Yesterday, in its conference call covering its 4th Quarter 2011 earnings,  United Parcel Service (UPS) provided strong evidence that the parcel delivery industry is now more closely tied to the growth in e-commerce than to the economy in general.   In addition, it provided some idea as to how UPS is changing its operations, pricing, labor relations, and marketing to deal with the change in the mix of parcels that its customers want UPS to deliver.

Highlights of the conference call are as follows:

• UPS is bullish on the U.S. economy and is particularly bullish on manufacturing in the United States.
• In December, business-to-consumer was over 50% of UPS’s volume.
• The December volume actually included two mini-peaks.  The first followed Black Friday and Cyber Monday and the 2nd peak came during the last week before Christmas.
• In January, business-to-consumer business remained strong, but no proportion of volume information was provided.
• E-commerce results in UPS’s 4th quarter (October through December) generating more revenue and profits than other quarters
• UPS sees the growth in the importance of business-to-consumer, e-commerce-driven shipments as a worldwide phenomenon.
• UPS’s business is tied to consumer sentiment.
• The growth of e-commerce means that UPS will see out-sized gains when consumer sentiment is positive and smaller volume troughs when consumer sentiment is weak.
• The shift toward e-commerce has the effect of intensifying volumes during good times and lessening the loss of volumes during bad.
• E-commerce means that the average weight per shipment is down 3%.  This results in a lower yield (revenue per package)  The inclusion of SurePost revenue in domestic ground statistics results in even lower yield growth per package. Yield may not be as good an indicator of the average change in prices due to change in the mix of volume.
• Consumers that purchase frequently on-line want a better delivery option than delivery to their home address.
• UPS signed up 3/4 of million people for its My Choice service, a service that charges for delivery to a UPS Store rather than the person’s home.
• These people averaged 4 shipments delivered to a UPS store in the quarter.
• SurePost was frequently mentioned in this conference call, as it is UPS’s newest service.
• It’s introduction more than likely had some impact in the average weight and average yield of UPS Ground shipments.
• Mentioning SurePost in the press release and in the discussion during the conference call was important as analysts needed to adjust their revenue models to accommodate the impact of lower shipment weight and yields going forward.  (More about SurePost in an upcoming post.)
• UPS mentioned that customers that sent SurePost shipments sent 4 to 5 shipments delivered by a UPS Teamster truck driver for each shipment delivered by the U.S. Postal Service.
• UPS’s Second Day air product saw growth due to e-commerce.
• This growth came from retailers that wanted to provide a faster shipping option for lighter-weight shipments.
• The change in mix of shipments resulted in the average weight and yield for the 2nd-day air product to be down.
• UPS did not see growth in imports from Asia that matched the growth in e-commerce sales of items manufactured in Asia.
• Inventories were tight in the U.S., which resulted in many e-tailers running out of inventory.
• Inventories appear to still be tight, so UPS is hoping for some pick-up in its Asian air-freight volumes.
• The growth in volume in 4th Quarter combined with the growth of SurePost resulted in significant productivity gains.
• UPS saw operating statistics, such as direct labor hours, miles driven, and block hours, all grow at a rate slower than volume growth.
• UPS’s productivity improvements related to improved labor utilization during the peak period, in the 4th quarter offset its entire wage increase.  UPS does not expect to see that happen in other quarters when volumes fall below 4th quarter levels.
• UPS expects compensation levels (wages and benefits ) will rise 1 -2% a year.   The relatively low rate of increase will reflect a reduction in the average seniority of employees. UPS expects that as its business grows it will be hiring more full-time employees at lower wage rates than its current average. UPS also expects turnover of its part-time package handlers to increase as part-time package handlers find full-time work in the improving job market.
• UPS’s long term goal is to generate 2-3% increases in rates. [It is unclear if they mean a 2-3% increase in rates or yields.  If they mean yields, the shift in average weight of shipments would tend to lower the increase as compared to rate increases.   If UPS means rates, this  does not mean that published rates will go up 2-3%.  It means that the average rate that all UPS customers pay goes up 2-3% with some going up more and some less.  Regardless of what UPS means in its comments, published rates are likely to continue to rise faster than the 2-3% annual increase described here.]

