United Parcel Service, Inc.

Good morning. My name is Steven. I will be your conference facilitator today. I would like to welcome everyone to the UPS Investor Relations third quarter 2020 earnings conference call. All lines have been placed on mute to prevent any background noise. And after the speaker's remarks, there will be a question and answer period. It is now my pleasure to turn the floor over to your host, Mr. Scott Childress, Investor Relations Officer. Sir, the floor is yours.

Good morning, and welcome to the UPS third quarter 2020 earnings call. Joining me today are Carol Tomei, our CEO, and Brian Newman, our CFO. Before we begin, I want to remind you that some of the comments we'll make today are forward-looking statements within the federal securities laws and address our expectation for the future performance for operating results of our company. These statements are subject to risk and uncertainty, which are described in detail in our 2019 Form 10-K, subsequently filed Form 10-Qs, and other reports we file with the Securities and Exchange Commission. These reports, when filed, are available on the UPS Investor Relations website and from the SEC. During the quarter, GAAP results included a pre-tax charge of $44 million, equivalent to $0.04 on an earnings per share basis. The charge resulted from transformation-related activities primarily in the international and U.S. domestic segments. In the prior year period, GAAP results included a pre-tax charge for transformation cost of $63 million, equivalent to six cents on diluted earnings per share. Unless stated otherwise, our comments will refer to adjusted results, which excludes transformation costs. The webcast of today's call, along with the reconciliation of non-GAAP financial measures, are available on the UPS Investor Relations website. Following our prepared remarks, we will take questions from those joining via the teleconference. If you wish to ask a question, press 1, then 0 on your phone to enter the queue. Please ask only one question so that we may allow as many as possible to participate. you may rejoin the queue for the opportunity to ask an additional question. And now, I'll turn the call over to Carol.

