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United Parcel Service, Inc. (NYSE:UPS)

Q2 2009 Earnings Call

July 23, 2009 8:30 am ET

Executives

Andy Dolny - Vice President Investor Relations

Scott Davis – CEO

Kurt Kuehn – CFO

Analysts

Gary Chase – Barclays Capital

William Green – Morgan Stanley

Edward Wolfe – Wolfe Research

Tom Wadewitz – JP Morgan

Ken Hoexter – Merrill Lynch

Helane Becker – Jesup & Lamont

Art Hatfield – Morgan Keegan

David Ross – Stifel Nicolaus

Chris Ceraso – Credit Suisse

David Campbell – Thompson, Davis & Co.

Nate Brochmann – William Blair

Justin Yagerman – Deutsche Bank

John Barnes – RBC Capital Markets

Operator

Welcome to the UPS investor relations second quarter 2009 earnings conference call. (Operator Instructions) It's now my pleasure to turn the floor over to your host, Mr. Andy Dolny, Vice President of Investor Relations. Sir the floor is all yours.

Andy Dolny

Good morning everybody and thanks for joining us today. Scott Davis, our CEO and Kurt Kuehn our CFO, are ready to provide insight into the company’s second quarter results and our expectations going forward. Before I turn the program over to them, however, I want to review the Safe Harbor language.

Some of the comments we’ll make today are forward-looking statements that address our expectations for the future performance or results of operations of the company. These anticipated results are subject to risks and uncertainties, which are described in detail in our 2008 Form 10-K and first quarter 2009 10-Q reports. These reports are available on the UPS Investor Relations website or from the Securities and Exchange Commission. This conference call is being web cast and will be available on our Investor Relations website.

In our earnings announcement today you will notice there was an after-tax charge of $48 million. This non-cash charge was for the re-measurement of certain foreign currency obligations which did not qualify for hedge accounting treatment. It had no impact on operating income or cash flow; however it did reduce diluted earnings per share by $0.05. Excluding this charge, EPS for the second quarter was $0.49.

Reconciliation of this adjustment to comparable GAAP measures is explained in the Schedules that accompanied our earnings release this morning. The Schedules are also available on the UPS IR website in the financial section. When Scott and Kurt discuss second quarter performance they will refer to results excluding this charge.

During the question-and-answer session, I remind you that you will be limited to one question and a follow-up. This will ensure that all will have an opportunity to participate. I will turn the program now over to Scott.

Scott Davis

Thanks Andy and good morning everyone. On our last call we told you that economic conditions for the second quarter would be slightly worse than the first and UPS’ performance would reflect those conditions. That is what happened. The results we announced today are a clear indication of the tough economic environment. As you are aware, the rates of decline of some key indicators like GDP and industrial production have slowed. Other indicators like manufacturing and service sector indices are exhibiting signs of improvement.

Most forecasters are saying we may be at the bottom. Whether or not we are at the bottom is not the main issue. What is important is how long we remain here and what type of recovery we will have. Remember, all these indicators are still well into negative territory, illustrating the challenges that lay ahead. We will continue to manage the company under the assumption that the economy will stay at this level until definitive signs of improvement materialize.

Looking at UPS’ results for the quarter everything played out pretty much as we thought with the exception of international volume which declined more than we had anticipated. Our cost initiatives are exceeding target levels. However, these savings were not enough to fully offset the impact of global economic weakness.

Nonetheless, UPS is continuing to be alert and investing in growth opportunities to assure we are ready when economic activity revives. During the quarter we expanded our global footprint in Eastern Europe and the Middle East with acquisitions in Slovenia and Turkey. We also formed a joint venture headquartered in Dubai as a springboard to grow package, freight and contract logistics services in 21 countries across the Middle East, Turkey and Central Asia. Turkey has become a vital link in global commerce. We see it as the transportation bridge between Asia and Europe.

In the logistics arena we established a field stocking location network in India to address critical parts service in that country. We opened two healthcare logistics facilities, one in the Netherlands and one in Puerto Rico, expanding our global presence in this sector with state of the art certified capabilities to serve pharmaceutical, medical device and biotech customers.

Prudent investment even in challenging economic times not only helps our customers but it also UPS remain positioned to capitalize when trends improve. We are a company that will weather this recession and emerge even stronger.

Just after the quarter ended we released our 2008 Corporate Sustainability Report. This is the most data rich and global report we have ever produced and it has been well received. We disclosed both our direct and indirect missions, a level of reporting that is unusual for our industry. Because of our integrated network, most modern aircraft fleet and extensive use of the rails, UPS is the environmental leader in the U.S. delivery industry. Nonetheless, we have committed to reduce our airlines’ carbon emissions by an additional 20% by 2020 for a cumulative reduction of 42% since 1990.

