UPS - Q4 2014

Transcript

Operator (participant)

Good morning. My name is Brad. I'll be your conference facilitator today. At this time, I would like to welcome everyone to the UPS Investor Relations Q4 2014 earnings conference call. All lines will be placed on mute to prevent any background noise. After all the speakers' remarks, there will be a Q&A period. Please note we will take only one question from each participant to accommodate more analysts during the call. Thank you for your cooperation. It is now my pleasure to turn the floor over to your host, Mr. Joe Wilkins, Investor Relations Officer. Please go, go ahead, sir. The floor is yours.

Joe Wilkins (Head of Investor Relations)

Good morning, and welcome to the UPS Q4 of 2014 earnings call. Joining me today are David Abney, our CEO, Kurt Kuehn, our CFO, along with International President Jim Barber, President of US 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 risks and uncertainties, which are described in detail in our 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 Q4 and full-year results.

First, expense recognition related to our company-sponsored pension and post-retirement plans. A 90 basis point decline in average year-end discount rates more than offset improved asset returns. This led to a non-cash, mark-to-market, after-tax charge of $670 million. Second, recent contract ratifications triggered the recognition of $22 million in after-tax charges for our Q2 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 Q4 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. Just a reminder, as on previous calls, please ask only one question, so that we may allow as many as possible to participate. Now I'll turn the call over to David.

David Abney (CEO)

Thanks, Joe. Good morning, everyone, and welcome to our Q4 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 Q4 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 reduced 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 and 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 non-peak 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 multiyear period as contracts come due. These pricing strategies will be designed to ensure we are 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 am 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 seven 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 TPA 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 are 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 are 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 multiyear transition.

2015 will be a year of progress, and we expect solid growth in all three business segments. I am 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 (CFO)

Thanks, David, and good morning, everyone. Back on January 23rd, I shared with you our performance during peak season, and I also committed to provide you additional details on today's call. Now I will provide you with more information on our results, as well as further insights into what we expect in 2015. UPS Q4 earnings per share were $1.25. The US 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 one-time 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, US 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, and 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 are seeing benefits from ORION as miles driven increased just 5.8%. As David mentioned earlier, we are committed to lowering our long-term operating cost, while at the same time, implementing pricing strategies that ensure we are 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 one-time items, Q4 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 one-time 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 cost higher. Now, turning to supply chain and freight, which performed pretty much in line with our expectations. Revenue was 7.4% higher due to strong growth in distribution in 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 Q4. 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 up 6%-12%. This includes a $240 million headwind from pension expense and currency. Overall operating profit is expected to improve 5%-9%. Total shipments per day are anticipated to rise about 4%, with revenue up 3%-4%.

Excluding the fuel impact, underlying revenue growth would be 5%-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 are expecting solid base rate improvements due to DIM Weight 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%-9%. International shipments should grow by 3%-4%, with revenue growth of 2%-3%. Falling surcharges in international will lower yields by approximately 300 basis points. Operating profit is expected to increase by 6%-12%, with currency being a $50 million drag.

Supply Chain and Freight revenue is expected to grow 2%-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%-12% to a range of $5.05-$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 Q4s earnings per share growth to be higher than the year's average, while the second and Q3s will fall below. Looking at the balance sheet, we are 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. 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.

Operator (participant)

As a reminder, please ask only one question so that we may accommodate more callers. Feel free to get back in the queue, and we'll take a second question, time permitting. With that, our first question comes from the line of Christian Wetherbee with Citi. Please go ahead.

Christian Wetherbee (Senior Research Analyst)

Great, thanks. Good morning, guys.

Kurt Kuehn (CFO)

Morning.

Christian Wetherbee (Senior Research Analyst)

Just wanted to ask, I guess, a question on pricing and the outlook for 2015. Kurt, you laid out the domestic outlook on the revenue side. Ex the fuel headwind, it seems like maybe there's, 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 into 2016, 2017 and beyond to catch up on that pricing side? Thanks.

