FedEx Corporation (Qtr End 8/31/07) Earnings Call Transcript

Sep.23.07 | About: FedEx Corporation (FDX)

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FedEx Corporation (NYSE:FDX)

F1Q08 (Qtr End 8/31/07) Earnings Call

September 20, 2007, 8:30 AM ET

Executives

Mickey Foster - VP, IR

Frederick W. Smith - Chairman, President and CEO

Alan B. Graf, Jr. - EVP and CFO

T. Michael Glenn - EVP, Market Development and Corporate Communications

David J. Bronczek - FedEx Express President and CEO

David F. Rebholz - FedEx Ground President and CEO

Douglas G. Duncan - FedEx Freight President and CEO

Christine P. Richards - EVP, General Counsel and Secretary

Analysts

Ken Hoexter - Merrill Lynch

Art Hatfield - Morgan Keegan

Jon Langenfeld - Robert W. Baird & Co.

Tom Wadewitz - J. P. Morgan

Bill Greene - Morgan Stanley

Donald Broughton - A. G. Edwards

Ed Wolfe - Bear Stearns

Scott Flower - Banc of America Securities

Gary Chase - Lehman Brothers

Jason Seidl - Credit Suisse First Boston

David G. Ross - Stifel Nicolaus

Presentation

Operator

Good day everyone and welcome to the FedEx Corporation First Quarter Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mickey Foster, Vice President of Investor Relations. Please go ahead.

Mickey Foster - Vice President, Investor Relations

Good morning and welcome to the FedEx Corporation First Quarter Earnings Conference Call. Our earnings release and stat book are on our website at fedex.com. This call is being broadcast from our website and the replay will be available for approximately one year. Joining us on the call today are also members of the media. During the Q&A session, callers will be limited to one question and a follow up so we can accommodate all those who would like to participate.

I want to remind all listeners that FedEx Corporation desires to take advantage of the Safe Harbor provisions of the Private Securities Litigation Reform Act. Certain statements in this conference call may be considered forward-looking statements such as statements relating to management's views with respect to future events and financial performance. Such forward-looking statements are subject to risks, uncertainties and other factors which could cause actual results to differ materially from historical experience or from future results expressed or implied by such forward-looking statements. For additional information on these factors, please refer to FedEx Corporation and its subsidiaries press releases and filings with the SEC.

To the extent we disclose any non-GAAP financial measures on this call, please refer to the Investor Relations portion of our website at fedex.com for a reconciliation of such measures to the most directly comparable GAAP measures.

Joining us on the call today: Fred Smith, Chairman, President and CEO; Alan Graf, Executive Vice President and CFO; Mike Glenn, Executive Vice President, Market Development and Corporate Communications; Chris Richards, Executive Vice President, General Counsel and Secretary; Rob Carter, Executive Vice President, FedEx Information Services and CIO; Dave Bronczek, President and CEO of FedEx Express; Dave Rebholz, President and CEO of FedEx Ground and Doug Duncan, President and CEO of FedEx Freight.

And now our Chairman, Fred Smith, will share his views on the quarter followed by Alan Graf, and after Alan, we'll have Q&A.

Frederick W. Smith - Chairman, President and Chief Executive Officer

Good morning ladies and gentlemen. Thank you for joining our conference call highlighting our FedEx financial performance during the first quarter of fiscal year '08. As you saw from the release, FedEx increased revenue and earnings despite a U. S. economy that has slowed by sharp correction in the housing market, financial volatility and high energy costs.

Outside the United States, the global economy is performing solidly with some signs of strengths in major emerging markets and most industrialized countries. We remain upbeat about long-term economic trends.

FedEx is a true global company with a presence in more than 220 countries and territories. We understand that our business is ultimately driven by long-term macroeconomic trends such as deepening trade and the broadening of global integration. In the long run, we believe FedEx is well positioned to benefit from these developments.

In the first quarter of FY08, total average daily package volume at FedEx Express and FedEx Ground grew 8% year-over-year. Volume increases were helped by growth in international domestic express shipments as a result of recent acquisitions in the United Kingdom, China and India.

Now as we've said before, we intend to continue to expand and strengthen the FedEx portfolio of services, giving more options to our customers and more opportunities to FedEx. In that regard, we recently launched a dedicated direct FedEx Express flight between Manchester in the United Kingdom, the fastest growing region in the United Kingdom and the U. S. FedEx Express will fly a wide-body MD-11 freighter daily Monday through Thursday between Manchester International Airport and our Super Hub here in Memphis, Tennessee. The flight originating at the FedEx European Hub in Paris will increase FedEx daily capacity on the important UK to U. S. route by up to 50% and increase daily capacity from Europe to the United States by about 20%. Later cut-off times will benefit our customers substantially.

In Europe, FedEx Express plans to locate our largest German gateway from Frankfurt/Main to the Cologne/Bonn Airport in 2010 as a result of the rapidly growing demand for our express services in Germany and Eastern Europe.

In China, FedEx Express in expanding its next-business-day intra-China service to reach more customers. Since FedEx began that service on May 28th, coverage has grown from 19 to more than 30 cities and countries... excuse me, cities and counties within China. Our 48-hour day-definite service is offered in more than 200 cities. Because of increasing customer demand, the number of cities being served continues to expand rapidly.

We announced the expansion of FedEx Transborder Distribution services for cross-border trade between Mexico and the United States. This enhanced solution provides importers and exporters with a portfolio of FedEx services designed to simplify cross-border trade and help their businesses flourish. This expansion includes the recent opening of two border facilities: one in Juarez, Mexico and the other in El Paso, Texas. It helps simplify the supply chain process by managing transportation, brokerage and distribution of services that cross the Mexico-U. S. border.