To us, sustainability isn’t just corporate jargon. It is a commitment to our customers, employees, shareholders and the communities we serve to remain transparent and follow responsible business practices.

Before I turn the program over to Kurt I want to thank UPS’ers around the world for their efforts and dedication in managing through these tough economic times. We will not only create better leverage in our operations but UPS will be a stronger organization when the economy recovers.

Now Kurt will provide detail on our second quarter results.

Kurt Kuehn

Thanks Scott and good morning everyone. Stagnant economic activity around the world negatively affected all of our business units. Although we exceeded our target cost savings, they were not enough to offset revenue declines in the quarter. Operating expense declined almost 10% excluding fuel and diluted earnings per share were $0.49, in the middle of the range we provided.

UPS is ahead of plan on our cost reduction initiatives and we expect to come in 20-25% higher than our initial target. Therefore we anticipate realizing between $1.2-1.3 billion from our cost control efforts for the year. Our compensation and staffing initiatives coupled with our continued productivity improvements allowed us to reduce direct payroll by almost 5%. This was partially offset by healthcare inflation and increased pension expense.

Total block hours in our airline were down 11% enabling us to reduce fuel consumption by 14 million gallons. Our consolidated quarterly margin was 8.3% which is low for UPS but still the best in the industry.

Now let’s start our overview with the U.S. package operations. For the quarter package volume declined 4.6% a little more than in the first quarter. Ground volume was down 5.4% while air volume was essentially flat with last year and slightly better than in the first quarter. Let me remind you that the apparent strength in the air volumes is attributable to DHL’s exit from the U.S. domestic market.

Revenue per piece was down about 8%. The decline was driven by the reduction of fuel surcharges on air and ground products of 24% and 5% respectively. Lighter average weight per package and changes in product mix also contributed to the decline. These trends along with the decrease in volume eroded margins. As we have said in the past, margins in this segment will remain under pressure until economic conditions improve.

During the quarter we launched the UPS Advantage sales program. It aims to build awareness among customers of our comprehensive value proposition based upon reliability, speed, technology and service. The current pricing environment continues to be very challenging driven by the economy and our customers’ urgent need for help in reducing their transportation spend but the pricing environment remains rational.

While we are working with our customers to address their needs we believe in the value offered in our superior service and reliability and do not compete on price alone. In fact, our solutions can often reduce overall supply chain costs without necessarily leading to direct price reductions. As the economy improves we expect pricing to improve as well.

UPS’ers are managing operations well in the face of reduced volume. For example, labor hours were down almost 7% with productivity improvements across the board. In addition, miles driven were down 5% and domestic block hours decreased almost 6%. The full benefit from these operating metrics is being reduced, however, by a higher direct average hourly wage rate, healthcare inflation and increased pension expense.

Notwithstanding today’s weak economy we have continued with our $1 billion expansion of the Worldport air hub in Louisville. In early July we announced the completion of that expansion which increased sorting capacity 15% to 350,000 packages per hour. The final phase of this expansion will be completed next year bringing our sort capacity to 416,000 pieces per hour. Maximizing the volume that moves through Worldport allows us to optimize our network, flying fewer but larger and more efficient aircraft.

This is a great example of UPS’ long-term strategy. We are keeping one eye on the economic challenges of today and the other on the opportunities of tomorrow.

Let’s move now to the international segment. Weakness was apparent in all regions of the world. Volume declined 5.5% with export volumes down 7.3% and domestic down 4.3%. Excluding the impact of the timing of Easter, export volume would have been down about 5%. Reduced revenue and volume reflect our customers’ lower levels of business activity. In spite of this reduced volume, UPS continues to gain market share in contrast to double digit volume declines in the marketplace.

Excluding the effects of currency, revenue per piece declined 11.4% as a result of reduced fuel surcharges, changes in product mix, lower weight packages and volume shifts across global trade lanes. Despite the reduction in both volume and revenue, operating margin for the segment was 13%. This was essentially flat with last quarter and only 80 basis points below last year and is still the best in the industry.

Aggressive cost control contributed to maintaining our strong margins. For example, international block hours dropped almost 16% in the quarter without impacting our service footprint. Indirect operating expenses declined almost 8%. As Scott indicated, UPS is committed to controlling our costs while still making the strategic investment that will enable growth when economic conditions improve.

Turning now to the supply chain and freight segment, revenue was down almost 23% with all business units experiencing declines. However, the 7% operating margin reflected successful cost management in each business. Logistics posted solid performance with improved revenue management and targeted growth particularly in the healthcare and high tech sectors. Forwarding margins improved as cost initiatives successfully took hold.

