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United Parcel Service, Inc.

Q4 2008 Earnings Call

January 3, 2009 8:30 am ET

Executives

Andy Dolny - Vice President Investor Relations

Scott Davis – CEO

Kurt Kuehn – CFO

Analysts

[Rob Samanon] – Wachovia Capital Markets

Gary Chase – Barclays Capital

Edward Wolfe – Wolfe Research

Jon Langenfeld – Robert W. Baird

Tom Wadewitz – JP Morgan

Chris Ceraso – Credit Suisse

William Green – Morgan Stanley

John Mins - BB&T Capital Markets

Ken Hoexter – Bank of America

David Ross – Stifel Nicolaus

Robin Byde – HSBC

David Campbell – Thompson, Davis & Co.

Operator

(Operator Instructions) Welcome everyone to the UPS Investor Relations Fourth Quarter 2008 Earnings Conference Call. It is now my pleasure to turn the floor over to your host Mr. Andy Dolny, Vice President of Investor Relations.

Andy Dolny

I’m here this morning with Scott Davis our CEO and Kurt Kuehn our CFO to discuss the company’s results for the quarter and our outlook for 2009. Before we begin, however, I’ll briefly review the safe harbor language.

Some of the comments we’ll make today are forward looking statements that address our expectations for the company’s future performance or results of operations. These anticipated results are subject to risks and uncertainties which are described in detail in our 2007 10-K and 2008 10-Q reports. These reports are available on the UPS Investor Relations website or from the Securities and Exchange Commission. Today’s call is being webcast and will also be available on our Investor Relations website.

In the remarks today Scott and Kurt will compare results for 2008 against 2007 excluding the effects of adjustments that occurred in both years. This comparison is more reflective of UPS’s true performance. There were two adjustments recorded in the fourth quarter 2008. The first was a $548 million good will impairment charge in our UPS Freight unit which is part of the supply chain and freight segment. This charge resulted from a number of factors. We acquired Overnight in 2005 when the economy was much stronger and valuations were higher.

We then invested in technology and operational improvements to enhance service and performance and expand product offerings. Unfortunately the current Freight environment has been a challenging one for new investments and customer focus is primarily on price. Long term, we believe our strategy is sound and will be viable when market conditions improve. We felt it prudent to reevaluate the good will associated with this acquisition and make a reduction based on current market comparisons and cash flow outlook.

The second adjusted recorded in the quarter was a $27 million write down of intangibles in the UK Domestic operations, included in the International Package segment. This relates to a domestic customer list which was part of an acquisition. With the weak conditions in the UK and our emphasis on the export market this domestic customer list proved to be of less value then estimated.

In the fourth quarter 2007 if you remember, we recognized a $6.1 billion charge in US Domestic Package segment to withdraw employees from the central states pension plan as part of our long term labor contract with the Teamsters. Any reference Scott and Kurt make to full year results excludes the impact of these adjustments as well as other charges in 2007 totaling $335 million. A reconciliation of these results is included with our earnings announcement this morning and appears on UPS’s IR website in the financial information tab.

Just a quick reminder, in December, based on customer considerations we decided to suspend pickups on the day after Christmas. We had one less operating day in the quarter then we had originally planned. We believe there was little if any volume lost in total. That’s why when we talk about volumes today we’re speaking about overall totals not average daily.

To begin our review I’ll turn the program over to Scott.

Scott Davis

What a difference a year makes. A year ago on the heals of momentum from our historic contract with the Teamsters we were optimistic about our prospects. Economics were predicting slow but growing US GDP and industrial production. It was debated whether we were in or heading into a recession. Globally experts question that decoupling theory. Very few saw what was about to unfold.

Two thousand eight was very difficult. However, we responded well. Our operations team in the US continued to adjust the network as package volume deteriorated under worsening economic conditions. In our International segment export volume increased 6.8% as we benefited from the industries most diversified global network.

The Supply Chain and Freight segment posted a 5% annual operating margin. This was at the top of the range we had provided at the beginning of the year. Our strong balance sheet and ability to generate cash enabled us to weather the financial market meltdown. Clearly we didn’t meet all the goals we had set at the beginning of 2008 yet we still finished the year with an industry leading small package operating margin of 13%.

Conditions in the fourth quarter of 2008 continued to worsen. Industrial production fell, consumer spending dried up, and economic hardships spread throughout the world. In previous recessions consumer spending remained steady helping keep recessionary periods relatively short. This time, however, the consumer is not spending. Consequently experts predict that this recession will be worse then any we’ve seen in several decades.

We are adapting our company to the current environment. We are looking at everything; organizational structure, compensation, network configurations, products and services. How we do business, why we do it that way, what do we really need, what can we do without. We’ve made changes in the last six months in the way in which we operate. One of those changes involves revenue enhancement initiatives.

Perhaps the most significant revenue opportunity stems from DHL’s departure from the US Domestic market. We went after that business vigorously with a well executed plan. We gained significant new volume as a result. We have more opportunities in 2009 as we compete globally with them particularly on volumes in and out of the US. As for the airlift contract, we and DHL had been working on, negotiations are continuing. With reduced scale of airlift need we’re finding it very difficult to reach an agreement.

