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United Parcel Service, Inc. (NYSE:UPS)

Q4 2009 Earnings Call

February 2, 2010 8:30 am ET

Executives

Andrew Dolny Vice President, Investor Relations

Scott Davis Chief Executive Officer

Kurt Kuehn Chief Financial Officer

Analysts

Helane Becker Jesup & Lamont Securities Corporation

Jon Langenfeld Robert W. Baird & Company

Gary Chase – Barclays Capital

Tom Wadewitz – JP Morgan

Edward Wolfe Wolfe Research

Ken Hoexter Merrill Lynch

Robin Byde HSBC Securities

William Greene Morgan Stanley

Art Hatfield Morgan, Keegan & Company

David Campbell Thompson, Davis & Company

John Barnes RBC Capital Markets

Justin Yagerman Deutsche Bank North America

David Ross Stifel, Nicolaus & Company

Scott Flower Macquarie Securities

Operator

I would like to welcome everyone to the UPS investor relations fourth quarter 2009 earnings conference call. (Operator Instructions) It is now my pleasure to turn the floor over to our host, Mr. Andy Dolny, Vice President of Investor Relations. Please go ahead.

Andrew Dolny

Good morning, everyone. Welcome to our fourth quarter earnings call. I'm here this morning with Scott Davis, our CEO, and Kurt Kuehn, our CFO, to discuss the company's results for the quarter and our outlook for 2010.

Before we begin, however, I will review the safe harbor language. Some of the comments we'll make today are forwardlooking statements that address our expectations for the company's future performance or results of operations. These anticipated results are subject to risk and uncertainties, which are described in detail in our 2008 10K, and 2009 10Q reports.

These reports are available on the UPS Investor Relations website or from the Securities and Exchange Commission. Today's call is being webcast and will also be available on our Investor Relations website.

In their remarks today, Scott and Kurt will compare results for 2009 and 2008, excluding the effects of adjustments that occurred in both years. Such a comparison is more reflective of UPS' true performance. The adjustments in 2009 that I am referring to include charges of $258 million during the first half relating to the acceleration of the retirement of aircraft and the remeasurement of certain foreign currency denominated obligations.

In the fourth quarter of 2008, we took impairment charges of $575 million in our UPS Freight unit and in the International segment. A reconciliation of these results is included with our earnings announcement this morning and appears on UPS’ IR website in the financial information tab.

In addition, Kurt will refer to UPS' free cash flow, which is a nonGAAP financial measure. Reconciliation is included with the news announcement this morning and is available on the Investor Relations website. Before I turn the call over to Scott, a reminder. During the questionandanswer period, please limit yourself to one question and one followup. Now here's Scott.

Scott Davis

Good morning, everyone. Several times over the last year, I shared with you my conviction that UPS has the ability to manage effectively in response to changing market conditions. That certainly proved true in 2009. UPS has emerged from a very difficult year leaner, more focused, and better positioned to take advantage of improving economic trends. Let me illustrate.

During 2009, UPS improved operating efficiency through a comprehensive costmanagement effort. We demonstrated the nimbleness of our international business unit by quickly adjusting our network to match volume levels and ending the year with operating margins that are near historical norms.

UPS bolstered our technology leadership with the introduction of new mobile shipping applications and the expansion of our WorldShip platform by adding the ability to ship air freight as well as small package and LTL. Our investment for growth continued around the world through new construction in China that will facilitate global trade, facility expansions like Worldport that create network efficiencies, and acquisitions that strengthen our presence in growing markets.

We took our service performance to even higher levels and continued to build upon our environmental commitment as evidenced last week when we were ranked number nine among the top 100 global companies in Maplecroft's Climate Innovation Index.

Lastly, once again UPS produced cash flow and margins that are the best in the industry; and we're not standing still. We're in the process of streamlining our U.S. small package structure. This effort is about improving how we go to market and interact with our customers. It's also about being more efficient with our resources to generate better returns in our domestic business. It will enable us to reduce costs and move market and resources and decision-making closer to the customer.

This restructuring has been in the planning stages for quite some time and would have happened regardless of the business environment. Over the last few years, UPS has greatly expanded the breadth and depth of the solutions we offer. Through this new structure, we now have the opportunity to better deliver the value our solutions bring to small and mediumsize customers. That's what's driving this change.

It will take some time the see the full impact of our new structure. But in the long run, this may prove to be one of the most significant changes to our domestic business in quite some time.

On a different note, the fourth quarter marked the tenth anniversary of UPS' IPO. Going public has helped the company in a number of ways. It affords us greater financial flexibility since we no longer have to support a closely held stock. And the IPO introduced a new voice at the table, outside investors.

While it's been a turbulent decade in the stock market, since the IPO our total return to shareowners has outperformed the S&P 500. Over the last ten years, our brand has become truly global as we expanded our presence around the world.

Before Kurt reviews our fourth quarter results, I want to take a moment to thank UPSers for their flawless execution and cando spirit during our peak season. Everyone should be proud of what they accomplished. I also want to say that our hearts go out to those suffering from the earthquake in Haiti. UPS has responded. Along with our partners in the logistics emergency team's coalition that supports the U.N. World Food Programme, we are providing transportation and logistics services to help manage the massive recovery effort.