Kurt Kuehn (CFO)

Chris, you're right. It is. There's 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%-3% targets that we normally have. So that, we're well on our way towards that. But it is a, 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 (Chief Commercial Officer)

So you know, we're certainly expecting throughout 2015, including peak, excuse me, to see additional revenue per piece improvements, just like we, Kurt alluded to last year. We saw quarter-over-quarter gains from the second, third to the Q4, and that's gonna continue into 2015. Certainly, the Ground DIM Weight changes are gonna impact the 2015 results. We're also continuing to work with our customers on their packaging to obtain mutual cost reductions, so we'll see a little bit of impact there on the cost side. So, you know, we are gonna see improvements throughout 2015, and it is gonna be on the high end of the 2%-3%.

Kurt Kuehn (CFO)

Although it certainly will be masked a bit, as I said, by the, with fuel surcharges down 200 basis points. But, we feel very confident that the underlying momentum is strong.

Operator (participant)

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

David Vernon (Senior Analyst)

All right, thanks for taking the question. So it sounds like the overshoot on costs in this Q4, and I'm trying to understand how the $200 million extra that we spent in the Q4 plays into the guidance for next year. Should we be expecting that level of inefficiency that we saw in the Q4, you guys are 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 (CFO)

Maybe let's start. David, I know, wanted to at least put a recap onto peak season of 14. He could talk a little bit about what our intentions were, and then we can migrate from that into guidance.

David Abney (CEO)

Yes. Well, first, you know, 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 (CFO)

So I think as we look into 2015, you know, 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 are a little cautious, I guess, going forward, twice burned, thrice wise. And so we have, you know, 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, and but right now, at least, that guidance does assume the more drag in the Q4. Certainly, the revenue will help to cover that, and because we do feel that cost is maybe more structural than we thought, that's why we are focusing more on revenue. We do think over time, though, Q4 will become much more profitable. It wasn't too many years ago, just a couple of years ago, where the Q4 was our most profitable quarter, and but it is gonna take us a few years to get there.

David Vernon (Senior Analyst)

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

Kurt Kuehn (CFO)

Some portion.

David Vernon (Senior Analyst)

All right, great. Thank you very much for the time.

Operator (participant)

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

Brandon Oglenski (Director and Senior Equity Analyst)

Yep, good morning. And Kurt, coming off of that comment about how the Q4 used to be the most profitable, I mean, you know, David, your prepared remarks here, obviously, your customers like the service that you provide in the Q4, 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, you know, your shareholders obviously have a little bit different priorities here, which, you know, 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, then ultimately we're gonna be exposed to a lot of cyclical downside whenever the economy does potentially roll over.

So I guess, you know, 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've 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 underestimate on the pricing ability?

David Abney (CEO)

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 think what we, I know we covered it in 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 in the Investor Conference, but the tone is much, much stronger today, is that we are taking this revenue management side very serious. The fact that we realized that 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 cost 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 (President of US Operations)

So 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'll have over 70% of our drivers deployed. We'll continue with hub 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, 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. And 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 (CEO)

Just wanted to sum that question up with, we are certainly focused on our long-term strategies. We are 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.

Brandon Oglenski (Director and Senior Equity Analyst)

Thank you.

Operator (participant)

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

Thomas Wadewitz (Senior Equity Research Analyst)

Good morning. 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, that's broader, 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've fallen, you know, you've said $200 million difference in cost in Q4. You know, I don't know if you'd say it's $200 or more than that shortfall on operating income, probably more than that. So is half of that shortfall going to be on these peak season price changes?

You know, you're looking for $200 million, or what? What's just the magnitude of that pricing change when you look at the peak? Thanks.

Kurt Kuehn (CFO)

Well, well, clearly, Tom, the solution for the Q4 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. We've got a number of initiatives there, both physical capacity and operating changes. And then the other half, equally important, is the yield side, to make sure that, you know, for that disproportionate increase, we do need to increase yield. Also, as we've talked, certainly we are more focused on yield in aggregate because of the, you know, 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.