Other changes we’ve made include reduction of non-operating expenses through district and corporate consolidations. We’ve made adjustments in our Ground and Air networks worldwide to reduce costs and adapt to the market conditions. These initiatives total over $500 million and will partially offset the impact of continued economic weakness. In addition, we are freezing management wages, reducing other forms of compensation and suspending the company’s 401(k) match and other benefits.

However, I want to be clear, we will still make strategic investments that provide worldwide opportunities to grow UPS. Hence strengthen the services and solutions we bring to our customers. We believe our strategy and business model are sound in that UPS offers a vastly better value proposition to the marketplace then any of our competitors. Plans are in place to manage our costs while ensuring that we maintain high quality service to our customers.

In times of economic difficulty like today’s environment there is one certainty in business. When trends improve, and they will, the landscape will be different. Some companies will be gone. Others will still be viable but damaged and no longer competitive leaders. UPS will emerge stronger, leaner and more customer focused and well prepared to benefit from improving trends.

Now I’ll turn it over to Kurt for a review of fourth quarter results.

Kurt Kuehn

In short, UPS’s results clearly reflected the fourth quarter economic conditions. All of our businesses were negatively impacted. Earnings per share of $0.83 for the quarter, however, did enable us to achieve overall EPS of $3.50 for the year, within the range we provided to you over six months ago.

I’ll begin today’s review with the Domestic Package operations. The 4.4% decline in total quarterly volume reflected a worsening of the economic trends we saw last year. UPS captured significant new volume as a result of DHL’s departure from the US Domestic market. That volume, however, was not enough to offset declines from the economy.

Revenue per piece was up marginally at 0.6%, because of the shift away from premium products and lower average weights. Weight per piece declined almost 10% for Air products and over 5% for Ground packages in the quarter. This is by far the largest decline in weight we’ve seen in this decade. The benefit we realized from the two month lag in the fuel surcharge was more than offset by reduced volumes, lighter weights and declines in premium products.

When we provided guidance back in the third quarter there was an implied fuel surcharge lag benefit based on the forward curve. This lag actually provided an additional benefit of $0.10 per share over what we’d expected.

During December we experienced a peak season that was very similar to last year, with shipping concentrated during the last week and a half prior to Christmas. Based on what we learned in 2007 we brought on peak season helpers later this year which allowed us to better manage the process. Our operations continue to adapt to the new environment. For the quarter block hours were down mid single digits, direct labor hours were down over 5% and miles driven declined by 4.5%, while service metrics continued at all time highs.

During the quarter we proceeded with numerous restructuring and network changes. We announced the closure of six district offices and the elimination of night sort operations at our regional air hubs in Dallas, Texas, and Columbia, South Carolina. All as part of a rigorous realignment of our Air network. We also announced the closure of a large office facility in Georgia in an effort to consolidate our corporate functions. These moves are a part of an ongoing program to resize the organization to match the changed business environment.

Now for a look at the International business, UPS benefits from very strong regional networks in all major areas of the world tied together by a global air network. This balanced presence is a competitive differentiator and one that we will continue to nurture with future investments. Export volumes increased by 1.6% this is significantly below the 5% growth we had anticipated for the quarter but it remains market leading.

We saw weakness in the US with mid single digit export volume declines. Asia was also down slightly although China achieved double digit growth. Europe posted a mid single digit improvement based on continued strong intra-regional growth and Latin America experienced a double digit volume gain.

International operations are experiencing the same impacts as the US Small Package business, declining average weight per package and a shift away from premium products. This shift was much more pronounced in the fourth quarter then we’d seen in prior quarters as we helped our customer’s trade down not out of our comprehensive portfolio. These factors along with the currency impact contributed to a revenue per piece decline of over 8%. Removing currency, revenue per piece was down 3%.

International operating margins declined to 14.9%. The positive impact on operating profit from fuel was more than offset by weakening global economic activity. For the quarter the fuel surcharge lag provided a benefit of $0.02 per share over what we’d expected when we provided guidance.

We pointed out in the past that there are higher fixed versus variable costs in our International network and we’re addressing this issue vigorously. We’ve identified opportunities to reduce block hours in our worldwide air network during 2009 without sacrificing service or footprint. In Europe we’re optimizing our ground network opportunities and have identified changes to be implemented in management and compensation of our outside service providers.

At the same time we will continue to move forward. Non-US Domestic expansion will occur where there’s minimal investment required. An example is our recently announced expansion of Domestic Express pickup and delivery service to 16 additional countries in Europe, Africa, Middle East and Latin America.

In the quarter, UPS also continued investing to support long term growth opportunities. We opened our Air hub in Shanghai and broke ground on our new intra-Asian hub in Shenzhen, China that will be operational in 2010.

Now let’s look at the Supply Chain and Freight segment. Revenue declined 6.5%; operating margin was 2.6% for the quarter but came in at 5% for the year, at the high end of the range we had targeted at the beginning of 2008. As Andy mentioned, we did take a $548 million impairment charge in UPS Freight which experienced a disappointing fourth quarter. Declines in revenue and shipments reflected the very slow environment in the LTL sector. This poor performance severely impacted the operating profit for the segment. For the year UPS Freight did post slight profit.

Weight per shipment improved slightly, although shipments per day were down. Price has become a major headwind today as excess capacity causes carriers to pull the pricing lever to defend share. Market watchers are of the opinion that this is one of the worst LTL environments ever.