Looking to 2010, I'm optimistic about the future. Recovery is under way in many regions of the world, but it will be gradual. I firmly believe global trade will be a major stimulus that powers economic recovery. And UPS is better positioned today than ever before to make that happen. Let me turn the program over to Kurt.

Kurt Kuehn

Thanks, Scott, and good morning everyone. 2009 was challenging to businesses worldwide. I'm pleased with the way in which UPS wrapped up the year, but I for one am glad that the year is over.

For the quarter, earnings per share of $0.75 were a substantial increase over our original guidance. That increase was achieved through higher volumes than expected and a wellexecuted game plan. As Scott said, UPSers did a great job, particularly during the peak holiday season.

Other noteworthy highlights – first, tremendous results from the International segment with a 6% gain in revenue, producing a 19% increase from operating profit. Second, substantial improvements in our U.S. package segment. Although we have a long way to go, domestic profit increased over 60% from its low point in the second quarter. Third, despite the worst economic environment in 70 years, UPS' free cash flow for the year was exceptional, $4.1 billion or over $4 per share for only the second time since going public.

As you can see from fourth quarter results, the benefits from our cost initiatives are becoming increasingly evident. For example, in the quarter total compensation and benefits grew at a much slower pace than volume increases. Also of note in the quarter, we saw a clear demonstration of the value inherent in our broad portfolio of services.

Unexpected demand for air freight in Asia exceeded market capacity, squeezing margins in our forwarding business. However, our International Package segment benefited from the increased volume as UPS customers upgraded into our Express network. This is the unique advantage of an integrated portfolio.

Now let's start the review with the U.S. Package business. In the fourth quarter, we again saw growth in average daily air volume with Next Day Air up almost 3% and Deferred up over 4%. Growth decline for Ground moderated in the quarter.

Revenue per piece was down 5.2% primarily as a result of lower fuel surcharges. Air and ground fuel surcharges were down yearoveryear approximately 16% and 4%, respectively. Weight per piece down about 5% had a bit less of an impact than in previous quarters. And base rate pricing, my number one priority heading into 2010, improved sequentially.

Typically, operating margin in the fourth quarter is less than in the third. However this was not the case in 2009. The segment's 10.1% margin was an increase of 260 basis points over our third quarter results, and the first time all year that it was in double digits.

We experienced reductions in expense per piece as the impact of our initiatives took hold. Although the margin did decline 160 basis points yearoveryear, keep in mind that the fourth quarter of 2008 benefited significantly from the timing of fuel surcharges.

Now let's turn to the International segment. Average daily volume increased almost 12% with exports up 3%. All regions of the world experienced growth with Asia and the U.S. leading the way. This clearly exceeded our expectations as Asia volumes improved when customers upgraded from air freight to international small package due to the capacity constraints in the freight market and emergency restocking.

NonU.S. domestic volume increased almost 18%. You may recall in the third quarter, we experienced a substantial uptick in this volume due to our acquisition in Turkey. Although that did contribute to the fourth quarter's growth, so did increases in other countries. In fact, excluding Turkey, domestic volume would have increased 7%. This is another advantage of our broad portfolio. We're winning new business and increasing our share from current customers.

During the quarter, the positive impact of currency on total revenue was essentially offset by the negative impact of lower fuel surcharges. As a result, the revenue increase of almost 6% was due to strengthening business conditions and continued share gains. International operations did an excellent job of controlling costs as evidenced by the improvement in operating margin to 16.7%. This is 180 basis points higher than last year and demonstrates the operating leverage inherent in our international network. Impact from currency was negligible.

I would be remiss if I didn't mention peak season, which was strong in both the U.S. and International segments. We experienced 8 days of worldwide volume over 22 million packages, two of which were over 24 million. This was stronger than we had expected and necessitated exceptional execution of our peak season plan.

Now for the Supply Chain & Freight segment. Disappointing performance in the forwarding and LTL operations offset another good quarter in logistics. Logistics revenue increased yearoveryear posting strong operating margins. Business continued to successfully develop and deploy solutions that deepened customer relationships and drive transportation spend. Particular strength was evident in the health care and hightech sectors.

In forwarding, a surge in demand in a capacityconstrained Asian market led to rapidly escalating transportation costs. This margin squeeze negatively impacted operating profits. We are working diligently to negotiate customer rates that reflect market conditions.

UPS Freight's fourth quarter performance was below expectations. LTL shipments were flat and weight per shipment declined. As a result, the unit reported a loss in the quarter. We do have a very challenging pricing environment; however, revenue per hundredweight was up 2.8% as we maintained our pricing for value approach in this business. UPS Freight also did see a gain in market share yearoveryear. We will continue to optimize the Freight network and focus sharply on the middle market. The unit should return to profitability in 2010.

Turning now to a distinction that UPS has long enjoyed  our financial strength. Even in one of the worst years in decade for economic activity, UPS generated $4.1 billion in free cash flow through excellent management of working capital and constrained capital expenditures. We also paid $1.8 billion in dividends, invested $1.6 billion in capital expenditures, repurchased a total of 10.9 million shares for $569 million, and ended the year with $2.1 billion in cash and shortterm investments.