Thomas Wadewitz (Senior Equity Research Analyst)

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 you know, as peak has become more costly. There's been additional pressure on the margins. 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 firm in our strategy to better align revenue with cost during the peak season as well as throughout the year. And certainly also very focused on, you know, the value creation that UPS does with our customers, and ensuring that, you know, we're getting paid for that.

David Abney (CEO)

You know, one other addition to the peak pricing is this past year, we really focused on the 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 (CFO)

I think one thing maybe we could bridge to a little bit is that 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 (President of International)

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're in, you've got a different market characteristics, capabilities, and situations and operating models. So it really does present us some unique opportunities as we grow in 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 8,000, 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.

You would also probably have noted the acquisition of i-Parcel that gets us into this cross-border e-commerce as well, and here recently, that we plan to roll out globally. Lots of change on the forefront, and international provides us a great platform to experiment and grow the business. Thank you.

Operator (participant)

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

William Greene (Analyst)

Hi, good morning.

Kurt Kuehn (CFO)

Hey, Bill.

William Greene (Analyst)

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 Q3s to the point where if we've 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 (CFO)

Well, Bill, it's a great argument. We'd love to have, you know, the rest of the year, pumped up that high, but if we could scale to it. Certainly, what you're seeing is an industry in transition. You know, part of the challenges that we're wrestling with is that this factor of peak versus the rest of the year has gotten much more extreme. 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 are seeing an uptick in our commercial growth. Our B2B business was up over 3% in the Q4.

So, you know, 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 in the rest of the segments?

Alan Gershenhorn (Chief Commercial Officer)

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, you know, the peakiness of retail.

Operator (participant)

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

Nate Brochmann (Analyst)

Good morning, everyone, and thanks for taking the question. Wanted to follow up back on Tom's question, like, with regarding the pricing and getting the surcharges, and, you know, that certainly all makes sense in terms of going back and getting paid for all that high service. But how far, going back to a question not too, too long ago, how far do you think you can really push that without forcing those various shippers to go in a different direction? You know, we'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 (CFO)

Clearly, that's the judgment that we have. We have long-term relationships with our customers, and you know, 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 that this is really a multiyear cycle, as contracts come due, right?

Alan Gershenhorn (Chief Commercial Officer)

So I mean, you know, 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 you know, we think that, you know, the GRI we just implemented, the DIM Weight changes that we're already seeing the effect on, are gonna pay some dividends in 2015. It is a multiyear process with some of our customers, because they do have multiyear agreements, but we do expect to see positive results from the actions we're taking during 2015.

Operator (participant)

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

Ken Hoexter (Analyst)

Great. Good morning. You know, 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 and hiring 100,000 workers with the returns on those price increases.

Kurt Kuehn (CFO)

It is very difficult to just with the tower ever recover the your incremental cost for just those few pieces over a threshold are challenging. That will just be one of many mechanisms that we deploy. And so, you know, it is a multipronged process. You know, 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 on handling these spikes, and also pursue revenue on a number of fronts, Ken, not just the Control Tower.

David Abney (CEO)

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

Ken Hoexter (Analyst)

Thanks for the thoughts.

Operator (participant)

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

Kevin Sterling (Analyst)

Thank you. Good morning, gentlemen.

David Abney (CEO)

Morning.

Kurt Kuehn (CFO)

Morning.

Kevin Sterling (Analyst)

Thank you. 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 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'd love to hear your thoughts looking forward regarding products closer to consumer and the trade down.

Kurt Kuehn (CFO)

Kevin, I guess, there's 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 up 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's good opportunity. But Alan, I know this omni-commerce, omni-channel is quite a trend that's revolutionizing retail.

Alan Gershenhorn (Chief Commercial Officer)

So we're, you know, 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, you know, fulfill the e-commerce needs of their distribution centers. So you know, 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 5,000 stores in 2014. So we expect this trend to continue and certainly echo Kurt's comments on, you know, how the retail industry and e-commerce is gonna handle, you know, the overnight or shorter shipping time frames.

Kurt Kuehn (CFO)

It does make for some real changes in distribution patterns that keep us busy, though.

Kevin Sterling (Analyst)

Gotcha. Okay, thank you so much.