To combat this situation we are intensifying our focus on cross selling the Freight portfolio to our Small Package customers. We have rolled out an enhanced world ship platform that allows customers to seamlessly optimize the selection between our hundred weight package service and LTL. This tool can help save a customer 10% to 15% in shipping costs.

Global forwarding experienced a step down decline in revenue in November and December, reflecting the economy driven decreases in demand for customer’s products. However, profitability for this unit improved in the quarter as compared to last year. Weight per shipment declined and lower fuel surcharges had a negative impact on revenue for the quarter, a trend that we expect to continue into 2009.

Our logistics operation performed quite well. Revenue increased in high tech and healthcare but was down in retail and industrial sectors. Service levels in this business remained very high and profits continue to improve. Over the past several years UPS has built a comprehensive supply chain management capability focused on the healthcare industry. Merck’s selection of UPS to operate a significant portion of its US distribution demonstrates the success that we are achieving in this market sector.

Now for a recap of our end of year financial position. Even in the midst of the toughest environment in our careers UPS remains rock solid. UPS generated cash flow from operations of $8.5 billion for the year. Our capital expenditures for 2008 were $2.6 billion, about $400 million less then we’d anticipated at the beginning of the year. This equates to approximately 5% of revenue at the low end of our historical range. We paid $2.2 billion in dividends and $3.6 billion to repurchase 53.6 million shares.

We did slow our 2008 stock repurchase program when the long term debt market became volatile. With the dramatic changes in the economy during the year and continuing economic uncertainty we will be particularly prudent in our financial management. We will continue repurchases but at a significantly reduced rate. One of the defining characteristics of our business has always been UPS’s ability to generate cash flow and 2008 was no exception with free cash flow of $5.7 billion.

Now a quick update on our fund flow from operation to total debt metric. We targeted a range of 50% to 60% that we would reach by the end of 2009 and we finished 2008 at 68%. We’ll continue working towards that range. As Scott said, everything is being evaluated from a financial as well as an operational perspective. We will manage the business in light of today’s realities but also to make sure that we’re in position to capitalize on opportunities as they materialize.

Now for some insights into 2009. We have our work cut out for us this year which will likely be even more difficult than 2008, with forecasters not anticipating any real economic recovery until 2010 UPS earnings for 2009 will suffer. Because of the amount of uncertainty surrounding global economic conditions it is premature to give full year guidance. If we did it would have to be a very wide range which in our opinion is not helpful.

Instead we will provide earnings guidance for the first quarter of this year which we expect will be between $0.52 and $0.68 per share. The first quarter will be weak, with slight improvements later in the year as initiatives take hold.

At the end of 2008 our pension plan funding levels were down substantially from the previous year, in concert with the decline seen in the investment markets. Although these plans remain well funded we will experience a pension expense increase that will have a drag of approximately $0.10 per share for the year.

Another impact on the year involves fuel surcharges. When they were rapidly escalating, in some cases we discounted base rates in order to preserve the surcharges. Now as they have fallen it will take time to cycle through the contract negotiation process to pull back some of those base rate discounts. We believe this will be an impact throughout 2009.

For the first quarter average daily volume in the Domestic operation is expected to decline between 3% to 5%. We anticipate package weight will remain lighter than our historical averages until the economy begins to rebound. International export volume should be down somewhat for the quarter. The Supply Chain and Freight segment should post an operating margin similar to that of the fourth quarter with UPS Freight particularly challenged through 2009.

Over the longer term we are evaluating operational changes that would leverage our small package, forwarding and freight ground assets in the US in an effort to capitalize on network economies of scale. Ultimately it’s our plan to generate operational changed through both better alignment of our networks and asset utilization.

With respect to capital expenditures our budget for 2009 will be $2.2 billion, some $400 million less then 2008’s total. At less then 5% of revenue this will be the lowest we’ve seen this decade. While the current outlook is sobering to say the least we are taking measures to strengthen the company while focusing on helping our customers survive today’s economic difficulties. These steps will help UPS preserve its financial strength and enhance its leadership position in the industry.

Now Scott and I will be happy to answer your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from [Rob Samanon] – Wachovia Capital Markets

[Rob Samanon] – Wachovia Capital Markets

Could you guys give us a sense; in the prepared remarks you indicated that the pricing trends were stable in the Domestic Small Parcel. Could you give us a sense of how the pricing trends were throughout the quarter particularly after DHL had made their announcement if you guys had seen a step up in terms of pricing? If you could give us the actual price per package for each month as well as January would be helpful.

Kurt Kuehn

I won’t get into that granular of detail. Certainly we do see over time improved pricing power in the industry. At the same time the dramatic changes in fuel surcharges are creating a lot of moving parts so it is going to be challenging externally to fully be able to map all of those factors. In general, we do feel that the pricing environment is very rational.

Certainly the DHL exit has a big impact on the market. Their volume is however lighter weight than average and most likely at a lower average revenue per piece although clearly as we have priced these DHL customers we are extracting an appropriate premium for UPS service and quality. It will be a year transition but overall we remain resolute in being disciplined for pricing. As the fuel surcharge impact filters through we think that it will be evident that the market is very rational.

[Rob Samanon] – Wachovia Capital Markets

Shifting gears to the capital expenditure side of things, could you give us a sense in terms of your share repurchase plan. You had indicated that you would scale it back significantly what that means and how we should be thinking about the repurchase throughout 2009 as well as if you could give us a sense what your thoughts are on the dividend here as well.

