United Parcel Service, Inc. (UPS) Earnings Call Transcript & Summary

So for those of you that don't know me, I'm Tyler Brown. Said that a few times at this conference so far. I'm the senior analyst here at Ray Jay, I cover transportation, I also do the environmental services industry. Brian, I don't know if you know that.

No.

But that's not what we're going to talk about today, so -- or at least at this moment. So this morning, I suppose, I'm excited to have UPS with us. So presenting today is the company's new CFO, Brian Newman. We have Scott Childress out in TV land here. He kind of heads up the IR effort. So I think a lot of us know UPS. I think everybody maybe even uses it daily, so to speak. But UPS has been going through a lot of transformation. There's a lot of change kind of at hand. We're in the middle of a big investment cycle. We think on the other side of that cycle, things look pretty good as they manage the whole B2B to B2C shift. I think we'll talk a little bit about that. So Brian, I think you have a few slides, maybe we'll kind of talk about the state of the union, a little bit about UPS, and then we'll kind of move into a fireside chat. It's dynamic. So if anybody has questions, please raise your hand and feel free to ask. So Brian?

Thanks very much, Tyler, and good morning. It's my first time at Raymond James, so it's good to be here representing UPS. Why don't we get started? Before I begin, I'll just take advantage of the safe harbor provision of the Private Securities Litigation Reform. Also during today's presentation, I'll make some references to adjusted results and non-GAAP financial measures. Reconciliations will be available along with the presentation on the UPS investor website later today. So with that, I thought I'd start and just share 3 or 4 slides and then sit down with Tyler and take some Q&A in terms of the state of the business. Starting with 2019, it was a dynamic year. We had headwind and tailwinds. However, I think we made the right strategic and network adjustments. As a result, we delivered good year-over-year results, demonstrating progress in the transformation effort that we're currently going through. Relative to the original expectations in 2019, the combination of global trade dynamics coupled with industrial side of the economy, which was softer than we expected. However, our focus on operating margins was able to enable us to leverage and contribute to positive growth opportunities, which allowed us to overcome some of the headwinds. So at a high level, on the -- we were able to adjust to the conditions and deliver within the original guidance from the start of 2019. The segments which are showing up at the screen, in the U.S., delivered both strong top and bottom line results. The automated hubs that we've been executing over the course of 2 years enabled a solid peak performance in November, December. International continued to operate very well. They executed strongly, improved their operating margins in a soft trade environment. And then finally, supply chain expanded their operating margins. Two businesses that did very well, logistics and market were really driving the profit on that side of the house. So operating margins, as you see, expanded in 2019 and was a positive contributor to the overall business performance, but not the only one. As we think about the transformation strategies and investments, which really anticipated the growth that Tyler referenced in terms of the e-commerce development, it really positions UPS to be -- and capture the opportunities for all our customers. So the structural shift that happened over the last couple of years really brought a surge in Next Day Air. It was over 22% in 2019, and it was an increase we were well equipped to take advantage of with the investments we had planned ahead of that. We clearly gained market share in the air products, and our operating teams took advantage of the 20 new aircraft and the additional 10 million square feet that we had automated and added to our network in 2018 and 2019. Investments drove productivity gains and lowered unit costs on a year-over-year basis. We generated positive operating leverage for the year in the fourth quarter. All of our segments were up over 100 basis points. And then finally, looking to the future, as we think about accelerating forward, we leaned into some drone technology and working with customers today on hospital campuses and health care. From a strategic growth initiative, we have 4 strategic growth initiatives that we're focused on at UPS. Underpinning all that is really revenue diversity. Revenue diversity and growth in the most profitable sectors is a priority for us. We're reinventing a portion of our transformation savings or reinvesting into new and unique areas and solutions. I think we've introduced more solutions in the past 12 months than we have in the past 5 years. So we're on a good glide path. The 4 strategic initiatives, first and foremost, the small and medium business, SMBs. The second, as you see up there, is our international growth markets and opportunities, global B2B and B2C e-commerce, and then finally our health care and life sciences business. I would say -- we would all say that there have been dynamic economic conditions and certainly the structural shift in the market. We feel good about taking the aggressive steps to invest for the growth that lies ahead. In 2020, on the earnings call recently, we announced some investments to speed up the ground network, launching new SMB-centric solutions to help compete and grow. Additionally, across the network, we're investing in our Express services to thousands of additional postal codes across 40 countries. We launched UPS Premier, which is a new critical health care product, which enables advanced tracking capabilities. And finally, we just stood up a new health care and life sciences division that I talked about to take advantage of growth in that segment. So I'm sure many of you have been hearing at the conference about recent developments. I thought I'd comment on just a few and I'm sure we'll go deeper with Tyler in a minute. But we provided investors with additional transparency during our fourth quarter earnings call. I think you heard that pension discount rates and SMB initiatives are a headwind to us in 2020. The good news is that net pension is a slight benefit from an EPS standpoint, and the SMB initiatives we invest -- we talked about investing in this year will be accretive in '21. Turning to more recent developments. The coronavirus was not in our 2020 guidance. And as our CEO, David, said during his February 24 interview on Bloomberg, we do anticipate an impact on our results. But given the uncertainties, I still think it's too early for us to quantify the impact at this point with another month left in the quarter. We're closely monitoring U.S. industrial production. And so despite some of those challenges, on a more positive note, I would say the enhanced flexibility of our network is going to allow us to minimize emerging headwinds where possible. And I think we have a track record of that. One last slide before we get into Q&A. We remain confident in our strategies and continue to grow our dividend. On February 13, we announced the quarterly dividend of $1.01 per share on all our outstanding Class A and B shares. It'll be payable March 10 for shareholders of record as of February 25. And for nearly 50 years, UPS has either increased or maintained its dividend. And since 2000, UPS' dividend has more than quadrupled. So Tyler, that's a bit of a backdrop. I appreciate you giving me a chance to make some opening statements. Maybe we'll sit down and have -- take some Q&A. Maybe I should leave that slide up there with the dividends.