Operator (participant)

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

Scott Group (Analyst)

Hey, thanks. Morning, guys. So, wanted to follow up on, on the pricing. You know, there's been, you know, good broad discussion, but maybe we can put some numbers around it. Is there any way that you can talk about, you know, how much your cost per package has gone up domestically? And maybe that's a way to quantify, you know, 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 Q4 is gonna start being the most profitable margin quarter again?

Kurt Kuehn (CFO)

Certainly that's our goal over time, Scott. You know, we think that 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, you know, for, I think, 6 years up till 2012, we had, I think, both the highest margin and the highest profit in the company in the Q4. 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-prong 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 just were disappointed that we overswung last year.

Operator (participant)

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

Helane Becker (Analyst)

Thanks very much, operator. Hi, guys. Thanks for the time. I was just wondering if we could get away from the Q4 for a second and just look out to 2015 and the Q1 and what you're seeing. I was wondering if you can make-

Kurt Kuehn (CFO)

Thank you, Helane. Thank you.

Helane Becker (Analyst)

I was just wondering if you could make, you know, 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, you know, energy-focused, and if there's something you can, you know, fill us in about what you're seeing there.

Kurt Kuehn (CFO)

Our exposure to the energy sector is not huge. There's 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 are impactful. 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, are good for the economy and will help, certainly, the U.S. continue to grow.

I think trends so far in January certainly 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 (President of International)

Well, I think it's just as you said, we've got, we're about where we thought we would be, and of course, year-over-year, it's different across 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 ocean side of the supply chains, it's really, though, 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 ocean 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 got to get into the port, through the port, and out of the port, and that's where our network provides them some, some really good options. So that I would say the port would be the big one in the wild card here going forward in, 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 (CEO)

You know, just a couple of things on the economy. One is, things seem to be continuing to be going up or, or getting slowly better in the US. Unemployment rates are getting much down, very close to pre-recession 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, in this year in the US. In Europe, of course, there's a lot of concern about the economy there, but, 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 (President of International)

Sure. So you know, we've—as we know, the transborder network, we've talked about it many times in 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 curves, curve as we've talked about it back to some of the days where it was at its best. So we would continue to do that.

The other wild card 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 network patterns move around that. So that would be another wild card, but we're happy with Europe and its continued growth for the business.

Helane Becker (Analyst)

Great. Thank you so much for the comprehensive answer. I really appreciate it.

Operator (participant)

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

Benjamin Hartford (Analyst)

Hey, good morning, guys. 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'd be interested in your perspective on the yield dynamics in the Q4 and how you see that playing out in 15. It seems as though there's a desire for some more yield discipline in that space, whether that comes true or not. I'd be interested-

In your take. And then also, if you could include your perspective on some of the attempted changes from the airfreight carriers to commingle fuel surcharge with base rates and what effect that might have for 2015 as well, that'd be helpful. Thanks.

Jim Barber (President of International)

Sure, I appreciate it. So if you look at our forwarding unit, like many, we've got the ocean product, we've got, you know, 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 of 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 of 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 the 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 in 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 in it going forward, but we feel like we've got good controls in place to do that.

Benjamin Hartford (Analyst)

Helpful. Thank you.

Operator (participant)

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

Scott Schneeberger (Analyst)

Thanks. Good morning, guys. Pulling us back in the peak on U.S. domestic. You know, obviously, you're going to try a lot on the yield side. Going into 2015, I'm just curious on the cost side, there's so much opportunity, and you're talking of structurally higher costs and sounding very conservative, but with driving density, SurePost redirect now, you know, feeling like maybe the pendulum swung a little bit to the other side on overtime and training. It seems like there's 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, maybe planning for 2016? Or is there a real opportunity there, and we should potentially view some conservatism in that guidance? Thanks.

David Abney (CEO)

Let me just kick that off with the Our long-term initiatives that we've talked about are certainly going to be very important to us over the next 3-5 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 (President of US Operations)

Earlier in my statement, I 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. But there were 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 that. We won't do that moving forward next year. We obviously also, in some cases, drove our driver pay day too low and added too many drivers. We'll have a tighter dispatch this year, and we'll seek to have driver pay days that resemble peaks of the past.