Kurt Kuehn

Right now the mantra has been conserve capital. Given the current uncertainty our balance sheet remains a thing of beauty and is an absolute strength for us that we intend to protect. We are being prudent, we did slow the stock repurchases, we do remain committed to repurchasing and retiring shares over time but we also want to make sure that we preserve our liquidity and flexibility.

We did, as you can see, take aggressive steps to reduce capital expenditures, pulling back to just committed deliveries of assets, completing our world port hub expansion which is one of the things that’s allowing us to make such dramatic improvements in our air network. We’ll be very prudent and cautious on that but still with a strong AA rating we’ve got plenty of horsepower.

Scott Davis

Our intent is to continue to reward our share owners be it dividends and share repurchase in 2009, even in this economic environment. Kurt said earlier that likely share repurchase will be at a smaller amount; I think that is prudent based on what’s gone on in the credit markets. We are seeing some stabilization in the credit markets recently.

As far as dividend policy it’s determined at the discretion of our Board of Directors. I will remind you that despite earnings being down about 15% in 2008 versus 2007 that our free cash flow was outstanding at $5.7 billion. The cash position is great. We will take a look at that, the Board meets next week and normally looks at dividend policies at that point in time.

Operator

Your next question comes from Gary Chase – Barclays Capital

Gary Chase – Barclays Capital

I wondered if you could shed a little bit more light on the change in weight per package. You said DHL was a lower weight competitor. How much of what you’re experiencing is just mix in picking up that volume and how much of it is customer mix and what should we expect looking forward with industrial economy doing what its doing should we expect the weight problem to get worse during the first quarter?

Kurt Kuehn

That’s one of the first times I’ve heard a weight problem being lowing weight, in this case it may be. The majority of it is the economic cycle. We’ve been talking to that the last three or four quarters. Clearly in slow economic times there are just plain less widgets per box and so the average weight of each package does tend to drift down.

Having said that we did see an acceleration in that in the fourth quarter. Certainly we think some of that acceleration is market share gain from DHL. It’s still a moving target; DHL really has just wrapped up their domestic operations. It’s too soon for us to really characterize that or give you any specifics on the impact. We do think that that will continue to bring volume to our network but in some cases lower weight than average.

We did see the same trends internationally where the weight shifts were substantial. Certainly that’s primarily economically driven right now.

Gary Chase – Barclays Capital

As you think about the actions that you’re taking to resize the networks; segment reductions, compensation changes, etc. is there a way for us to think about how much of that was completed and in place within the fourth quarter result that we’ve already seen and how much is yet to come.

Kurt Kuehn

The $500 million in network changes, operational changes and some of those, the majority of that is still rolling out. Certainly there was some portion of that towards the end of the year. I would say the majority is still to be realized. The compensation changes that we announced that are in addition to that really don’t begin to kick in until March which is our normal annual pay cycle.

There’s certainly still benefits to come from that and we will both extract benefits out of that and frankly we’re busy working on continued review of initiatives all across the company, it’s a top priority for us and we’re going to make sure the company stays in good shape.

Scott Davis

We’ve had a hiring freeze on throughout most of 2008 and all that benefits with attrition as people leave the payroll we don’t replace those people. Kurt mentioned in his earlier comments that remember that we’re managing our workforce everyday and you saw that in the last quarter where direct labor hours were down more than volume 5.1% versus 4.4%. We’ll continue to manage the variable costs on a daily basis.

Some of the organizational structure changes, we made some of the last year, we made some of them effective in January where we took down six more district offices which will help our organization moving forward. Some of it you saw in 2008 but a lot of it is coming in 2009.

Gary Chase – Barclays Capital

Is this sizing into the current economy or something a bit deeper?

Scott Davis

We certainly expect the first half of this year to be worse then what we saw in 2008. As a result, we’re going to manage the company to those levels. We don’t know when its going to turn around but we’re going to manage it as if it’s going to stay down for certainly all of 2009.

Operator

Your next question comes from Edward Wolfe – Wolfe Research

Edward Wolfe – Wolfe Research

When you think about right sizing the network and let’s call it you giving guidance of -3% to -5% in Domestic and slightly negative in International. Let’s call it negative low something for the rest of the year. Can you catch up by third; fourth quarter assuming we don’t go from -3% or 5% to -10% if it just says in that range? Can you start to see the margin year over year improve or that’s impossible the way the network is over that period of time?

Scott Davis

It’s going to be very difficult to improve the margins if we have a declining economy. We’re going to do everything we can to hold the margins the best we can. With the mix of the products and as Kurt talked about the huge drop in weight in the products we saw in the fourth quarter it’s likely to continue the first half of the year. It’s going to be a challenge for us to do that. We’re going to do everything in our power and we’re going to presume the economy keeps getting worse.

Frankly I think the economy you’re going to see the biggest drop in the first quarter of ’09 even worse then the down 3.8% and down 6% IP numbers we saw in the fourth quarter. Second quarter will probably negative not quite as bad. It’s not unrealistic to say it’s going to flatten out at the end of the year, the economy. We’re going to manage it as if it’s going to stay at the first and second quarter levels.

Edward Wolfe – Wolfe Research

If Domestic and International volume are both negative should we assume in International margins deteriorate more given the fixed cost nature of it and that they’re coming from higher places.

