United Parcel Service's (UPS) CEO David Abney on Q4 2014 Results -- Earnings Call Transcript

United Parcel Service, Inc (NYSE:UPS) Q4 2014 Earnings Conference Call February 3, 2015 8:30 AM ET

Executives

Joe Wilkins - IR

David Abney - CEO

Kurt Kuehn - CFO

Jim Barber - International President

Myron Gray - President of U.S. Operations

Alan Gershenhorn - Chief Commercial Officer

Analysts

Chris Wetherbee - Citi

David Vernon - Sanford Bernstein

Brandon Oglenski - Barclays

Tom Wadewitz - UBS

Bill Greene - Morgan Stanley

Nate Brochmann - William Blair

Ken Hoexter - Merrill Lynch

Kevin Sterling - BB&T Capital Markets

Scott Group - Wolfe Research

Helane Becker - Cowen

Ben Hartford - Robert W. Baird

Scott Schneeberger - Oppenheimer

Tom Kim - Goldman Sachs

Keith Schoonmaker - Morningstar

John Barnes - RBC Capital Markets

David Campbell - Thompson Davis

Operator

Good morning. My name is Brad. I will be your conference facilitator today. At this time, I would like to welcome everyone to the UPS Investor Relations Fourth Quarter 2014 Earnings Conference Call. [Operator Instructions]. It is now my pleasure to turn the floor over to your host, Mr. Joe Wilkins, Investor Relations Officer. Please go ahead, sir. The floor is yours.

Joe Wilkins

Good morning and welcome to the UPS fourth quarter 2014 earnings call. Joining me today are David Abney, our CEO; Kurt Kuehn, our CFO, along with International President, Jim Barber; President of U.S. Operations, Myron Gray and Chief Commercial Officer, Alan Gershenhorn.

Before we begin, I want to review the Safe Harbor language. Some of the comments we'll make today are forward-looking statements that address our expectations for the future performance or results of operations of the company. These statements are subject to risk and uncertainties which are described in detail in or 2013 Form 10-K and 2014 10-Qs. These reports are available on the UPS investor relations website and from the Securities and Exchange Commission.

As previously disclosed there were two accounting events that influenced our fourth quarter and full year results. First, expense recognition related to our company-sponsored pension and postretirement plans. A 90 basis point decline in average year-end discount rates more than offset improved asset returns. This led to a noncash mark-to-market after tax charge of $670 million.

Second, recent contract gratifications triggered the recognition of $22 million in after tax charges for our second quarter transfer of certain Teamster employees to union healthcare plans, neither of these charges affect benefits paid to plan participants or required pension funding. Ignoring the impact of these charges, diluted earnings per share for the fourth quarter were $1.25 and GAAP earnings were $0.49. A tutorial has been provided on the IR website to provide additional information on mark-to-market accounting.

In our remarks today, all quarterly and full year comments and comparisons will refer to adjusted results. In addition, we will discuss UPS's free cash flow which is a non-GAAP financial measure. The webcast of today's call along with a reconciliation of free cash flow and adjusted results, are available on the UPS Investor Relations website and just a reminder, as on previous calls, please ask only one question so that we may allow as many as possible to participate.

Now we'll turn the call over to David.

David Abney

Thanks, Joe. Good morning, everyone and welcome to our fourth quarter earnings review. By now I suspect almost everyone on the call reviewed the press release and Kurt's audio message from January 23, those that did understand that we're disappointed in fourth quarter financial results but pleased with our strong service levels. Peak season 2014 provided us an opportunity to deliver excellent service during periods where UPS volume more than doubles. To meet the challenge, we invested in capacity with new facilities, automation and expanded operations. It was important to fortify the trust of customers and protect our brand and from that perspective, UPS was successful.

UPSers around the world went the extra mile to ensure service levels remained high throughout the holiday season and our customers were delighted with the results. The management team and I received numerous calls and emails from customers of all sizes. They expressed their appreciation for the efforts of UPSers. I'm extremely proud of our team and the service they provided this year. And while we met our commitments to serve customers, we certainly did not achieve our financial objectives. Executing an efficient operating plan to meet the surge in demand is complex.

Ultimately, we erred on the side of caution and built an operating plan that would provide superior service if volume levels exceeded expectations, contributing to higher than expected costs.

In addition, the rapid growth of online retail over the last few years has pushed us beyond our normal peak workload and limited our traditional economies of scale. To illustrate the enormity of peak season, consider that during this peak we averaged over 30 million deliveries per day. Looking back just two short years ago, that's about 6 million more per day than we handled in 2012. In those two years, we saw peak volumes go from 55% above our average day to 75%. This is a trend we expect to continue as e-commerce expands its influence over the retail sector.

Going forward, there are two clear paths to improved results. As we laid out at our investor conference, UPS will continue our long term initiatives to invest in technology and capabilities, ultimately bending the cost curve lower. While at the same time we will pursue specific revenue initiatives that will improve yields and ensure we achieve our financial objectives.

Looking shorter term, there were obvious cost overruns that will be addressed. On the operating side of the equation, we will improve production with a tighter dispatch, improve helper utilization and reduce overtime. We will expand hub capacity in key areas ultimately reducing the need for temporary sorts. Additional hiring and training costs associated with staffing the new sorts and facilities will be reduced going forward with the permanent capacity expansions. We made the decision to conduct full operations on Black Friday this year with the expectation of smoothing the network during Cyber Week. While we did achieve benefits for our hub and feeder network, the pickup and delivery network was underutilized. In 2015, we will adjust operations as needed.