Despite very weak market conditions, UPS freight posted increased revenue, LTL shipments and tonnage over first quarter results. Effective cost control and productivity gains enabled UPS freight to break even for the quarter. This business continues to take market share while remaining disciplined on yields. Its 1.9% decline in shipments year-over-year was in sharp contrast to severe market declines. Our no fee guarantee for both regional and long haul shipments continues to be a competitive advantage and we are also benefiting from leveraging our small package sales force and further penetrating the key middle market customer sector.

This quarter we did mark down certain preferred shares and auction rate securities to their market value. The write down was $17 million and is reflected as an offset to our investment income. In spite of the earnings decline, free cash flow for the first six months of 2009 increased by $195 million over last year excluding the impact of the tax refund in 2008. An intense focus on capital expenditures and working capital enabled UPS to generate a total of $2.7 billion in free cash flow.

For the first six months UPS also invested $671 million in capital expenditures, spent $248 million to repurchase 5.1 million shares, paid dividends of $876 million maintaining our $0.45 dividend and ended the first half of the year with $3.3 billion in cash and marketable securities. Clearly strong cash flow remains a hallmark of the UPS business model.

Now for our outlook. We expect business conditions in the third quarter will be similar to those in the second. In our U.S. domestic operations, average daily volume should decline at a pace similar to the second quarter. Operating margin will remain weak due to seasonal trends and the continued challenge of lighter average weight, mix shift and lower volume. In the international segment export volume is expected to decline about 4-6% with operating margins similar to the second quarter.

The supply chain and freight segment should see trends similar to the second quarter with operating margins slightly less than last year. Our ongoing cost control initiatives will continue to provide benefits across all business units.

Considering all of this, earnings per share should be in a range of $0.45 to $0.55 for the quarter, the same range we provided for the second quarter.

With that Scott and I will be happy to answer your questions.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from the line of Gary Chase – Barclays Capital.

Gary Chase – Barclays Capital

On the outlook as you talked about business conditions remaining the same can you talk about what you are seeing and what you expect in terms of weight per package and how that has been trending? Do you expect that will continue to decelerate or just kind of bounce along at these lows? What is kind of embedded there?

Kurt Kuehn

The real theme that we are seeing right now is that the negative trends have stabilized. Year-over-year weights and product mix are down but if you look sequentially really over the last 3-4 months we are seeing the trends stabilize. We are in a flat period right now. Certainly very negative to last year both in trends and statistics. We don’t see any increase in negative momentum. Weight trends should be very similar to Q2.

Scott Davis

You just have to look at industrial production too and when it turns and it will at some point in time here in the future and you still start seeing manufacturing sector kick in more and that will certainly help weight.

Gary Chase – Barclays Capital

The supply chain was surprisingly good for the quarter. You wouldn’t have expected that kind of performance after the first, or at least I wouldn’t have. Was the variance there that freight broke even or was it more on the logistics side and should we be considering this as a sustainable level or was there something unique about the second quarter for you there?

Kurt Kuehn

It was really improved performance across all three of the primary sectors. Certainly UPS freight has done a good job of continuing to have relative momentum to successfully gain share across all sectors but most notably in the middle market and even though pricing is challenging our revenue per hundred weight after you take out fuel is pretty stable. So freight did show substantial benefit over the last three quarters and the earnings bringing it back to break even was important.

Logistics has been very successful in the last few quarters in tightening its focus. We think we have created some very unique solutions for high tech and of course healthcare which we talked a lot about. We have been very disciplined in adding capacity where we know there is sustainable business that will generate good margins. We have seen good results. We have trimmed down some locations and streamlined that business so you are seeing the benefit of a couple of years of hard work.

In the forwarding business clearly the growth is challenged but we were very successful really managing costs on all fronts. The purchase transportation opportunities are pretty good right now. You have seen other forwarders improving margins in that sector but we have also done a very comprehensive review of our operating expenses, the number of facilities we need and our indirect expenses. Good cost management on all fronts there helped us to create pretty good profits even in a tough environment.

Having said that, we are not necessarily going to be at 7% margins all quarters. Q3 is a little more challenging. We do expect some of the great deals in forwarding may tighten up a little bit as rates begin to reverse. We feel very positive on all three fronts.

Operator

The next question comes from William Green – Morgan Stanley.

William Green – Morgan Stanley

When you talk about your outlook saying you have stabilized but not really see much in the way of improvement. If this is sort of the new normal, a level off which we will have gradual growth, is the network right sized or is it over resourced? How do you think about where you are if this is the level off which we will be for awhile?