Excerpts from Opening Statements

D. Scott Davis – UPS Chairman, Chief Executive Officer and Chairman of Executive Committee

 In the U.S. we saw a robust growth in e-commerce. While traditional retailers experienced mixed holiday sales, continued migration to B2C, contributed significant growth in UPS’ residential shipments. This rapidly expand in market segment enables more and more opportunities for consumers to experience the unique solutions provided by UPS. Solutions like UPS My Choice, the industry’s first offering that puts receivers in control of their shipments. UPS delivered almost 3 million packages to My Choice users during the quarter. Enrollment exceeded expectations approaching 3 quarters of 1 million subscribers, not bad for a service offering in its first 3 months of existence. All in all, the U.S. market performed very well, going at a faster pace than we projected.

Kurt Kuehn – UPS Chief Financial Officer, Principal Accounting Officer, Senior Vice President and Treasurer

Revenue per piece was up 3.4%. Higher base rates and fuel surcharges were somewhat masked by a decline in weight per shipment and changes in both customer and product mix. Growth from large e-commerce customers outpaced smaller accounts, impacting both customer mix and package characteristics. As a result of this rapid growth in B2C, UPS experience a meaningful decrease in weight per shipment, down almost 3% compared to the fourth quarter of 2010.

We successfully adapted to this changing product mix, with an operating profit increase of 24% and margin expansion of 200 basis points to 14.9%. The U.S. domestic operations executed one of their best peak seasons, demonstrating the benefits of scale, as well as the flexibility and efficiency of the UPS network. And of course, a little help from Mother Nature never hurts. Key operating statistics, like direct labor hours, miles driven and block hours, all grew at a slower pace than volume.

 …

For the full year, U.S. Domestic segment average daily volume is projected to grow around 2% to 3%. Revenue is expected to be up mid-single digits. Base rate improvements of 2% to 3% are expected although these may be masked somewhat by continued growth in lightweight solutions that serve the ever-expanding e-commerce market. Operating profit should grow at an upper single-digit pace, as we anticipate continued margin expansion.

Questions and Answers

Was Improvement Due to a Growing Economy or Growing Online Sales

Thomas R. Wadewitz – JP Morgan Chase & Co, Research Division

I was wondering if you could give a bit more perspective on how much of the volume improvement was, really, just a very strong peak season and you’re, obviously, good traction with your products to serve online, those shipping online sales. And how much is, I guess, either a change in your share performance or a change in the economy? Because it’s a pretty notable difference in your Domestic Package volumes versus kind of flat in the third quarter. And your guidance in 2012, also implies, I think, a better volume trajectory than you saw in 2011. So I wonder if you could give more color on that.

D. Scott Davis

Let me start, Tom, with kind of the macro approach. I think that we certainly are seeing a better U.S. economy than we would thought back in probably August, September, back in Investor Conference time. I think that, back to that time frame, people are talking about chance for a second recession. We don’t hear that anymore. Clearly, we saw a strengthening economy and a strong holiday season. And frankly, it stayed fairly strong into January. So I think the U.S., while I wouldn’t call it a robust economy right now. I do think small package market is performing better than we would’ve thought 4 and 5 months ago.

Kurt Kuehn

Yes. That’s right. So at a macro level, clearly, we feel a little better about where the U.S. is at. Looking more specifically, I guess, to your question, Tom, we clearly were pleasantly surprised by the demand surrounding the holiday season. Really, this is the first peak where we’ve really had our full suite of lightweight product offerings in place. And about half of the additional growth we do, we did see in our basic and SurePost products. If you recall, SurePost really was just launched in 2011. So we did see a big uptick and clearly, this fits into the trend of lighter weight products, computers moved to tablets or portables and a lot of small products. And then the e-commerce growth continues unabated. We estimate, in general, e-commerce was probably up about 15% for the holiday season. So basically, we were in place with the new suite of products that was able to both attract volume and at the same time, handle it very profitably. So we were pleasantly surprised, frankly. I think, that combined with the increased focus we’ve had on B2C with My Choice and really differentiating our residential products, created a nice uptick. We also saw, the other number that might have surprised you a little bit, was the substantial growth in deferred air. And a lot of this is also surrounding the e-commerce trends, I guess, that there were a number of Internet retailers that decided to differentiate their products by offering a tighter Time-In-Transit. So we’re seeing some pieces moving around. But all in all, we were thrilled that our business model and our product offerings were able to generate a great quarter.