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 so that these peak operations that we have won't drive so much training and associated costs with them. But we'll operate much tighter this year in 2015.

Scott Schneeberger (Analyst)

Great. Thanks.

Operator (participant)

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

Thomas Kim (Analyst)

Good morning. Thanks. Staying on the topic of peak season, you know, what seems to be, you know, over the last two years, what we can easily derive is the fact that predicting demand around the peak season is obviously difficult. And, you know, you and the shippers can try to influence the timing of shipping, but I would think that demand, you know, will remain uncertain, which leads me to think, you know, that there may 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 (CEO)

Well, you know, I'll 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, you want to talk a little more?

Alan Gershenhorn (Chief Commercial Officer)

You know, I mean, we're always going to have a max capacity of what we can handle, and, and we certainly need to manage to that, you know, 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, you know, how much volume they were going to have, and we came to mutual agreements on that. We'll 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, you know, we never want to turn business away, if we don't have to.

Thomas Kim (Analyst)

I guess I'm just a little bit confused, because on the last call, you know, Myron had talked about being able to adjust capacity if the demand expectations were optimistic. I'm just wondering, you know, what had, you know, gone wrong there? What was missed, given that the Control Tower was intended to foresee, you know, 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.

Myron Gray (President of US Operations)

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 forecasts 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 those, in that flat period. So thanks.

David Abney (CEO)

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

Operator (participant)

We do have a question for the line of Keith Schoonmaker with Morningstar. Please go ahead.

Keith Schoonmaker (Analyst)

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

Jim Barber (President of International)

Great, Jim. So, I would say this, obviously, the business you can see is, is smaller relative to the US and more dispersed, but the same patterns actually exist internationally as they do in the US. It depends on what country you're in. I would tell you that, you know, 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 US, some of our, our local competitors actually, didn't make it through this peak. They actually, as they say the investors pulled back on them.

The UK, we had some issues, and we think that our operating model does, in fact, with the 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 US. You're starting to see that with Myron rolling out Access Points. We're bringing My Choice to international. It is a, it's a feedback and forth, and we like where we are on that, Europe is our probably best market to prove that in the years to come.

Operator (participant)

We do have a question for the line of John Barnes with RBC Capital Markets. Please go ahead.

John Barnes (Analyst)

Hey, thanks, guys. Thanks for taking my question. I hear your commentary around customer collaboration, and I recognize the need to have those conversations, but if, if I'm looking at this incredible surge in volume a couple of times a year, and especially around peak season, and there's only a couple of networks in this country that, that can handle that level of surge, I'm trying to understand why there has to be this level of, of collaboration. I mean, if, if the e-commerce revolution's taught us anything, it's people want a lot, and, and they don't want to pay a lot for it. And so there's, it seems to me like there's always going to be this give and take.

And if there's only a couple of networks and you are in what is essentially a duopoly situation, you know, why not be more aggressive, right? Or why does this have to take multiple years? Why can't this be a much more aggressive focus on getting paid for what you're offering?

Jim Barber (President of International)

John, I think certainly that is our focus. We may disagree on the speed and the intensity of it. This is a competitive market. There are certainly, 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.

John Barnes (Analyst)

Okay, thanks for your time.

Operator (participant)

We do have a question from the line of David Campbell with Thompson Davis & Co. Please go ahead.

David Campbell (Analyst)

Yes, thanks for taking my question, gentlemen. 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 that, I mean, we're, I just wonder, in general, it doesn't seem to reflect the fact that we have $50 oil and the possibility that we're gonna get faster growth, not less growth. And I just get curious as to, you know, 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 (CFO)

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

David Campbell (Analyst)

Okay, thank you.

Operator (participant)

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

Joe Wilkins (Head of Investor Relations)

Thank you, Brad. I appreciate it. With that, I'll turn it over to David for closing comments.

David Abney (CEO)

All right, thanks, Joe. So yes, we do feel we have customers back on board 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.