From a more tactical approach, we think it is plausible that the stock is unable to find any lift in today's session for reasons Jim explained in today's Daily Rundown video here, and that's why we would wait to buy the stock until later in the trading day.

We'll get a better handle on the UPS quarter and where the company is headed later tonight when Jim interviews CEO Carol Tome on Mad Money.