UPS, FedEx Are Best Barometers of Recovery

BOSTON ( TheStreet) -- Investors searching for signals of the strength of the economic recovery can look to UPS ( UPS) and FedEx ( FDX), which fund managers and analysts say are the best barometers of business activity in the U.S.

As fierce competitors in the shipping business, FedEx and UPS move so much freight that investors are offered a clear view of economic and business activity. With both companies on tap to report financial results for the critical holiday quarter, what they say about business can affect other companies as well.

"Every day, they're moving north of 10% of U.S. gross domestic product combined," says Kevin Sterling, transportation analysts with BB&T Capital. "They're busy, and that's pretty good for the U.S. economy."

Sterling, who has a "buy" rating on both UPS and FedEx, says the shippers may have seen their busiest Christmas on record. But investment manager Dan Genter says investors don't need a quarterly filing to get that information. All they have to do is speak with the local delivery person in the elevator.

"I spoke to our UPS delivery guy the other day and he said they were up 15% year over year," says Genter, CEO and CIO of RNC Genter Capital Management. Genter's firm has $3.6 billion in assets under management and investments in UPS. "They know what's going on. And when UPS and FedEx are picking up, overall business activity is probably picking up even faster because of what is happening off their radar."

UPS and FedEx are up 22% and 16%, respectively, over the past year. And Sterling warns investors that earnings-per-share and revenue data aren't the only figures they should be watching when the shippers report quarterly results.

"When they report Q4, that's in the past. So first and foremost, I'll be looking at the outlook," Sterling says. "The market is a forward-looking mechanism, so that's how investors have to focus. I'll also be looking at key metrics, such as growth in international segments, growth in ground segments, the pricing and margin expansion, as well as any cost headwinds."

Those headwinds are small in number but great in impact. Poor weather conditions across the U.S. have grounded hundreds of flights, which has an effect on shipping. Higher fuel costs likely dented each company's bottom line, as oil rose from below $80 a barrel to above $90 in the fourth quarter. Lastly, the Department of Justice is looking into possible antitrust issues between the two, although Sterling downplays the risk there.

"We'll probably hear about it because it makes for good fodder and good headlines," he says. "But they are both very fierce competitors. They literally hate each other. I can tell you they're not talking to each other. It's like the Hatfields and McCoys."

The DOJ probe comes as both UPS and FedEx have raised prices by 4% to 16% in all shipping segments. So while both stocks have outpaced the broader market's gains over the past year, analysts say investors may still be underestimating the amount of leverage in their models.

"If you get pricing increased, you get that much more leveraged to the bottom line, and you get margin expansion," Sterling says. "That might be the disconnect that people are missing. UPS and FedEx haven't been able to push pricing in the past couple years because of lower volumes. But now they are very, very focused on pricing. That might be where they could surprise."

For that reason, Sterling says he will be paying attention to gross margins. Genter, on the other hand, is looking at the wider view. "The big picture is that the economy is recovering and we have moderate growth," he says. "Businesses are spending and there is more shipping."

On the following pages, TheStreet previews both UPS and FedEx and what investment managers and analysts are looking for in fourth-quarter financial results.

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Company Profile: UPS offers an array of services in the package and freight delivery industry. It operates through three segments: U.S. Domestic Package, International Package, and Supply Chain and Freight.

Reporting Date: Feb. 1, before the market opens

Expectations for the Quarter: UPS is expected to report a quarterly profit of $1.05 a share on revenue of $13.4 billion, according to a poll of analysts by Thomson Reuters.

Investment Take: Investors looking for exposure to shippers probably find UPS more attractive than FedEx as UPS pays a larger dividend and the company has more cash on its balance sheet. Currently, UPS shares have a dividend yield of 2.7% and close to $10 billion in cash on their balance sheet.

"They'll be returning a little more cash to shareholders," Sterling says. "I would expect to see an aggressive share buyback program or maybe a dividend increase."

Sterling points out that UPS is going to face some headwinds, with fuel costs rising and weather affecting the company's business, but he expects that management is going to offer a 2011 outlook that he believes "could be rather positive based upon this pricing dynamic."

Sterling also says UPS will benefit more than FedEx by DHL Express' exit from the U.S. market. "With DHL out of the picture, you get a low-price guy out of the way. UPS has the dominant ground market share so, with pricing increases, they're more poised to benefit," he says.

