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United Parcel Service, Inc. (NYSE:UPS)

Q3 2009 Earnings Call

October 22, 2009 8:30 am ET

Executives

Andy Dolny - Vice President Investor Relations

Scott Davis – CEO

Kurt Kuehn – CFO

Analysts

Jon Langenfeld - Robert W. Baird & Co., Inc.

Gary Chase - Barclays Capital

Thomas Wadewitz - J.P. Morgan

Ken Hoexter - Merrill Lynch

Edward Wolfe - Wolfe Research

William Greene - Morgan Stanley

Robin Byde - HSBC

Nathan Brochmann - William Blair & Company, LLC

David Ross - Stifel Nicolaus & Company, Inc.

Justin Yagerman - Deutsche Bank

David Campbell - Thompson, Davis & Co.

Christopher Ceraso - Credit Suisse

John Barnes - RBC Capital Markets

Operator

Good morning. My name is Kent, and I will be your conference facilitator today. At this time I would like to welcome everyone to the UPS Investor Relations third 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 yours.

Andrew 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 third 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 10-K and 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 webcast and will be available on our Investor Relations website for a few weeks. In his remarks Kurt will refer to UPS’s free cash flow which is a non-GAAP financial measure. Reconciliation is included with the news announcement this morning and is available on the Investor Relations website.

During the Question-and-Answer period, please limit yourself to one question and one follow up. Doing so will enable everyone a chance to participate.

Now I’ll turn the program over to Scott.

Scott Davis

Thanks Andy and good morning. It’s encouraging to see some economic forecasts like GDP and IP beginning to show consistent improvement. However, as Christina Romer, Chair of the Council of Economic Advisors, put it recently, “To say the economic recession is over is different than to say we’ve recovered. While recovery has begun, it has a long way to go. Sustained economic gains will occur only when unemployment declines meaningfully.”

Turning to UPS’s performance, business conditions early in the third quarter were similar to those in the second, though we did see improving trends as the quarter progressed. UPS also benefited from effective cost management. As a result, profitability improved over the previous quarter.

However, there are more opportunities to improve the way the business is performing. We are evaluating additional structural, network, and go-to-market strategy changes to enhance profitability.

One of UPS’s international growth strategies has been to supplement export volume with profitable domestic volume around the world. Earlier this year we expanded express services into 16 additional countries, bringing the total number served to 50. We’re seeing the benefits from this strategy with domestic volume up significantly in the quarter, aided by our recent acquisition in Turkey.

Affiliation with the international Olympic Games has broadened our brand recognition in the global community. We are honored and excited to have been selected to manage the transportation and logistical operations for the London games in 2012. This entails similar responsibilities to those we executed in the Olympic Games held last year in Beijing. These opportunities enable us to showcase on a global scale the breadth of our capabilities. We will bring the same expertise to the London games as we did to those in Beijing.

Also in the quarter UPS stepped up, taking a leadership position to help improve the ability of global relief organizations to respond to emergencies. This multi-year initiative not only includes financial grants, but also puts our core competencies of transportation and Logistics management to work. Among the relief organizations that will benefit from this commitment are the Aidmatrix Foundation, the American Red Cross, CARE, UNICEF and the World Food Programme.

In line with our commitment to environmental improvement, two weeks ago UPS became the first small package carrier to offer carbon offsets to customers in the United States. Through this carbon neutral program shippers now have the option to offset the climate impact of their package shipments. In addition during the quarter, the Carbon Disclosure Project named UPS one of the top 50 companies in the world for transparency and high quality environmental disclosure practices. UPS is the only company in our industry to achieve this recognition.

Before I turn the program over to Kurt, I want to take a moment to thank our employees around the world for their hard work in a very difficult economic environment. I know everyone has made a lot of sacrifices and I truly appreciate the dedication and teamwork.

Heading into our peak season, I am confident that we have a finely honed organization, ready to execute flawlessly for our customers during this demanding time. As I look at the global business environment, I’m encouraged that recovery is underway. UPS’s worldwide presence and comprehensive portfolio of products and services and the international team of dedicated employees make a winning combination for our customers and investors alike.

Now I’ll pass the program to Kurt for specifics on the quarter.

Kurt Kuehn

Thanks Scott and good morning everyone. Given the business environment that existed when we began the quarter, I thought it would be difficult to find a silver lining. Fortunately I was mistaken.

UPS did make progress compared to the second quarter. Volume was a little bit stronger, especially in International. And by managing the business effectively we earned $0.55 per share, at the top of the range we provided.