Scott Davis

We still have work to do. Clearly we are not thrilled with the results we had in Q2. We have been chasing the market down. We have been making what we think are some pretty dramatic changes in our network. Taking block hours down 16% for the quarter for international is a great example. Stabilized at this level, we still have work to do. Our network changes in some cases lagged. We still have plenty of opportunity to leverage the expanded Worldport capacity, taking a large number of aircraft out of the air. On all fronts if it stabilizes at this level we are going to continue to work real hard because we are not happy with where we are at.

Kurt Kuehn

I wouldn’t call it the new normal. I think you still go back and look at the second quarter we had industrial production drop 13.2% year-over-year which is a staggering number. The issue going into the third quarter is we think that the big drops are over with but we are still going to have tough year-over-year comparisons. It will come back. Industrial production will grow again. This isn’t the new normal.

William Green – Morgan Stanley

Can you give us B to C growth, what it was in quarter and also can you tell us or remind us what the fuel headwind is for the third quarter?

Kurt Kuehn

B to C was close to break even, maybe very slightly positive which is quite a difference from the double digit trends we have seen. Fuel was a bit of a headwind in the second quarter and clearly the third quarter we don’t know how it is going to end up but our guess is it won’t be a big factor either way.

William Green – Morgan Stanley

But you had a tailwind last year from it. You made money on fuel isn’t that right just because of the timing?

Kurt Kuehn

$90 million domestic last year.

Operator

The next question comes from Edward Wolfe – Wolfe Research.

Edward Wolfe – Wolfe Research

Again on the outlook, when you gave the guidance a quarter ago you talked about second quarter which is normally a seasonally better quarter than first being impacted by the timing of Easter and the year-over-year Easter. Now you are giving third quarter guidance and saying it is the same as second and the same as first but we don’t have those Easter issues, you have most cost savings under your belt and things seem to be stabilized. It feels kind of conservative. What am I missing here?

Kurt Kuehn

You are missing the fact as you said initially that Q3 is typically one of the weakest quarters of the year. Certainly there are challenges. Europe tends to take a lot of the months off for vacation. Our trends so far for July show no material up tick in growth. We are cautious frankly. We don’t think things are getting dramatically worse but we don’t have any confidence that either demand or activity is going to pick up substantially so that happens in Q3 which is typically one of our weakest quarters leads to the guidance that basically says things will offset the Easter impact in the second quarter.

Edward Wolfe – Wolfe Research

Can you talk about the domestic volumes and export volumes, how they trended from April through July so far directionally in the quarter if you can’t give exact numbers?

Kurt Kuehn

It is that same kind of flat trend we are talking about. April was a little distorted because of the Easter impact so April was worse than the following month. If you filter that out basically we have seen trends across domestic transactions very negative but steady I guess all the way through the current time. Internationally no huge changes in trends although clearly the overall total international did weaken sequentially from Q1 to Q2. Within that we still see that relatively stable also. So we are sitting here at this bottom and that is why, as Scott said, the real question is how do we and when do we work out?

Operator

The next question comes from Tom Wadewitz – JP Morgan.

Tom Wadewitz – JP Morgan

I wanted to ask you a bit more about the revenue per piece and if you could give us perhaps a sense on domestic air and ground side and what the break out looks like in terms of how much is fuel, how much is price, how much is weight per piece. If you don’t want to be specific at least directionally and talk maybe a little bit about the pricing environment. Has that gotten any better or is it still pretty challenging?

Kurt Kuehn

Clearly this is a challenging time for all businesses to show substantial yield increases and our industry sector is no exception although I would say the small package environment remains much more rational than certainly the LTL environment where it is very challenging. The big pressure, as I mentioned in my prepared comments, is that customers are urgently looking for ways to reduce their expenses so we do see tremendous requests from our customers to find a way to take costs down.

Our first approach is let’s look at the supply chain; let’s look at your supply chain. Let’s see how we can help you optimize and in some cases we are driving trade down to help customer’s trade off speed for cost. That is keeping us very busy. All of our sales people and solutions people are actively engaged.

The overall competitive environment remains rational but challenging. We see the primary pressure coming directly from customers rather than any specific competitors. If you factor out fuel and some of the characteristics changes like weight, basically we show slight increases in base rates for the ground business and basically flat base rates for the air. So those are not great numbers. Clearly historically we have seen better trends but it is stable.

Tom Wadewitz – JP Morgan

A follow-up on that is there a time, you have contracts that re-price through the year but when might be the timing you think you have lapsed the re-pricing pressure and when you maybe get beyond that resetting the tougher contracts down a bit? Is there any time you think we will get to that or are we close to that?