Purchase transportation expense including contract carriers in TOFC will be optimized with more efficient use in 2015. In addition, we will improve our cost profile through the acceleration of ORION deployment and enhanced operation technology. We will be implementing peak residential surcharges that are differentiated from our nonpeak time of year on a customer segmented basis. These surcharges will focus on SurePost and residential packages. In some cases, these changes will be implemented over a multi-year period as contracts come due. These pricing strategies will be designed to ensure we're properly compensated for the value we provide. We will align revenue with cost, extracting the value for the investment in our network, especially during peak periods.

The control tower was put into effect in 2014 and was mainly focused on capacity management. In 2015, the control tower will continue to focus on capacity management and also be utilized more for revenue and yield growth opportunities. I'm confident our team will manage costs, tighten up the plan, keep service levels high. At the same time, we will implement rational new revenue actions to improve yield during this period. UPS has a high value offering in the market which our customers appreciate. These steps will further align value, cost and yield. Overall, the other two business segments performed fairly well this quarter and Kurt will provide you more details in a moment.

Looking to the future, the global economy is expected to be modestly stronger in 2015 with global GDP and exports increasing at a faster pace. While the U.S. economy is expanding, parts of Europe and Asia are expecting slower growth. Fortunately for UPS, there are opportunities for growth outside general economic expansion.

E-commerce is expected to outpace global GDP growth by fourfold and cross border e-commerce at 7 times. Concentrated investment in growth industries like healthcare and retail put UPS in the position to capitalize on market expansion. One way our government can help advance economic growth is by supporting global trade. We were pleased hearing the President's support for advancing trade promotion authority. We continue to urge Congress to pass PPA legislation that will facilitate new trade agreements. Free trade enables businesses to gain access to new markets and compete on a level playing field.

Before I turn it over to Kurt, I want to emphasize that we're resolute in improving the financial performance of the company. During the next couple of years, the cost initiatives will provide escalating benefits and the revenue strategies will continue to be implemented. We're 100% committed to our long term financial targets that we shared in November. UPS is focused on the key points of our long term strategy which include investing to position UPS for future growth, developing innovative industry-specific solutions and adapting our B2C delivery model to improve profitability.

Keep in mind this is a multi-year transition. 2015 will be a year of progress and we expect solid growth in all three business segments. I'm confident we have the right strategy, the right solutions and the right people to deliver on these objectives.

Now Kurt will take you through the financials.

Kurt Kuehn

Thanks, David and good morning everyone. Back on January 23, I shared with you our performance during peak season and I also committed to provide you additional details on today's call. Now I'll provide you with more information on our results, as well as further insights into what we expect in 2015. UPS fourth quarter earnings per share were $1.25. The U.S. Domestic segment results came in less than planned due to higher than anticipated peak operating costs. Meanwhile International results were in-line when adjusted for currency and onetime items and the supply chain segment was pretty much on plan. On the positive side, our revenue growth was 6.1%, the best we've seen in some time.

Now I'll take you through the segment details. The U.S. Domestic average daily package volume for the quarter was up 6.6% driving total revenue up 7.5%, daily shipments for ground increased by 7% which includes over a 28% jump in SurePost shipments. Deferred Air increased 11% while Next Day Air declined by 3%. The drop in Next Day Air was primarily due to changes in the holiday calendar and distribution channels including the proliferation of omni-channel. This year retailers employing a local distribution strategy increased by 50% and the number of stores participating was up by 30%.

Products distributed closer to the consumer have resulted in some trade down from premium products, package yields declined by 0.8%. Underlying base rate increases were offset by lower fuel surcharges and changes in product mix. This does mark however another quarter of improving trends in both reported yields and underlying base rates. Operating profit was $63 million lower than last year as operating margin contracted 150 basis points to 11.4%. In total, U.S. domestic operating cost was more than $200 million higher than anticipated.

During the quarter, operations ran well in October. However, the opening of an unprecedented number of new buildings and sorts in November caused a notable decline in productivity as operations geared up for peak. Early seasonal hiring and training, as well as working nontraditional operating days, contributed to excess hours. As a result, direct labor hours per day increased by 11%, outside carrier costs were up 65% due to both increased usage and higher rates. Also contributing to the cost overrun was the disruption to our network from the West Coast port dispute. On a positive note, we're seeing benefits from ORION as miles driven increased just 5.8%.

As David mentioned earlier, we're committed to lowering our long term operating costs while at the same time implementing pricing strategies that ensure we're properly compensated for the additional cost of peak season operations.

Now looking at our International segment, the volume growth was healthy and operating profit showed positive momentum. In fact, if you strip away the currency impact and the onetime items, fourth quarter performance was very good. Total International revenue when adjusted for currency was up 5.9% and daily shipments increased by 4.3%. Our International Export volume was up 5.2% with high single digit growth in Europe and double-digit gains on the Europe to U.S. trade lane. Average revenue per package was down 0.6% on a currency-neutral basis. This is actually a continuation of an improving trend in yield.

Total operating profit was flat with last year at $536 million and operating margin declined slightly to 15.6%. International results were negatively impacted by the fluctuations in global currencies, lowering operating profit by $40 million. UPS does hedge the major currencies like the euro, the British pound and the Canadian dollar. However, the volatility and rapid devaluation of our unhedged currencies in comparison to the U.S. dollar weighed on results.

During the quarter, the segment also experienced $30 million in onetime items including a restructuring charge in Europe. The International business experienced increased in-country expenses especially in Europe where demand during peak season exceeded network capacity and did push costs higher.