Cost initiatives continued to generate significant benefits. Last quarter I told you that UPS would achieve $1.2 to $1.3 billion in savings this year. Given the success we’ve had through the first nine months, we believe savings this year will approach $1.4 billion. Year-to-date we have saved $900 million. Going forward about two-thirds of these reductions are sustainable. Let me remind you that these savings are in addition to the gains we realized by managing our variable costs as volumes declined.

Excluding fuel expense, operating costs for the quarter were down $683 million or 6.6% compared with last year. There are 17,000 fewer employees on our worldwide payroll than a year ago. Compensation expense excluding benefits, for the quarter decreased by 4.5%, reflecting productivity improvements and staffing reductions. These gains enabled UPS to narrow the gap between the percent decline in volume versus comp and benefit expense.

We continued to improve the efficiency of the UPS air network. Total block hours were down 10% allowing us to reduce fuel consumption by almost 9 million gallons.

Consolidated operating margin remained at 8.3%, the same as last quarter, but down from 12.4% a year ago. Keep in mind that last year’s third quarter had a substantial benefit from the timing lag of the fuel surcharge.

In addition, you’ll see that our effective tax rate for the quarter was reduced to 34.8%. We expect to see similar rates through next year.

Now let’s start our review with the U.S. package operations. For the quarter, total domestic volume was 799 million pieces, down 3.6%. Total volume is more indicative of the year-over-year performance than average daily volume in this third quarter. Here’s why. UPS operated on Friday, July 3 and included it as an operating day. Volume on that day was substantially lower than average. Counting this as an operating day resulted in an average daily volume decline of 5.1%. The Domestic Package environment is actually better than this number implies.

Ground daily volume was down 6%. However, we experienced a 2.5% increase in next day volume. This was the first time in almost two years we’ve seen growth in our next day products. Volume improved sequentially through the quarter, driven by both seasonality and some economic recovery.

Revenue per piece was down over 9%. The decline was driven mostly by reduced fuel surcharges versus last year, 29% lower on air and almost 7% lower on ground products. Although package weights improved from the second quarter, they were still down about 7% from last year. Changes in product mix also contributed to the decline in revenue per piece. Despite these ongoing trends, operating margin improved 7.5%, up 50 basis points compared to second quarter.

The current pricing environment remains challenging, driven by the economy and more specifically by our customers own margin pressures. As we’ve told you in the past, UPS solutions help our customers take costs out of their supply chain well beyond just the cost of the transportation service provided. It’s critical that we at UPS convey the true value of these services. Therefore a top domestic priority today and into 2010 is improving our package yields. Our intention is to drive yield improvements from existing customers that did not provide a fully adequate return. Results from these efforts will become more meaningful as we progress through next year.

UPSers managed operations well despite reduced volumes. Once again labor hours, miles driven and domestic block hours all declined by a greater percent than the percent of volume declines with productivity gains across the board. We are now down 13,000 people in our U.S. direct labor force. The benefits from productivity improvement and reduced headcounts were mitigated somewhat by a higher average hourly wage rate, healthcare inflation and increased pension expense.

Let’s move now to the International segment. Signs of recovery emerged in the third quarter. Export volume declined only 3.2%, less than the market and less than the 4% to 6% we had anticipated three months ago. We did see sequential improvement in export volumes across all regions of the world compared to the second quarter.

Average daily domestic volume was up 9%. A portion of this improvement was contributed by our acquisition in Turkey, which was included in results for only two months of the quarter. But even without the impact from this acquisition, domestic volume growth turned positive with particular strengthening in the UK, Germany, France, Poland and Canada.

Excluding the effects of currency, revenue per piece declined 17.5%, primarily the result of reduced fuel surcharges. Changes in product mix and volume shifts across global trade lanes were also contributing factors.

Despite the reduction in volume and revenue, operating margin for the segment was 12.9%, essentially flat with last quarter and with last year. This remains by far the best in the industry.

UPS International is also doing a great job with cost management and generating positive operating leverage around the world. International block hours dropped by almost 15% in the quarter without impacting our service footprint. UPS remains committed to controlling costs while still making the strategic investments to enable growth when economic conditions improve.

Turning now to the Supply Chain & Freight segment, even though revenue was down almost 20%, all business units experienced moderation in the rate of decline. Operating margins remained

Operating margins remain at 5.5%, similar to last year. We maintained margins through successful cost control and effective revenue management.

Our Logistics Group posted a solid performance. Margins were strong due to operational efficiencies and good contract management. We believe there is opportunity for margin expansion as we streamline our processes and rationalize our service offerings.

In forwarding, revenue and profitability improved while operating margin was flat with last quarter. Global airlift capacity constraints have begun to squeeze industry margins. Taking advantage of our unique position as both an airline and a forwarder will enable us to reduce this margin pressure.