On our Northern border, FedEx Freight Canada opened its service center in Calgary, making the first ever direct LTL carrier presence for FedEx in Alberta and Western Canada. By the end of this year, FedEx Freight Canada will offer service in more than 7000 cities and 10 Canadian provinces. The company also will provide direct coverage to the continental United States as well as service to Alaska, Hawaii and Mexico through FedEx Freight. Overall, we believe FedEx Freight has an outstanding value proposition with 99% on-time service.

The freight business, however, has been impacted by the slowing economy, especially the housing markets. At FedEx National LTL, the reengineering of that network is complete and we are pushing record productivity levels. FedEx National LTL now is delivering 98.9% on-time service, which is consistent with the FedEx brand and in line with the value proposition we described when we acquired Watkins Motor Lines and turned it into FedEx National LTL. We now have a single integrated sales force that is well educated on our product portfolio and well equipped with a maximum sales effort underway.

Now I would like to bring to your attention two announcements within our earnings press release. One is the realignment of FedEx Kinko's to become part of FedEx Services, which has overall responsibility for sales, marketing and customer-facing information technology for all FedEx companies. And secondly, a new incentive program designed to help FedEx Ground contractors grow their business. We believe the realignment of FedEx Kinko's makes strategic sense because the previous reporting alignments simply did not paint a true picture of the value of the FedEx Kinko's network to FedEx Corporation.

The FedEx Kinko's network is now handling about $900 million of express and ground business annually. This is growing rapidly and adding substantially to our bottom line. Now I would note again that the vast majority of the profits generated out of that $900 million are reported in the transportation segments. These packages that come through the FedEx Kinko's locations are among the most profitable in our networks. By bringing the critical access of FedEx Kinko's into FedEx Services, we will leverage the complete portfolio of shipping and office services to more fully penetrate high growth customer markets. We can achieve synergies in sales, marketing, information technology, pricing, and administrative areas by putting FedEx Kinko's into FedEx Services, and this network will continue to play a critical role in the FedEx growth strategy.

At FedEx Ground, we are investing in a new nationwide program, providing greater incentives to any of our 15,000 contractors who chose to grow their business by adding additional routes. This is part of our ongoing efforts to strengthen our independent contractor network.

Also in California and in response to regulatory and legal uncertainty there, FedEx Ground is offering special incentives to encourage single-route contractors to transform their operations into multiple-route businesses or sell their routes to others. At the same time, multiple-route owners are being offered incentives to acquire available routes.

In closing and before I turn the microphone over to Alan Graf, I want to remind you of our steadfast commitment to continue to grow our revenues, to achieve 10% operating margins, to increase earnings 10% to 15% per year, to continue to improve cash flows and to increase the returns on our investments.

Now I would like to turn it over to Alan Graf, our CFO. Alan?

Alan B. Graf, Jr. - Executive Vice President and Chief Financial Officer

Thank you very much Fred. Good morning everyone. We are very pleased with our first quarter results of $1.58 per share versus $1.53 a year ago in the midst of what is a sluggish U. S. economy as Fred mentioned. Our performance was led by improved performance at Express and Ground.

At Express, international priority package revenue grew by 9% as volume was up 6% and yield up 3%. That's our strongest volume performance in some time. Volume growth in Asia Pacific was a strong double digit and U. S. outbound and EMEA also had a strong growth. Productivity at Express continues to improve as technology and new efficiency programs are working very effectively. My partner, Dave Bronczek, will have more to say on that later in the meeting.

Ground's volume growth of 10% is again leading the industry. Margins improved in the segment by 50 basis points as improved port productivity and revenue growth more than offset increases in legal and settlement fees and SmartPost performance was up sharply as well.

In the Freight segment, revenues increased 22% during the first quarter as a result of the inclusion of results of FedEx National LTL. The inclusion of FedEx National LTL led to an increase in average daily LTL shipments of 13% and contributes significantly to the LTL yield increase of 8%. However, average daily LTL shipments excluding FedEx National declined slightly in the first quarter as demand for services in the entire LTL sector has been significantly restrained by the slowing U. S. economy. Freight segment operating income decreased 30%, reflecting operating losses at National and slower year-over-year growth in regional LTL yields. Operating losses at National continue to be driven by softening volumes due to the slower U. S. economy.

FedEx Services segment revenues, which now include the operations of FedEx Kinko's as well as FedEx Global Supply Chain Services were flat year-over-year. Copy product revenues declined at FedEx Kinko's, more than offsetting higher package acceptance fees and revenue generated from new locations.

I want to expand a little bit on Fred's previous comments and what we've said in the release about our accounting reorganization of Kinko's.

During the first quarter, we revised our reportable segments as a result of this internal reorganization. Kinko's is now a part of the FedEx Services segment. FedEx Services and FedEx Kinko's have missions that are uniquely aligned. FedEx Kinko's provides retail access to our customers for our package transportation businesses and an array of document and business services. FedEx Services provides access to customers through digital channels such as fedex.com. Under FedEx Services, FedEx Kinko's will benefit from the full range of resources and expertise of FedEx Services to continue to enhance the customer experience, provide greater, more convenient access to the portfolio of services at FedEx and increase revenues through a retail network.

As part of this reorganization, we will be pursuing synergies in sales, marketing, information technology and administrative areas. With this reorganization, the FedEx Services segment is now a reportable segment and prior year amounts have been revised to conform to the current year segment presentation.

On June 1, 2007, we adopted Financial Accounting Standards Board Interpretation Number 48, accounting from uncertainty in income taxes. This interpretation establishes new standards for financial statement recognition, measurement and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. The cumulative effect of adopting FIN 48 was immaterial. Upon adoption, our liability for income taxes under FIN 48 was $72 million.