Kurt Kuehn

I think you would have to see a little bit of a boost in the economy to change that balance. There is some lapping but I think it is more driven by economic conditions. As long as the trends are flat or year-over-year comps are dramatically negative customers are going to be very cautious about speeding up the supply chain.

Operator

The next question comes from Ken Hoexter – Merrill Lynch.

Ken Hoexter – Merrill Lynch

You talked a bit about the 16% reduction on the international block hour side as a way of really controlling costs on the international side. Can you talk about what opportunities are on the domestic side to really look at some additional cost cutting and getting those margins back up or is it just simply the volumes turning?

Kurt Kuehn

No, work continues. We have been thrilled. If you remember a couple of quarters ago I mentioned one of our biggest challenges was creating a very intense cost control focus in our international business. It is really in the last decade we have seen great growth trends and I do want to commend our international network and operations people for very quickly reassessing the network and making changes that keep our customers happy but also has trimmed down expenses dramatically. We have been very pleased. I know Scott has been pleased also with our progress on international.

Domestically we have had no less of intense a focus. We have taken block hours down 6%. But we were starting from a much more well tuned and refined base. The low hanging fruit perhaps is a little harder to get to. We have made dramatic changes in our domestic environment we are going to continue to leverage this expansion of capabilities at Worldport. As you know we shut down two major air hubs and we are significantly reducing the number of aircraft. It is a little harder work there but we have made substantial benefits.

I also mentioned our direct labor hours are down 7% against less than 5% volume decline. We are working very hard there. Much of that is being offset by some of the indirect expenses of our pension increases and healthcare increases and the adverse wage mix impact as we have a more senior workforce since so much of our growth has disappeared and we don’t have as many junior drivers. There is great productivity trends going on. We will towards the end of the year start to lapse some of that wage pressure so that will moderate and then as we get growth we should see some real benefit.

Scott Davis

I think we know volumes will come back and we are positioned extremely well. The network efficiencies will certainly improve dramatically with volumes. Increased densities will reduce our costs. Obviously as talked about the effective wage rate for our drivers will drop. A lot of leverage there when we get some volume back.

Ken Hoexter – Merrill Lynch

To follow-up on the DHL side on domestic air, can you quantify how much of that gain or change in volumes is still coming from DHL? Just to wrap up, there is no legacy way the union can pull in any kind of costs is there on the multi-employer pension plan?

Kurt Kuehn

I will squeeze both those in. We think conditions have stabilized and the flat growth in the air sector is certainly helped by the DHL exit. One data point we do see is if you factor our DHL in our ground business and our next-day air business actually are growing about the same. Which we see as a good data point. It shows as we mentioned earlier that some of the trade down has probably stabilized. I will ask Scott to talk a little on the legacy issues on multi-employer.

Scott Davis

I think in general we talked a little bit last quarter we are very active working with the Teamsters and the competition committee looking for flexibility in ways to help manage our costs in this tough economy. I would say both parties are working aggressively together to figure out the flexibilities.

Ken Hoexter – Merrill Lynch

There is not something they can pull you in on is what I’m asking on the plan you have heard of last?

Scott Davis

On the central states?

Ken Hoexter – Merrill Lynch

Yes.

Scott Davis

It is extraordinarily remote. All of the employers [have been] dropped from the plan between now and the end of 2010.

Operator

The next question comes from Helane Becker – Jesup & Lamont.

Helane Becker – Jesup & Lamont

As you look through this economic downturn and you look ahead to where you want UPS to be positioned internationally, can you address you are talking a bit about the acquisitions you are thinking about in the Middle East and Dubai and so on. Can you just talk about how your expansion in those areas either expands your footprint, lowers your cost, helps you worldwide?

Scott Davis

First of all, we are really proud of our track record internationally. We have grown market share pretty much every quarter for the last several years in all regions of the world so we are pleased. That doesn’t mean there isn’t room for improvement. As we said before we are clearly focused on Central and Eastern Europe and Asia where there is more room for us I think to take advantage of opportunistic investments and continue to fill out our network which again I think is still the most complete global network in the world.

I think there is opportunities. As we have talked before down the road one of the challenges will be domestic China. We are going to keep looking for opportunities there. It is going to be a market with a lot of consumers over the next 20 years and we need to be positioned there. I think what we have done recently with Eastern Europe and Turkey, for example, our most successful contractor was out of Turkey. We made that acquisition and really used his expertise to help develop the Middle East.

I think again overall we are positioned extremely well internationally but we are certainly not complacent in those areas we can still invest in.

Helane Becker – Jesup & Lamont

A follow-up question, when I look at the sequential numbers in other expenses going from $1.2 billion to $953 million is there something non-recurring in there or is that just where all your cost cutting is coming through?

Kurt Kuehn

You are looking quarter-to-quarter?