Kurt Kuehn

We’re really not in a position to go too far on outlook right now. Clearly there is a higher portion of fixed costs but we’re taking some pretty dramatic steps to take that cost out. One silver lining since you’re binning for some good news, the dramatic reduction in fuel surcharges from up in the 30% plus down to what will be only a 1% surcharge in February.

We think will have a beneficial effect on our premium products. Certainly in a tough economy that’s not going to come booming back but we do think that we will begin to see more of a balanced growth between our ground and air and our deferred products and our premium air. That will certainly be a positive as we begin to reverse some of those negative headwinds.

Scott Davis

As challenging as the economy has been including Europe we still showed pretty good transporter growth in Europe and expect to continue that growth in 2009.

Edward Wolfe – Wolfe Research

The deferred Air yields that really weakened this quarter is that DHL stuff coming towards deferred more than other products or is there something you’re doing in particular there?

Kurt Kuehn

That’s always a very volatile segment. Yes, plus or minus a few big customers can make a big difference in that. You’ll see that one jumps around. I wouldn’t draw too fine a point on that.

Scott Davis

The majority of DHL volume is heading towards Ground also.

Operator

Your next question comes from Jon Langenfeld – Robert W. Baird

Jon Langenfeld – Robert W. Baird

Can you talk about the balance sheet and primarily the shareholder equity? I’m assuming there’s probably a pension hit in there and you’ve got the write down. Essentially shareholder equity down by about $4 billion sequentially can you walk me through the puts and takes there?

Kurt Kuehn

The big factor on that were the declines in our pension. We had a fairly substantial pension asset at the end of last year that basically has been eliminated and actually we did then show an increase in liability of a couple billion on that side. In addition, we did repurchase $3.6 billion of shares this year. In aggregate the combination of the loss on the pension, the repurchase of stock and we did have one extra dividend payment in ’08 due to a tightening up the calendar but we really paid the November dividend before the end of the year combined. Those were really the three primary factors.

Scott Davis

The pension thing was a difficult issue for all companies with defined benefits. What happens everybody has investment losses in 2008. At the end of the year the discount rate actually came down so it increased the liability. Its one of those things that hopefully see that turn around the next year or two.

Kurt Kuehn

We do our pension plans are still in pretty good shape, they’re about 90% funded. That’s with us coming into the year with about 130% funding something like that. The combination of investment reductions and expenses reduced that. It is an issue for us; it is adding about $0.10 a share headwind on costs this year. We’re going to continue to manage that and we think the strength of our pension plan remains an asset for the company.

Scott Davis

Even in this environment where we saw that kind of drop in asset value in pension plans we’re still well funded. A lot of other companies in the US are not well funded and we use our free cash flow to fund pensions in future years.

Jon Langenfeld – Robert W. Baird

How big was the pension charge to shareholder equity in the quarter?

Scott Davis

$3.5 billion after tax. That’s the hit on equity.

Jon Langenfeld – Robert W. Baird

The fuel side you quantified it in the call relative to your expectations that is was $0.10 more, $0.02 more in Domestic and International. What was it in total benefit excluding your expectations?

Kurt Kuehn

There’s a lot of moving parts on that. You have to factor in expenses direct and indirect and all of that so really the guidance we’ve been giving is the relative impact of the month over month changes with the two month lag. That’s really all that we’re comfortable saying today.

Jon Langenfeld – Robert W. Baird

You had some expectations in your original guidance; the numbers you gave on the call were incremental to that.

Kurt Kuehn

Absolutely and that’s what we tried to provide some clarity on.

Jon Langenfeld – Robert W. Baird

On the International side how much of the cost initiatives and revenue enhancement initiatives, two different things, are targeted on the International side versus Domestic?

Kurt Kuehn

There’s a significant amount of focus on the International. It’s maybe a half a step behind the Domestic frankly. Our growth has remained very strong just up until this fourth quarter. We are digging in very heavily on that looking at our air network, making sure that we’re being prudent in the amount of capacity we have in the air.

We’re also looking at operational models, I mentioned our European ground network looking for opportunities to better align our large forwarding operation in Europe and our package operations. There are plenty of opportunities. It is, as I’ve said a little behind the progress of the Domestic where we’ve been facing reduced demand for some time.

Operator

Your next question comes from Tom Wadewitz – JP Morgan

Tom Wadewitz – JP Morgan

I wanted to try to get a sense of how you’re thinking about the pace of operating expense increase when you look at 2009. You’ve got some pretty significant cost reduction actions but I know you have some inflation and your Teamster labor contract and so forth. If you take out the impact of fuel and you consider some of the cost savings and maybe your volume outlook what’s the magnitude of operating expense change in 2009, do you have any sense of that? Is it down a couple percent, is it down mid single digits, can it be down 10%?

Kurt Kuehn

As you know we’re very focused, always focused on making sure that we adjust our hours to match the demand. Our operations people did a superb job in the fourth quarter reducing direct labor hours in excess of volume. We’re going to continue to have high expectations from them to adapt and react and make sure that we are eliminating and reducing hours wherever possible.

As you correctly pointed out we do have a labor increase that becomes a little more challenging in a no growth environment because the average seniority moves up and with the very favorable contract we got we get the full benefit with moderate growth. There are some headwinds in that area; pension expense as we mentioned will be up.

