On Monday, the credit ratings agency Moody’s (NYSE: MCO) announced that it was changing UPS’s (NYSE: UPS) ratings outlook from positive to negative, while reaffirming its A-1 senior unsecured debt rating, essentially the middle of the ‘investment grade’ spectrum of bond ratings.
Moody’s wrote that UPS’s 4.6x debt-to-EBITDA ratio, its guidance for capital expenditures of 9% of revenue in 2019 and 2020, its pension liability obligations, and its use of cash for share buybacks had the potential to substantially weaken the parcel carrier’s credit profile. UPS invested about 5% of revenue annually in capex prior to 2018, Moody’s wrote.
“The negative outlook reflects the potential for funded debt to remain elevated through and beyond 2020 because of 1) sustained significant returns to shareholders during a period of weaker free cash flow generation because of stepped up capital investment and 2) ongoing contributions to the company’s defined-benefit pension plans,” said Moody’s Senior Vice President, Jonathan Root.
UPS shares closed down 1.47% on Monday, lower than both the S&P 500, down 0.39% and FedEx (NYSE: FDX), which dropped 0.83%.
A raft of analyst notes followed UPS’s fourth quarter earnings call on January 31, and several mentioned the free cash flow issues that concerned Moody’s.
Bascome Majors, equity analyst at Susquehanna, said it best.
“Over time, we continue to see UPS stock tracking FCF generation, which was more in line with our expectations (initial guide $3.5-$4B/$4.02-$4.60/share/~4% yield, down from $6.1B in 2018), and remains heavily dependent on an eventual ramp-down in the elevated capital envelope (2019 is year two of three at the 8.5-10% of revenue range, reiterated today),” Majors wrote in a January 31 note.
“Management said that it plans to 1) increase the dividend in 2019, and 2) buyback $1bn worth of stock,” wrote David Ross, Managing Director – Research at Stifel, in a February 1 note. “Raising the dividend implies spending >$3.2bn in 2019 and adding on $1bn of buybacks exceeds the company’s FCF target range. If it’s an issue, buybacks will be reduced to make room for another dividend increase. And then moving into 2020, we do not expect a dividend cut, even if the economy softens, as the company would likely defer capex to make the dividend.”
Ross also noted that UPS’s basic guidance assumes that more parcels will move in 2019 than in 2018, which depends on a flat to growthy view of global macroeconomics.
Kevin Sterling, Senior Research Analyst at Seaport Global, provided color on UPS’s projected capital expenditures.
“Expenditures are centered around the airline fleet replacement and growth, hub and facility automation, and vehicle replacement,” Sterling wrote in a February 1 note. Sterling also described the effect that Amazon’s in-sourcing of transportation and logistics services might have on UPS’s business.
“It appears Amazon is morphing into more of a competitor than customer and Amazon is learning plenty from its Prime Now product in select markets and that in certain highly dense markets an in-house delivery product will eventually make sense for Amazon,” Sterling wrote. “Increased competition could reduce UPS’s growth and market share and create downward pressure on freight rates which may adversely affect financial results.”
Moody’s concluded its report by outlining UPS’s way out of its ‘negative’ outlook rating, both to the upside or the downside.
“The ratings could be downgraded if share repurchases exceed free cash flow or based on Moody’s adjusted metrics before its MEPP adjustment, Retained Cash Flow to Debt remains below 25%, EBIT to Interest is sustained below 12x or Debt to EBITDA remains above 2.2x,” Moody’s wrote. “The potential for a higher rating is limited until funded debt declines by more than $10 billion. Demonstrating that the current capital investment program and transformation strategy would solidify UPS’ ability to preserve its leadership in its markets and the ability to thrive as its markets evolve with growing e-commerce would also support a ratings upgrade.”