Helane Becker – Jesup & Lamont

Yes.

Kurt Kuehn

The $1.2 billion was impacted because of the impairment on the DC8. Although we are still making good progress but I can’t take credit for that on an ongoing basis.

Operator

The next question comes from Art Hatfield – Morgan Keegan.

Art Hatfield – Morgan Keegan

I apologize if you already addressed this but looking at the quarter-to-quarter changes in yields, domestic yields across the board were down in Q2 relative to Q1 and I assume a lot of that was fuel and some of the other issues you talked about. But internationally they were up. Can you talk a little bit about why the difference in the trend in the two areas?

Kurt Kuehn

International has the additional moving part of the currency impact. We are also seeing continued changes in the lane mix. Our worldwide traffic, Asia to Europe and Asia to U.S. continues to show more pressure and so there is some shifting there with more regional trade patterns than global. We have been talking about how strong the Asia Europe lane was. That has changed over the last couple of quarters. You do get a lower weighted average revenue per piece although frankly we have been able to offset that with substantial block hour reductions. It is our job to try to match those changing trade patterns with our network.

Scott Davis

On the domestic side we averaged only 0.33% fuel surcharge on air and 2.5% on ground.

Art Hatfield – Morgan Keegan

As a follow-up into another area. Can you talk a little bit about what you are doing in the LTL business? What you are doing to perform better than what we are seeing from some of the other carriers so far this quarter?

Kurt Kuehn

We have been working hard for the last couple of years to build a sustainable, differentiated service in the LTL industry. We have spent a lot of money and done a lot of work on creating technology integration that is fairly unique in the LTL service. Our half million world ship customers now have the ability to do transactions in an automated fashion and to have visibility with our inbound visibility and outbound visibility tools. So the technology and ease of use is a big differentiator. We have spent a lot of time training sales forces on both sides to help customers do real time optimization between what should be in small package and what should be in LTL.

We have sped up our network and improved time of transit and made substantial enhancements to service and so you bring all that together and we think we offer a very compelling value proposition that allows customers to get better service, better control and also lower costs with optimizing what should happen on a day to day basis.

That is kind of a mouthful but this has been a work in progress. We did have to take a big impairment a couple of quarters ago but we were very confident and are very confident in the momentum of the business.

Operator

The next question comes from David Ross – Stifel Nicolaus.

David Ross – Stifel Nicolaus

On the international side can you talk about what percentage of your international volume today is generated over in Europe and then also can you talk about the competitive environment in Europe. It is a more mature market, more competitors actually than in the U.S.

Kurt Kuehn

In general Europe represents about half of our international revenues. The vast majority, 80% plus, of export shipments that originate in Europe stay within the European continent. That has really been our big focus, building an integrated Pan European capability. So we continue to see good results although frankly this quarter we didn’t see growth in any region of the world.

As customers look to save money and have more streamlined operations in Europe our value proposition is pretty strong. We think we have still got great opportunity to help European companies operate more effectively and even though it is a mature market for us it has been one heck of a great platform really for a decade.

David Ross – Stifel Nicolaus

Is the pricing environment much different over there in this downturn than it is in the U.S. or is it fairly rational in Europe as well?

Kurt Kuehn

It is more fragmented. Clearly there are different competitive groups in every country and it is hard to characterize. In general it is a challenging pricing environment. Maybe a little less rational than the U.S. but we feel pretty confident we can differentiate ourselves and as the market secures we will continue to make progress.

Scott Davis

The economic pressures aren’t a lot different in Asia and Europe than they are in the U.S. right now. You have the same pressures to customers there as you do in the U.S. I do believe that Asia and the U.S. are going to come out a little bit quicker than Europe. But also probably haven’t dropped in Europe as much as we have in the other countries.

Kurt Kuehn

One other point on Europe is one of the reasons we are so focused on Eastern or Middle Eastern Europe anyway is the linkage of low cost sourcing in the region. That is why you have heard of acquisitions in Slovenia, Romania, this Turkey joint venture and acquisition have all been a part of linking that part of the East back into Western Europe. We think continuing to execute that way is a good value proposition.

Operator

The next question comes from Chris Ceraso – Credit Suisse

Chris Ceraso – Credit Suisse

I think you had said a positive sign that you look for to gauge an economic turn was small businesses opening new accounts with UPS. Are you seeing any of that yet?

Scott Davis

I don’t think we have seen any big movement there at all at this point in time. We certainly feel we are in the bottom of this economy but I haven’t seen a big change in small business as of yet.

Chris Ceraso – Credit Suisse

Maybe if you could comment on your expectations about the back to school season. I think you mentioned that Asia to U.S. still looks weak but broadly what are you expecting for the back to school seasonal up turn?