We are very focused across the company to right size and match the management compensation and variable comp plans are changing, our operators are reinventing the wheel as it is to make sure that as volume continues to be down and this will really be two years as we wrap some of these other declines, those are substantial changes. We’re re-jiggering the network and doing everything we can. The goal is to have our direct hours move in concert with the volume reductions and then we’re working very hard on all the other expenses.

Tom Wadewitz – JP Morgan

If you consider the inflation in the union agreements and then you consider the cost reductions are you essentially offsetting the inflation in the union agreements with the specific cost reduction measures you have?

Kurt Kuehn

If we can fully offset expense increases we’re doing great. We do expect real revenue per piece to continue to increase. That would be an admirable goal if we can really hold cost per piece absolutely flat in a tough economy with shrinking volumes. I’m not sure we can get all the way there but clearly that’s the kind of thing we’re working towards.

Tom Wadewitz – JP Morgan

On the pricing side you sounded rational pricing which obviously is good but you also said maybe base rate is down because the optics of what you had done to preserve fuel surcharge mechanism might hurt you going forward. If you take out weight per piece impact and take out fuel surcharges do you think on a comparable basis the base rate is actually down in 2009?

Kurt Kuehn

No we don’t. We’ve gone back and done some extensive look at this over the last eight or nine years and there’s clearly an inverse relationship between fuel surcharges and base rate retention. When fuel surcharges go up we do see a very clear reduction in our ability to keep more of the base rate. Conversely if that corrects we do see better base rate retention. Actually over the course of ’09 we should see better base rate retention then ’08 but there is a little bit of a lag as we go back, renegotiate contracts.

Our Air customers will see dramatic reduction in expense this year because of the precipitous declines in the fuel surcharge. We think that will allow over time better base rate keep. It’s a transition and it needs to be rational and sensitive to our customers needs. We do feel good over the longer term that you’ll see solid and continued base rate retention.

Operator

Your next question comes from Chris Ceraso – Credit Suisse

Chris Ceraso – Credit Suisse

In the first quarter guidance how much have you assumed on a per share basis from fuel or from the squeeze on base rates?

Kurt Kuehn

If you look at our fuel surcharges you are going to see some pretty dramatic surcharge reductions versus last year. Ballpark for the quarter based on what’s in the bank and where the forward curve looks at we’ll probably have about a 15% lower fuel surcharge Q1 of ’09 versus Q1 of ’08 on the Air and probably a 3% headwind on the Ground. Those are some fairly significant shifts year over year. Not all of that goes directly to what the overall revenue per piece will be. Compliance is not 100% and we do think we’ll have some compensation on the base rate side.

It will be a very volatile series for you to track as we have these very significant year over year changes. We will get a slight benefit of the fuel lag. Certainly no where near what we saw in the fourth quarter. The predominant issue we’ll be facing is to make sure that we are working with our customers in beginning to balance the appropriate rates now that the fuel has come way back down.

Chris Ceraso – Credit Suisse

On a net basis then is fuel, does it turn to a negative in Q1 or do you still have some lag benefit.

Kurt Kuehn

There’s still a slight benefit in Q1.

Chris Ceraso – Credit Suisse

What was the effect in Q4 of exchange at a total company level both on revenue and on operating profit can you break that out for us?

Kurt Kuehn

Exchange rates were relatively neutral. We do fortunately had some favorable hedges in place that actually cost us some profits as the Euro and the Pound were at very high rates because we sold away some of the top end but now that they’re plummeting we are able to stabilize it. That’s really the intent of the hedges to stabilize earnings volatility.

There was a benefit to the hedges and a slight benefit for some revaluation of assets but you’re talking small amounts. We were very pleased for the International that the hedges were as we expected. We are well hedged through ’09 for the Euro and for the Pound through the first half of the year.

Chris Ceraso – Credit Suisse

You’re bringing down CapEx; slowing down the share repurchases I would assume you’ll still generate significant cash flow. Is the first priority to start paying down some of the debt or where else would it go?

Scott Davis

UPS is always a company that generates free cash flow, you saw that in 2008. You’ll see it again in 2009. We’re still going to make distribution to shareowners via dividends and via the share repurchase. Share repurchase not at the same level probably as we saw in 2008. There will be opportunities out there for us too. We think great companies get stronger in down economies. We think there will be opportunities for UPS to buy assets and/or companies below market value in the year or two ahead of us.

We think this is a great opportunity to keep our powder dry and look for opportunities to make UPS a strong company for the future.

Chris Ceraso – Credit Suisse

No emphasis on debt repayment at this point you’re happy with the current leverage?

Scott Davis

We’re happy. Our funds from operations to debt is about the 60% level we targeted and we’ll keep it probably in that level in the future.

Operator

Your next question comes from William Green – Morgan Stanley

William Green – Morgan Stanley

As we looked at the fourth quarter, economic activity obviously slowed. Can you give a little bit more color around how your volumes trended by month in the quarter?

Kurt Kuehn

It was an interesting quarter that way. We saw sequential worsening from October to November. The discussion we had in October things began actually trending down even worse in November. There is the impact of when Thanksgiving fell that makes the November/December results a little tangled. We actually were somewhat pleased by the way the holiday turned out. Volume overall for the holiday season was close to flat with last year. Although as we mentioned earlier it was the wait until the last week and a half syndrome that we had that does make things a little challenging.