Now turning to Supply Chain & Freight which performed pretty much in-line with our expectations, revenue was 7.4% higher due to strong growth in Distribution and UPS Freight. Operating profit was up 5% to $179 million with an operating margin of 7.3%. Forwarding revenue improved slightly during the quarter primarily from strength in North American Air Freight. Operating profits declined as gains in Ocean and North America were offset by the continued challenges in the International Air Freight unit. Distribution revenue was up more than 10% while operating profit improved by 9%. Growth in the retail and healthcare sectors offset a slight decline in high tech. UPS Freight expanded operating profit and margin over the prior year. Revenue increased by 8.6% to $773 million during the fourth quarter. LTL tonnage increased by 5% and LTL revenue per hundredweight was up 2.4%.

Now for an update on our cash position, for the full year 2014, UPS generated $3.4 billion in free cash flow. This includes after tax contributions of $800 million to company sponsored pension plans and $1.5 billion for the transfer of certain union employees to multi-employer healthcare plans. UPS made capital expenditures of approximately $2.3 billion, slightly below our $2.5 billion guidance due to the timing of project payments at year-end. In addition, the company paid dividends of $2.4 billion, an increase of 8.1% per share. UPS repurchased 26.4 million shares for approximately $2.7 billion. In total, the company returned over 100% of net income to shareowners in 2014.

Looking now at our expectations for 2015, as we look at the year, continued investment in making the business model more flexible and adaptable will weigh more on operating margin expansion than originally anticipated. However, this is absolutely the right thing to do to position UPS to capitalize on future market growth opportunities. The company expects growth across all business units with earnings per share of 6% to 12%. This includes a $240 million headwind from pension expense and currency. Overall operating profit is expected to improve 5% to 9%. Total shipments per day are anticipated to rise about 4% with revenue up 3% to 4%. Excluding the fuel impact, underlying revenue growth would be 5% to 6%.

Now looking at the segments, the U.S. Domestic Package volume is expected to increase by approximately 4% with revenue up at a similar rate. We're expecting solid base rate improvements due to dim weight and other and other pricing initiatives. However, the gains will be mostly offset by lower fuel surcharges which will be around a 200 basis point drag on package yield. Operating profit is anticipated to increase by 5% to 9%. International shipments should grow by 3% to 4% with revenue growth of 2% to 3%. Falling surcharges in International will lower yields by approximately 300 basis points. Operating profit is expected to increase by 6% to 12% with currency being a $50 million drag.

Supply Chain & Freight revenue is expected to grow 2% to 3% as faster growth in Distribution and UPS Freight is offset by revenue management actions that we will be taking in Forwarding. Operating profit is expected to increase approximately 5% with modest margin improvement. UPS Freight will be challenged by the decline in fuel surcharge revenue as it isn't fully compensatory at the current low fuel prices. Total company 2015 diluted earnings per share are anticipated to increase 6% to 12% to a range of $5.05 to $5.30 and our effective tax rate is anticipated to be about 35.5%.

Looking specifically at the quarters, there will be variability in the quarterly results due to the year-over-year comparisons. We expect the first and fourth quarters' earnings per share growth of be higher than the year's average while the second and third quarters will fall below. Looking at the balance sheet, we're planning 2015 capital expenditures of approximately 5% of revenue or about $3 billion as hub automation and capacity expansion projects accelerate. Share repurchases in 2015 are expected to be $2.7 billion continuing our philosophy of robust distributions to shareowners and of course, dividend growth will remain a priority.

So 2014 was a year of demonstrating our ability to handle the peak surges and we met that challenge. 2015 will be a year of continuous improvement and positioning UPS for the future. Advances in our strategic initiatives have great potential for the company. E-commerce growth, operations technology implementation, emerging market expansion and industry-specific solutions will all provide momentum for UPS as we move throughout this year and into the future.

Well thanks for listening. That completes our prepared remarks and we're ready to take your questions. I'll turn it back to the operator.

Question-and-Answer Session

Operator

[Operator Instructions]. Our first question comes from the line of Chris Wetherbee with Citi. Please go ahead.

Chris Wetherbee - Citi

Just wanted to ask I guess a question on pricing and the outlook for 2015. Kurt, as you kind of laid out the Domestic outlook on the revenue side, ex the fuel headwind, it seems like maybe there is I think a consistent amount of core pricing embedded in the guidance. I guess I just want to understand, as you're taking on some of these pricing initiatives to offset some of these costs, how quickly can you start to realize that? How much is in 2015? Does it take a little bit longer, 2016, 2017 and beyond to catch up on that pricing side? Thanks.

Kurt Kuehn

Yes. Chris, you're right. There is certainly underlying momentum and if you look at the quarter-to-quarter changes, you can begin to see some of that picking up already. We did say at our investor conference that we expect our base rates to be at the high end of the 2% to 3% targets that we normally have. So we're well on our way towards that, but it is a long term process and I'll have Alan talk a little bit about some of the moving parts with that.

Alan Gershenhorn

Yes, so we're certainly expecting throughout 2015 including peak, to see additional revenue for piece improvements just like Kurt alluded to last year. We saw quarter-over-quarter gains from the second, third to the fourth quarter and that's going to continue into 2015. Certainly the Ground dim weight changes are going to impact the 2015 results. We're also continuing to work with our customers on their packaging to obtain mutual cost reductions. So we will see a little bit of impact there on the cost side. So we're going to see improvements throughout 2015 and it is going to be on the high end of the 2% to 3%.

Kurt Kuehn

Yes, although it certainly will be masked a bit, as I said, with fuel surcharges down a couple hundred basis points, but we feel very confident that the underlying momentum is strong.

Operator

And we do have a question from the line of David Vernon with Sanford Bernstein. Please go ahead.

David Vernon

So it sounds like the overshoot on costs in this fourth quarter and I'm trying to understand how the $200 million extra that we spent in the fourth quarter kind of plays into the guidance for next year. Should we be expecting that that level of inefficiency that we saw in the fourth quarter you guys are sort of baking some of that into the model or are you guys also adding additional operating expense into 2015 that's keeping that cost recovery that we had been expecting in this year from last year out of the numbers and out of the guidance numbers?