Two years ago, we introduced our funds flow from operations to total debt metric and said we were targeting a range of 50% to 60% by the end of 2009. We ended the year at 58%. Last week, S&P reaffirmed our AA credit rating, although they changed our outlook from stable to negative. This was based largely on their calculation of funds flow from operations to total debt which includes pension liabilities as debt. By their calculation, UPS is slightly below their target. We have 18 to 24 months to close the gap, which I am very confident we can do.

Now for our outlook. Because we have more clarity into economic conditions going forward than we did a year ago, we're providing annual guidance for 2010. Diluted earnings per share should be within a range of $2.70 to $3.05, which is an increase of 17% to 32% over 2009 earnings. As Scott indicated, the recovery should be gradual; therefore, the first quarter will be the most challenging of the year with earnings per share only slightly improved from the first quarter of 2009.

In the U.S. Domestic segment, average daily volume should increase in line with GDP with ground improving a little more than air. Volume growth will be more evident as the year progresses. Yields should increase as pricing strengthens and package characteristics improve. In addition, we're reinstituting management compensation increases. We anticipate operating margin for the first quarter will be a little below last year which should expand through 2010.

In International, export volume growth is expected to outperform the market. Domestic volume should increase at a midteens rate until the third quarter, when we lap the date of our Turkish acquisition. For the year, domestic volume should increase in the high single digits. Operating profit should grow at an annual midteens rate with margins strengthening over the course of the year.

We expect the Supply Chain & Freight segment to achieve a mid to high single digit revenue growth rate for the year. Operating margin should improve slightly in the first quarter compared to last year, expanding to about 5% for the full year. As I mentioned on our last call, our overall tax rate for 2010 should be between 34% and 35%.

Capital expenditures are projected to be $1.8 billion. At less than 4% of revenue, this is significantly below our historical range of 5% to 8%. In fact, CapEx for the next few years will remain well below our historical range. Reduced capital expenditures reflect the fact that many of our current strategic investments are nearing completion.

For example, our air fleet is the youngest in the industry. Infrastructure is in place in Asia with the Shanghai hub opened last year and Shenzhen slated to open this quarter. And the comprehensive expansion of Worldport will be completed this year. We clearly will have the global network that we need to support growth.

This year, we will accelerate funding of our new IBT pension plan due to recently released regulations. The funding for 2010 will be approximately $200 million more than last year. This will reduce contributions in 2011, and thereafter and we expect the IBT plan to be fully funded by 2013.

Lastly, the streamlining of our domestic business will require a onetime charge and provide an ongoing benefit. The amount of the charge will depend on the number of people who accept the company's voluntary retirement offer. We anticipate it could be up to $80 million pretax and will be recorded in the first quarter.

Let me remind you this restructuring will eliminate 1,800 positions. We expect that the voluntary retirement program UPS offered to 1,100 management people will yield many opportunities for the displaced individuals. In 2010, savings from this restructuring will be minimal since it will be offset by expenses like relocation that are not included in the onetime charge. But in 2011 and beyond, we expect an annual benefit of about $0.10 per share.

To conclude, you are seeing the fruits of the hard work that UPSers completed in 2009. Going forward, we will build on today's accomplishments by capitalizing on the operating leverage of our global network, by maintaining disciplined pricing practices, and by leveraging the power of our broad portfolio. Thanks for your attention, and now Scott and I will be happy to answer your questions.

QuestionandAnswer Session

Operator

We will now begin the questionandanswer session. As a reminder, please limit yourself to one question and one followup. (Operator Instructions) Your first question comes from Helane Becker.

Helane Becker Jesup & Lamont Securities Corporation

I am just kind of curious on the international side. I know there was a lot of capacity that came out on that main, from passenger side as well as some main deck capacity coming out. Can you just talk about what you're seeing now, kind of in January, ahead of Chinese New Year and what you expect through the first quarter on that side?

Kurt Kuehn

We are seeing demand continuing to be fairly firm so far in January. It's not quite the squeeze that we saw in November and December when there was clearly a significant amount of freight left standing on the runways. But it continues to be fairly firm so far through the month anyway.

Helane Becker Jesup & Lamont Securities Corporation

Then you have that, just for my followup, you have that shutdown for about a week and then ramp up again. Is that how we should think about it? So January pretty good, February soso, and March kind of stronger than that?

Kurt Kuehn

Actually the seasonal impact is fairly similar to last year. We don't see this as being a period in which the timing of the New Year is going to make a big difference in yearoveryear comps.

Operator

Your next question comes from Jon Langenfeld Robert W. Baird & Company.

Jon Langenfeld Robert W. Baird & Company

You had mentioned in your prepared remarks that base pricing domestically is number one priority in domestic for 2010. Can you elaborate on that? What are some of the things you have in place to help support that priority, and what are some of the changes you've made?

Kurt Kuehn

Clearly as we’ve mentioned a couple of times in the last couple of quarters, now that the economy is stabilizing, we’re focusing much more on yield management, on making sure that we negotiate and extract the value that we’re creating. It’s been fairly comprehensive. It involves first a solid rate increase. It involves us making sure that we are pricing according to what the value is.

We’re frankly looking at some customers that perhaps were very aggressively negotiated during some of the tough times and revisiting those. On top of that, we do think that a firming economy begins to lift all boats, characteristics get a little stronger, weight goes up. So we clearly intend to be disciplined on this. We will be aggressive on pricing where it makes sense and the volume is very profitable, and in other areas we will be a little more disciplined.