Also contending with very weak market conditions, UPS freight reported a modest 1.7% decline in LTL shipments. Despite the challenging operating environment, this business outperformed the market and maintained yields. The already weak LTL pricing environment deteriorated in the third quarter. UPS freight, though, opted to maintain its price discipline to the extent possible to ensure payment for value. This decision has resulted in the loss of some shipments and tonnage. Nevertheless, we believe this is the best strategy to preserve yield and the long-term health of the business. LTL revenue per hundredweight declined 6% and would have been positive without the impact of the fuel surcharge. In addition, our price index firmed slightly from the second to the third quarters.

Strong cash flow distinguishes UPS's business model. For the first third quarters of 2009, free cash flow was $3.4 billion, flat with last year after excluding the impact of tax refunds in 2008. This is a strong result considering that we contributed over $500 million to pension plans in the third quarter.

For the first three quarters of this year, UPS also invested $1.2 billion in capital expenditures, spent $396 million to repurchase 7.8 million shares, paid dividends of $1.3 billion, and finished with $2.8 billion in cash and marketable securities. We anticipate that our capital expenditures for the full year will be $1.7 billion. This is down about $250 million from the last projection we provided you and down about $0.5 billion from our initial budget of $2.2 billion. This will put us below 4% of revenue this year, even after adding capacity in our global hub network.

Looking forward, we expect to benefit from reduced interest expense as a result of a swap program that we initiated earlier this year that converts fixed-rate debt to floating. During the third quarter this program reduced our effective borrowing rate by approximately 40 basis points. We should see some additional benefits as this program continues.

Looking at fourth quarter operations, our customers have widely differing views regarding peak season volumes this year. Let's say we have a healthy mix of bulls and bears. Overall, though, for the quarter we expect to see firming in U.S. volumes relative to the third quarter but still below last year. Operating margins should be similar to third quarter results.

In our International segment we expect our export volume and operating margins to improve modestly over the third quarter, but we'll still be down from last year also.

The Supply Chain & Freight segment revenue trends should improve compared to third quarter results but remain below last year. We do anticipate operating margins should be similar to what we saw in the third quarter, which is substantially above last year.

Based on our expectations for stronger sequential operating results in the fourth quarter, diluted earnings per share should be within a range of $0.58 to $0.65.

We'd now be happy to answer your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Jon Langenfeld - Robert W. Baird & Co., Inc.

Jon Langenfeld - Robert W. Baird & Co., Inc.

Can you first just maybe bucket the cost savings that you have been talking about and talk about which of those buckets will tend to be more permanent than others?

Kurt Kuehn

Yes, Jon, we have been taking a look at that and trying to get a good sense of really what is sustainable.

There are some things that we did certainly in the short term given the emergency and the condition we saw in the economy, like freezing salaries, that frankly I hope we won't have to continue going forward, so some of those things. We've done some reductions in advertising; we did freeze salaries - some quick things just to stabilize the results. And those things presumably will go back to normal as the economy returns.

But we've also done a lot of hard work to realign the network and are harvesting the benefits of that that will stay. We have continued to shrink our infrastructure of operating units both in the U.S. and across the globe to reduce some of our SG&A. As you know, we've opened up the first phase of our Worldport hub expansion that's allowed us to reduce the number of aircraft we use in our Domestic network substantially by retiring our DC-8s. That will continue to provide benefits. And we've also made a lot of creative changes in how we operate.

So we do think about two-thirds of these savings will be sustainable, at least in the medium term.

Scott Davis

Jon, I would add that I think we'll have additional savings. We've done an awful lot of things on the network that we see more opportunities in the future. And with the expansion of Worldport, the final piece of that being completed next year gives us more opportunity to generate more network savings. So we're not done generating savings, also.

Jon Langenfeld - Robert W. Baird & Co., Inc.

And then the second question was on the ground volume side. I understand the days adjustment that you'd mentioned, but most of the freight environment that we've seen has shown a noticeably less negative trend, whether it's rail, whether it's trucking freight, truckload, less than truckload, ocean liners. I'm a little bit surprised we didn't see more movement on the ground business sequentially from the developments in the second quarter. Any thoughts on that front?

Kurt Kuehn

Well, if you factor out the working day effect, that we divided by one extra day than some of the market, that gets us probably closer to about a 4.5% decline, which is a sequential 1% improvement in the ground. And we saw a little better sequential improvement later in the quarter, July both for the holiday and just the results were pretty bleak.

So it is what it is. We did see modest improvement, both because of seasonality and we think some because of sequential improvements. We're not trying to say that things have gone fully back to recovery, but we did see some strength in that.

And typically the small package ground lags some of your heavier modes and your express in a recovery a little bit if there's some urgency for restocking.