Kurt Kuehn

Yes, maybe let's start, David, I know, wanted to at least put a recap onto peak season of 2014. He can talk a little bit about what our intentions were and then we can migrate from that into guidance.

David Abney

Yes, first, our main priority going into peak was protecting the brand. After 2013, we just felt that was something we absolutely had to do. We were successful in doing that. We also made significant progress working with our customers in forecasting capacity, vision, visibility and communications, but the cost associated with providing this quality of service was greater than expected. We built our operating plans to accommodate higher volume and that was based on the volume surge of 2013. So we certainly erred on the side of caution. We did overbuild to some extent and that is the basis for some of our 2015 initiatives where we will be able to eliminate some of that expense lessons learned from 2014.

Kurt Kuehn

So I think as we look into 2015, we were certainly a little concerned and surprised at the challenges of opening up so many operations in November. It's really unprecedented for us and that was the primary disconnect I think that happened between where we thought we were heading. Just bringing that much capacity on after what had been a breakneck speed on the engineering and operations side getting ready overshot. So we're a little cautious I guess going forward, twice burned thrice wise and so as we look into 2015, this forecast does assume that a higher portion of that expense -- the peak season added expense stays with us.

Clearly over time, we will work through it, but right now at least that guidance does assume more drag in the fourth quarter. Certainly the revenue will help to cover that because we do feel that cost is maybe more structural than we thought. That's why we're focusing more on revenue. We do think over time though fourth quarter will become much more profitable. It wasn't too many years ago, just a couple of years ago where the fourth quarter was our most profitable quarter but it is going to take us a few years to get there.

David Vernon

And does the guide also have some of that peak season surcharge in it as well?

Kurt Kuehn

Some portion, yes.

Operator

And we do have a question from the line of Brandon Oglenski with Barclays. Please go ahead.

Brandon Oglenski

Kurt, coming off that comment about how the fourth quarter used to be the most profitable. I mean, you know, David in your prepared remarks here, obviously your customers like the service that you provide in the fourth quarter definitely better than where you were in 2013 and with 6% volume growth and operating earnings down, I'm sure customers do like that outcome, but your shareholders obviously have a little bit different priorities here which a lot of them are taking significant risk investing in a cyclical stock like yours.

And if we can't convert the upside right now in a very robust growth period, ultimately we're going to be exposed to a lot of cyclical downside whenever the economy does potentially roll over. So I guess with you being in the leadership role here for the last half year now, what is the real priority of UPS going forward for the next few years because it's been a while since you guys have hit your long term earnings growth targets and it seems like the discussion here is all about additional capacity, additional service. It doesn't sound like there's a lot of aggressiveness to take yield from customers which are obviously benefiting from all these additions you have put in the network.

So can you tell your shareholders what is the priority here? Is it really returns and a financial focus or is it more about protecting the brand and potentially this is a cycle where we just don't hit those long term growth targets because we're putting so much capacity in the marketplace and underestimating on the pricing ability?

David Abney

Well first, let me tell you that we certainly take our responsibility to our investors very seriously. In fact, when I talk about this first priority of protecting the brand, we believe that was necessary in order to take care of the interest of our investors, but let me focus on and I know we covered it at the investors conference, but, based on peak, I'll really focus on a couple of things to solve the peak issues that we saw and then we can of course talk about the entire year of 2015.

One is it is a cost reduction story and we're going to ask Myron in just a second to really focus on some specific things that we're doing that will be in the best interest of the shareholders, lessons learned, lessons learned, things that we will be able to improve this year. We can also talk a little more long term. But the other thing and we mentioned it at the investor conference, but the tone is much, much stronger today is that we're taking this revenue management side very serious. The fact that we realized some of these extra costs in peak are going to be with us for a few years has just made us that much more determined. So what you're hearing today is that we absolutely will charge our customers more for the extra costs that we have in peak and that we absolutely are pushing our foot down harder from a revenue management side.

So Myron, why don't you talk a little bit about some of the cost initiatives and what you're going to do this year?

Myron Gray

Thank you, David. We will continue to ultimately bend the cost curve lower by our continued deployment of ORION, by the end of 2015, we will have over 70% of our drivers deployed. We'll continue with automation and modernization and then, of course, there are other operational technologies and innovations that we'll continue to focus on such as driving density with SDS, SurePost Redirect and we're going to continue with our deployment of Access Points to take cost out of the system.

As David and Kurt both alluded to earlier, we erred on the side of caution considering the peak surge of 2013. However, there were a lot of lessons that were learned. I'll give you just one example, we made the decision to conduct a full operation on Black Friday in the intention of smoothing out demand on our network during cyber week. While that benefited our hub and feeder operations, we did underutilize our pickup and delivery operations. We'll make the necessary adjustments in 2015 to cut the cost.

David Abney

And just wanted to sum that question up, we’re certainly focused on our long term strategies. We're 100% committed to the long term financials that we reviewed for the time period 2015 through 2019 during our investor conference. So we have not backed up from those numbers. We do have some challenges that we have to address and we certainly will do so.

Operator

And we have a question from the line of Tom Wadewitz from UBS. Please go ahead.

Tom Wadewitz

I wanted to focus a little bit more on the revenue actions that you're talking about. It sounds like this is primarily focused on peak, but is there any element of saying that's broad or that says we just need to be more aggressive on price and so we're going to look for more in base rate with our B2C shippers? And also I guess just in terms of understanding the magnitude I think you said $200 million difference in cost in fourth quarter. I don't know if you would say it is $200 million or more than that shortfall in operating income probably more than that. So is half of that shortfall going to be on these peak season price changes, so you're looking for a couple hundred million or what's just the magnitude of that pricing change when you look at the peak? Thanks.