Scott Davis

It’s also part of our restructuring was geared to taking our marketing locally. I think that’s a big change for the company. In the past, all of our marketing was really centralized at corporate. Each market is somewhat different. I think the fact now that we’re having the local presence we’ll be able to educate our salespeople better on the value proposition we bring to our customers.

Jon Langenfeld Robert W. Baird & Company

Then as a follow-up question, on the guidance. Does the guidance or the 1Q commentary either, do they include the charge that you talked about? Or is that separate?

Kurt Kuehn

We will likely report that charge at the end of Q1. Our guidance does not reflect the one-time charge. Although there will be some expenses from this restructuring that aren’t in the one-time charge, training expenses and the beginning of relocation expenses. That expense will be spread in Q1, Q2, and Q3. There will be some charges, and that’s why the overall P&L for the year is neutral, that are not considered one-time. That’s the moving of people that stay with the company and the training, etc. But the one-time charge for the voluntary retirement will show up as a one-time item in our Q1 reporting.

Operator

Your next question comes from Gary Chase – Barclays Capital.

Gary Chase – Barclays Capital

I wondered if you could elaborate a little bit. Kurt, you talked in the prepared remarks about the sequential up-tick in domestic margin. You attributed it to cost performance. Is there any way to put a little more color around that? Are those initiatives full up, or should we expect to see more of those unfold as we move through 2010?

Kurt Kuehn

Clearly there will be some additional initiatives, the domestic restructuring being the most notable. Plus we’ll continue to have some refinement of our air network as the Worldport expansion is complete. There will be even more volume that gets centralized through that network. That allows us to reduce our air network.

Although we did really see the culmination of a large number of initiatives that culminated in Q4, that was part of why you saw really the best operating results and the in effect our unit cost per piece for comp and benefits below the previous year. A lot of the stuff we talked about did reach its final completion for Q4, but we have a few more tricks in the bag that we’ll be using going forward.

Gary Chase – Barclays Capital

Second, you’ve talked about this concept. You were just mentioning in a prior answer about demarketing some of the business that isn’t meeting your threshold. I wondered if that process has started yet. And, again, if you could give us a sense of how that might play out through the year as well.

Kurt Kuehn

Clearly it has begun. We talked about that back in October. That’s been ongoing. During the depths of the recession, huge pressure on pricing and cost reduction; and in that environment we have certainly negotiated accordingly. As we’ve look forward a little bit, we have selected some customers that we think perhaps we should be charging a little higher. We have gone back and begun negotiations with them. Or at least as their contracts renew, we’re taking a slightly different philosophy.

It’s nothing earthshaking. Just making sure we’re getting a fair return really across the portfolio from all customers.

Gary Chase – Barclays Capital

Sounds like most of that opportunity is ahead of you, right?

Kurt Kuehn

Yes. It takes a year or so, at least, to cycle through contracts. It will be just an ongoing process as we move forward. That’s why we do have more confidence in those results showing improving over time. As a result, we expect quarter-to-quarter things to continue to get better.

Operator

Your next question comes from Tom Wadewitz – JP Morgan.

Tom Wadewitz – JP Morgan

I wanted to see if you could give a few further comments on the thoughts on first quarter which relative to the thoughts on the full year and they appear, I guess they're not including that $80 million charge so they appear to be kind of conservative in first quarter versus what you are looking at for the full year.

But it doesn't sound like demand had slowed down versus fourth quarter, so I am just wondering if there's something else on the cost side that hurts you more in first quarter or is something else we should be considering just in terms of the way the guidance is a little more conservative in first than what the full year looks like?

Kurt Kuehn

Yes, Tom. We have heard that question from a couple of people already even before the call. We are migrating to an annual guidance. Clearly last year we dropped back and went very specifically to quarterly guidance because we frankly couldn't see through the fog of war of the economic deterioration.

As we look out over 2010, we see a story of a gradually firming economy, of pricing for UPS continuing to get stronger and stronger, of volume results getting better, continued improvement on cost management, and ultimately the restructuring beginning to kick in late in the year. All of those lead to an upward slope over the year and lead us to produce, we think, a fairly ambitious goal for our earnings for the year of between 17% and 32% increase.

Q1 is a good question. There are a couple of things that are in Q4 that we're a little hesitant to extrapolate. We did have a surprising uptick in December frankly as the domestic and the international peak season came in strong. I mentioned we had 8 days over 22 million pieces and 2 days over 24 million pieces. We're being a little cautious that momentum may slow a bit; although we do think that volumes at least will be firm in the U.S. in Q1, probably flat, maybe slightly up.

We also saw the incredible squeeze in Asia with just unprecedented increase in demand which flowed into our package network substantially. It cost the forwarder a little bit, but it definitely allowed us to produce tremendous results in international. We're a little hesitant to extrapolate that. Plus we are going to be having some of these relocation expenses and training expenses beginning to hit Q1.

You lever all of that together, plus if you note that in Q4 we were still 9% below last year. We are expecting earnings to be up in Q1 over last year, just not at the overall average rate for the year. We took our best shot at it. If economic conditions, the momentum, continue, then certainly there's upside potential. At least at this point, that's kind of what we think is appropriate.