Yes. That's a good one. It's absolutely a good one. Yes. So again, this is an interactive fireside chat. If anybody has any questions, certainly, feel free to raise hand and ask those questions. But just to start a little bit with the coronavirus, I mean, this is obviously a big issue. The market's gyrating all over the place. The stocks have been impacted. So what are you guys seeing, though, on the ground, specifically in China? You obviously have a large presence over there. Is there anything you can kind of share, at least, in that regard?

Sure. So I've been meeting with investors all morning, and that's generally been the first question that came up. So first, we have a lot of employees and customers on the ground over in China. So anyone who is impacted, we're obviously focused first and foremost on making sure they have the right health care and needs from a protection standpoint. The business obviously slowed. I referenced in my comments, we maintained our Lunar New Year operations, coming out of Lunar New Year and sort of extended that by a couple of weeks, recognizing the downturn in the market. The -- our planes are flying in and out of China right now. This week, we're starting to see a rebound in activity in China and Hong Kong, specifically, Tyler. But this thing is moving quickly. I think we're trying to position ourselves to take advantage of some pent-up demand, and we'll take it week-by-week as far as extended impact. But we are seeing a rebound this week.

Okay, that's great. And I don't want to keep it too near-term focused, but what happens in the Air Freight market when something like this happens? All the wide-body domestic flights going to Asia are just not there. There was a lot of capacity that's basically been taken out. It seems like the parcel carriers are still flying. Is that market getting extremely tight? And is that an opportunity, quite frankly?

Yes. It's -- the big question is timing. They're with the belly space in a lot of the commercial aircraft coming off-line. And I think expected deliveries that would be coming over from China in the next week or 2, it's -- there's going to be a need probably to shift some from sea to air. And so I mentioned our planes are flying. So the real question for me is not if, it's when and how. And so is it a gradual or accelerated recovery? And that's one of the reasons we're taking a look here in the month of March to see how that comes back online.

And maybe just out of -- this is more curiosity than anything, but have you seen any pickup in e-commerce just as people maybe kind of stay shelter in place, if you will? I don't know if that's right or how to put it.

Yes. I -- are you talking about in Asia specifically?

Just -- yes. Anywhere that's been affected.

In general? I would say, e-commerce remains a steady growth area for us, but I'm reading a lot of the same reports that you are about people going to the stores and stocking up, et cetera. So I think there is a bit of a reaction happening right now.

Right. So Brian, I think you've been at UPS for 6 months.

Yes.

If I -- correct me if I'm wrong, but you came from PepsiCo, so kind of outside UPS. Now UPS has been known to obviously bring a lot of people, kind of UPSers, through the ranks and move up. You came from the outside. It's not completely unusual. It's unusual, but not clearly unheard of, I should say. But I'm just curious, what really drew you to UPS? What do you think drew UPS to you, so to speak?