The Shift in the Parcel Business from a Business to Business Focus to a Business to Consumer focus

Justin B. Yagerman – Deutsche Bank AG, Research Division

I wanted to ask about the B2C trends, obviously, a point stronger in the quarter. So it sounds like, deferred strength was driven partially there. But you also talked about a mix shift that’s occurring. So maybe you could put some numbers around the growth in B2C that you saw in your business this year versus last year, some expectations going forward. And then, maybe help us think about why that weight for shipment is lower and how that affects mix from a yield standpoint?

Kurt Kuehn

Yes. I guess a ballpark number, I think there’s a couple of parts to it. Number one, B2C is growing robustly, especially through the e-commerce venue. Clearly, the e-commerce branches of companies seemed to do a lot better than the brick and mortar. In fact, in December, B2C volume was over 50% of our volume. December, it always spikes. So we are continuing to see that growth. The other new ones, and this is more company specific, is the substantial success of our SurePost product, which for the first time has offered a broader suite of services for lightweight products, lower values. So that was another big part of the success. So a combination of the trends in general, UPS positioning and us being able to differentiate. And as we mentioned, sign up 3 quarters of 1 million customers for the new My Choice service, we think really puts us in a great position to capture some of the benefits of these trends.

D. Scott Davis

And Justin, I think you’ll also see these trends international, it’s not going to be unique to the United States. I think the whole global B2C phenomenon is still in their early innings and we’ll see that growth going forward. But the key is that UPS is adapting the operations to be profitable in this business.

SurePost is UPS’s Service that competes with FedEx’s SmartPost

Justin B. Yagerman – Deutsche Bank AG, Research Division

Can you guys just remind us, SurePost, it’s the competitive product with SmartPost on your primary competitor side?

D. Scott Davis

Yes. SurePost is for lightweight, relatively low-value products where we do postal injection. We also, though, have a basic product that’s a mix of both UPS delivered and injection.

If e-commerce is Growing so Strongly Why isn’t Import Volume Stronger?

Nathan Brochmann – William Blair & Company L.L.C., Research Division

I wanted to talk a little bit about the disconnect that I’m kind of picking up on a little bit between the very strong U.S. e-commerce activity through the different channels, coupled with the kind of slower import growth in terms of wondering where, in terms of the shift in production, a lot of those e-commerce products that might be coming from or how the supply chains are moving?

D. Scott Davis

I think, in general, it’s been all about inventory levels. And I think that we did not, even though inventory seemed to add to GDP in the fourth quarter, we feel that most of the inventories are still pretty slight in the United States. I think we saw the holiday season, a lot of people are running out of product. We have seen a pretty strong January. I guess people had to replenish inventory levels. So I think that, that because of low imports from Asia, hopefully, we see some improvements in the near term as people replenish the inventory levels.

Kurt Kuehn

I think, we are fairly bullish though on production within the U.S. seeing somewhat a renaissance. If you look at the cost of energy with natural gas so low, you look at the fact that wages on a global competitive perspective have improved in the U.S. And the fact that people are realizing that it’s nice to have local sourcing in addition to global sourcing. We feel generally bullish that the U.S. economy is seeing a bit of an uplift and will next year.

Challenge of Comparing Results Quarter to Quarter When E-Commerce Represents Such A High Proportion of Volume in 4th Quarter

H. Peter Nesvold – Jefferies & Company, Inc., Research Division

If we got to your model together fast enough before the call, it looked like the deferred air yields in the U.S. Package business were up 2.5% year-over-year in 4Q, which was kind of a notable step down from the 9.8% in 3Q. And again, assuming that the model together is fast enough, is there any kind of trade down that’s happening in that business or is there anything else that maybe impacting the yields there?