Scott Davis

I think it goes hand in hand with the fact that we do believe this is going to be a gradual recovery. Even if you go back and look at the fourth quarter where you saw big economic numbers, you saw GDP quarteroverquarter up 5.7%. Yearoveryear it was somewhat flat, up a tenth of a percent. Industrial production was up 7% quarteroverquarter, but actually yearoveryear it was down over 4%.

We think that's going to continue to get better as the year goes on. In 2010, we actually see industrial production growing over 4%. But it's going to take throughout the year to get to that level. It's going to grow more at the end of the year than at the start of the year.

Tom Wadewitz – JP Morgan

My followup in terms of volume in January, if you could just give a sense of domestic package, international perhaps on the forwarding side, what the volumes have looked like in January and whether you've seen any falloff in demand or whether that momentum has been pretty good in January.

Kurt Kuehn

So far I think we've been modestly pleased with the momentum in January, domestic volumes have been holding at about flat. Clearly they were higher than that during those peak days in December. So that's stabilized a little bit. Our international growth seems to be holding solid. The rush in Asia, perhaps, is moderated a little bit on the freight side.

But on the forwarder side the rates have begun to come down a little bit from their skyrocketing arena. And also the UPS Freight is continuing maybe a little stronger in January than the previous month. Modestly positive trends, I think, is the best way to look at it.

Operator

Your next question comes from Edward Wolfe Wolfe Research.

Edward Wolfe Wolfe Research

With the CapEx coming down and the tremendous free cash even with the difficult earnings year this year, when do you go back to more aggressively buying the stock back? I know, Kurt, you mentioned about S&P and building up your reserves a little bit; but when should we think about increased dividends and share repurchase and how do you think about those two going forward in a multiple year of lower CapEx kind of period?

Kurt Kuehn

That's a good question. We clearly hunkered down last year and late '08. We have been very pleased at our results on cash flow. That didn't happen by accident. We've done a good job in a lot of arenas. We are going to be back soon, hopefully, to that problem of what to do with the excess cash generation. As I mentioned, we do think this low CapEx will extend for several years. The Worldport expansion and our international assets have positioned us well. We are going to have a number of years of belowtrend CapEx and abovetrend free cash flow.

We do review dividend primarily at our February board meeting, and we'll make some decisions on the dividend policy going forward. Scott?

Scott Davis

As far as the share repurchase, I think we'll be looking at that hand in hand. Clearly last year we decided to sustain our dividend, and we held off on share repurchases. We did last year redistribute to shareowners about 100% of our net income. So we did that through reduced share repurchase, but continued dividend. Clearly we have no intentions of building a large hoard of cash. Over time, we will be deciding when it makes sense to get more aggressive in the market.

Edward Wolfe Wolfe Research

As a followup or a second question, Kurt earlier you said existing contracts, when you were talking about pricing, even some existing contracts that may be assigned during a more competitive period below market you would go back into. How do you go back into them? Can you explain the mechanism and how prevalent that ability is?

Kurt Kuehn

That's pretty limited. I guess what typically happens for ones that may be outside the normal contract renewal, certainly we're doing during the very tough economic times a lot of customerinitiated renegotiations in which you may have a twoyear contract, but the customer comes back and says, hey, we've got to do something.

As those opportunities occur, we are discussing those; and clearly in this environment we're making sure we look at which way the prices should go if the contracts open back up. That's more of what it is than us aggressively reopening customers that are happy with where they're at.

Operator

Your next question comes from Ken Hoexter Merrill Lynch.

Ken Hoexter Merrill Lynch

You mentioned, Kurt, about a dime or so led to the $100 million of savings. I want to clarify none of that is in your target yet, to clarify that. If it's not, looking at labor or comp and benefits as a percent of revenue, you've gotten down to kind of about 53% now if you take out that other $100 million, maybe get into the 52% range. A couple of years ago you were down almost at 50%.

I am just wondering is that a trend you can see continuing to get those costs down? Is there something on the labor side in addition to that you can keep getting cost down or is this about as tight, you think, on the labor side as we're going to see it?

Kurt Kuehn

I think that has more to do with our mix of businesses. That movement has more to do with whether domestic packages is a higher or lower total proportion of the total company. If you look at forwarding, if you look at our logistics group, those all have dramatically different mixtures of direct labor to total revenue.

We're very pleased with the momentum we've seen in our domestic and international labor results. You can see probably the better measure to look at is the relationship of volume and comp and benefit expense which we more than offset, even with the headwind we've had of high inflation in the wages because of the reduction in our staffing. As our growth comes back, we'll begin to hire new employees. That has a very beneficial impact on our overall average wage rates and should further accelerate some of our efficiencies.

Scott Davis

That's a good point. Clearly the effect of wage rates is the thing that we saw several years ago, even though we had a higher contractual increase, we were running probably a little under 2%. This year we ran over 5% in part of the year and went down to 4% in the fourth quarter. That's without growth. As we start seeing this growth come back in 2010, clearly that will have an impact on that ratio.

Kurt Kuehn

In Q1, we do kind of cycle through most of those increases in our percentage of fulltime people that are at the seniority rate. That's another benefit as that issue starts to flatten out. That will help us as we move forward in the year.

Ken Hoexter Merrill Lynch

Then on the LTL side, on the freight side, were you surprised that I guess with the struggles of some of the competitors out there that volumes weren't a little bit stronger or is that sounds like on your pricing side maybe that was an intentional move not to get some of that freight? I am just wondering if you can talk a little bit about your move there.