Kurt Kuehn

Well clearly Tom, the solution for the fourth quarter for us in peak is really two-pronged. We're going to need to improve operations, streamline it, lessons learned, find how can we scale up 100% without driving our marginal cost so high that it's unprofitable and we've got a number of initiatives there both physical capacity and operating changes. And then the other path equally important is the yield side to make sure that for that disproportionate increase, we do need to increase yield and also as we've talked, certainly we're more focused on yield in aggregate because of the -- last year was a brand-building and capacity-building and this year clearly the value is there. So Alan can talk a little more on the revenue side.

Alan Gershenhorn

Yes certainly, as we said before, the Ground dim weight changes are going to amplify the impact in 2015 and go a long way to increasing the yields and specifically in the B2C market, as well as more broadly and as peak has become more costly, there has been additional pressure on the margin. So going forward, we do plan to better align the revenue against this increased cost. So we're going to focus on residential and peak surcharges for specific customer segments and we're firming our strategy to better align revenue with costs during peak season as well as throughout the year. Certainly also very focused on the value creation that UPS does with our customers and ensuring that we're getting paid for that.

David Abney

One other addition to the peak pricing is this past year we really focused on a control tower from a capacity management standpoint and we had a lot of success from that end. This year, the control tower is still going to be focused on capacity management, but also will be focused on taking more revenue action for those real peak weeks. So it's going to be a big step for us from a revenue management standpoint.

Kurt Kuehn

I think one thing maybe we could bridge to a little bit is certainly the revenue management is a critical part of peak. Outside the U.S. where we're a little farther ahead with some of our alternative delivery modes, we're looking at both revenue enhancement and also some cost reduction with our Access Points network. So Jim maybe you could talk a little bit about how the e-commerce surge is working for you guys internationally.

Jim Barber

Sure. I think that, Kurt to that point, I think one thing you have to first look to is that as you move outside the U.S., depending on what part of the world you are in, you have got different market characteristics, capabilities and situations and operating models. So it really does present us some unique opportunities as we've grown this International business to experiment in different ways.

Our Access Points are up to about 16,000 outside the U.S., when we bought that company; they were at about 6500 so we've organically over doubled that network. It's providing us good opportunity and benefits in this B2C space to actually get at this and provide different solutions to customers and you would also probably have noted the acquisition of i-parcel that gets us into this cross-border e-commerce as well here recently that we plan to roll out globally. So lots of change on the forefront and International provides us a great platform to experiment and grow the business.

Operator

And we do have question from the line of Bill Greene with Morgan Stanley. Please go ahead.

Bill Greene

Kurt or David, I wanted to ask you about the rest of the year. So obviously, peak has all of its challenges that we're aware of given the increase in the peak volumes and you'll do what you can with the surcharges and whatnot and I'm sure you'll work hard on the cost there, but is there something to be said for trying to smooth this out not by managing peak but more increasing the volume in first, second and third quarters to the point where if we have added structural costs, the average profitability in the other periods gets much better and peak will just do what peak does? So the real key here is getting more balance through increasing throughput in the first three quarters to adjust for those structural costs. Is there an argument for that or does that not make sense in your mind?

Kurt Kuehn

Well, Bill, it's a great argument. We would love to have the rest of the year pumped up that high if we could scale to it. Certainly what you're seeing is an industry in transition and part of the challenges that we're wrestling with is this factor of peak versus the rest of the year has gotten much more extreme. So what used to have very low marginal cost for us as we grew the volume has gone beyond that. I think one silver lining to your comment is that we're seeing an uptick in our commercial growth. Our B2B business was up over 3% in the fourth quarter.

So as the U.S. economy has begun to broaden its expansion and the industrial manufacturing components grow, that does actually help to grow the other quarters frankly. What we have seen up until last year was a small package growth business driven primarily by B2C which exaggerates the Q4. So Alan I know has a big focus on these industry-specific solutions and Alan, maybe you could talk about how are we tackling the opportunity and the rest of the segments.

Alan Gershenhorn

We've certainly seen a revitalization of growth outside of the B2C retail market. Five of our top six industries are growing now and we're very, very focused on healthcare, high tech and the industrial manufacturing segment and creating value for those segments to create more year-round type of opportunities for UPS versus the peakiness of retail.

Operator

And we do have a question from the line of Nate Brochmann with William Blair. Please go ahead.

Nate Brochmann

I wanted to follow up back on Tom's question regarding the pricing and getting the surcharges and that certainly all makes sense in terms of going back and getting paid for all that high service. But how far kind of going back to a question not too, too long ago, how far do you think you can really push that without foreseeing those various shippers to go in a different direction? You’ve often talked about maybe some competing opportunities out there for them and I know it's a growing space, but how do you balance that in terms of pushing that price to the point where you don't push your shippers to go think of different alternatives?

Kurt Kuehn

Clearly that's the judgment that we have. We have long term relationships with our customers and we tend not to have dramatic price swings as part of the value proposition as a large company for us to do. But that is clearly part of the activity and Alan, I know you guys have talked about but this is really a multi-year cycle as contracts come due, right?

Alan Gershenhorn

Yes. So you're right, but we do have a long history of revenue management that balances aligning the revenue with the cost and also the value that we provide to our customers while maintaining a fair and rational pricing environment. So we think that the GRI we just implemented, the dim weight changes that we're already seeing the effect on are going to pay some dividends in 2015. It is a multi-year process with some of our customers because they do have multi-year agreements, but we do expect to see positive results from the actions we're taking during 2015.

Operator

And we do have a question from the line of Ken Hoexter with Merrill Lynch. Please go ahead.