Looking ahead, I would like to remind everyone that in our previous guidance we had expected the economy to improve by late summer or early fall. We now know that is not the case. In fact, we believe that U. S. GDP will grow less than 3% on a quarter-over-quarter basis for the rest of fiscal '08. As a result of this weaker than anticipated economic environment, and almost entirely based on the LTL freight market and the outlook for Freight results, we have reduced our earnings forecast by 4% for the full year to $6.70 to $7.10 per share. In the second quarter, in particular, rising fuel price is working against us versus our previous year's earnings.

Lastly, beginning this quarter, we are expanding our operating statistics disclosures significantly. FedEx Express is now disclosing volume and yield information for international domestic shipments. These are shipments where the origin and destination are both within the same non-U. S. country and include the United Kingdom, Canada, China and India. Additionally, FedEx Ground is now disclosing volume and yield information for FedEx SmartPost.

Steve, we are now going to open up for questions. I would remind everyone, we would please to limit yourself to one question and one follow up so that we can hear from everybody.

Question And Answer

Operator

Thank you. [Operator Instructions]. And we'll first go to Ken Hoexter with Merrill Lynch.

Ken Hoexter - Merrill Lynch

Hi, good morning.

Frederick W. Smith - Chairman, President and Chief Executive Officer

Good morning, Ken.

Ken Hoexter - Merrill Lynch

Can you talk a bit about, in your outlook, what kind of level of Express growth have you built in? If we go back to fiscal '01, '02, we saw Express volumes down about 7%. How do you anticipate this housing credit crunch looking into the volumes impacting the results? I mean last quarter we saw you kind of set a target that was probably a little bit better than people thought. Now, is it coming back down to below that $7 range on the lower end. Just want to see what you are building in as far as the weakness on as you commented on the GDP.

Alan B. Graf, Jr. - Executive Vice President and Chief Financial Officer

Well, I think the news there, Ken, is we are going to probably see more of the same for the rest... for the year that we saw in the first quarter. We are anticipating continued very solid international priority growth and yields. Obviously, we are benefiting some from exchange rate on a yield side, and that's helpful as well. The domestic express market with the very high surcharges as a result of high fuel price probably going to remain flat, and I'll let Mike expand on that a bit.

T. Michael Glenn - Executive Vice President, Market Development and Corporate Communications

Ken, that's been our position for some time that the U. S. domestic express market will remain relatively flat to slightly declining. We see that continuing into the future, although, clearly, if you look at our network on a global basis, we do have significant growth opportunities outside the U. S.

David J. Bronczek - FedEx Express President and Chief Executive Officer

Ken, this is Dave Bronczek. Let me just add a little bit more to that. The comment that Alan made in his opening remarks are important. We obviously have managed our business as Mike Glenn just pointed out on a domestic express volume and revenue basis to the point where we are very pleased with our cost controls and our overall productivity. In fact, if you look at our system wide productivity, our costs grew only half that of our revenue around the world excluding acquisitions.

Ken Hoexter - Merrill Lynch

Okay. If I can get my follow up on the Ground side, very solid volume and yields, but it looks like costs crept up aside from fuel, looks like the purchase transportation cost. This whole incentive or pressure on the single-route drivers, is that part of the purchase transportation costs? Were there other legal fees thrown in here? Are we going to continue to see that climb until you convert those single-route drivers? And can you kind of detail what kind of incentives or pressure are on those single-route drivers to now sell the routes to or form multi-route... multiple routes?

Alan B. Graf, Jr. - Executive Vice President and Chief Financial Officer

Ken, it's Al. I'll take part one and I'll turn it over to Dave Rebholz. In the first quarter, as I mentioned, we had a number of legal settlement charges that impacted Ground's expense structure. But even with that, we still had a 50 basis point improvement in the margins. And again, that's based on strong growth, volume growth of 10%, industry leading by far, good yield management and really great productivity, the same as we are seeing at Express. I'll turn it over to Dave for the rest of that question.

David F. Rebholz - FedEx Ground President and Chief Executive Officer

Yes, Ken, this is Dave. Alan pointed out the high level points. If you look at all the fundamentals of our business outside of the legal settlements, we are hitting with all eight cylinders; volume growth is great, revenue growth is great. On a go forward basis, he already mentioned the fact that it's immaterial in terms what the expense associated with the California conversion is. But to give you a sense of it, we have just simply offered choice to our contractors that allow them to pick one of five different options. Our interest is not elimination; our interest is compliance in dealing with this ambiguous situation, which, by the way, our contractors are frustrated with as much as we are. So we simply made a decision to help facilitate a move forward direction within California. We are still very strong and committed to the contractor model. While it is immaterial, rather than going through the details of the options, I would love to have the opportunity to express the options today to my contractors. But again, it's all about choice, it's not to drive them out the door and it's not a material financial implication. And then behind that, nationally, we are very committed to facilitating what we call the multi-work area model, which is contractors that have employees working for them. We find that there are both quantitative efficiencies associated with that model and there are qualitative aspects that allow that model to just really provide the kind of experience we are looking for for our customers. So while we support the single work area contractor model, California simply puts itself in a position where we had to make a choice, and this is the choice we made because we support the contractor model.

Operator

Thank you. Our next question comes from Art Hatfield with Morgan Keegan.

Art Hatfield - Morgan Keegan

Good morning guys.

Frederick W. Smith - Chairman, President and Chief Executive Officer

Good morning, Art.

Art Hatfield - Morgan Keegan

Hey, just Alan, quick question on the guidance you gave. Looking at the results in Q1 and kind of midpoint of the range for Q2, looking out for the rest of the year, getting to the midpoint would assume somewhat of a little bit of a year-over-year pick up in earnings growth. Can you address that a little bit kind of what your expectations are for the economy for... I know you mentioned GDP growth expectations, but what your expectations are for industrial production growth and other factors that can impact your business over the next couple of quarters?