We did see firming up of our volume trends during the holidays. Certainly some of that is most likely customers that decided to jump over to UPS in light of the dramatic uncertainty at DHL during the holidays. Trying to separate exactly what was that transition and what was true strength in the economy is tough. We do think though, based on our guidance we gave you that trends are going to return back closer to what they looked like in October and maybe November then what we had in December.

One interesting note, on the internet shipping this year we did see much more modest growth and really the internet shippers did not outperform the rest of the bricks and mortar this year, although certainly there were a few notable exceptions like Amazon. It was a little different peak as far as the mix of customers.

William Green – Morgan Stanley

Was your B to C trend was it much slower then you’ve seen in the past? You had been adding a point or so in terms of total percentage of the Domestic volume I think around 30% or so.

Kurt Kuehn

It certainly continued to outgrow but we have seen big sequential changes back to Scott’s comments about the consumer in B to C volumes slowing. The consumer did come through and we did see B to C increases in the fourth quarter at least in December.

William Green – Morgan Stanley

In January the trends that you gave for the quarterly guidance January trends were roughly in line with that?

Kurt Kuehn

Pretty much. It’s been a noisy January with substantial weather events, with the Inauguration. In general we think that based on what we’re seeing in January that guidance is appropriate.

Operator

Your next question comes from John Mins - BB&T Capital Markets

John Mins - BB&T Capital Markets

Looking at the CapEx budget what’s your minimum maintenance CapEx level?

Kurt Kuehn

We’ve had a number of discussions on that. Probably the best approximation we have for maintenance CapEx is our deprecation expense. We are still modestly above that. We’ve been fairly rigorous this year in looking at CapEx. We do have some growth CapEx in for next year, the completion of the world port hub and additional receipts of some aircraft, 767’s and 747’s. Certainly we’ve tightened up in most areas and are really restricting to maintenance on our facilities and our vehicles at this point.

Having said that, the world port expansion is both an expansion of capacity and also a tremendous efficiency move as I mentioned earlier. Because of having such amount of capacity in one location we are able to reduce the number of regional air sorts we have, make much better utilization of our aircraft. We’ll continue to invest where it makes sense. We have to the capital but we’re going to be prudent right now.

John Mins - BB&T Capital Markets

Where I was getting at was if you break down stuff like aircraft deliveries of what’s scheduled for ’09 of the 767’s and the 400’s?

Scott Davis

Three 767’s and three 747’s come in in ’09.

John Mins - BB&T Capital Markets

The 26 other planes are 2010 and beyond. I was trying to see if its possible to push those back especially with fuel is not as big an issue now if flying the 200’s and some of the older planes is more attractive if you can hold off on those purchases.

Kurt Kuehn

We’re looking at that. At the same time we do intend over time to migrate the DC-8 suite out with aging aircraft directives, it’s likely in the next three to four years that most of those will become uneconomic. We’re balancing that. We do have cash. We think we’ve got favorable terms and if it makes sense to defer out we’ll certainly talk with Boeing and any other providers.

Operator

Your next question comes from Ken Hoexter – Bank of America

Ken Hoexter – Bank of America

You were talking about pricing before in the contract; I want to understand that a little bit better. If you’ve got contracts with customers and as fuel was running up did you go back to them and reduce the base rate in that in order to keep them. Obviously you felt some competitive pressure to do that if that’s exactly what you were highlighting. Did the contract not automatically revert if fuel fell as dramatically as it has? I want to understand the process and the time that it’s going to take to retest some of those base rates.

Kurt Kuehn

Maybe the simplest way to think of it is more that as we do our annual rate change and go to customers with a rate increase we negotiate how much of that to retain in their expenses. When you’ve got fuel at 20%, 30% plus percent it’s very difficult to retain much of that base rate increase. It’s more over the course of last year. In some cases we did sacrifice base rate increase because of the extreme costs that our customers were facing for fuel.

As that moderates then we do begin to recover and get more back on to a normal approach of keeping the base rate increase.

Scott Davis

That shouldn’t really be a surprise. We’ve talked about that over the last two years of the impact fuel had on base rate.

Kurt Kuehn

Its one of the reasons it’s very difficult to just purely pull the fuel surcharge out of our overall rate changes as far as what the real pricing is going on.

Ken Hoexter – Bank of America

I was trying to see if there was a timing impact on that. On the UK it sounded like on this write down that you’re taking are you shifting from providing Domestic services in the UK or did I misinterpret what you were saying there.

Kurt Kuehn

What that is, is we did make a domestic acquisition in the UK several years ago. Over the last couple of years have been busy integrating that with expanded hub in the domestic area. As we reviewed the operations there and looked at the impact of the economy most notably on the Domestic UK business it was clear that the value we had assigned to their existing customer base really was not appropriate. Many of those customers had churned out. Certainly we brought Domestic services to a lot of our import/export customers so in general the business is healthy.

As part of the acquisition we attributed a value to the customer base and as we reviewed that it was clear given where the economy is and the migration in our customer base more from the ones we had from the acquisition to our existing customers with Express that it made sense to adjust it.