Ken Hoexter

In terms of using the tower for volume seemed to work well in trying to allay some of the volumes to different dates, but adding 100,000 temp workers for a few days. How quickly can the surcharges be implemented to smooth out those peak days and when you think about getting a return on the investment for the $3 billion? You're jumping CapEx nearly 30%. So just wondering the balance of those permanent costs in hiring 100,000 workers with the returns on those price increases?

Kurt Kuehn

Yes, it is very difficult to just will the tower ever recover. Your incremental costs for just those few pieces over a threshold are challenging, that will be just one of many mechanisms that we deploy. So it is a multipronged process. We've accomplished the first step which was maintaining and sustaining the value of the brand and our commitment to our customers and going forward, as we said, we'll both reduce our costs with more streamlined operations as we get a little smarter in handling these spikes and also pursue revenue in a number of fronts, not just control tower.

David Abney

As we invest in the capacity of our buildings and facilities and vehicles and others, you got to remember that we still expect a real high return on invested capital. And we've said before, we'll continue to say that we expect a 25% to 30% return. So these investments are made with the investor in mind and it is to get the return that our investors have become used to and that we certainly are committed to continuing.

Operator

And we do have a question from the line of Kevin Sterling with BB&T Capital Markets. Please go ahead.

Kevin Sterling

Kurt, I think in your prepared remarks you talked about products being closer to the consumer which resulted in some trade down from premium products. I want to ask you kind of going forward do you think this trade down will continue as you say more distribution centers are built? I would think this trend might continue that way, but I would love to hear your thoughts looking forward regarding products closer to the consumer in the trade down.

Kurt Kuehn

Yes, Kevin, I guess there is really two things that are going on. One of them is really a comparison to last year where a number of customers given the challenges of peak accelerated and traded up, but the other one is more of a structural issue and we do think that Next Day Air, at least for B2C fulfillment is likely to decline over time. We think the B2B as the industrial base grows there is good opportunity. But, Alan, I know this omni-commerce omni-channel is quite a trend that's revolutionizing retail.

Alan Gershenhorn

Yes, so like we've said before we're seeing a significant amount more of our brick-and-mortar retailers utilizing the inventory from their stores to fulfill the e-commerce needs of their distribution centers. So this year, we've got about 120 retailers, nearly 22,000 stores that have the ability to ship packages now using omni-channel solutions and this year we've added about 41 retailers and more than 5000 stores in 2014. So we expect this trend to continue and certainly echo Kurt's comments on how the retail industry and e-commerce is going to handle the overnight or shorter shipping timeframes.

Kurt Kuehn

It does make for some year-over-year changes in distribution patterns that keep us busy though.

Operator

And we do have a question from the line of Scott Group with Wolfe Research. Please go ahead.

Scott Group

So wanted to follow up on the pricing, there has been good kind of broad discussion, but maybe we can put some numbers around it. Is there any way that you can talk about how much your cost per package has gone up domestically and maybe that's a way to quantify how much pricing you need to get to offset that cost? And just along those lines, just want to understand is the idea with the peak surcharges that fourth quarter is going to start being the most profitable margin quarter again?

Kurt Kuehn

Well certainly that's our goal over time, Scott. We think it is the time when the capital is fully deployed, so to recover cost of capital for that it should have our highest margin. It's also the time of the greatest demand. So for I think six years up till 2012 we had I think both the highest margin and the highest profit in the company in the fourth quarter. So is this a challenge for the company? Absolutely. Have we figured it out and operated successfully in the past? Yes. It's just gone beyond that economy of scale to where the added volume is creating diseconomies. We will get this solved. It is a two-pronged process with operational enhancements, some automation, some smart capacity and efficiency and also making sure that price recovers it. So we really can't decompose all of that stuff at this point yet, but it is job one for us and it's a great problem to have. We're disappointed that we over swung last year.

Operator

And we do have a question from the line of Helane Becker from Cowen. Please go ahead.

Helane Becker

I was just wondering if we could get away from the fourth quarter for a second and just look out to 2015 and the first quarter and what you're seeing. I was just wondering if you can make some general comments about what you're seeing in the economy, maybe with a specific comment to what you're seeing from your corporate accounts who are energy focused and if there is something you can fill us in about what you're seeing there.

Kurt Kuehn

Yes, our exposure to the energy sector is not huge. There is not a tremendous amount of small package. But clearly all industries are having an impact over time with this low energy cost. On the procurement side, it will ripple through into reduced prices we hope for things like tires and some of our commodities. Clearly, the fuel surcharge changes our impact. We did mention that the UPS Freight and the LTL surcharges are a bit of a challenge, but we think in general the reduced fuel prices are good for the economy and will help certainly the U.S. continue to grow.

I think trends so far in January -- certainly things look better than they did a year ago at this time because of the incredible disruption of all the snowstorms. Although those people in Detroit and Chicago right now may not be feeling that way. So we feel pretty good in general. I know, Jim, around the globe anyway, the Chinese New Year is a little later than normal. Maybe you could talk a little bit about trade flows and anything you guys are seeing.

Jim Barber

Well I think it's just as you said. We're about where we thought we would be and of course, year-over-year it's different because of weather and some other options. I think the port delays are presenting some unique trade patterns. I think generally though, since that port delay is heavy into the oceanside of the supply chains that really presents some challenges for our customers. We've been at it for a year now actually. We started last February 2014 with webinars with all of our folks and customers to give them solutions and some of that you've seen appear in Myron's side of the business when it actually gets into -- because you've got to get into the port, through the port and out of the port and that's where our network provides some really good options. So I would say the port would be the big one and the wildcard here going forward as it moves from freight off the ocean, not so much into the air, but other surface modes as it appears in the U.S. side of the business.