Alan B. Graf, Jr. - Executive Vice President and Chief Financial Officer

I'll start and then I'll have Mike elaborate, Art. Really, the issue that we are dealing with versus our previous guidance in Freight, as you well know, the LTL and trucking business in general is in disarray. Tonnage is down year-over-year. We are holding or increasing our market share, but we are nowhere near the volumes that we had planned for. So we have unbelievably stringent cost controls and capital reductions going in there because we don't think we are going to see the growth that we had originally felt we were going to see, and that's having an impact on this particular year's earnings. If we get any sort of better pick up, then what I outlined to you and growth kicks up a bit, that will... we will be very well positioned to benefit from that. But we frankly just don't see it. I'll let Mike and Doug to that.

T. Michael Glenn - Executive Vice President, Market Development and Corporate Communications

Art, on just industrial production numbers, what we see looking at calendar quarters here, in the fourth quarter, we see a decline from the position of third quarter somewhere in the neighborhood of 3.2%, again, quarter-over-quarter in the first quarter of '08 dropping below 3% and then in Q2, which would be roughly equivalent of our fourth fiscal quarter right around 3. So certainly not an increasing trend. Consumer spending again less than 2.5 and the next couple of quarters right around there on an average basis, picking up maybe a little bit in the second quarter of '08. So, clearly, not a strong outlook, not as strong as we would like.

Douglas G. Duncan - FedEx Freight President and Chief Executive Officer

Art, this is Doug. Clearly, we are being... we can track most of our softness to the durable goods sector, which is heavily influenced by housing, which I don't think is going to get better quickly. But having said that, we still have 60% of the market where we can go chase, that is growing and we do have a value proposition that's superior to our competition. So we can begin to take market share in some of those other segments. And of course, as Fred mentioned, having the reengineering now completed at National, we have a whole new market that we can chase and we do have a superior value proposition with reliability and the low cost producer in that market. So we'll certainly be turning up the steam on that one.

Art Hatfield - Morgan Keegan

Thank you. If I could ask one follow up, Alan. Just so I understand the new reporting, from the reportable segment standpoint, Services, you are going to report a revenue number but the net will be allocated to the different transportation units?

Alan B. Graf, Jr. - Executive Vice President and Chief Financial Officer

Precisely.

Art Hatfield - Morgan Keegan

Okay. Thank you.

Operator

Thank you. We'll take our next question from Jon Langenfeld with Robert W. Baird.

Jon Langenfeld - Robert W. Baird & Co.

Good morning. First on the CapEx outlook. What sort of magnitude do you think is a possible revision range and when will you determine that?

Alan B. Graf, Jr. - Executive Vice President and Chief Financial Officer

Well, two or three buckets there to talk about Jon. One, we are going to be very aggressive in international. We are not going to back off that any. That's the best value adding proposition we have for our shareholders and our customers. And so at Express, those plans are going to remain intact. In fact, if we have an opportunity to accelerate, we will. The Manchester route is one of the best performing we have ever put in, accretive within 6 months and posted the normal 18 to 24 months to get to profitability. So I think we are in great shape there. Same with the Ground. 10% year-over-year growth is a lot of packages, requires a lot of sort capability and we are going to continue to expand that network as we continue to grow that volume. As I mentioned, we are going to back way off of the freight and slow down the addition of doors and some other things until we see that growth get back on the plane [ph]. But that's just short term; in a long run, we are still very confident in those networks. We think they are going to provide a significant return. So I don't think we'll spend the $3.5 billion this year, and we'll just have to see how it goes. But right now, it's just mainly focused in the freight area, and that's not as significant of the capital expenditures as international express.

Jon Langenfeld - Robert W. Baird & Co.

Got it. Okay, that sounds good. And then on the guidance side, the outlook that everyone has given here is not expecting much of a pick up here in the near term. And yet, relative to what you are going to come in in the second quarter, looks like the [ph] second half, you are still expecting double-digit earnings growth. How reasonable is that given that the outlook from the segment leader here still [ph] appears to be pretty benign?

Alan B. Graf, Jr. - Executive Vice President and Chief Financial Officer

Well, I think it's extremely reasonable. Our first quarter performance at Express and Ground, we believe, is going to continue. And as I said, the real reason that we took the range down is just because of the freight market, not our company's performance but the market in general. So we have a very good comfortable feeling with this and I think it's extremely reasonable.

Jon Langenfeld - Robert W. Baird & Co.

And fuel... fuel, that's a modest impact in the second quarter, it looks like.

Alan B. Graf, Jr. - Executive Vice President and Chief Financial Officer

Well, we are chasing it up again. As you know, we have a lag in the surcharge to the price. And obviously, the weakness of the dollar and who knows what other things are driving that up to... oil prices to record levels. So jet fuel cost is going to go up faster than the surcharge. That's going to have a negative impact in the second quarter this year. And I would remind everybody in the previous year, it had a positive impact in the second quarter. So that's just part of the volatility of energy prices. Over the long run, we think they work out to about even, but sometimes we have quarter-over-quarter differences.

Operator

Thank you. We'll take our next question from Tom Wadewitz with J. P. Morgan.

Tom Wadewitz - J. P. Morgan

Yes, good morning.

Frederick W. Smith - Chairman, President and Chief Executive Officer

Good morning, Tom.

Tom Wadewitz - J. P. Morgan

Let's see, I know you've had a couple of questions on the fiscal second quarter. I was wondering if you could give us a little more sense on that guidance being... I think implying worse performance then in the rest of the year and a bigger reduction versus where the expectations were. Is LTL going to have a further sequential significant lag down, and that's where we should really model it where Express and Ground performance isn't going to be a lot different or how should we think, maybe a few further comments on how we should think about that?

Alan B. Graf, Jr. - Executive Vice President and Chief Financial Officer

Definitely continuing to see weakness in Ground, particularly versus the previous year and Express has been restrained a bit in the second quarter by the fuel price increase. There area a few other odds and ends, but that's the majority of it.

Unidentified Company Representative

Weakness in Freight.