Yes. It's all about the company, not about me, but I'll take the question because you asked it. The same thing probably attracted me to UPS that attracted them to me, which Tyler was -- I spent the last 26 years at a consumer products group, and I did CFO roles all around the world, lived in 6 countries in Asia, Europe, South America. So the global nature of my background, the global nature of UPS were similar. And then I started up the e-commerce business over at PepsiCo, I ran their global supply chain, and I ran global strategy. So I think the need for UPS to transform itself, my experience in supply chain, strategy and e-commerce, it was probably kind of a natural fit.

Right. So is there anything that you would note that you were surprised by? I'm always curious by this as somebody who kind of walks in, particularly a large kind of entrenched organization with hundreds of thousands of people. I'm just curious if there is anything that you were surprised, I'm not sure if you were in Atlanta before.

I was not.

Maybe the traffic?

No.

For goodness sake, it's not good, but...

Atlanta is a big Coke town. So I didn't spend a lot of time down there from Pepsi. But yes, the traffic has been one negative surprise. That's the only thing I don't like living about in Atlanta, but the people have been the biggest, Tyler. You mentioned most of UPS senior leadership comes from within. And I think the willingness of the team to embrace an outsider, helping learn the business. And really, the team wants change. And for me, it's all about accelerating. So that's what I'm focused on.

All right. So I'm going to kind of move over to a very important topic. We've been hearing a lot of chatter about this amongst investors, and it relates around some recent Amazon disclosure. So I'm just kind of curious, can you talk about that disclosure? You noted that it was roughly, call it, 11.5% of revenue. My hunch is it's maybe a bit more of a strategic relationship than maybe some people appreciate. That may be the wrong read, I'm not sure. But I'd love if you could kind of talk about that relationship. How do investors kind of get comfortable around such a high customer concentration around, particularly, a customer who's shown, let's just say, in times that they've kind of moved and shifted volumes or carriers in the past.

Yes. It's probably the second most popular question I've had today. So you're on a good path. Look, we did disclose that Amazon is 11.6% of the revenues. So it is our largest customer. The reality is we have -- 89% of our business is with other customers. And so, normally, we don't talk about one single customer, but with the disclosure requirements, I'll take it on. Amazon is a big, important customer. They're driving a lot of growth. They're part of the ecosystem of e-commerce. And so I think the investments that UPS started about 3 years ago to automate the network and automate the hubs positioned us to take advantage of the structural change that's going on in e-commerce right now, which is the Next Day Air. Without that head start, it would have been difficult to execute a second good peak season that we just went through. There are -- of the top retailers in the U.S., Tyler, we work with 90% of them. So it is a balanced network and customer base. That said, I think when you have a mutually beneficial relationship between a customer like Amazon and UPS, that -- when it stops becoming mutually beneficial, okay, then there is a problem to solve. Today, they're driving a lot of growth. We want to participate in that growth as long as it makes economic sense for us. You look at the margin expansion, 14% B2C growth in the fourth quarter, we were able to expand our margins over 100 basis points. So it's working from a margin and economic perspective. The other thing that I'm sure all of you know is we have a very peaky business. And in November-December, our volumes spike about 70% to 80% over what they do in the rest of the year. And when we work with big customers, we work them for 12 months, not for 2 months. And so in order to handle the peak, et cetera, I think there is a good relationship and balance there between the two.

So there also was a disclosure in the 10-K around your AR, your receivables, that I think 17% was Amazon. So I'm just curious, how do we read that? Was that just a simple timing issue? Or would that somewhat indicate that maybe Amazon at a -- on a go-forward or a run rate basis was even higher?

No, it's a -- it has to do with the peak volume. So at the end of the year, 60% was sort of B2C. We had 14% B2C growth. And it's the concentration of that 70% to 80% spike at the end of the year. So it's more of the timing of the year that it occurs.

Okay. And I don't know if you can speak to this, but is it all domestic package? Or is it broad -- the revenue broadly across maybe multiple segments in UPS? I'm just curious, if you can speak to that.

So yes and yes. We -- the majority of the business is through the domestic small package business, but we do service them through all 3 segments of the business.

Okay. Yes. So maybe -- yes, go ahead, sorry.

It's been a couple of years of an elevated CapEx cycle. So what do you think the run rate [indiscernible]

Yes, it's a great question, and it ties nicely to cash flow as well. And so I would say the answer is about 7%. Lately, we've been running at about 8.5% of revenue. As far as CapEx, that's coming off trends years ago of 4%. So there is a big ramp-up to get the system automated. We were about 40% automated 3 or 4 years ago. We're now approaching 80%. So now when you run that play, you can start to bring the capital down. It won't happen overnight, but we'll moderate to about 7%. That's the current trajectory.

