A Perfect Package of Yield and Growth

03/14/2011 12:42 pm EST

Focus: STOCKS

Josh Peters

Editor, Morningstar DividendInvestor

UPS delivers economies of scale, operational efficiency, and an attractive dividend approaching 3%, write Josh Peters and Keith Schoonmaker of Morningstar DividendInvestor.

UPS (NYSE: UPS) is the colossus among global transportation companies, and powerful barriers to entry guard its economic profit. Its $45 billion of revenue in 2009 exceeded the combined sales of the four largest North American railroads.

The stock looks about fairly valued here, but we're encouraged that the company’s recent 10.6% boost to its dividend will be the first of several handsome increases as the global economy revives.

Despite its extensive unionization and asset intensity, UPS produces returns on invested capital about double its cost of capital and margins well above those of its competitors. We credit the firm’s leading package density and outstanding operational efficiency, enhanced by extensive investment in information systems.

UPS and its competitors have turned to Asia and developing nations for growth, and we think UPS has a lot of runway left to build speed. Even existing operations have revenue expansion potential because of the firm’s rare pricing power.

While rapid changes in shipping demand during 2009 demonstrate the potential for short-run uncertainty because of macroeconomic factors, we are only optimistic about UPS’ future—and expect solid, if not record, results for 2011.

No Letup in Sight
UPS is in fine shape, financially speaking, with a Morningstar credit rating of A-. The firm has increased its use of debt in recent years, both to satisfy pension obligations and repurchase shares, but debt burdens remain fairly modest. In 2010, the dividend represented 53% of earnings, and the indicated payout ratio for 2011 looks to be around 50%.

While UPS operations are cyclical thanks to the high fixed costs of supporting its worldwide network, profits covered the dividend with room to spare even in the trough year of 2009 (per-share earnings of $2.31), and free cash flow remained strong.

While the cyclical nature of its business has kept UPS from raising its dividend every year, it has either increased or maintained its dividend for more than four decades, and the dole has risen in ten of the 12 years since the stock’s 1999 debut on the public market. (This probably has a lot to do with the fact that an impressive 36% of outstanding shares are Class A stock owned by employees, retirees and descendants of founders.)

The compound growth rate for dividends over the past decade has been a handsome 10.6%, although this pace includes an upward drift in the payout ratio (which averaged 39% from 2002 to 2007).

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We believe overall global parcel-shipping market expansion and consistent price increases will enable UPS to grow at a compound annual rate of 8% during the next five years, a pace we expect the dividend to match.

At the stock’s current yield of 2.8%, we think UPS can deliver average total returns approaching 11% a year.

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