Scott Davis

I think, clearly, as you head into October and November, that was kind of the worst case last year, when there was somewhat paralysis and the financial crisis. So the comps get much easier in October and November. We had a pretty good Christmas season the two weeks before Christmas, but up until then it was a pretty weak fourth quarter. So comps get easier going forward.

Operator

Your next question comes from Gary Chase - Barclays Capital.

Gary Chase - Barclays Capital

A few questions on fuel, the topic that seems to be increasingly on people's minds these days for obvious reasons. First, we saw a lot of trade down in the air business as fuel prices peaked. I'm wondering as you talk to customers how they're thinking about the thought that seems to be front and center in just about everything you read, that energy is going to accompany any upside movement in the economic trend. Are you getting any feedback to suggest there might be more trade down coming?

Kurt Kuehn

No, I think if anything we're seeing a little bit of the opposite right now. The last year third quarter had 29% higher fuel surcharges than what we had in the third quarter of this year, so we're actually seeing tremendous stability and, in fact, you are seeing our air products show some resilience. So at least at the current levels, where you do have surcharges that are significantly below last year, and the gap between air and ground is fairly modest, we're seeing if anything really no signs of continued trade down. I think we mentioned last quarter that we'd seen that stabilize.

Clearly with fuel heading back up to $80 or so today, there will be some short-term headwinds for us with the lag of the fuel surcharge, in dramatic contrast to the tailwind we got last year. But our sense is unless fuel climbs another, I don't know, $15 a barrel or so, it's unlikely that those surcharges will be too detrimental to demand. And hopefully, if the economy continues to pick up, that'll be outweighed by the need for rapid replenishment of inventories.

Gary Chase - Barclays Capital

And as a follow up, you talked in the past about the discounting of base rates during this process of fuel peaking. Were the surcharges largely intact so as energy prices move we should expect pretty good surcharge coverage looking forward?

Kurt Kuehn

Certainly compliance is higher with fuel surcharges in the single digits than it was when it went through 30%. That really created some tremendous pain for our customers and a lot of pressures on us for incentives. So we do see higher compliance rates right now. But, as I said in my prepared comments, yield management and making sure that we extract the value for the services we perform is one of our absolute top priorities in the domestic environment.

We are seeing base rates up modestly if you factor out fuel and other factors. But it's still not a level we think it should be, and that'll continue to be a priority for us.

Operator

Your next question comes from Thomas Wadewitz - J.P. Morgan.

Thomas Wadewitz - J.P. Morgan

I wanted to see if you could give us some perspective on the impact of currency. We estimate something like 10% of your revenue comes from your Europe business, and obviously you've seen a pretty sharp move of dollar weakness recently. It seems like there'd be a natural benefit there, but I know you're active with hedging. So I wonder if you could just take us through how dollar weakness potentially affects your International profitability and also kind of the timing of that impact in light of your hedging?

Kurt Kuehn

Yes, well for Q3 currency was a headwind. If you recall last year, the euro spiked up significantly higher than it was in Q3. So currency was a headwind for us in the third quarter.

Scott Davis

The dollar actually weakened late in the third quarter. It's going to help us in the fourth quarter, but not much in the third.

Kurt Kuehn

It will show certainly a strengthening coming into Q4, but Q3 was a headwind.

Thomas Wadewitz - J.P. Morgan

I guess I was thinking more in terms of 2010. If the dollar stayed at $1.50 to the euro or weakened further, just kind of how to does hedging offset the benefit or would you pretty clearly get a margin benefit and a translation benefit in 2010 if the dollar keeps weakening?

Scott Davis

Tom, we've talked about this a lot in the past. We are hedged in 2010, and we would not expect a negative comparison based on our hedging position we have right now. And we have some upside, too. We deal with collars, but we have quite a bit of room on the upside. So we're positioned very well for 2010.

Thomas Wadewitz - J.P. Morgan

We've heard about strengthening air freight out of Asia on the heavyweight air freight side; we heard about a spike recently in China. Does that follow through that you would see some good pickup in your parcel side out of Asia? Do you see a spike there as well, or do you think that's kind of decoupled from what's happening on the heavyweight side?

Kurt Kuehn

Well, we did see some sequential firming really across the world and Asia through September. The most notable event that's happened, which really confirms what you're saying, is the last several weeks we have seen a significant firming of demand on the air freight side. So things are very busy on the air freight side.

I think it's too soon to call whether that'll ripple through as substantially in the package. But the combination of us having both the air freight and the package and the hard assets of the aircraft allows us to prosper, really, from either one of those two.

Operator

Your next question comes from Ken Hoexter - Merrill Lynch.

Ken Hoexter - Merrill Lynch

Can you just talk a bit about on this air and ground divergence here. In past downturns have you seen the dichotomy get this wide, where you're seeing the express run up so much more in advance of ground?