D. Scott Davis

On deferred air, it’s really trade up, if anything, from ground. The big issue there is the weights are significantly lower. That was the product hit most significantly by reductions in weight. So a lot of e-commerce volume with lightweight volume being shipped. So we’re very conscious of it, the base rates underlying, as we said, remains strong 2% to 3%. But a 4% reduction in weight for deferred air, clearly, caused the big impact.

Challenge of Understanding the Impact of Price Changes on Yield (Revenue per Piece)

Scott H. Group – Wolfe Trahan & Co.

So I wanted to talk a little bit about the pricing guidance. I think you mentioned 2% to 3% pricing in the U.S. And I know that’s in line with the longer-term expectations, but it seems like a step down from what we got in 2011. And I wanted to understand kind of the drivers of that, is this just being conservative or is there something changing in the pricing market that’s not letting you get in ’12 what you got in ’11?

Kurt Kuehn

No. We think the core momentum as I was — certainly, something we’ve been looking at very closely. The core base rates are continuing very stable. We did see in Q4 significant impact of customer mix with our lightweight product suite, really kicking into gear. And we do expect that momentum to continue for a while. So the overall reduced weights, 3% in Q4, and that trend may continue given the customers and the e-commerce that we’re seeing. Thus, create a net impact that shows lower yield. But as you can see, we are able to profit on that. So all in all, we think the market pricing is stable, that remains a very high priority for us. You’re just really seeing a fairly significant market change and also a significant change in mix to UPS as we’ve really hit our stride with the slight rate e-commerce volumes.

D. Scott Davis

As Kurt said, the market is rational from a pricing standpoint. What can help us obviously is, Kurt referred earlier to the manufacturing increase in the U.S. If we see that throughout 2012, that certainly can help the weight and help the yield.

Scott H. Group – Wolfe Trahan & Co.

I mean, I understand the negative mix impact from lower weight. I guess, I would’ve thought, though, with an improving macro outlook that there could have been an opportunity for better than 2% to 3% underlying pricing, and just trying to understand the drivers of that if it’s just being conservative or what?

Kurt Kuehn

It’s consistent with what we talked about in September. Our long-term goal, in the domestic environment, is to generate 2% to 3% base rate increases. As long as we can keep yields moving at that rate and be able to keep our unit cost below that rate, we’ll see gradual and positive margin expansion. So Scott, we think that’s a very disciplined and appropriate approach. It maintains a stable relationship with our customers and we’re very pleased if we can continue that positive balance of yield and unit cost.

Is Parcel Delivery Becoming More of a Seasonal Business and How Does that Affect Managing the Business

Robert F. Pickels – Manning & Napier Advisors, LLC

Hope it’s not a repeat, I think it’s a little different from Tom Wadewitz’s question. But I’m just wondering how all of this growth in e-commerce is changing the seasonal nature of your business. It seems like the e-retail might make 4Q even stronger than some of the other quarters on a go-forward basis. And I’m just wondering how you managed this? Is it significantly different? Do you have to take capacity up and down more than you used to? Just comment on that, please.

Kurt Kuehn

Yes. Robert, you’re absolutely right. And we’ve done a lot of work studying this. If you look at the seasonal factors of how different quarters and different seasons compared to themselves, we are really seeing that the fourth quarter become more and more important. And really 2 issues, I guess, number one, the demand for the fourth is really created almost 2 peaks. We are extremely busy after the Black Friday and Cyber Monday period, that was a peak, it settled down. And then, certainly, the last week of the holidays was another peak. But the one piece of great news and this is reflected in our earnings results, is that the big challenge for us in the past of a large peak was tremendous amounts of training, a lot of disruption in our operations. As you guys saw in our investor conference, we have done a tremendous amount of work through operational technology to streamline our jobs, to deskill, so we don’t have to train as much, and to optimize in real time. So what you really saw in the fourth quarter was a great demonstration of operational performance, driven by data-driven operations. And so the good news is we can handle these peaks and this growth in e-commerce very productively.