Thank you, Scott. We are moving quickly and operationalizing our strategy under the Better Not Bigger framework. We're leaning in on the wildly important areas of our business and tackling challenges head on. This morning, I'm pleased to discuss our achievements and the opportunities we see before us. One thing is certain. Everything we accomplish is the result of our winning people and culture. We have everyday heroes at UPS who are keeping the world's supply chains moving and delivering what matters. From essential household items to critical health care needs, UPSers are making a positive difference in the world. And for that, I am so very proud of this team and want to thank them for their hard work and efforts. During the quarter, we continued to flex our network to capture market opportunities and better position UPS for the long term. Our performance was better than we expected, even amid the challenges from the pandemic. Consolidated revenue in the quarter rose 15.9% from last year to $21.2 billion, and operating profit grew 9.9% from last year to $2.4 billion. Well, our commercial business remained under pressure due to the economic downturn. During the quarter, we began to optimize our network and captured share in SMB or small and medium-sized businesses. As a result, we saw revenue per piece improve sequentially in the U.S. from what we reported in the first two quarters of this year. Further, revenue growth in our international and supply chain and freight segments was the highest quarterly growth we've seen in nearly three years. Brian will share more details about the quarter in a moment. Over the past few months, we've intensified the focus on executing our strategy, customer first, people led, innovation driven. From a customer first perspective, there has been a step change in the composition of retail sales, as e-commerce sales are now projected to make up more than 20% of all U.S. retail sales this year. We don't think the penetration of e-commerce retail sales will decline, even after the pandemic. But it isn't just retail. Our customers across all business segments are reinventing the ways they do business. We've heard from customers that speed and ease are most important. So we are focused on delivering the capabilities that matter most to our customers. Let's start with speed. In the U.S., we completed our weekend expansion ahead of schedule, enabling broader market coverage as we are the only carrier that provides both commercial and residential pickup and delivery services on Saturdays as a general service offering. And next week, we will complete our Fastest Ground Ever initiative, eight months ahead of plan. We have improved ground transit times between millions of zip codes, and we will be at parity or better than the competition in 20 of the 25 most populated U.S. markets. And customers have noticed. Weekend ground volume is up 161% versus last year. And SMB volume on our fastest ground ever lanes has grown 25.7% since we made the improvement. Moving to ease, it's all about removing friction from the customer experience and serving customers the way they want to be served. For SMBs, we are highly focused on our digital access program, which we refer to as DAP. Through platform partnerships, we are making it easier for SMBs to open a UPS account and access the world's largest small package network. Revenue growth from our DAP program exceeded our expectations. As we added 150,000 new accounts, and several new partners in the quarter. Our fastest ground ever, weekend services, and DAP complement each other, enabling our customers to deliver what matters to their customers, speed and a better experience. Our efforts in the United States are having a positive impact. In the third quarter, total U.S. SMB volume grew 18.7 percent, outpacing our larger customers. and was the highest growth rate we've experienced with SMBs in 16 years. We are seeing strong results in the international segment, too, with international SMB volume up 9.9% during the quarter. Another area that we are leaning into is healthcare logistics. UPS Healthcare spans all reporting segments, has world-class technology, deep expertise, and the most sophisticated suite of services in the industry. We are significantly expanding our freezer farm capacity by installing validated freezers that range from negative 20 to negative 80 degrees Celsius. These farms are strategically located in Louisville, Kentucky, and Venlo, the Netherlands, and are good distribution practice certified. And for added control during transit, UPS Premier, our next generation package sensor technology, offers priority handling real-time monitoring, and continuous visibility. We understand that healthcare logistics isn't just about the package. It's about the patient. Our market healthcare team is supporting clinical trials across all stages for COVID-19 vaccines. Early involvement gives us valuable data and insights to design commercial distribution plans and manage the logistics for these complex products. We have a great opportunity and, frankly, a great responsibility to serve the world when a COVID-19 vaccine becomes available. When that time comes, our global network, cold chain solutions, and our people will be ready. Moving to the second element of our strategy, people-led, we know successful outcomes are built from a strong culture of teamwork, respect, trust, and empowerment. We are enabling our people to move the business forward by giving them more decision-making authority, and we're identifying which activities add value and stopping those that don't. We are also investing in training on topics including unconscious bias and diversity and inclusion to ensure our actions match our values. In the past, we have talked to you about Transformation 1.0, We are on track to deliver the more than $1 billion of benefit we identified when we kicked it off in 2018. In September of this year, we began Transformation 2.0 by announcing a voluntary separation allowance program. To the UPSers who will take this offer, I thank you for your service to our company. Transformation 2.0 is about creating fewer but more impactful jobs. We will share more details with you as we finalize our plan. The final piece of our strategy, innovation-driven, comes down to being better, not bigger. Now, that doesn't mean UPS is not going to grow, because we are. It means that we will lean into growth from the right opportunities, like SMBs, international, global freight forwarding, and other high-yielding sectors. And we will grow from our revenue quality initiatives. We are on a journey to optimize the volume that flows through our network. Additionally, our approach calls for greater efficiency and requires that we lower our cost to serve. Our transformation efforts are vitally important to our ongoing success. While we are finishing Transformation 1.0, we've already begun Transformation 2.0, and we are roadmapping Transformation 3.0 in preparation to launch next year. Transformation 3.0 will focus on decreasing core operating expense. Further, to improve our return on invested capital, we are applying greater scrutiny to capital spending and ensuring clear linkage to cash returns. You should expect our 2021 capital spending to be significantly lower from what we are spending in 2020. Since being named CEO, I've immersed myself in our business and spent lots of Zoom hours with our people. I've also helped our team build out a value-creating strategic and financial framework. As a reminder from our last call, outside of our five core principles, everything else is under review. I've spent a lot of time looking at the risks and opportunities facing our business, including an evaluation of our business portfolio. We are an opportunity-rich company. We are making progress, but given the size of our business, it will take time to optimize our network, to stop processes that have added cost and no customer value, and to fully reach our potential. Now, moving on to the upcoming holiday season, peak is extremely important to our customers, so it's extremely important to us. We have been operating in a peak-like environment globally for many months, which is helping us prepare for the elevated demand ahead. 2020 peak will have two more operating days than last year and two full weeks between Cyber Week and Christmas Week. We are projecting a pretty peaky peak, but there are some industry capacity constraints, as Brian will detail. As a result, we expect to see solid volume growth year over year, but sequentially, the quarterly growth rate in the U.S. will moderate in the fourth quarter. Our peak preparations start with ensuring the safety of our people and our customers. From that, we are employing two key strategies. First, we will continue to collaborate with our customers to help them time their promotions and match their needs to our available capacity. Second, we will leverage proven and some new tools to ensure flexibility, control, and visibility across the network. This year, we added automated sort capacity and greatly expanded our weekend operations. We sped up our ground network and are using more real-time data to better manage the expected increase in volume. From my involvement in our peak preparations, I will tell you that while we expect this holiday season to have its challenges, we are ready to deliver a successful peak. As you can see in our results, We are making progress against the better, not bigger framework we outlined in July. We have more work to do and plan to provide additional detail about our actions during an investor day we will host in 2021, once the environment is more stable. And with that, I'll turn the call over to Brian.