Scott Davis

I think we are hopeful we are going to have a back to school session. It is really too early to tell. We have not seen any early signs yet based on the air freight market and the ocean freight market. I think we are hopeful that things will come back. I saw yesterday that Wal-Mart is going to increase computer inventories by 40%. That is a sign. There are some signs out there that maybe back to school season will be better.

Kurt Kuehn

There is some data on this whole question as to when the inventory work off is going to finally stabilize. Most of the inventory sales ratios are still pretty high although some of the latest data on the retail side suggest they are getting close to more of a new normal which may begin to kick loose some shipments and get the flow of goods moving a little north.

Operator

The next question comes from David Campbell – Thompson, Davis & Co.

David Campbell – Thompson, Davis & Co.

You mentioned several times your growth in international packages is better than the market. That is the decrease is less than the market. I am curious if some of this might be due to the fact that DHL is less competitive without their domestic ability to bundle services. Do you have any indications that is part of the reason for your better than market share over particularly in Europe?

Kurt Kuehn

Absolutely. Although clearly our market share gains have been a story over the last decade not just the last couple of quarters. DHL’s decision to withdraw the vast majority of its people and assets from the U.S. has left them with a much smaller network for their import/export coverage. That really gives us a significant point of differentiation for our European and Asian customers that are doing business in the U.S. That is one of our highest priorities for our international sales people and frankly in many markets they are the market leader so our ability to differentiate ourselves as being the only player that really has a strong presence in all major theaters is a great boost for our sales people and we think it will continue to pay dividends.

David Campbell – Thompson, Davis & Co.

I noticed here the data is correct but there are published reports out there that you and FedEx are spending record amounts of money trying to convince congressmen and administration people about various issues. I don’t know if the data is correct but given the focus on cost savings, wouldn’t it make more sense to cut back substantially talking to these guys who don’t understand probably anything you are talking about?

Scott Davis

We appreciate your comments. I don’t think our lobbying efforts are any higher than they have been in the past. We have a PAC that spends money through employee contributions and that is where the spending is. It is not coming out of the company’s coffers. I think in general it is an important issue for us. It is a matter of basic fairness that workers performing the same job should be covered by the same law. It is something we are very interested in. Not just us but the entire transportation industry but we all should be governed under the same laws.

As far as spending money it is not a distraction. I think it frankly more of a distraction for our competitor than it is us.

Operator

The next question comes from Nate Brochmann – William Blair.

Nate Brochmann – William Blair

Just wanted to kind of go back a little bit to talk about the international network a little bit and talk about how there has been some low hanging fruit in terms of flexing that network and taking the block hours out. What have you learned from the initial phases of that because we knew that was going to be a challenge because you had never done it before? How much more low hanging fruit is there to go?

Kurt Kuehn

We have learned that even though we have been primarily on a growth run for the last decade we still have those muscles of cost control inherent in the company that relate across the globe. It is just shifting gears a little bit and the top priority isn’t keeping up with rapid increases it is with optimizing the network to the current level. It is looking at the balance of air and ground movements. We have this unique integrated portfolio. We are now starting to really look at how do we keep aircraft out of the air, keep stuff on the ground but still have guaranteed services. It is streamlining our freight forwarding operations. There has been a lot of changes in that in the last 3-4 years. We are now integrating and finding how to manage and get benefits of being both a freight forwarder, an airline and an express company.

So tremendous synergies across those that allow us to better utilize our assets and also offer customers better choice. A lot of hard work on that front. I think there is more to come. Hopefully this won’t be the top priority for too many quarters to come in the future because we would love to get back on a growth curve but it has been reassuring to see us be able to hang onto margins even with some of the worst economic conditions any of us have seen.

Nate Brochmann – William Blair

Into China we have been reading a lot of the reports in terms of the China stimulus kind of working a little bit over there to re-energize a bit of growth. We see some internal GDP forecasts going up. What are you seeing in that market and kind of what is the near-term opportunity there in terms of inter-China and also in and out of China?

Scott Davis

Clearly our focus has been on import/export out of China over the last few years. We do have a domestic express offering but we are still working on that and it is an area we are looking to invest in as time goes on. We do think over the next 10-20 years that is a big market. We are seeing signs of increased imports into China. That is something we have not seen a lot of over the last few quarters. We are seeing a higher amount of imports into China. Exports out of China are still a little weak and a lot of that is because U.S. imports and a lot of China exports go to the U.S. and until the U.S. starts importing again that is going to cause some pressure to China.

Nate Brochmann – William Blair

To follow-up on that where are you seeing the imports into China coming from? Is that from the U.S.?