Yes?

The percent of revenue that you reported [indiscernible]

The -- it's included. It's included.

So maybe we'll kind of follow up more on the cash flow, but I want to talk about the next few years. This is something that we're very interested in, not next quarter, but the next few years. So maybe can you talk just, first off, at a high level, just to make sure that everybody understands kind of what's going on. But there is a lot of CapEx, there is a lot of P&L penalties that are running kind of -- penalties running through the P&L as you go through your Smart Global Logistics Network investments and all of that. So how should we kind of think about what are those investments really? What is the end result of those investments? What's the main purpose, I guess, ultimately, for those investments?

Yes, it's twofold. One is service and one is economics. On the service side, well, first let me paint the picture -- did I lose my mic? There we go. Paint picture. We announced a $0.33 investment in SMB initiatives specifically designed to speed up time in transit and to go to a weekend service. And so with those 2 investments, we think it positions us more competitively with the SMB customers, which is an economic opportunity, given the margins in the SMB segment. So if you're able to deliver better service to your customers that leads to the economic piece, which is the -- those investment returns become accretive in 2021. So we thought from a timing perspective, it was the right time to act now, given we laid all the track to automate the network, so we can handle all the volume at a more accelerated rate and more efficient rate. And then by putting in those 2 services for our SMB customers, it balances the mix between B2B and B2C.

Right. Yes. I mean it's just, frankly, been noisy. I mean the P&L has been noisy. Particularly in the U.S. domestic margin, there was accounting -- or pension accounting changes. And we have discount rate movement and all these accelerated investments. But you guys -- you showed a data point up there that cost per piece is actually falling in domestics. So when we think about longer term, when do we start to really see the leverage, I suppose, in the U.S. domestic margin? I think that's what a lot of investors are looking for, frankly.

Yes. And so, Tyler, you're right. With pension discount rate investments, there is a lot of noise. We've put up a reconciling slide on the earnings call and talked to that to try and break it down in terms of what is the pension headwind, $0.26, the $0.33 investment in SMBs, et cetera. But the reality is, where are we headed? We're headed towards 10.5% to 11.5% margin in the U.S. business. We've been on a trajectory of 30 to 50 basis points improvement per year. The 9.4% is where we finished up at the end of last year. As you look at the rollover in terms of where we're going to be going into 2020, we'll actually be low 9s, not high 9s, as you would have expected, 30 to 50 basis points. What's the difference? The difference between a low 9% margin versus a high 9% is $0.33, which happens to be the SMB investment we're making. So that's a delta. It's pulling forward those investments we were going to make in 2021, but we think it's the right time to do that, given the payback going forward.

Right. So hopefully, we kind of move through this valley. The domestic margins begin to kind of improve. At the same time, we talked about it with CapEx. There is hopefully a crescendo in CapEx. I'm presuming that's probably '21, '22 and we kind of start to moderate down. But the idea -- and you guys have always had a hallmark of generating tremendous free cash flow, but my hunch is that, that number should really start to accelerate as those 2 dynamics start to play out.

Yes. I mean you've got to be careful going too far out, right? But the CapEx elevation starts to come down, as I talked. You're making these investments to balance the margin as the U.S. margins go up. And by the way, we didn't talk about international. The margins in international are very, very solid. I think you saw them up on the screen, but we're in the low 20s internationally in this market. So that's a good story as well. So net-net, you combine those, a bit of a taper down on CapEx with improving margins. And you'd like to see the output in cash flow, that's what I'm focused on.

Right. And maybe broadly on the pension. Where is the funded status of the pension? How do we think about how much cash you need to continue to pump into the pension? I know there's been some change in discount rates and such, and maybe that affected the PBO. But I'm just curious if you can talk broadly about the pension.

One of my favorite topics, pension and economics. We're in the mid- to high 80s as far as funded status. We've put a $2 billion discretionary payment in last year, anticipating about $1 billion this year. So look, managing pension, you want to balance shareholders, employees, et cetera, and maintain flexibility. So we're very focused on managing that and having a healthy balance sheet.

Well, I think we're about out of time, top of the hour. It's probably lunch time. So I appreciate, Brian. Thank you very much.

Thank you. Appreciate it. Thanks.