Thanks, Carol, and good morning. Overall, we are pleased with our results in the quarter. As I share the details, you'll see early indications that our actions are having a positive impact on our operating performance and financial returns. I'll also share the trends we are seeing as we approach year end. Starting with the macro environment, the global economy continued to feel the effects of the coronavirus pandemic. Global trade has generally improved with Asia outbound leading other geographies. However, Both global and U.S. real GDP growth rates in the third quarter are estimated to be down 3.7%. In the U.S., consumer confidence has held up well. However, industrial production remains mixed. Auto manufacturing has fully recovered, but it will take more time for all industrial production to return to pre-COVID levels. So what does this mean for our business? We see no signs that the structural market shift to e-commerce will slow anytime soon. In fact, forecasters estimate the e-commerce share of retail has been advanced by two to three years due to the pandemic. And at the same time, we expect the commercial side of our business to face continued softness extending into 2021. During the quarter, we adjusted our network and took deliberate actions to better position UPS for the future. Three key items underscored our performance. First, both the international and supply chain and freight segments delivered record profits. We executed extremely well within a tight capacity market and were able to meet high demand out of Asia. Next, in the U.S., SMB growth accelerated and our revenue quality actions began yielding results. And lastly, we faced both planned and unplanned expense pressures in the U.S. domestic segment. For the quarter, consolidated revenue increased 15.9% to $21.2 billion. Operating profit totaled $2.4 billion, or 9.9% higher than last year. The operating margin for the company was 11.3%, which was 70 basis points below last year. Diluted earnings per share was $2.28, up 10.1% from the same period last year. Moving into the segments. In U.S. domestic, average daily volume increased 13.8% year-over-year, to a total of 20.4 million packages per day. The SMB volume growth rate accelerated by 820 basis points, going from 10.5% in the second quarter to 18.7% in the third quarter. B2C shipments increased 33.4% year-over-year and represented 61% of total volume. Conversely, B2B average daily volume was down 7.8% year-over-year but has improved from the second quarter. While we saw positive B2B growth in healthcare and automotive, that growth was not able to offset weakness in other industrial sectors. For the quarter, U.S. domestic revenue was up 15.5% to $13.2 billion, driven by the strength in ground and deferred air products, as well as the impact of one additional operating day. While reported revenue per piece was flat year over year, Excluding the negative impacts from fuel and SurePost, revenue per piece grew both sequentially and year over year. Lower fuel prices reduced revenue per piece growth by 130 basis points, and elevated SurePost volume reduced revenue per piece growth by 230 basis points. As a reminder, SurePost is a higher return on invested capital product. The underlying improvement in revenue per piece indicates that our revenue quality actions are beginning to have a positive impact. Turning to costs, expenses were up 18.4% over the third quarter of last year and grew faster than volume and revenue. Cost per piece, excluding fuel, increased 37 cents or 4.4% over last year. Several items drove expense deleverage in the quarter. First, Our initiatives to expand weekend operations and speed up the ground network. Second, benefit expenses from the additional employees we hired in the second quarter. And third, lower productivity gains than we planned and lower deliver density. For the quarter, the U.S. generated $1.1 billion in operating profit, a decline of 8.8% compared to last year. Operating margin was down 220 basis points year over year. We are focused on improving revenue and reducing cost in the U.S. domestic business, and we are pleased with our early revenue progress. Additionally, we see opportunities to decrease our cost structure as we optimize our network and implement transformation initiatives. Moving over to international, the segment delivered another quarter of record operating profit with double-digit positive year-over-year growth. The flexibility of our global network and winning solutions allowed us to lean into the most profitable areas of elevated demand. Volume increased globally by double digits year over year. Asia outbound, average daily volume growth was 37.6%. With air capacity in tight supply, we added 268 flights above our normal schedules to meet the high demand. And Europe continued to see elevated cross-border B2C, with export average daily volume up 15.5%. We saw growth across customer segments with SMB volume growing in all regions. B2C mixed moderated to 31% of total volume and B2B improved, but was still down 3.2% year over year. For the quarter, international revenue was up 17% to $4.1 