Operator

Your next question comes from David Ross – Stifel Nicolaus

David Ross – Stifel Nicolaus

A question on UPS Freight, it looks like you’ve lost some money there in the fourth quarter and its pretty challenging LTL environment out there as you mentioned. With the network you currently have in place after integrating overnight and motor cargo have you had to rationalize that at all, have you closed any terminals or tweaking that network?

Kurt Kuehn

We really did quite a bit of that as part of the integration of the motor cargo group and the overnight group. We don’t see dramatic changes in the physical assets. We do believe we’re going to continue to gain share. You can see that our growth did slow substantially. Some of that is in some cases losing some big customers that we have just decided not to chase. We still feel pretty confident that we will get back on a very strong growth curve with market share gains. It has been a tough year and we’re still trying to strike that balance of helping our customers save money as we bring them more value.

As I said, one of the things that are proving most successful now is what we call our Freight Rate Calculator, which allows shipping managers to see rates in an LTL format for both our small package and our freight services. It’s been very successful of us going to customers, helping them reduce their spend by 10% to 15%, without a lot of rate pressure because we can find the best mode for each shipment individually and show that in a way that’s apples to apples.

We are going to continue to enhance service, invest in technology but at the same time in this environment we’ve got to make sure that we don’t get ahead of ourselves and we will continue to be cautious on that. Clearly UPS Freight is on a cost reduction campaign also. Long term we’re optimistic but given the current environment we just thought it was prudent to take the impairment.

David Ross – Stifel Nicolaus

With the cross sell between LTL and Parcel where are you in penetration of Parcel customers with the LTL business? I know it’s been targeted for a while but any color, just scratching the surface or you have a ways to go?

Kurt Kuehn

We’re still in the early innings. We’ve been a little disappointed that that’s taken us longer than we’d hoped. Some of the economic uncertainty and chaos has distracted our customers and maybe even our sales people a little bit. That is a priority for us this year and we are very confident it’s a unique differentiator.

Scott Davis

I’ve just come back from visiting all of our Domestic region locations. That’s a high topic, big priority for our company in 2009. Our people are going to pay a lot of attention to that cross selling opportunity.

Operator

Your next question comes from Robin Byde – HSBC

Robin Byde – HSBC

On DHL and your Q1 earnings guidance, to clarify, does the range you’ve given assume volume gains from the DHL shutdown or is this guidance just on the underlying business?

Kurt Kuehn

This guidance is our best guess of what will come through in Q1. As I said, it’s still a little bit of a moving target as operations just ceased there last week. We have a number of customers that came on board in the fourth quarter. Certainly there’s more that we’re brining on board in January. Until the dust settles we’re hesitant to give you any specific information. Clearly we’ll talk more about DHL in the next quarters call.

One note I do want to make though is that this is not just a domestic US event. Within the US we are also seeing a number of customers come to us related to their import/export needs as DHL reduces their service footprint. We think our value proposition for our international network is compelling. Also we are seeing increased interest outside the US in customers coming to UPS. We intend to press the advantage across the globe.

Robin Byde – HSBC

A question on your European operations, could you tell us what you’re seeing in terms of slowdown on Asia to Europe trade. Are market trends getting weaker or flattening out?

Kurt Kuehn

There certainly getting much weaker. The areas of continued strength, although strength is stretching it, we’re continuing to see intra-Europe trade remain more vibrant although that’s primarily small package. Clearly Asia to Europe is close to flat now where we had seen very strong growth.

Scott Davis

That’s probably the biggest change we might have seen in the fourth quarter was the Asia to Europe was growing at a fast pace up until the fourth quarter and really moderated.

Operator

Your last question comes from David Campbell – Thompson, Davis & Co.

David Campbell – Thompson, Davis & Co.

I’m surprised how much money you made internationally in the quarter given the fact that revenues were down substantially from the third quarter you made almost the same amount of money as the third quarter, in fact you made a little bit more on an adjusted basis. What is it other than fuel consumption is there anything going on there?

Scott Davis

There’s seasonality there to a certain extent. We expect to make normally more money in the fourth quarter then we do in the third. If you recall the third quarter in Europe, there are so many holidays there in August that it almost shuts down, it’s a tough quarter for us. We did a nice job internationally; we’d still like to see more profits in the fourth quarter then what we made.

David Campbell – Thompson, Davis & Co.

You wouldn’t expect that same situation in the first quarter.

Kurt Kuehn

Q3 to Q4 is always an increase. As Scott said, we’re looking to continue to improve margins. We do see challenging comps Q1 over Q1 and that’s built into our guidance. The International though is changing more rapidly then the Domestic. Domestic we’ve been fairly stable over the last quarter or two although month to month it can change. The International we’re staying on our high alert to make sure we right size the network.

Scott Davis

Let’s wrap up with a few comments. Nobody is escaping pain in this financial crisis. Our employees feel it, our customers feel it and certainly our shareowners feel it. I want to remind you that we’re a great company that’s operating in a bad economy right now. Great companies do weather the storm and they come out stronger. What it comes down to is the strength of our balance sheet, the power of our brands, the value of our services, the contributions of our people and the quality of our leadership. UPS has all of these strengths and we will prosper as we move into the future. Thanks so much.

Andy Dolny

Thanks for joining us this morning.

Operator

That does conclude your conference for today. Thank you for your participation and for using AT&T’s Executive Teleconference. You may now disconnect.

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Source: United Parcel Service, Inc. Q4 2008 Earnings Call Transcript
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