Alan B. Graf, Jr. - Executive Vice President and Chief Financial Officer

Continuing weakness in Freight, yes.

Tom Wadewitz - J. P. Morgan

Okay. And in terms of --

Alan B. Graf, Jr. - Executive Vice President and Chief Financial Officer

I am sorry, I said Ground. I didn't mean Ground; I meant Freight. My apologies.

Tom Wadewitz - J. P. Morgan

Okay. Thank you. And in terms of the fuel surcharge reduction, which, at Freight... which I think equated to about a 4% price decrease. Is that just not having the impact you thought it would in terms of the volumes picking up? Is it something where you think instead of a quick impact, it will take a couple of quarters to really market that to the customers or what's going on with that fuel surcharge reduction at LTL and an impact from it?

Douglas G. Duncan - FedEx Freight President and Chief Executive Officer

Tom, this is Doug. The purpose of the fuel surcharge reduction was really to reach our small and medium-sized customers to make us more competitive in that space. With the large customers, we already negotiate fuel surcharges individually in our contracts. But the fuel surcharge reduction was to really reach out to a couple of hundred thousand small and medium-sized customers that we don't have a sales person calling on every week the way they have become more competitive and help us grow in that space. And it takes longer to get to those customers. So the customer response has been phenomenally positive to our fuel surcharge reduction, but the activation rates have been a little slower than we anticipated. But we still believe we'll get the benefit of this, but it takes longer to get to those small and medium-sized customers than it does the large ones that we call on every week.

Tom Wadewitz - J. P. Morgan

Okay. So you still think you'll see it, but it's just pushed out a few quarters.

Douglas G. Duncan - FedEx Freight President and Chief Executive Officer

We still think that was the right move to make. It really set us apart in the industry and really nobody has matched us. So that's really given us a real positive to market in the small and medium customer segment.

Tom Wadewitz - J. P. Morgan

Okay, great. Thank you.

Operator

Thank you. We'll take our next question from William Green with Morgan Stanley.

Bill Greene - Morgan Stanley

Yes, Alan, I'm wondering if you can talk a little bit about what percent of your expenses at Express and at Ground would be considered sort of fixed in the short term so that if we did see a reduction in the growth rate and volumes or revenues, how could you adjust... how quickly could you adjust the expenses?

Alan B. Graf, Jr. - Executive Vice President and Chief Financial Officer

Well, we are adjusting very rapidly. I'll let Dave and Dave both describe what's going on. It's very good news.

David J. Bronczek - FedEx Express President and Chief Executive Officer

Yes, William, I mentioned this earlier, but I think it's worth repeating. Our revenue around the globe excluding acquisitions is growing twice as fast as our expenses are. And as Alan pointed out, we are very fluid on this. We can ratchet down our expenses in a number of different areas. We are working on a lot of productivity initiatives. We are very optimistic about that program going forward for Express.

Bill Greene - Morgan Stanley

And on Ground?

David F. Rebholz - FedEx Ground President and Chief Executive Officer

Yes, William, this Dave Rebholz. Part of the contractor model value is based around this whole issue of volume flexibility. When contractors contract with FedEx Ground, they assume a level of risk and benefit. Now we don't expect volume to go down, but in any different area or under any different circumstances, that directly rolls back to the contractors. So in fact the contractor has a vested interest to maintain and growth the relationship with the customer because it's directly impacting them. And so therefore, we don't have the normal volatility that happens with a fixed structure. Having said that, our overhead structure is nominal outside of our capital investments, which we try to time very effectively against this volume growth. And again, we are expecting to continue to grow.

Bill Greene - Morgan Stanley

Okay. And then just one last question on the Ground yields. Can you estimate how much of that came from the change to dim weight, the growth, that is?

David F. Rebholz - FedEx Ground President and Chief Executive Officer

At this point, no... in fact, I couldn't give you an exact number with --

Alan B. Graf, Jr. - Executive Vice President and Chief Financial Officer

I'll do that.

David F. Rebholz - FedEx Ground President and Chief Executive Officer

Okay, go ahead.

Alan B. Graf, Jr. - Executive Vice President and Chief Financial Officer

It had a positive impact and helped us out on a year-over-year basis. So did rate increases and so did higher delivery surcharges, offset somewhat by a little bit of decline in weight.

Bill Greene - Morgan Stanley

Alan, is it safe to say all of those were sort of about the same in terms of percentages or was one a big driver versus the other?

Alan B. Graf, Jr. - Executive Vice President and Chief Financial Officer

Well, I think that's kind of information that I would like to keep in house.

Bill Greene - Morgan Stanley

Okay. Thanks.

Operator

Thank you. We'll take our next question from Donald Broughton with A. G. Edwards.

Donald Broughton - A. G. Edwards

Good morning everybody.

Frederick W. Smith - Chairman, President and Chief Executive Officer

Good morning, Donald.

Donald Broughton - A. G. Edwards

I noticed that the average pounds per package in Express keep going up and in previous cycles and previous slowdowns, usually the average pounds per package fall off a little bit as people are more reluctant to pay higher express package prices on the more heavy packages. Why... the slowdown in the economy happening and yet your revenue... your pounds per package keeps going up in Express. What's driving that today?

David J. Bronczek - FedEx Express President and Chief Executive Officer

Well, let me start off and then I'll kick over to Mike. This is Dave. Our international priority pounds of course keep going up and of course that's... we are focused very heavily on certain segments of the market. And of course, in the United States, it would be the bigger boxes, and that's been a lot of our strategy for the last several years. So, yes, you are right, but a lot of it has been driven by our international priority package weight growing.

Donald Broughton - A. G. Edwards

Fair enough. Great. Thanks gentlemen.

Operator

Thank you. We'll take our next question form Edward Wolfe with Bear Stearns.