billion. Revenue per piece was up 2.7% and included a decline of 260 basis points from fuel and a benefit of 140 basis points from currency. On the expense side, cost per piece declined 2.3% year over year, primarily due to lower fuel costs. For the third quarter, international generated operating profit of $972 million, an increase of 40.3%, led by elevated demand out of Asia. And finally, our international operating margin expanded 400 basis points. Looking at supply chain and freight, the segment results were excellent, Elevated demand drove revenue up 16.5% to $3.9 billion, and we generated record quarterly profit. Market capacity remained tight while economic activity picked up in the quarter. Slowing demand for PPE was offset by inventory replenishment. More specifically, we saw high air and ocean freight forwarding demand out of Asia, led by the high-tech, retail, and industrial sectors. Our LTL business improved efficiency and productivity while at the same time advancing the revenue quality in our freight business. Revenue per hundredweight, excluding fuel, increased 7.2% in the quarter. Conversely, performance in our truckload brokerage unit had a negative impact to profit on a year-over-year basis due to continued market challenges. Operating profit was $302 million, an increase of 18% year-over-year with multiple units contributing and which highlights the diversity within the supply chain and freight portfolio. Looking at the overall enterprise, in the third quarter, UPS generated operating profit of $2.4 billion, up 9.9%. A few notable items on the income statement include other pension income was $327 million, driven by last year's 17.6% return on pension assets, and the discount rate was 90 basis points below last year. We had $176 million of interest expense, which is above last year due to our $3.5 billion debt issuance in March. And lastly, our effective tax rate came in at 22.5%, compared to last year's third quarter tax rate of 20.8%, reflecting certain discrete tax items that did not repeat this year. Now let's turn to cash and shareowner returns. Our cash flow remains very strong. For the first nine months of the year, we generated $9.3 billion in cash from operations and about $5.9 billion in adjusted free cash flow. This includes $725 billion from the CARES Act federal payroll tax deferral, offset by a $1 billion discretionary contribution to pension plans. Capital investments totaled $3.4 billion through September, and we expect full-year CapEx of $5.6 billion. and remain on track with our automation targets for 2020. So far this year, UPS has distributed $2.7 billion in dividends, which represents a 5.2% increase on a per share basis over the same period last year. Now I'll make a few comments regarding the balance of the year. We expect strong consumer demand during peak. As Carol mentioned, in the U.S., we will have two additional operating days between Thanksgiving and December 31st compared to last year, which helps our operations. We anticipate some industry capacity constraints through the period. In response, we're working closely with customers to pull demand ahead of the traditional peak period. In fact, many large retailers ran e-commerce sales events in mid-October, and our network performed well during this period. with high service levels and good productivity. Looking ahead, our peak plans, volume management, and surcharge approach will also help promote a more optimized volume mix. We will also leverage our technology to control the volume we bring into the network, utilize available capacity, and efficiently operate during peak. While we are not providing consolidated revenue or diluted earnings per share guidance, I want to provide some color to help frame up the fourth quarter. In the U.S., average daily volume is anticipated to increase by high single digits and revenue growth to be above volume growth. Working against us are difficult year-over-year comps and known expenses that will pressure operating margin. They include an increase in benefits expense between $150 and $200 million due to additional union headcounts over last year, including the new employees we hired in the second quarter. New legislation in 2019 for alternative fuel tax credits and reductions in management incentives, which together lowered operating expense last year by about $150 million, are not expected to repeat. And the acceleration of our time in transit and weekend operations initiatives. Working in our favor are the positive effects from our revenue quality efforts and growth from SMBs. In our international segment, we expect the year-over-year profit growth rate to be in the high teens. And in supply chain and freight, we expect operating profit growth to be relatively flat given the anticipated market dynamics, particularly in the truckload brokerage business. In summary, while macro conditions remain dynamic and the recovery uncertain, market demand continues to be elevated. We are laser focused on improving cash generation by executing our strategy under the better, not bigger framework. Thank you, and operator, please open the lines.