D. Scott Davis

And in fact, in the fourth quarter, our productivity improvements offset the entire wage rate increase. Now you’ll see that because of the large scale in the fourth quarter, you won’t see that necessarily in Q1, 2 or 3. But it does come through in a large-scale period like the fourth quarter.

Difficulty of Using Fourth Quarter Results to Project Strength of the Economy

Jeffrey A. Kauffman – Sterne Agee & Leach Inc., Research Division

Does it make it harder for the — is it possible the fourth quarter is less indicative of broader economic trends because of the e-commerce?

Kurt Kuehn

Yes. I think that’s a valid point. I mean, if you look at overall retail, it was a little better perhaps than expected but not hugely. With our bias with the e-commerce hitting our industry more heavily, you do get a little bit of an outside gain.

D. Scott Davis

But it’s still tied somewhat to consumer sentiment. And if consumer sentiment is negative, you’re going to get impact in of the fourth quarter or the first quarter. So it’s going to be a good sign on what the consumers are thinking, consumer confidence in the fourth quarter.

Size and Magnitude of SurePost

Keith Schoonmaker – Morningstar Inc., Research Division

Can you please comment on SurePost facilities, magnitude and margins? I’m wondering is this handling existing sort facilities? Is the order of magnitude below percentage point of ground volume and I imagine ground margins, or margins, are certainly lower than SurePost than they are in your own network?

Kurt Kuehn

Yes. The concept of unique SurePost facilities is a misnomer. This is another product in the UPS suite portfolio. Virtually all of the SurePost volume comes to us from customers that give us multiple times volume in our traditional networks. So really the only difference with SurePost is the last final mile of lightweight volume going to the post office. But the pickup process, all of our sortation and our feed networks that really remains in the UPS network. So it’s traditional UPS taking advantages of the economies of scale and integrating it. So it is just one product in a suite of products that our customers choose from. And as I mentioned, for every SurePost package we have, a given customer will have 4 or 5 other packages with them.

Cost Inflation and Productivity

Thomas R. Wadewitz – JP Morgan Chase & Co, Research Division

I wanted to get your comments on cost inflation and productivity within the domestic network in 2012, I think I’ve heard much of that on the call. And given that you expect positive volumes, could you see your seniority begin to come down and kind of how would you view the per hour inflation when you look at the labor side in Domestic Package in 2012?

Kurt Kuehn

Yes. Tom, we do expect those trends. Certainly as the business grows and we’re able to add new employees or see turnover as people find full-time jobs that are part-timers today, we will see some benefit. And our wage rates mitigated and moderated just a touch in the fourth quarter. It wasn’t a huge driver but it was a slight positive. We do expect to keep comp and benefits somewhere between 1% and 2% increases year-over-year as opposed to volume. So as long as we’re able to do and at the same time manage the yield environments above that, then we’re pretty confident we can manage margin expansion.

D. Scott Davis

Again, we are confident that our products will offset probably half of the wage rate increase, which is consistent with what we’ve been doing.

Impact of Accessorials on Rate Increases

William J. Greene – Morgan Stanley, Research Division

If you look at what you did on rates in 2011, I think they were basically in line with your guidance sort of in this 2% to 3% range. But I think it also, correct me if I’m wrong, I think it benefited from some unique changes, things like dim weight, if I remember correctly or maybe I don’t. So can you just clarify sort of are there any unique attributes to the rate changes for 2012 that we need to keep in mind when modeling?

Kurt Kuehn

There’s always moving, multiple moving parts within the rates structure, Bill. I mean dim weight was a visible one, but it wasn’t material outside the scope of normal adjustments we do for rates. So we expect a fairly typical rate environment for the coming year. We did announced our rates for both air and ground last quarter, and do expect base rates to remain in the 2% to 3% level. The guidance, really, is just that with this change in mix and the influx of lighter weight e-commerce packages that’s coming in at a greater-than-expected rate, the top-level rate may look a little lower than that. But if you get to the bottom, the core rates will remain strong.

William J. Greene – Morgan Stanley, Research Division

Yes. The yields, you mean, right?

Kurt Kuehn

Right.