Genter, meanwhile, says he will be keeping a watchful eye on UPS' unit traffic, especially domestic traffic. "I'd be great to see the overnight deliveries picking up," he says. "It's the most profitable for them because it's the most expensive because people are willing to pay for it. It's a good sign to see their highest-margin products being consumed."

UPS has gained a competitive edge over FedEx, Genter says, thanks to success in the overnight business as well as the company's labor-contract situation.

"People looked at FedEx as the undisputed standard of overnight for a number of years," Genter says. "UPS has pierced that veil and they are now viewed as comparable in the overnight business, whether that's domestic or international, as well as having superior service on the ground. Many businesses are looking at them as a better complete package with very strong pricing.

In terms of current labor contracts, UPS doesn't change compensation for its labor force based upon unit volume, according to Genter. While that would hurt the company during a recessionary period where it isn't shipping as many units, it works for the company's advantage in an expansionary period. "They'll have better margins on each incremental unit going up," Genter adds.

Genter will be watching to see how UPS performs on the top and bottom line, as the company has consistently surprised Wall Street to the upside. "For the last six quarters, Wall Street estimates have been too low, and I think they're still too low," Genter says. While he notes the risk of analysts bumping their expectations to unrealistic levels, he thinks that is far in the future as analysts can't quite measure the margin increase yet.

That said, Genter notes that UPS shares aren't cheap on a valuation basis. He expects the company to earn $4.20 a share in 2011, which would give UPS a price-to-earnings ratio of 18.5, which is in line with the broader market. Genter says that would mean the stock would hit $92 at full value.

"A lot of good news is in the stock. The chance to have significant P/E expansion is limited at this point," Genter says. "We're not as excited as we were before, just because of where the valuation is. But we still look at it as being conservative. And we look at it because it is going to participate in the business cycle. There is a fairly good predictability of earnings. Earnings predictability is what you need for support, especially with the market stalling here."

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FedEx ( FDX)

Company Profile: FedEx provides a portfolio of transportation, e-commerce and business services through companies competing collectively, operating independently and managed collaboratively, under the FedEx brand.

Reporting Date: March 17, before the market opens

Expectations for the Quarter: Analysts are predicting that FedEx will report a fiscal third-quarter profit of $1.09 a share and revenue of $9.7 billion, according to a poll by Thomson Reuters.

Investment Take: FedEx is more attractive to investors looking for exposure to airfreight, as the company has the largest cargo airline. Sterling says that segment is seeing tremendous growth as retailers have maintained lower inventories through the global economic recession.

"With the supply chain becoming much more flexible, you can get more exposure to airfreight through FedEx," Sterling says. "FedEx might offer a little more leverage because of airfreight."

FedEx's less-than-truckload, or LTL, division is in the process of a restructuring, and Sterling expects that business to turn from losses to profit, whereas UPS has always had a profit in that division. "You could have a little more pop as they get that business turned around," he says.

Other Wall Street analysts are similarly bullish on FedEx's turnaround potential. Jefferies analyst Peter Nesvold wrote in a recent research report that FedEx's earnings power is at an inflection point thanks to a series of corporate initiatives, including the LTL division restructuring.

"Key among these is a renewed focus on yield improvement in U.S. Express and Ground operations, now that DHL is out of the picture," Nesvold wrote. "Many other variables could push EPS above consensus. As a result, we believe there are multiple ways of being right on FDX." Nesvold has a 12-month price target of $112 on FedEx shares.

That said, Nesvold trimmed his fiscal third-quarter estimates for FedEx due to fuel costs and weather effects. He assumes a headwind of 9 cents a share due to fuel and a 5-cent-a-share impact of weather during the quarter.

Bank of America/Merrill Lynch analyst Ken Hoexter, on the other hand, boosted his 2012 and 2013 fiscal-year earnings estimates and upped his price objective to $115, noting "significant tailwinds" that boost FedEx's growth potential.

Among those tailwinds, Hoexter singles out easier expense comps, its pending LTL restructures, and the incremental margin from its focus on pricing. He also notes the potential for this year's $260 million pension expense to be "at least flat, if not a significant improvement when it is adjusted at fiscal year-end."

-- Written by Robert Holmes in Boston.

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Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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