Thank you. We will now conduct a question and answer session. And as a reminder, for teleconference participants, if you would like to ask a question, please press 1 and 0 on your telephone keypad. And our first question will come from the line of Amit Mahotra. Please go ahead.

the call and the ability to ask a question. Carol, I think it's still early days with respect to the transformation 2.0, 3.0, but the facts as it relates to the third quarter, the profits in the domestic business were down over $100 million from the prior period. Revenues were up almost $2 billion. When does that equation shift and When do you think you'll be able to, you know, maybe report more positive operating leverage and, you know, margin expansion in the business?

Well, Amit, thank you very much for your question. And let's just unpack the performance on the expense line a little bit more than Brian did. Brian called out three drivers of the leverage in the U.S. business in the third quarter, the first of which was our decision to speed up our Fastest Ground Ever initiative. That decision cost us $179 million in the quarter. It was the right thing to do because you saw the market share gains that we enjoyed with our SMB business. So it was the right thing to do, but it certainly put some pressure on the expense line. If you back that out, our operating profit would have grown year on year. The outer line item that was a deleverage in the quarter was productivity below our expectations. And here we have a real opportunity as we turn that around, looking past the fourth quarter of this year and into 2021 and 2022. One reason for the decline in productivity is the fact that we had 40,000 new UPSers and higher turnover this year than we did last year. Turnover is a function of many things, including COVID, candidly. But when you have a lot of new people in your operations, sadly, we just weren't as productive as we should have been. We have a new leader over our U.S. domestic small package business. Nando is all over this. And productivity is going to be a laser focus of Transformation 3.0. And it's not just about putting more packages through our facilities on a per-hour basis. It's about how we get better at running the business. better at keeping our people so we lower our cost of turnover, better at keeping our people safe so we lower our casualty reserves. There's a real opportunity here to just get better in running the business without a lot of investment, actually. So we are building our 2021 financial plan as we speak. We're roadmapping three years. And once that plan is finalized, we will share with you our actions that we are taking to grow the operating margin in the U.S. small package business.

I appreciate that, Carol. But, I mean, just to make sure that I understand your comment, are you saying that starting in the fourth quarter, because of some of the idiosyncratic costs in the third quarter, that the business will return to positive operating leverage in the fourth quarter and that will extend it to 2021? Is that what you're saying, if I'm understanding you correctly?

That is not what I'm saying. The turn won't happen until 2021 because of the expense pressures that Brian carefully called out in the fourth quarter. And Brian, you might just want to remind Amit what those expense pressures are in the fourth quarter.

As we look forward to the fourth quarter, Amit, we do have the underlying benefits, as Carol said, of optimizing volume and improving pricing. But there are three in particular that Q4 headwinds We've got the seasonality, which you know, year over year, we normally go about down 200 basis points on a sequential Q3 to Q4 standpoint because of peak. So there's that natural seasonality impact. We've got benefits ranging in $150 to $200 million that will be impacting Q4. And then we're lapping last year. We had some legislation around alternative fuel tax. as well as a low management incentive number last year. Together, those are about $150 million laps. So those combined with the fastest ground ever that we'll finish off in Q4 investments, that's going to put pressure on the fourth quarter as we look forward.

Now, at the end of the second quarter, we said that we thought that the operating margin for the back half of the year could be 100 basis points lower than the operating margin in the first half of the year. Because of our outperformance in the third quarter, And because of the revenue quality that we are enjoying in the U.S. business, we now think the operating margin in the back half of the year will be higher than the first half of the year. So hopefully that's helpful to you as you build your model.

That's very helpful. Thank you, Carol. Thank you, Brian. Appreciate it. Thanks, Amit.

We have a question from the line of Chris Weatherby of Citi. Please go ahead.

Hey, thanks, and good morning. You know, Carol, you talked about CapEx on the call, and I thought that was kind of interesting. I think the comment was significantly lower than 2020, which I think is running just under 5.6 billion. Can you talk with a little bit more specificity about what significantly means and sort of where you potentially see that saving? It seems like there's a lot of growth out there, so I want to get a sense of kind of the order of magnitude we might be talking about.

Well, we are finalizing our capital plans as we speak, but for modeling purposes, I would use $4 billion. So that's a significant reduction from what we're running today, and it's really a reduction across all major categories of our capital. As we've unfilled the layers of the onion, we've discovered an opportunity to sweat our assets in a more efficient way. You know, we have over 500 hub sorting facilities in our U.S. business, over 1,000 delivery facilities. And as I look at the capacity utilization in those facilities, we've got opportunities. Now, clearly, we need to work with our customers to optimize the fixed investments that we've made. But we clearly have opportunities here to sweat the assets. The same is true with the airlines. as we think about where the demand is going for next-day air in the United States versus where the demand is exploding outside of the United States, we have an opportunity to optimize our aircraft globally. So that's enabling us to take our capital down. Brian, any color you want to add there?