Scott Davis

I think if you look historically, Ken, you do see air have more leverage, both positive and negative. So that isn't totally surprising. There is certainly also more impact from the DHL departure from the U.S. market on the air business, so I don't want to draw too strong a point on it.

But on the other hand, also, this recession is much different than some of the ones in the past. Inventory levels are very low. We think it's premature to say that restocking is a dramatic part of that. But it is an interesting time for that, and we're going to be continuing to watch that closely.

Ken Hoexter - Merrill Lynch

Then just secondly on the LTL segment, I know it's small but the weight per shipment really dropped very significantly this quarter relative to where you were. Is there something driving that business, because it seems to have impacted the profitability a bit there?

Kurt Kuehn

No, we're pretty pleased with our operating results on the UPS freight. Clearly, the industry is still struggling dramatically. We do think there's some cannibalization of the heavier weight shipments going to truckload.

I think another big part of it is that our go to market strategy of targeting the very large base of UPS customers, most notably in the middle market, is paying off, and they tend to have lighter weight shipments. But that's obvious in our yields, our revenue per hundredweight just down 6%. That would have been up 4% positive just taking fuel out of the equation.

So we feel very good that we are seeing very good discipline on the yield side and continuing to outgrow the market on our shipments.

Scott Davis

I think the key to us getting weights back across the board in our products is industrial production. And even though we're starting to see it strengthen and the third quarter was positive quarter-over-quarter, it was still down almost 10% year-over-year.

Now, we're optimistic going forward that IP will actually perform GDP as it comes back, but it's got a long ways to go to get back to 2007 levels. That will help our weight.

Operator

Your next question comes from Edward Wolfe - Wolfe Research.

Edward Wolfe - Wolfe Research

Just kind of big picture, if I look at the Domestic Package OR it's worse than I would have expected down here, and probably the International's holding up a bit better. And it just feels like the Domestic Package volumes have weakened and the margin's not improving like the other margins are. Is that a fair way to think about it, that the mix, as ground shrinks and the air maybe from some of the DHL stuff and so forth grows, that it's tougher to get this margin back to where it was historically? And is there a plan to start to work on that mix and kind of focus on the ground a bit as you go out longer term?

Kurt Kuehn

Yes, we continue to be very focused on managing this domestic environment, Ed. We are seeing still a headwind on our average weights. Weight's down about 7%.

And maybe to follow up a little more on the ground trends, the ground is significantly impacted by this industrial and wholesale environment, as Scott mentioned. That's part of why you're seeing a little bit of a lag. We are seeing some firming in the economy, but it's not showing up substantially in industrial production. That really makes that ground product and our Domestic business move heavily.

If you look, though, sequentially, quarter to quarter we actually improved margins from Q2 to Q3, Ed. And historically those margins dropped, say, 40 - 50 basis points sequentially. We actually improved them 50 basis points. So we're pretty confident that the aggressive cost management we're doing and the firming of yields that's beginning to take some impact are actually kicking in and that we do feel that the Q3 performance was better than Q2.

Edward Wolfe - Wolfe Research

As a follow up, on the International domestic side, volumes are up quite a bit relative to last quarter. Can you talk about how much of that's acquisition and what else is driving that?

Kurt Kuehn

Yes, there's really three factors driving that, and it is a substantial difference than the negative results in Q2. First is that we did see some sequential firming in our major markets. The U.K., Germany, France, Poland, Canada, all of them, both our execution on market share gains and we think some stability in the market helped us generate positive growth in those countries.

In addition, as Scott mentioned, we have expanded our domestic services, added another 16 countries. We've found we can effectively layer in domestic express services in some of these smaller countries where we offer export services.

And then third is the inclusion of the Turkey numbers in our results. Turkey is a substantial economy, and it did take us from being just slightly positive to substantially positive. We will continue to see the benefit of that and are excited about having that extra capability in our portfolio.

Scott Davis

I think the one area that I was surprised with was Europe. I think on previous calls I've said I've been a little more optimistic on Asia and probably the U.S. export than I have been in Europe, but we did see surprisingly good improvement in Europe, as Kurt mentioned - good growth in German, France, the U.K.'s shown some improvement. So, again, I'm not quite as bearish on Europe as I was on previous calls. It's looking better.

Edward Wolfe - Wolfe Research

Did I hear right - it's 9 points of improvement from the acquisition give or take?

Kurt Kuehn

No, we would have been modestly positive without that, so it's a little less than that.

Operator

Your next question comes from William Greene - Morgan Stanley.

William Greene - Morgan Stanley

Just a couple of data questions. Can you tell me what the U.S. import volume trends look like and what B2C volume trends look like as well in the quarter?