Ed Wolfe - Bear Stearns

Thanks. I hate to beat a dead horse, but just more clarification on the guidance. And I don't think the issue, at least for me, is that you are taking guidance down. You said you expect the economy is not great. What I'm surprised is your reported earnings that's up 3% year-over-year this quarter. You've given guidance at the mid range next quarter that's down 11%. And then if you back out those two numbers, you get positive 12% for guidance at the midpoint for the next two quarters. What is it that's driving you so hard down in this next quarter and then you think is going to bounce up? Is it legal fees related to this case? Is it comparisons? What makes for the difference here? I mean why do you go from positive 3 now to minus 11 at the midpoint and then spike up the positive 12 in the back end for expectations?

Alan B. Graf, Jr. - Executive Vice President and Chief Financial Officer

Ed, Alan here. Number one reason, fuel price increases and just fuel cost at Express, particularly versus we had the reverse a year ago and continued weakness in Freight. We start to lap the National acquisition, Freight gets a little better in the second half and IP growth continues, and we are expecting fuel to level off. So it's the timing issue more than anything else.

Ed Wolfe - Bear Stearns

Okay. And so what I heard from that was fuel leveling off is one of the expectations and the expectation to see some benefits from the LTL acquisition?

Alan B. Graf, Jr. - Executive Vice President and Chief Financial Officer

Right. And remember, a year ago in the third quarter, we absolutely got hammered by fuel.

Ed Wolfe - Bear Stearns

Okay. And then is a follow up, Grounds, Dave, can you talk a little bit about your volumes increased in the quarter in terms of 10% versus where you've been at 8% and 9% the past two quarters. Is that market share or is that something you guys are doing or is it the overall market stabilized or improved? And also operating margin, you've been all over the place lately with 50 basis points improvement this quarter, 240 year-over-year last quarter and minus 80 two quarters ago. How should we think about modeling margin as we go out?

David F. Rebholz - FedEx Ground President and Chief Executive Officer

Well, Ed, first of all, the market itself... volume has been extremely strong in the retail sector. We have gained share in a number of cases. We have certainly seen some of our large non-retail customers' volumes go down through this economic situation, but retail has been extremely strong for us and the value proposition we have in our home delivery market is attracting customers. So that's clearly one of the advantages we have. I think that the timing relationship on the quarter-to-quarter performance has been related to some one-time issues; you mentioned the legal fees type situation. And some of the very strong volatility, not to be extent that Express is, but where we picked up some very good gains on certain quarters that have just not washed out simply on a year-over-year basis. But consistently, 10% has been between 1 and 2 points and then a couple of one-off nuances. And I want to remind you, and I know you watch us closely, we also do capital investments for this growth, and they are timed to happen on particular quarters to handle that volume. We do a terrific job of bringing on numerous projects that both from a capital and operating expense standpoint are timed to minimize the capital expense and maximize the efficiency we get from the growing volume. So you can see that as one of the spikes that occur on a quarter-over-quarter basis as well.

T. Michael Glenn - Executive Vice President, Market Development and Corporate Communications

Yes, this is Mike Glenn. I just want to comment. I think you know, we have been taking share in this market since we went to market as FedEx Ground and rebranded the former RPS under the FedEx brand. That's due to two primary reasons. One is we made tremendous investments in the Ground value proposition, speeding up the network, improving information and reliability and really positioning Ground as part of a broader FedEx portfolio. And our sales team has done a great job at helping our customers understand the significant improvements we have made in our Ground service. So while we did see a little bit of rebound in market performance in the overall Ground segment, we continue to grow much faster than the market.

Operator

Thank you. We'll take our next question from Scott Flower with Banc of America Securities.

Scott Flower - Banc of America Securities

Yes, good morning all.

Unidentified Company Representative

Good morning Scott.

Scott Flower - Banc of America Securities

Good morning. Yes, I just wondered, could you... I know there are a lot of moving parts and pieces in Express relative to some of the incremental acquisitions you all made, and obviously the performance... and Dave Bronczek's pointed out on the cost side ex acquisition position. But could you give us some sense on international priority, what the organic volume growth was? And obviously, we've got the total, so we can do the math after that.

Alan B. Graf, Jr. - Executive Vice President and Chief Financial Officer

Scott, it's Alan. The IP growth at the moment is still all organic. The acquisitions that we made, FedEx UK, for example, we simply replaced our old service provider with our own people for IP pick up and delivery, and we are penetrating markets better since we have more control. But we are early on in those stages and I expect to see that growth over time accelerate. Same thing with China. We have been in China for a very long time with IP and the domestic business is in the start-up phase right now and we are picking up a few additional IP packages as a result of being in a domestic China. But at this point, it's not material, but it will be going forward.

Scott Flower - Banc of America Securities

So the acquisitions all impacted the domestic international component?

Alan B. Graf, Jr. - Executive Vice President and Chief Financial Officer

Yes, and I should say that we are very pleased with what's happening at FedEx UK; strong volume and yield performance, great profitability ahead of plan, rebranding is going great and it's an outstanding performance by our European management team.

David J. Bronczek - FedEx Express President and Chief Executive Officer

Yes Scott, this is Dave. It is all organic growth in the IP product and it's growing exceptionally well. Alan pointed out it's many, many quarters now that we have... this is the highest growth rate that we have had there. I should point out that it's growing all around the world. Every region of the world has grown year-over-year in the first quarter including Canada, Latin America, of course EMEA and U. S. outbound and led by Asia Pacific.

Scott Flower - Banc of America Securities

Okay.

David J. Bronczek - FedEx Express President and Chief Executive Officer

Very pleased.

Scott Flower - Banc of America Securities

Okay. And then the other question is, and obviously again, the results speak for themselves, but I am just wondering SmartPost is growing so nicely and yet I just noticed recently that some of your U. S. freight, which, obviously a decent component of that is the wholesale arrangement with the Postal Service. Is SmartPost taking share from the Postal Services offering, be it Priority Mail or otherwise?