David Abney

Just a couple things on the economy. one is things seem to be continuing to be going up or getting slowly better in the U.S. Unemployment rates are getting much down, very close to prerecession rates and consumer confidence is increasing and it's one of the reasons that we believe that our revenue is going to continue to grow and grow at a good pace in this year in the U.S. In Europe, of course, there's a lot of concern about the economy there, but our results have been and continue to be much better than we're seeing from an economic standpoint. Jim, could you talk a little bit about the transborder in Europe and the success we've seen there?

Jim Barber

Sure. As we know, the transborder network, we've talked about it many times on the previous calls it continues to drive our growth. You've seen that in the export numbers. Kurt mentioned about a year ago we would continue to reinvest in Europe, his number at that time was about $1 billion. We actually have sized it for the next five years. It's actually above that. We won't get to the specific numbers because there's changes, but it's above $1 billion and we believe that investment in essentially the Western side of the European operations, A, is needed, but, B, can bend that cost curve as we talked about it back to some of the days where it was at its best. So we would continue to do that.

The other wildcard I would mention at the same time though, David is I think the strength of the dollar will have implications going forward that we're going to have to watch as trade patterns move around that, so that would be another wildcard, but we're happy with Europe and its continued growth for the business.

Operator

And we do have a question from the line of Ben Hartford with Robert W. Baird. Please go ahead.

Ben Hartford

Jim, maybe if we could just continue down that path and focus on international freight forwarding for a moment. There was some acknowledged weakness this quarter. I would be interested in your perspective on the yield dynamics in the fourth quarter and how you see that playing out in 2015. It seems as though there is a desire for some more yield discipline in that space, whether that comes through or not, I would be interested in your take. And then also if you could include your perspective on some of the attempted changes from the air freight carriers to comingle fuel surcharge with base rates and what effect that might have for 2015 as well that would be helpful. Thanks.

Jim Barber

Sure. I appreciate it. So if you look at our forwarding unit like many, we've got the ocean product, we've got the surface stuff; we've got the air products. Our North American operation, we continue to see it grow and do very nicely for us. Ocean was a turnaround story for the last five years. It continues to do really well for UPS and our customers and bring differentiated solutions to them. The air freight issue for us, you might have heard me say a couple times previously that we had some overexposure to some verticals around military and so forth.

At this point, I think it's all about the mix of our air freight product. We're still heavily concentrated in some of the enterprise segments of the business. We believe we've got capacity going forward to extend that product into the middle market in a different way and change the mix and the structure, we will do that. You would see that in some of our guidance going forward with respect to a bit of a slower growth and so we'll manage that yield and the kilo growth which you've seen really good growth over the last couple years, but we believe it's time for us to shift.

Your second question really got at this issue of fuel and the mixing of that into transportation. In fact, it's already started to happen with a dip in the oil. We've got some different looks at that. Obviously each organization has to deal with that and how they see that, but yes that is happening in the market right now with the concept of trying to split that apart in a different way and capture that dropping oil price. We have some solutions and some strategies to make sure that we do that on an equitable basis, but right now as we move out in the first part of the year, our strategy remains as I just walked you through and we will obviously have to deal with the fuel dip going forward, but we feel like we've got good controls in place to do that.

Operator

And we do have a question from the line of Scott Schneeberger with Oppenheimer. Please go ahead.

Scott Schneeberger

I'm kind of pulling us back into peak on U.S. Domestic. Obviously, you're going to try a lot on the yield side going into 2015. I'm just curious on the cost side. There is so much opportunity and you're talking of structurally higher costs and sounding very conservative, but with driving density, SurePost Redirect now feeling like maybe the pendulum has swung a little bit to the other side on overtime and training. It seems like there is a lot of opportunity, I guess Myron, perhaps for you, is that something that you're going to be conservative and be cautious and protect brand again in 2015 may be planning for 2016 or is there real opportunity there and we should potentially view some conservatism in that guidance? Thanks.

David Abney

Let me just kick that off with our long term initiatives that we've talked about are certainly going to be very important to us over the next three to five years and so we're going to continue to bend this cost curve. We're going to continue to use technology and accelerate ORION deployment and our automation. All of those will help us from a long term perspective and we're going to continue to use other operational technology. But there are some real specific things that we need to do this year to reduce our costs and Myron, why don't you review some of the specifics.

Myron Gray

Earlier and my statement reflected on Black Friday operations, but certainly there are additional things that we'll certainly do and one is certainly not to err so much on the side of being cautious. In certain locations where we probably brought helpers on too early during peak, we obviously drove up our contract carrier costs by going out and securing contract carriers earlier in peak and paid a premium for them. We won't do that moving forward next year. We obviously -- also in some cases drove our driver paid day too low and added too many drivers. We'll have a tighter dispatch this year and we'll seek to have driver paid days that resemble peaks of the past.

And we've also made some significant progress working with our customers on forecasting and as we get additional visibility tools, we can tighten our dispatch on a daily basis. However, peak does continue to be more complex and it will require that we run a tight dispatch. So we'll certainly plan to do that and make the obvious cost improvements that we can while we continue to invest in hub modernization and show that these peak operations that we have won't drive so much training and associated costs with them, but we will operate much tighter this year in 2015.

Operator

And we do have a question from the line of Tom Kim with Goldman Sachs. Please go ahead.

Tom Kim

Staying on the topic of peak season, what seems to be -- over the last few years what we can easily derive is the fact that predicting demand around the peak season is obviously difficult and you and the shippers can try to influence the timing of shipping, but I would think that demand will remain uncertain which leads me to think that there probably should be more focus on just controlling your capacity and your cost and I guess what's missing in today's conversation is your willingness to simply walk away from business and more specifically I'm wondering like how are you thinking about setting volume caps? Thank you.