Kurt Kuehn

Import U.S. improved modestly, still remain negative. Import and export U.S. are both about the same right now; we're not seeing a big move either way.

William Greene - Morgan Stanley

Sorry, Kurt, did you say improved modestly year-over-year?

Kurt Kuehn

No, no.

William Greene - Morgan Stanley

That was sequential?

Kurt Kuehn

Over the course of the quarter - it's still negative year-over-year. We haven't seen a big move in U.S. imports or exports.

Certainly the U.S.-Asia numbers are firming a little better than what we saw for the U.S. and Europe relationship.

Scott Davis

And I think other than that that the Europe exports to the U.S., obviously, are weak with the weakness of the dollar.

Kurt Kuehn

And the B2C numbers are flat to slightly positive. That segment has moved down dramatically versus some of the double-digit numbers we saw several years ago.

William Greene - Morgan Stanley

And then when you guys report UPS Basic, do you put it in the ground numbers?

Kurt Kuehn

Yes, that's included in our package numbers. We do have a mail innovation unit that handles flats and more in the mail injection services. That's included in our Logistics Group.

Operator

Your next question comes from Robin Byde - HSBC.

Robin Byde - HSBC

Just a question on international exports. I think I heard you say that volumes and margins should recover in Q4. Can you just say a bit about what's going to drive that, please?

Kurt Kuehn

Well, I think seasonally Q4 is typically a better quarter for us than Q3, so we do expect to see some modest margin improvements from that. Plus we are seeing modest firming, we think, in trends across the world.

And frankly, Robin, we continue to be very optimistic that we're gaining market share. I mean, UPS remains very focused. We've got a strong business model and some very large points of differentiation having a balanced capability across the world, so we're looking for continued market share growth, continued improvements in margins, and are pleased with our progress in that arena.

Robin Byde - HSBC

Is this market share gain mainly in Europe domestic?

Kurt Kuehn

No. It's the international export numbers. We've continued to dramatically outperform the industry by just about any measure. We think that we are continuing to do that. We're seeing good success in competing against DHL across the world, with them having a big gap in the U.S. portfolio. And frankly, we remain, we think, the only player that's got a strong value proposition in all areas of the globe.

Scott Davis

If you look at the trends over the last three to five years, it's been very consistent, the outperformance of the market.

Operator

Your next question comes from Nathan Brochmann - William Blair & Company, LLC.

Nathan Brochmann - William Blair & Company, LLC

Just kind of a bigger picture question as well. I know that there's still work to do, and I know that these early signs of recovery are kind of tepid at best. But do you start, in terms of the big picture strategy, kind of thinking a little bit differently now at this inflection point as things are firming up a little bit where we go from aggressive cost reduction to maybe a little bit more modest and looking a little bit more at some of the growth drivers?

Scott Davis

I think, Nate, that our strategy is sound, and I'm a firm believer that global trade is going to lead us out of this recession that we're in. So I think UPS is positioned extremely well, and I think our focus on the products we're looking at today - the international products, the domestic products  I think puts us in a very good position to participate in the growth. I'm very optimistic that UPS is in the right place at the right time.

Nathan Brochmann - William Blair & Company, LLC

And just as a tangent question to that in terms of the plans for [entering] China in terms of maybe an update there with a lot of growth coming out of that region?

Scott Davis

Clearly, we've done very well in China on the import and export side for many years, and I don't see any change ahead of us there.

There are some challenges competing domestically in China. I think it's pretty clear that people are aware of the new China postal law that came into effect on October 1st. That limits the international carriers from participating in the domestic letter market, which we think is unfair and think that it's bad for China to keep the international companies out of that marketplace.

But notwithstanding, we're going to continue to look for opportunities to expand in domestic China in the years ahead because it'll be a strong market. But in the meantime we'll continue to prosper in the import and export portion of that market.

Operator

Your next question comes from David Ross - Stifel Nicolaus & Company, Inc.

David Ross - Stifel Nicolaus & Company, Inc.

A question just on the UPS Basic. It's a very small piece of the portfolio, and I wanted to get your sense of how you think about growing that given the success that others have had growing the consolidator business as, I guess, a secondary offering to ground.

Scott Davis

We actually led the market with the introduction of Basic a number of years ago, and that continues to be a part of our portfolio.

We really have three product lines that can address the needs of B2C shippers -- our traditional UPS product, whether that's ground or air depending on the speed need, and that comes with all the bells and whistles, tracking capability, guarantees; we have the UPS Basic that's for lighter-weight packages in which UPS delivers the majority of those packages but in many of the territories that are more outlying we do inject those into the post office; and then we have our Mail Innovations Group - that's a key part of our Logistics Group - that offers services for injection into the mail primarily focused at third class injection, and that also handles a number of packages that are very lightweight, typically a pound or less.