Yeah, just a little bit, Chris, as you shape next year and we think about pulling the buildings. Buildings represent about 50% of our CapEx we spend. We've made those investments in capacity, so you'd expect to see that come down, the airline to likely come down, and it's this pivot to international healthcare, digital. That's where we're pivoting the capital spend.

Okay. Thank you very much. Appreciate it.

We have a question from the line of Allison Poliniak, Wells Fargo. Please go ahead.

Hi, guys. Good morning. Just turning to the SMB initiative, clearly gaining some share there. There's a lot of expense noise in the quarter, but when you put that aside, is the incremental pull through from those volumes that you're getting on SMB where you thought they'd be at this point in the cycle, the investment cycle for you, are they better? Any color on that?

Yeah, happy to give you some color on the SMB volume. We were so pleased to see 18.7% growth, the highest in 16 years. If I think about SMB as a percentage of our total business in the United States, it's grown from 23% last year to now 24% this year. So we're shifting the penetration, which is really about how we want to drive revenue quality in our business. If you unpeel the layer of the onions for our SMB business in the quarter, We see that they're figuring it out. The commercial side of SMB was down, call it 7% in the quarter, but the residential piece of SMB was up 62%. So they're figuring out how to go to market and they're using our end-to-end network to drive that. So if you then say, okay, Carol, is that flowing down to the bottom line? Well, we were very pleased with what we saw in that regard too. So we will continue to invest in this customer segment You've heard us talk about fastest ground ever. It doesn't just stop with that. You know, I think last time I talked about how we break apart our customer segments within SMB, and I told you it was D1 through D4, and I didn't really know what that meant. Well, the team has done a really great job of defining what it means. So now when you think about our SMB customers, think of them as medium, small, micro, and platform. And when you think of those customers, think of it like a pyramid. So at the top of the pyramid are our medium-sized customers, and those are several thousands of accounts. And as you go down the pyramid, the customer base will expand dramatically. From a revenue perspective, flip the pyramid upside down. So the bulk of the revenue is at the top, and the smallest piece of the business is at the bottom. But interestingly, when we looked at the performance of SMBs across all four of those segments, we saw each of them grow. And the growth came from our medium-sized businesses as well as our platform businesses. And within platform or the platform segment, that's where DAP falls. And, yes, DAP is small, but it's growing. In fact, we expect our revenue on our DAP accounts to grow 400% this year. And that is a very profitable segment for us.

Great. Thanks for the color.

Yep.

We have a question from the line of David Ross of Stiefel. Please go ahead.

Yes. Good morning, Carol. Good morning, Brian. Good morning. Carol, you made a comment in one of your interviews about green dots and red dots and coming in and looking at initiatives to see what you should stop doing and what were wildly important. Could you just add some more color, specifically mainly around some of the red dots that you guys came up with?

Yeah. Well, thanks for the question. It was such an interesting exercise because when we started it, all the green dots went up, but it was really hard to put the red dots up because initiatives, you love them, you fall in love with them, by themselves they sound like they're really value-creating, but the truth is not so much. So I can give you an example of one. We had this initiative called UPS Next, and UPS Next was all about driving innovation in the company. Well, when we looked at what the UPS Next team was working on, they were working on exactly the same projects as other groups within the company. So we put the red dot on UPS Next, and all those people who were working on that project, well, they are either gone or they'd be reassigned to additional work. So that gives you a sense of what we mean by stopping work. We are so opportunity rich. Let me give you another example. We haven't stopped this yet, but we're going to. So I asked Nando, I said, Nando, how many reports do we ask our operators to work every week? Because I had familiarity with this in my previous life where we tend to put too much work on our operators and they couldn't focus on things like productivity. So Nando came back and said, Carol, we send 462 reports to our operators every week to work. So you can appreciate what that means. it means none of that is being worked. So that's work that's going to stop. And think about the overhead here at the UPS headquarters that's producing those reports. So that's all being streamlined to those wildly important metrics that matter for the customer experience, for productivity, and the rest is just going to get stopped.