Kurt Kuehn

I think we have been extremely consistent this year in the LTL arena. We have not been aggressively pursuing volume at the expense of yields. That's why, I think, we have led the industry in our revenue per hundredweight consistently with it possibly up, I think, 2.8% this quarter.

We feel that the inherent advantages we have with the customer access, with the deep integration of technology into LTL processes, and with the quality and speed of the network, we would rather continue to steadily gain through our bringing LTL services to our existing customer bases, rather than being out there trying to aggressively gain share to perhaps drive a competitor out. We're being patient, but we think that will lead for sustainable results and also the most profitable outcome longterm.

Scott Davis

You got to remember that industrial production, again, in the fourth quarter was down 4.6% yearoveryear. That's still the best barometer for the LTL industry. Until you really see manufacturing kick in, that's when you will see LTL kick in.

Operator

Your next question comes from Robin Byde HSBC Securities.

Robin Byde HSBC Securities

Just two questions. On international package and the Shenzhen hub, are additional volumes from that facility opening in Q1 built into your fullyear guidance? Then, secondly, just a sort of more general question on demand recovery. Across your businesses, are you detecting a sustained restocking by purchasing managers or is it too early to come to that conclusion?

Kurt Kuehn

I will cover the Shenzhen hub and then Scott can talk a little bit about the restocking issue, which seems to be a hot topic. Certainly we have embedded in our overall annual perspective some benefit from the Shenzhen hub, although frankly we're not overextrapolating that. But it will give us a very efficient and also superior service for the intraAsian volume.

So we do expect to see some real benefits from that. It will also be a great way to serve the whole southern China area. That will kick in beginning in February and we'll continue to lever that. That, along with the global impact, which was a very large impact as Asia began exporting more in Q4, it helped to drive the recent results.

Scott Davis

I think the big change we saw in the quarter on inventories was not so much that inventories grew, but they stopped declining. I think that's what we saw drive the U.S. GDP last quarter. Not so much the growth in inventories, but the fact they stopped declining at the pace they had nine months of the year. I think inventories are still pretty low and have room to grow as we move into 2010.

Operator

Your next question comes from William Greene Morgan Stanley.

William Greene Morgan Stanley

Can we talk a little bit just on the B2C, the change in the domestic B2C volumes in the fourth quarter in 2009? Where were they?

Kurt Kuehn

They were up slightly. Certainly during the holiday season they were up more substantially. We did see modest growth in the B2C.

William Greene Morgan Stanley

Obviously all throughout 2009, they grew then. If we sort of look at this going forward, that seems to be an area where there should be a bit more growth just given the changes that are going on in customer behavior. How do you think about serving that? Obviously that has challenges from a cost perspective to service a single delivery to a rural location or whatnot. Is the Post Office a big part of the solution there, or do you think about managing that?

Kurt Kuehn

That's a good question. I guess for starters, though, what we're actually seeing the biggest change in sequentially is the B2B growth. We do think that at least for the next several quarters, this recovery will be more B2B driven. So the B2C has been more steady over the last few quarters. We have seen successive strengthening of the B2B.

On the B2C side, when the consumer gets a little more confident we will see a bigger boost in that. For some time we were seeing doubledigit growth. Clearly that's moderated. But the B2C certainly is a longterm trend that is positive. That's why we're focused on providing a range of opportunities.

We do have a portfolio from our traditional ground services, even premium services for residential, and to also our basic service, which is a bit of a hybrid solution in which the extended areas are given to the Post Office for last mile and we deliver in the more dense areas.

Then at the very lightest end we also have our Mail Innovations business, which is growing very strongly that sorts primarily packages of one pound or less and also injects those into the Post Office. We do see a collaboration on this environment. We think that's the direction of the future.

Scott Davis

I think clearly even with people on the smart phones today you are seeing more and more people buy over the internet using those phones. Obviously that's why we did the applications with BlackBerry and the iPhone. I think you are going to see continued growth in that area. As Kurt said, I think we're positioned very well to serve that.

Operator

Your next question comes from Art Hatfield Morgan, Keegan & Company.

Art Hatfield Morgan, Keegan & Company

Kurt on your comments about the 2010 guidance, you commented for the full year that Supply Chain & Freight would have margins of 5%. Can you comment on whether or not that's a level you're happy with and potentially where that could go?

Kurt Kuehn

In the shortterm, we see that as acceptable. We certainly would hope to be able to get higher than that over time with a good robust economy. We're looking more for upper singledigit margins over the long term.

And within that segment, clearly you will have different results for LTL versus forwarding. Forwarding is very asset light. Then our logistics business, which kind of sits in the middle. 5% is where we think we will get to this year. We would certainly like to get a little higher than that long term.

Scott Davis

I have made it pretty clear to our people around the supply chain side that we expect to be mid to uppersingle digits. So we're not happy at 5%.

Art Hatfield Morgan, Keegan & Company

Then as a followup, kind of jumping over to domestic. In your commentary and in the release you talk about yields being impacted by weight per package declining. Can you talk a little bit about that in more detail and maybe how that trended in the quarter? And if you're seeing maybe a more permanent mix shift or is that still just an economic impact you're seeing?