So that is a portfolio that we enjoy, and we do continue to offer value to customers based on the trade-off of service and speed and value.

David Ross - Stifel Nicolaus & Company, Inc.

And then just a follow up question on I guess the package cars that are running around the U.S. You've had some alternative fuel I guess tested in there. Can you explain what's going on with maybe a shift in the fleet?

Kurt Kuehn

Yes. We continue to aggressively develop and deploy alternative fuel vehicles. We continue to have the largest private fleet of alternative fuel vehicles in the U.S.

We have been adding natural gas vehicles, a number of those, in those locations where the infrastructure is available, and we'll continue to do that.

We also have added several hundred hybrid electric vehicles, and we're seeing good results there.

And then really our newest technology is the hybrid hydraulic that restores breaking energy into a hydraulic tank and allows the vehicle then to start off of that, and that has very substantial benefits on returning the energy that's lost. But it's still early in the game.

Scott Davis

We certainly have one of the largest rolling laboratories in the world out there right now, but it's going to take industry to come together and government to come together and agree on standardization of the right alternative energy vehicles to get this to be economically the right thing to do. So we're working on it, we're leading the way, but we've got a way to go.

Operator

Your next question comes from Justin Yagerman - Deutsche Bank.

Justin Yagerman - Deutsche Bank

We're starting to lap the comps on DHL pulling out of the domestic market here, and I guess when you do the postmortem how do you think you guys fared from a market share standpoint? Where did you get more than you thought you would? Where did you get less? And maybe you could talk a little bit about the stickiness of that business and whether or not you think there's still market share opportunities to attract it.

Kurt Kuehn

You know, Justin, it has been awhile, so the longer time goes on the fuzzier it gets as customers adapt and evolve. But clearly we are confident that we did get a little more than half of the available revenues from that opportunity late last year, and that we've been pretty successful in including that into our business and certainly solidifying relationships with those customers.

Those packages were lighter weight than average and so there was some impact, and you're seeing that in some of our yields. But we feel very good that we've successfully made that transition.

Domestic market share, that's pretty much stable, but the focus on international products against DHL continues to be a top priority for us. They are the market leader in much of Asia and Europe, and so we feel very comfortable competing with them. The value proposition of technology, service and quality that UPS offers stands up very well with them, and that continues to be one of the catalysts for our outperformance internationally.

Justin Yagerman - Deutsche Bank

And I guess along those lines, as we look at the free cash flow generation that you guys have been able to achieve and you think about an emerging recovery hopefully in the overall economy, when you start thinking about opportunities and acquisitions out there for you guys, I guess it'd be interesting to hear you talk about, I know you break down different geographies in terms of whether or not you think they're mature or opportunities, and maybe if any of those geographies have changed one way or the other and have become more attractive or less attractive.

And then maybe conceptually what types of acquisitions you're going to be looking for as we move into this environment, and if any of them are large scale or if you think that you're more in a tuck-in mode on a go forward basis.

Scott Davis

I think our strategy has not changed much. I think we've been active right through the recession. You've seen us doing a lot of acquisitions in the last 12 months, including Korea. We talked about Turkey - Romania, Slovenia. So we've been pretty active in that front. There's certainly been a lot of focus on Eastern Europe, a lot of focus still on Asia.

I think our priorities still are international package. I think that'd be our first priority, where we'd do our acquisitions.

I've said in the past that I wanted to see our forwarding units start generating better margins before we got back in the market. We've made a lot of progress in that area. You're starting to see the margins improve. You're starting to see us get close to generating an economic profit in those arenas, so it's more realistic that we'll look in that arena again moving forward.

But primarily we'd lead with international package, some interest in the supply chain arena, focused on forwarding, geographies still probably Asia, Mid East, Eastern Europe would lead the way.

Operator

Your next question comes from David Campbell - Thompson, Davis & Co.

David Campbell - Thompson, Davis & Co.

I just wanted to clarify the international situation, where you mentioned increasing demand, shortages in capacity in some markets, therefore, as a forwarder, when you're buying capacity you may get squeezed; as a cargo carrier you'll benefit from the higher yields. Do you think the rates will go up as fast as the cost of purchase in transportation markets as a forwarder? Do you think your rates will match those cost increases?

Kurt Kuehn

David, there clearly is a challenge in the forwarding industry right now. We saw a little bit of that in Q3 with margins beginning to tighten a little bit. So, no, I think there is an expectation that the forwarders will have to adapt to increasing demand and increasing rates. That's just part of the cycle you live through.

