UPS: Dividend Growth Stocks Are a Compelling Buy Now

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UPS delivery

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As a dividend growth investor, I focus on buying the highest quality stocks.

Along with the fresh capital injections, this investment approach has helped my annual term dividend income to grow steadily each year. An action it is a central position within my portfolio is United Parcel Service (NYSE:UPS).

For the first time since I initiated coverage of the stock in March 2019 (hereafter referred to as UPS), I will return to my reasons for reiterating my buy rating for the stock.

The safest dividend is one that has just been heavily traveled

In February, UPS announced a 49% increase in its quarterly dividend per share to $1.52. This is the largest dividend increase in the company’s history.

The massive increase in payouts was driven by both tailwinds and a change in UPS’s dividend policy to target an adjusted diluted EPS payout ratio of 50% of the prior year’s figure. But can healthy dividend growth persist in the future?

UPS generated $12.13 of adjusted diluted EPS in 2021. Compared to the $4.08 in dividends per share the company paid, this equates to a very sustainable adjusted diluted EPS payout ratio of 33.6%.

With UPS expected to pay out $6.08 in dividends per share for this year, the stock’s adjusted diluted EPS payout ratio for last year’s earnings would be 50.1%. And given the $12.75 of adjusted diluted EPS that analysts expect in 2022, that would represent a payout ratio of 47.7%.

Simply put, UPS meets this target payout ratio of 50%. Given that analysts are forecasting annual earnings growth of 14.1% over the next five years, I think an annual dividend growth rate of 6.5% is a realistic forecast for UPS.

UPS continues to deliver growth to its shareholders

Key Takeaways from UPS's First Quarter 2022 Earnings Report.

UPS First Quarter 2022 Earnings Press Release

UPS announced strong results for the first quarter ended March 31.

The company posted consolidated revenue of $24.4 billion in the first quarter. This represents a growth rate of 6.4% over the prior year period (all details from page 1 of the UPS Q1 2022 earnings press release).

UPS’s three operating segments (US Domestic Segment, International Segment, and Supply Chain Solutions Segment) achieved revenue growth of 8%, 5.8%, and 2%, respectively (data points according to pages 1-2 of UPS’s first quarter 2022 earnings press release).

The company’s growth was driven by rising revenue per piece. This was the result of price increases that were passed on to consumers in the form of fuel surcharges and higher shipping rates, according to CFO Brian Newman’s opening remarks on the recent earnings call. ‘company.

UPS posted $3.05 of adjusted diluted EPS in the first quarter, a year-over-year growth rate of 10.1% (figures per page 1 of the UPS earnings press release for the first quarter of 2022). Besides the higher revenue base, UPS was also more efficient in the first quarter. The company achieved 70 basis point year-over-year growth in adjusted operating margin to 13.6% in the first quarter (details taken from slide 8 of the call presentation on results of UPS 1Q22). This explains how UPS’s adjusted diluted EPS growth outpaced its consolidated revenue growth.

UPS's income statement for the first quarter of 2022.

UPS First Quarter 2022 Earnings Press Release

In addition to UPS’s strong first quarter operating results, the company is also in excellent financial condition.

This is supported by the fact that the company’s interest coverage ratio was 20.5 in the first quarter ($3.57 billion pre-tax earnings / $174 million interest expense). In other words, UPS has little difficulty meeting its financial obligations. This translates into a low risk of long-term bankruptcy.

Risks to consider:

UPS is arguably one of the best companies in the world. But even this carries risks, so investors should pay attention to these factors.

With nearly 70% of US GDP coming from personal consumption, high rates of inflation could weigh on consumers’ financial health and spending at some point. If that happened, the economy would go into recession. This would cause a temporary deterioration in UPS’s financial outlook.

A similar risk for UPS is the possibility that high transportation costs will reduce the company’s margins. This has yet to materialize as UPS has been able to raise its prices without much impact on its shipping volumes. But it’s something to watch for moving forward.

A favorable valuation

Every share has its fair value. Not surprisingly, the goal is to pay fair value or less for the best investment result. This is because a significant overpayment for a stock comes with both a reduced starting dividend yield and upside potential.

I will use two valuation models to find a fair value for UPS stock.

My entries in the discounted cash flow model show that UPS shares are deeply undervalued.

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The first valuation model I will use to value UPS stock is the discounted cash flow model, or DCF model. This consists of three entries.

The first input into the DCF model is trailing twelve month earnings. This figure is $12.41 in the case of UPS.

The second input to the DCF model is made up of the growth assumptions. I will use an annual earnings growth rate of 5.5% for the next five years and assume a deceleration to 4.5% per year in subsequent years.

The third input to the DCF model is the discount rate, which is the annual total rate of return that an investor demands from his investments. My personal preference is 10% annual total returns, so I’ll use that for this entry.

Using these inputs for the DCF model, I get a fair value of $246.19 per share. This implies that UPS shares are trading at a 25.8% discount to fair value and can offer a 34.8% upside from the current price of $182.60 per share (as of 2 June 2022).

UPS shares are valued at a slight premium to fair value using the dividend discount model.

Investopedia

The second valuation model I will use to value UPS stock is the dividend discount model. This is also composed of three entries.

The first entry for the DDM is the expected dividend per share, which is another term for the annualized dividend per share. The annualized dividend per UPS share is currently $6.08.

The next entry in the DDM is the cost of equity, which is the annual total rate of return an investor needs. Again, I’m going to use 10% for this entry.

The final input for the DDM is the DGR, or annual dividend growth rate. I’m going to use 6.5% for this entry.

Plugging these factors into the DDM, I arrive at a fair value of $173.71 per share. This means UPS shares are valued at a 5.1% premium to fair value and incur a capital depreciation of 4.9% over the current share price.

When I average these fair values ​​together, I calculate a fair value of $209.95 per share. This indicates that UPS shares are trading at a 13% discount to their fair value and offer a 15% upside from the current share price.

Summary: Market-leading payout without sacrificing total return potential

UPS has increased its dividend for 13 consecutive years, making it a Dividend Contender. And judging by the below 50% adjusted EPS payout ratio projected by UPS for this year, the dividend should not have growth issues for many years to come.

This argument is reinforced by the company’s single-digit consolidated revenue growth and double-digit adjusted diluted EPS growth in the first quarter. Finally, the interest coverage ratio above 20 is proof that UPS is doing well financially.

UPS’s impressive fundamentals also don’t seem to be fully recognized by the market at this time. This should lead to annual total returns of 11-12% over the next 10 years, making the stock an attractive buy for income investors.

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