The Background Info
UPS is a marvelously managed business. The company has outstanding returns on equity, industry-leading margins, one of the strongest balance sheets in the world with an AAA credit rating, and enormous growth potential throughout the world both in its core delivery business and supply chain services. That’s why I feel a bit bad picking on the firm; there are certainly much worse examples out there and with its excellent record of employee and shareholder-friendly actions, it deserves more praise than scorn.
A Fly in the Ointment - It Started with the Management Incentive Program
Between fiscal year 2004 and 2005, net income increased $537 million from $3.333 billion to $3.870 billion. Thanks to share repurchases, however, diluted earnings per share increased at a faster rate from $2.93 to $3.47. Given the ability of UPS to mitigate the cost of energy costs via price increases and fuel surcharges, investors probably felt very good about these numbers.That’s the whole story, or so it would seem. Deep in the annual report, under a section entitled Operating Expenses, investors will find the following paragraph (don’t panic! I’ll explain what it means later – it’s not nearly as scary as it looks):
During the first quarter of 2005, we modified our Management Incentive Awards program under our Incentive Compensation Plan to provide that half of the annual award be made in restricted stock units (“RSUs”). The RSUs granted in Novemebr 2005 under this program have a five-year graded vesting period, with approximately 20% of the total RSU award vesting at each anniversary date of the grant. The other half of the award granted in November 2005 was I in the form of cash and unrestricted shares of Class A common stock and was fully vested at the time of grant. Previous awards under Management Incentive Awards program were made in common stock that was fully vested in the year of grant. This change had the effect of lowering 005 expense. As a result, 2005 expense for our Management Incentive Awards program (reported in operating expenses under “compensation and benefits”), including the RSUs, decreased $334 million ($213 million after-tax, or $0.19 per diluted share) compared with 2004.
In other words, a large part of the Management Incentive Program will be offered in restricted stock (shares that cannot be readily bought or sold like those you or I would acquire through our brokerage accounts). These shares will vest, that is, become the property of the recipient, in equal installments over five years. This allows the expense associated with these shares to be spread out over time. In one quick swipe of the accountant’s pen, after-tax expense was lowered by $213 million – that is, net income was increased by $213 million. When you recall that the company’s net income increased $537 million for the year, it suddenly is obvious that 40% of that year-over-year growth was the result of nothing more than an accounting shift. The amount of cash the company has in the bank didn’t really change other than a few tax issues that may be juxtaposed as a result of the jumble.
That has very real implications: Namely, the company did not grow nearly as fast as its results would indicate. What does that mean for you? It all depends on your outlook for the company. Do you think the business will continue to grow fast enough to justify its recent price-to-earnings ratio? Can you find other investments that appear to be offering more value for the money? At the end of the day, only you and / or your investment advisor can answer that question.