Scott Davis

There is some from the U.S. but I think Japan is big. We are seeing some from the U.S. and some from Europe but Japan right now has the best results there.

Operator

The next question comes from Justin Yagerman – Deutsche Bank.

Justin Yagerman – Deutsche Bank

I wanted to follow-up on that. Bigger picture I guess one of my questions is where do you think the leadership will come bringing us out of this global economic downturn? There is a school of thought that we will see domestic emerging market demand actually pull us out first rather than the U.S. Are you of the opinion we need to see U.S. consumer demand pick up before we start to feel an improvement in the overall environment?

Scott Davis

I think we need to see some U.S. consumer demand pick up. Chairman Bernanke yesterday said a lot is going to rely on the rest of the world. The rest of the world has got to start spending money. It can’t be done all by the U.S. I think it is both to answer the question.

Justin Yagerman – Deutsche Bank

Are you seeing any seeds of that domestic emerging market improvement? Outside of the imports you noted into China?

Scott Davis

I think we are seeing some. I think you are seeing some of the countries in Asia starting to turn around. Countries that were really negative like Singapore are starting to put up better numbers. Korea is a little bit better. So we are starting to see some turnaround there but not as fast as we would like.

Justin Yagerman – Deutsche Bank

Another bigger picture question just thinking about domestic demand with auto production scheduled to improve over the back half of this year what are your thoughts on what that does to GDP and freight demand and how that affects your different business lines?

Scott Davis

I think it affects the LTL business probably the most. I think the LTL business in general has been hurt more by the weak auto production. Certainly it helps small package but I think you will see the most dramatic change in the trucking industry, the LTL industry.

Operator

The next question comes from John Barnes – RBC Capital Markets.

John Barnes – RBC Capital Markets

I think during the call in the first quarter you indicated that your debt levels were a little bit elevated because you had taken on some nicely priced fixed debt but you still had yet to pay down the commercial paper program. Yet it looked like the debt levels were still kind of elevated from there. Is there something I’m missing there? Did I misread that?

Kurt Kuehn

We did create $2 billion of new debt last quarter. We have paid down about $1 billion of commercial paper so net to net you see about $1 billion net. We do show a substantial increase in cash and marketable securities. Not a big deal either way on that. We are in the process of swapping some of our fixed debt to floating which over time hopefully will show some benefit on reducing our interest expense although that wasn’t a material impact in the quarter. Cash flow continues to be a great story. Cleary we are very disappointed with the substantial earnings declines we are seeing. We are determined to adjust the business to reflect that. We have cut CapEx by almost half so far year-to-date. We have been very diligent with our customer receivables and bad debt so cash flow actually has improved. That is a silver lining for us to an otherwise grey economy to us that we have been able to sustain cash flow and keep that in very good shape. That does help us on the cash and marketable securities.

Scott Davis

I don’t think it is emphasized enough that there aren’t a lot of companies that can show a 40% reduction in net income and yet grow free cash flow. So again hats off to our people for managing the working capital and the CapEx.

Kurt Kuehn

The debt is a transitional issue where we have got a little extra marketable securities and cash. We did take half of that debt down in the quarter.

John Barnes – RBC Capital Markets

Could you give us your CapEx guidance for full year 2009? Then working days for the third and fourth quarter could you give us clarification on that?

Kurt Kuehn

We did say last quarter we have pulled CapEx down and are confident it will be below $2 billion which would put us at the lowest percent of revenue really that we have seen since going public. We are being very aggressive on that front. We review that at least once a month and more frequently as we review capital projects.

Having said that though, as Scott mentioned, we are being opportunistic whether it is buying hard assets, whether it is buying facilities or whether it is buying companies to increase our global footprint we are spending money where we see opportunity.

Scott Davis

Working days I think there is one more working day in the third quarter. I think 65 working days. One more than a year ago. 61 in the fourth. I think it is the same. One more than last year. Both third and fourth quarter one more day than last year.

Operator

That does conclude our question-and-answer session. I would now like to turn the conference back over to Mr. Dolny and Mr. Davis for any closing remarks they may have.

Scott Davis

Let me just wrap up by reminding the audience of a point I made earlier. UPS really is poised to realize better leverage in our organization. As volumes increase, and as I mentioned before they will, network efficiencies will improve, increased densities will reduce costs, and new drivers will come on moderating average [rate] increases. Longer term we are extremely confident we will see margin improvement. With that I thank all of you for joining us today.

Operator

Ladies and gentlemen that does conclude our conference call for today. I would like to thank you on behalf of today’s panel for your participation. Have a wonderful day. You may now disconnect.

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Source: United Parcel Service, Inc. Q2 2009 Earnings Call Transcript

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