Kurt Kuehn

We've done a lot of work on that. There has been a longterm secular trend of modest weight declines over the years as goods have gotten smaller. That's been hugely accelerated by the economic slow down. As we've gone back and looked at past recessions, in the express business and in the commercial ground business, it's very typical that weights move with the economy.

On the residential side, that's been more of a steady one that moves beyond cycles. We are highly confident that weights will begin to improve this year in the commercial arena and in the express business. That's highly beneficial to us because those packages drive modest increases in cost, but substantial increases in yield. We're very confident that will happen. You still may see long term some slight declines in weight as goods continue to get smaller. But the big impact right now is the economy.

Operator

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

David Campbell Thompson, Davis & Company

I wanted to ask you why the cargo revenues were flat from the third quarter and down from last year despite these huge rate increases in the Asian Pacific region.

Kurt Kuehn

I think a lot of that was a good problem for us because a lot of people traded up to express package. As a result, there was less capacity on the airplanes to fly the heavy freight. Really it was a good issue for us.

David Campbell Thompson, Davis & Company

Then following up on that, is it that easy to fix the squeeze? It would seem to me we have demand, capacity hard to get that you should have been able to compensate for that with higher rates in the fourth quarter and not have to wait until the first quarter.

Kurt Kuehn

There's really three pieces to this. There's what percent of the plane has small package on it. And with the demand picking up, there was less available space for us to sell cargo. There's just plain less available space. We also directly sell cargo in our airplane for what's left. Then the majority of what we move actually is done by our forwarding unit. 80% of what they hire is not UPS assets.

That's really where the challenges on the rates were. We were able to fill up our airplanes with very high yielding express and higher yielding cargo, there just wasn't as much room left for cargo because of demand.

Scott Davis

The spike in demand came on awful quick. In fact our forwarders who have been in the business for decades have not really seen one come on quite that quick in the past. I think it caught all the forwarders a little by surprise.

Operator

Your next question comes from John Barnes RBC Capital Markets.

John Barnes RBC Capital Markets

Can you quantify a little bit the expenses associated with your employment initiative? You said those expenses were going to range from the first to the third quarter. Can you quantify the size of that expense bucket?

Kurt Kuehn

We said that after that is done for 2011, we expect to see $0.10 a share aftertax benefit. That gets you somewhere in $160 million to $170 million savings. For 2010, that will basically be offset with the expenses that we'll be booking for those items. Plus you don't have the whole year to get the benefit of those expenses. That would be the annual burn rate. Really the savings don't kick in until beginning in late April. You get about a half of the year, maybe a little more than that, worth of savings and that's total offset by the expenses.

John Barnes RBC Capital Markets

On the LTL side of the business, since you bought it, you have run into bad economy, struggling competitors, pricing environment that certainly has been pretty poor. Have you given any thought  has there been any change in your strategy as it relates to the freight division? Are you looking at potentially scaling it back or scaling it up? I mean do you think it's the right size now or do you need to get bigger? How do you think about it just given what you've faced since you bought the division?

Kurt Kuehn

Our timing wasn't the best. I will own up to that one. Clearly we studied the LTL environment, and we did purchase Overnite in 2005. We had a year or two of decent results as we began to restructure it. We have invested a lot of money in it, frankly, because we're very confident that it adds tremendous synergies to our customer base.

I think as we look at our confidence in can UPS bring value in this base, we are extremely confident. The technology initiatives we've done, we think, are reinventing the industry in some ways. The alignment of when do you use package, when do you use pallets, we think there's a lot of room for companies to save money.

At a high level, we think we're bringing value to the marketplace; and we think we can also drive value to shareowners. Unfortunately, it's been a very tough time for that. So we've been disappointed with the financials.

Scott Davis

You know our history. We're patient investors. We went through the international package area in the '80s and '90s. It took us a long time to get it there. Obviously it's tremendously profitable today. Supply chain, the forwarding logistics, we invested there in the early part of this decade. It's starting to show the profits in that arena. We expect the same in the LTL arena.

Operator

Your next question comes from Justin Yagerman Deutsche Bank North America.

Justin Yagerman Deutsche Bank North America

You have been talking about it on the U.S. domestic package side. Fuel was up sequentially, but yields were definitely off on a sequential basis. I know it impacted the yearoveryear, but I was a little surprised in that sequential change.

Can you talk a bit about the competitive dynamic in the ground market and maybe a bit about the impact from DHL on those yields on a yearoveryear basis? Then I guess as part of that, the repricing opportunity in the beginning of the year.

Kurt Kuehn

You threw out a couple of pieces there. I will try to knit them together. Certainly DHL exiting the market had a big impact both on volume shifts and also on average yields. DHL was significantly lighter on average than the UPS volume. As we absorbed their volume into our ground and air networks, it did have a negative impact on our average yields yearoveryear.

On top of that, the average weight of the packages across the network got lighter as there were less widgets per box with the economy being weak. Fuel surcharges were a headwind in Q4. For example, the air averaged about 21% fuel surcharge last year. This year's quarter it was just a little over 7%. Some pretty big headwinds still yearoveryear with fuel surcharges. That will begin to moderate in Q1.

All of those moving parts do have an impact as we cycle through. Now Q1 will be the first quarter really without a significant impact of the DHL overlap. There was some share shift in January for the air volumes, although the ground really had shifted totally by Q4. That noise will moderate anyway. As I said, we're highly confident with the firming economy we'll see strengthened weight and improved pricing power going forward.