David Abney

I will start that out and then hand it over to Alan. But the control tower absolutely did what you're talking about during the very peak moments. Now the purpose of it wasn't to see how much volume we can turn away. The purpose was how we could work with customers to maybe change the timing, maybe change the operating plan so that we could handle their needs. We also though made it very clear especially on peak days through this control tower that we would not be able to take additional volume and we had good cooperation from our customers from that. So Alan, do you want to talk a little more?

Alan Gershenhorn

Yes, look I mean, we're always going to have a max capacity of what we can handle and we certainly need to manage to that considering obviously the revenue and cost and profitability implications. But like Myron said, we've come a long way this past year in really working with our top shippers to coordinate our planning activities to understand how much volume they were going to have and we came to mutual agreements on that. We will do even more of that next year and we're certainly going to be looking at our capacity, but also looking at the revenue cost and P&L implications going forward understanding that we never want to turn business away if we don't have to.

Tom Kim

I guess I'm just a little bit confused because on the last call Myron had talked about being able to adjust capacity if the demand expectations were optimistic and I'm just wondering what had sort of gone wrong there, what was missed given that the control tower was intended to foresee how volumes were going to be shaping up and then adjusting around that. So if you could just help flesh that out a little bit, that would be helpful. Thanks.

Kurt Kuehn

Yes, I think the big issue is just that the demand has become much more spiky at the very beginning of peak and at the very end. And so forecast aside, the shape of demand around the cyber weekend and then the weekend before Christmas was the big spikes and there just wasn't as much needed in that flat period.

David Abney

And we did increase customer collaboration and made a lot of improvements when it comes to forecasting. That is something that we still though will need to continue to work with our customers on.

Operator

And we do have a question from the line of Keith Schoonmaker with Morningstar. Please go ahead.

Keith Schoonmaker

Both this morning and at the recent investor meeting, we've heard about UPS's commitment to investing in Europe. How would you characterize the current B2C growth in Europe, maybe what's the proportion of B2C in the most recent period? And then more importantly how applicable are the learnings from the U.S. peak season challenges in avoiding similar margin crunches in Europe?

Jim Barber

So I would say this. Obviously the business, as you can see is smaller relative to the U.S. and more disperse, but the same patterns actually exist internationally as they do in the U.S. It depends on what country you're in. I would tell you that the expansion of our Cologne operation has provided us great ability to move it transborder, but a lot of this does move domestically. I think you would have seen outside the U.S. some of our local competitors actually didn't make it through this peak. They actually as they say, kind of -- the investors pulled back on them. In the UK we had some issues and we think that our operating model does in fact with a combination of the Access Points and what we're looking at going forward give us the ability internationally to give our consumers choice on how they want this delivered at the right value proposition that in fact in the years to come may present some opportunities back in the U.S. And you're starting to see that with Myron rolling out Access Points, we're bringing My Choice to International. So it's a fee back-and-forth and we like where we're in that and Europe is our probably best market to prove that in the years to come.

Operator

And we do have a question from the line of John Barnes with RBC Capital Markets. Please go ahead.

John Barnes

I hear your commentary around customer collaboration and I recognize the need to have those conversations, but if I'm looking at this incredible surge in volume a couple of times year and especially around peak season and there is only a couple of networks in this country that can handle that level of surge. I'm trying to understand why there has to be this level of collaboration. I mean the e-commerce revolution has taught us anything, its people want a lot and they don't want to pay a lot for it. So it seems to me like there is always going to be this give-and-take and if there is only a couple of networks and you're in what is essentially a duopoly situation, why not be more aggressive? Why does this have to take multiple years? Why can't this be a much more aggressive focus on one getting paid for what you're offering?

Kurt Kuehn

Yes, John, I think certainly that is our focus. We may disagree on the speed and the intensity of it. This is a competitive market. It's not a duopoly, there are multiple players. Part of the value we create, part of why we extract such great returns is the long term success we help our customers get to. So it is a balancing act of trying to milk every dollar out of a couple of days versus creating a sustainable and profitable business year-round and that's the balancing act we're heading towards.

Operator

And we do have a question from the line of David Campbell with Thompson Davis. Please go ahead.

David Campbell

Kurt, you mentioned in your presentation that you were estimating in 2015 a 5% increase in domestic packages, I think that's what you said. I just wondered in general it doesn't seem to reflect the fact that we have $50 oil and the possibility that we're going to get faster growth, not less growth. I'm just curious as to is the 4% growth estimate based on what you see today or does it reflect a longer-term benefit from lower oil prices? Just how does that all work out?

Kurt Kuehn

Well David, we're looking at about a 4% volume level and certainly there is some range in that number depending on how the economy goes. We did have a very strong year last year and we're cycling across some fairly large wins. There is also some issue that we may be a little more selective in volume. Clearly, it's the flip side of the revenue management initiative. So we think our guidance reflects both an improving economy and also a prudent growth path. So we think that's certainly a number that's in excess of GDP growth and that there may be more volume out there, but we will be somewhat selective especially if we're not appropriately compensated for it.

Operator

And that does conclude our Q&A today. I now turn the conference back to your host, Joe Wilkins. Please go ahead.

Joe Wilkins

Thank you, Brad. I appreciate it. And with that, I will turn it over to David for closing comments.

David Abney

All right, thanks, Joe. So yes, we do feel we have customers back onboard after providing a great service during peak. The financial results will improve as we take the steps to lower the cost curve and adjust pricing where necessary.

The long term growth strategy for all of our business units that we laid out in November remains intact and will provide great opportunities for UPS in the future. UPS has always been a good place for investors, for customers, for employees and we certainly expect that to continue. And thank you for listening and have a great day.