David F. Rebholz - FedEx Ground President and Chief Executive Officer

Scott, this is Dave and then Mike might want to comment as well. I do not see that as part of the portfolio at all. One of the values with SmartPost is we mentioned at the Annual Meeting was for the customer who is trying to find the right solution set at the right cost, SmartPost is a nice opportunity. We see most of the customers we have in the SmartPost environment having mix of SmartPost Postal Service products and Ground and Express products. We have not seen a unique takeaway from the Post Office whatsoever from my perspective.

T. Michael Glenn - Executive Vice President, Market Development and Corporate Communications

Yes, I would add that SmartPost is a complementary service to our Ground offering, and especially obviously Home Delivery. Traditionally, FedEx Home has targeted heavier packages, heavier average weight transactions to move through our network, and SmartPost is a nice complement for that, which allows us to meet the customer's entire shipping needs including the light weight packages that require residential delivery. So it's more of a complementary service to Home Delivery.

Scott Flower - Banc of America Securities

All right, thank you.

Operator

Thank you. We'll take our next question from Gary Chase with Lehman Brothers.

Gary Chase - Lehman Brothers

Good morning everybody.

Unidentified Company Representative

Hi Gary.

Gary Chase - Lehman Brothers

Could you talk to what is contemplated looking forward in the Freight segment? I mean you talked to the fact that that was a driver of a lot of weakness. Just on the cost side, having completed your network reengineering and talking about strict cost controls, does the guidance contemplate a meaningful cost improvement there in the second half of the year?

Frederick W. Smith - Chairman, President and Chief Executive Officer

Well Gary, I have to talk about the two different networks. The regional network has a very material value proposition. It's the market leader. It's well in place and they are very good at managing cost at lower volume. So that sector is running extremely well and performing well. On the national, we got caught reengineering a network during a down economy, which we would have preferred to have been in cost control mode, but we didn't slow down. We got through the process. We now have superior service to anybody in the marketplace from a reliability standpoint and the reengineering has also given us productivity levels that will get us to the low cost position from a low cost producer standpoint. So we now have a value proposition in the long-haul network where we can go out and get market share.

In conjunction with that, we have also had to put the sales forces together so that they could sell the entire portfolio of freight services as well as collaborate with our package side of the house. So all of that education and realignment is done, all the sales people are in their territories, all of them are doing maximum call efforts on their territories today. And it's also a saturation strategy. We have got more sales people calling on the same amount of customers, so we get to call on them more often, we get more deeper into their organization. So I think we are in a position where we can really begin to grow market share in that national network, which is our plan all around. It would be better if it was in an upturn in the economy, but I don't think I have to wait for the economy to turn and begin to show market share results in that network.

Gary Chase - Lehman Brothers

And on the Ground side, just in a similar vein, should we be thinking there was anything unusual? I know you had higher legal costs year-on-year. Are we at a new run rate or should we expect those to tail off as we move through the year?

David F. Rebholz - FedEx Ground President and Chief Executive Officer

All other... Gary, this is Dave. All other components were absolutely within our plans in terms of productivity, line haul efficiency, density factors on line haul. But I don't anticipate with this growth and the additional capital cost coming on that there is a new run rate at this point.

Gary Chase - Lehman Brothers

We should expect that to come down a little bit?

David F. Rebholz - FedEx Ground President and Chief Executive Officer

Well, if you... are you talking about legal costs?

Gary Chase - Lehman Brothers

Yes, legal costs.

David F. Rebholz - FedEx Ground President and Chief Executive Officer

Well, it's a fluent situation. I don't know, Chris, if you want to comment.

Christine P. Richards - Executive Vice President, General Counsel and Secretary

Dave, why don't I help a little bit with this one. We have seen some variation in legal costs at Ground that are driven by a variety of the litigation matters that we have been addressing. The changes we have seen are nothing that I expect to continue. There will be some swings quarter-to-quarter that are simply timing, but I think we'll see a continuation of our past run rate rather than a change to a higher run rate.

Gary Chase - Lehman Brothers

Okay. Thanks very much.

Operator

Thank you. We'll take our next question from Jason Seidl with Credit Suisse.

Jason Seidl - Credit Suisse First Boston

Good morning all. I want to go back to a comment that was made on the Ground side. You mentioned you thought you were gaining some new customers, but you also mentioned that there has been strong performance by the retail sector. Is that the area that you are gaining some customers or is retail just strong organically?

David F. Rebholz - FedEx Ground President and Chief Executive Officer

Well, I'll Mike comment, but I will simply say that the existing customer base with retail has consistently throughout this economic change outperformed other sectors. There is not something uniquely strong in this particular quarter and we have gained a number of customers who have either switched a segment of their business or a certain application that's migrated. And so we have been seeing strength in the core of the retail business and some gains on the outside. Mike, do you want to comment beyond that?

T. Michael Glenn - Executive Vice President, Market Development and Corporate Communications

Yes, Dave, I would just add that our strength has been across a broad customer segment from small customers to mid-sized customers to large customers. We have shown strength across the board, and as Dave mentioned, a bit stronger in the retail area but we've had good solid performance across the board.

Jason Seidl - Credit Suisse First Boston

Okay, great. As a follow-up question that relates to freight, how do you see pricing in the freight market? If you break it down national compared to the regional, what are you sort of signing contracts at right now?

Douglas G. Duncan - FedEx Freight President and Chief Executive Officer

Well, obviously, the 25% reduction in the fuel surge has its impact on our yields, but as you can see from the 8% growth, we are still growing and when you separate national, which is... the long-haul business is helping grow that, even on the regional side, we are showing positive year-over-year yield growth and our contract renewals still show solid increases. We are very... it's a competitive market, but we are doing very well on that side of the business.