Justin Yagerman Deutsche Bank North America

From a competitive dynamic in the international on the same theme, do you find that you're picking up share that DHL has impaired from an international sales standpoint? Or are you picking up market share in Asia because of their impairment coming into the U.S.?

Kurt Kuehn

We are seeing, we think, continued share gains across the globe. In Europe which clearly is continuing to have economic struggles, we're continuing to see growth. You are seeing it in our nonU.S. domestic business, and we're seeing it in Asia.

We continue to feel very positive about the advantage UPS has of having a broad coverage in all three major economic environments. That story is still being written. It takes a long time to reach out to customers all across the globe. Our salespeople are very busy. We have had a significant focus on conversion opportunities, frankly, as UPS offers that unique coverage of Asia, Europe, and America.

Operator

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

David Ross Stifel, Nicolaus & Company

First a question on UPS Freight. I noticed that all the shipment levels stayed relatively flat, weight per shipment fell. That's been going on for a little while at UPS Freight now. I am not sure if it's just the economy or because you're penetrating the LTL market with your small package sales or if there's some characteristics of smaller shippers. Do smaller shippers have lower average shipment weights than kind of large national accounts?

Kurt Kuehn

That's a very insightful question. You are seeing a mix change at work here. We are growing more effectively in the middle market where UPS' value proposition is extremely strong. We are helping customers balance what goes in our ground hundredweight service, what goes on a pallet, and so the crossover point in some cases can be lower.

Typically we do see a lower weight in the middle market than you would at the very large end. Typically the shipment sizes aren't as large. All of those have lowered our average weight per shipment. We're continuing to show market leading results in our shipment growth, but the average weight per shipment is lower.

David Ross Stifel, Nicolaus & Company

Then on the technology front, you mentioned a little bit about the iPhone and BlackBerry shipping apps. I was curious just as to what the impact you think that's going to make over the next year or so. How does that really make it easier for shippers to ship? How many people use it? What is involved there?

Scott Davis

I think it's really another one of these major trends we're seeing where more and more people are going to use their smart phones to buy over the internet. I think us having the ability to have these applications  we think the best applications out there  will obviously enhance the use of UPS going forward. Clearly, I think it's going to drive more B2C shipments in the future.

Kurt Kuehn

And the UPS app is one of the leading B2B applications on iPhone right now, for example. We have seen good customer adoption.

Operator

Your last question comes from Scott Flower Macquarie Securities.

Scott Flower Macquarie Securities

I wanted to follow up a little bit on Asia and get a little more color. Are the patterns any different in terms where you're seeing volumes go in terms of the different trade lands? And then related is there any concern that some of this rush or displacement because the air freight side was so capacity constrained into the small package division will abate as you go further into 2010?

Kurt Kuehn

I think that is an issue. That's part of our conservative guidance, I think, in Q1 perhaps. We knew there was a big rush in Q4. It did help to drive volume both into our forwarding and our package network. We're a little uncertain just how that will wind down. So far for January, we are seeing continued firmness.

Coming out of Asia, we saw a real strong growth from Asia to Europe, actually  over 20%. That's been a real interesting story. That had been one of our leading lanes. It moderated during last year, but it was tremendous to see that coming back. Actually the yearoveryear Asia to Europe was a much stronger trend than Asia to the U.S., although the Asia to the U.S. did firm.

Scott Davis

There was an awful lot of technology demand both out of the U.S. and Europe in the fourth quarter. Not enough attention has been paid to that, but there was an awful lot of demand out of both Europe and the U.S. The other area is intraAsia is an area that will continue to grow and outperform going forward. I think our new Shenzhen hub will really highlight and help the performance there for UPS.

Scott Flower Macquarie Securities

Then my followup is I know you all talked about the changes in the structure in the U.S. I remember back, I think I am the last analyst from the IPO. Scott you talked a lot about restructuring, structural costs in the U.S. in trying to get leaner. Is this part of that longerterm roll out? Are there other things that become part of the structural costs in the U.S. that you are looking at longer term?

Scott Davis

This company has transformed many times over the 102 years we've been in business. This is just another transformation. Clearly the technology is allowing us to do a lot of consolidation. It wasn't that many years ago that we had 11 regions and 72 districts. Now we're down to 3 regions and 20 districts  so pretty dramatic changes.

More important than the consolidation is the fact that we're going to do business differently in the U.S. It's more about how we go to market and how we interact with the customers, more about decentralizing the U.S. operations. This is a big transformation for UPS.

Operator

I would now like to turn the conference back over to your host, Mr. Dolny, for any closing remarks from him or the panel.

Andrew Dolny

I am going to turn it over the Scott for closing remarks.

Scott Davis

It looks like this recession is finally over. Believe it or not, that makes 21 that UPS has successfully managed through. As we head into a brighter 2010, as our volume increases, you need to know that network efficiencies will improve, increased densities will reduce costs, and new employees will come on moderating our average wage rate increases. This will all lead to margin improvement in the years ahead. Thanks for joining us today.

Operator

That does conclude your conference call for today. I would like to thank you for your participation and thank you for using AT&T. Have a wonderful day. You may now disconnect.

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Source: United Parcel Service, Inc. Q4 2009 Earnings Call Transcript
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