We do think that with our unique position of both our assets and other assets we've got some options to route volume in a way that gives us a unique opportunity economically, and so we're looking forward to that challenge.

But we have seen, as I said, the last probably three, four weeks in Asia some real uptick, most notably on the high tech side, with goods being exported on the freight side. So that's a good sign, and we'll adapt. It may hurt us a little bit on the margin side, but it's good news overall.

David Campbell - Thompson, Davis & Co.

If demand is so strong, why is it that shippers won't match the increases in costs because they want to get their product out?

Kurt Kuehn

Well, we'll see. There's usually a lag but that's certainly our priority, you know, to make sure that we stay on the right side of this dynamic. But it's pretty typical as you see cycles work in forwarding that there's some margin compression on the way up.

Operator

Your next question comes from Christopher Ceraso - Credit Suisse.

Christopher Ceraso - Credit Suisse

It seemed like that you didn't get all that much leverage as you walked from Q2 to Q3. Revenues were up, but the increase in operating profit on the back of that increase in revenue was relative small. Can you give us some feel for why that may be? Is it fuel? Is it mix? And then is this the kind of contribution, something around 10% or 11%, that we should expect as revenues increase sequentially going forward?

Kurt Kuehn

Well, Chris, Q3 typically is a challenging quarter. Internationally, it tends to be one of the low quarters because there's significant vacations in August in Europe, and Europe is certainly a heavy quarter for us. And even domestically, the third quarter typically is a little less profitable than the second quarter, as we talked about.

We did see, I guess, a drag in our International segment, both from currency changes and fuel -- modest drags but that was a drag. And on a year-over-year basis clearly there were huge comps.

So we're pretty pleased actually that we operated effectively. We didn't knock it out of the park in the third quarter, but we are seeing excellent operating results, continued reductions in cost, and feel pretty good that we actually overcame the normal seasonal downturn from Q2 to Q3 with our results.

Christopher Ceraso - Credit Suisse

Then one big picture question: Have you seen any evidence, either in the U.S. or internationally, of small business owners opening new accounts with UPS? I think you'd mentioned in the past that that can be a lead indicator that the economy is starting to get better.

Scott Davis

I think we're seeing some of that, but I think Kurt summarized the conditions pretty well. There's still a mix out there. There's still some people who want to see a little more recovery, and we're in the early stages of it.

Obviously, we're seeing some new small business customers coming in but still not at the rate we'd like to see to know this is absolutely a sustained recovery.

Operator

Your next question comes from John Barnes - RBC Capital Markets.

John Barnes - RBC Capital Markets

Back to your comments about China domestic and your expansion possibilities there. It seems like you get a rule change a month or so from the Chinese government as to what can only be handled by China post and that type of thing. Has that influenced you at all in terms of timing and pace at which you would look to move into that market?

Scott Davis

I think it's something that all the international companies are concerned about, the new postal law that went in October 1st. We're still going to have great interest in competing domestically in China.

We've had actually great success with the Chinese government on the import and export and getting the rights, the plane rights that we have for our new hub, Shenzhen, in Shanghai. So the relationship has been good.

We're patient, and we think there'll be some good opportunities going forward.

John Barnes - RBC Capital Markets

And then as you look at the fourth quarter you normally do a fair amount of, I guess, part-time hiring in the fourth quarter for the holiday season and that type of thing. Given where volumes are and that type of thing - and I would imagine some capacity in your system - is there any need to do much of that at all in the fourth quarter?

Kurt Kuehn

Yes, John, we do expect to continue to do that. I actually started with the company as a temporary hire for Christmas, and we're estimating about 50,000 jobs that will be added for the seasonal growth. That's a little below what we normally do, but we're still looking. Even if numbers come in at the low range of expectations for holiday shopping, it's still a big increase over the normal time of year.

And as I mentioned, there is a pretty wide divergence of opinions. We're seeing some of the brick-and-mortar players be fairly conservative, but there's a number of the dot com players that are expecting substantial increases. So we'll see how that battle of the bulls and the bears turns out.

Andy Dolny

That concludes our Q&A today. I'm now going to turn the program over to Scott for some concluding remarks.

Scott Davis

Thanks, Andy. Let me make a couple of comments just regarding economic conditions.

I tend to be an optimistic by nature yet a realist by experience. And on balance I believe this recovery is real, but it's still fragile. I believe it's sustainable but vulnerable, at least for the foreseeable future.

But I firmly believe that global trade will lead it rather than lag it. And one thing I know for certain - UPS is at the forefront of global trade and is going to help lead the way.

Thanks so much for joining us today.

Operator

Thank you. And this does conclude the UPS third quarter earnings call. You may now disconnect.

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Source: United Parcel Service, Inc. Q3 2009 Earnings Call Transcript
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