Jason Seidl - Credit Suisse First Boston

Okay. So, solid Doug for the regional price increases. What about the national?

Douglas G. Duncan - FedEx Freight President and Chief Executive Officer

Well the national as well, but of course in the national sector, I am going to be the low cost producer. So I have a chance there to compete in the marketplace where the pricing is very sensitive and will do so.

Jason Seidl - Credit Suisse First Boston

Okay. Thanks all for the time.

Operator

Thank you. We'll take our next question from David Ross with Stifel Nicolaus.

David G. Ross - Stifel Nicolaus

Good morning everyone.

Unidentified Company Representative

Good morning.

David G. Ross - Stifel Nicolaus

You talked about your value proposition helping you really gain share in the Ground side and you continue to grow well in advance of the market. Just wondering if you could talk a little bit more what that value proposition actually is that allows you to gain share, whether it's price, better on-time service or transit times to competitor, or other services you may offer to the customer.

T. Michael Glenn - Executive Vice President, Market Development and Corporate Communications

Well, I'll start out. Our Ground operations team has done a wonderful job addressing the number one issue in the Ground market, and that is speed of the network. We have had a concerted effort over the last several years of taking individual lanes and taking a day out of those. We have the fastest network in the industry and our sales people really use that to their advantage in terms of presenting that as part of the total value proposition. Our on-time service levels are extremely strong. Dave can talk more about that, and we have opened up the channel. We are addressing more small customer markets. Our Home Delivery service has a unique value proposition in several services not available from other competitors in the marketplace. So it's a combination of service enhancements and operational excellence that's allowed us to position Ground as really a premier service in the industry.

David F. Rebholz - FedEx Ground President and Chief Executive Officer

David, the only thing I would add to Mike's comments, because our performance continues to improve and on a net service level basis, we just have been doing... the team has done an incredible job of eliminating exclusions and the normal things that services use to measure their service. We are getting as close to net service to the customer exclusive of excuses that you can get at the highest level possible. One thing Mike didn't mention that we did mention I think at the Annual Meeting was our alternate deliver day service, which is in the partial market, there are unique zip codes throughout the country that have such incredibly low density that the competitors would use additional time. One of the things we did beyond speeding up the lanes was eliminate our own internal excuses so that we would be days specific on those... 10% of these zip codes that are out in the hinterlands. And that's also having a positive effect in terms of customer selection because of the service commitment we are making.

T. Michael Glenn - Executive Vice President, Market Development and Corporate Communications

I also would add that we are now managing our retail network as one with drop boxes and affiliates and Kinko's. And we are seeing very strong growth in Ground as we make it more convenient for the small customers through that network, and that's also adding value.

David G. Ross - Stifel Nicolaus

And then a follow-up question on the retail network you have and the drop boxes. Out of the 900 million of, I guess, Ground and Express packages going through FedEx Kinko's, what's the split between Ground packages and Express packages?

T. Michael Glenn - Executive Vice President, Market Development and Corporate Communications

The retail business is still heavily weighted towards the Express business in the FedEx network. Having said that, we have a significant share opportunity in the retail network as we expand our network. And that was one of the main reasons why we wanted to bring FedEx Kinko's into the Services organization. It allows us to take advantage of that portfolio on a much more aggressive basis, make strategic investments that really will drive our total value proposition and specifically more retail packages through the FedEx Kinko network and associated networks. So it's very important... this move was very important and very strategic to our go-to-market strategy to allow us to take advantage of that share opportunity in the ground retail market.

David G. Ross - Stifel Nicolaus

Thank you very much.

Operator

Thank you. We'll take our next question from Scott Flower with Banc of America Securities.

Scott Flower - Banc of America Securities

Yes, I just had a couple of quick follow ups. I wonder if you could just broadly tell us where the FAA reauthorization bill stands sort of House and Senate. And obviously, there are some implications to sort of labor and landing [ph]. You all are close to the specifics of that bill and where it stands in Washington. I just wanted to get a sense.

Christine P. Richards - Executive Vice President, General Counsel and Secretary

Hello Scott, it's Chris Richards. We anticipate that the House will probably bring the FAA reauthorization bill to the floor this week either today or tomorrow. It is still in the Committee process on the Senate side and we would not expect it to move forward there probably until sometime in October if it does move forward on that side. The House bill does include language that would change and modify the RLA status of FedEx Express. The Senate bill, as we anticipated, will not. We are confident and ultimately, we will be able to have folks listen to the policy, arguments and the important impact that Railway Labor Act status can have on major national transportation networks in maintaining access for all customers to a continued service without being hostage to various kinds of labor disruptions. We feel very confident of our position on this and feel confident that we'll be able to see the bill move forward without any labor provisions that are troubling to us.

Scott Flower - Banc of America Securities

Okay. And then the other quick question, and maybe this is from Mike Glenn, have you seen any change in the domestic yield environment relative to air express? Has perhaps DHL then acting any differently than they have if you look back 6, 12 months ago?

T. Michael Glenn - Executive Vice President, Market Development and Corporate Communications

Well pricing has remained relatively constant over the last period. As I mention every call, we see aggressive pricing action on an account-by-account basis, and that's really nothing new. In some situations, you will see more aggressive than you have seen in the past; in others, it will be the opposite of that. So it really is an account-by-account basis, and I think that gets back to an individual competitors capacity in a certain market on certain lane segments and they price into that. And we do see that a lot. But overall, no material changes in terms of the pricing environment. Competitive on an account-by-account basis, but if you look at the overall market, fairly consistent with what we have seen in the past.

Scott Flower - Banc of America Securities

Great. Thank you.

Mickey Foster - Vice President, Investor Relations

Okay. I think we are coming up on the hour, so I want to thank everyone for your participation in our conference call today and please feel free to call any one on the IR team if you have any additional questions. Again, thank you very much.

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