Thank you.

You're welcome.

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

Hey, Carol, thanks for the time. I just wanted to kind of maybe talk about a similar thing. As you think about changing those behaviors inside of the company and stopping those activities, you're coming into the CEO seat from the board level. What surprised you about that transition, and how long do you think it will be before those changes you're making start to turn into the tangible operating leverage that the street is so desperately looking for inside of the domestic business?

Well, as a board member, I was always so very impressed by how UPSers respond to a crisis. In many ways, UPS is a first responder. They're always there to help the communities and customers that we serve. Coming into the company, I was blown away by our reaction to COVID. UPSers are essential workers, and I'm just so proud of them. for what they do every day. We all work, but they're actually going to work. They're putting on uniforms and they're flying planes and driving package cars and delivering packages and sorting packages, and I'm just so proud of them. What I didn't understand is how we went about what we do. UPS is a 113-year-old company, and many 113-year-old companies, they layer in bureaucracy and processes that are fine, but actually slow you down. So what I didn't know when I came on board is that we had 21 committees that were meeting to make decisions about the business. Twenty-one committees take just the amount of calendaring time to meet and discuss, and recommendations would be held until the committee meeting occurred. And that's not a way to run the business or effect change quickly. So we took those 21 committees down to six. And the fantastic thing is that the UPSers, they're energized by this. I was really worried about being rejected. That's not happened. The UPSers are embracing me. They're embracing change. They're excited about what we can do together as a company. And what this allows us to do, actually, is to Without debate or controversy, talk about the real opportunities to move and to get movement on the US operating margin. And part of that is about controlling our own destiny by improving the revenue quality in our business, working with our customers to enable that to happen, to look at the root cause of why we've been deleveraging and going after that in a meaningful way. In the past, we did it by increments. We're now doing it in a meaningful way, in a meaningful way. So if I told you that our casualty reserves that are driven by both workers' comp and auto liability, Brian, they stand at how much?

Today, we're over a billion dollars.

We're over a billion dollars in casualty reserves. Get a 10% reduction in that because you have a safer operation that's $100 million today. $100 million can move that U.S. operating margin in a meaningful way. If I talk to you about the cost of turnover, which I'm not going to do, but the cost of turnover is high for our company. If we've got 20% of that, it's another meaningful way to move the operating margin. If we improve delivery density, which we must do, we have had ideas on the shelf to do that. We just haven't operationalized those. that's a meaningful way to improve the operating margin. So this is a big company. You just can't pull the Band-Aid off because you could hurt the customer experience, and we don't want to do that. But as we start to pivot into this through the fourth quarter into 2021, we're going to be laying out tangible action plans that will show improvement in the operating margin. And then as we optimize our capital spending, or it all translates into higher return on invested capital.

We have a question from the line of Allison Landry of Credit Suisse. Please go ahead.

Good morning. Thanks. So, Carol, you've talked about a focus on what customers are willing to pay for and optimizing the volumes that flow through the network, and clearly you're starting to see that with to step up in SMB growth, but should we also interpret this as a signal that you might demarket some volume from large customers that aren't meeting the return threshold? And if that's the case, over what timeframe can you drive enough profitable share gains from SMBs that would allow you to walk from some of the lower margin business? So if you could just speak to how you're balancing this and while at the same time trying to maximize asset utilization.

Thank you. So as you know, there is a capacity constraint in the industry. It doesn't matter what supply chain you are, there's a capacity constraint in the industry. And if we took all the volume that was available to us, we would end up with a customer experience that wouldn't be good for us or our customers, and we would end up with what we call chaos costs. So we've actually been controlling the volume since July. And we're doing that in a number of different ways. We work with our customers to help them rethink their operations via buy online, pick up in store, different timing for their promotions, a different availability of their packages. So a number of alternatives and options that we've been working through a solution-based approach with our customers. When you have tight capacity, it also means that prices tighten. And as prices tighten, there is a shift in certain customers who are more price sensitive than others. We're okay with that if we're losing non-nutritive sales. We're okay with that. It's not about volume share growth. It's about value share growth. So that's how we'd like you to think about us, at least in the short term, value share growth. Now, clearly, the U.S. small package business is going to grow. It's estimated I think the volume ADV was something like 58 million in 2019. It should double by 2025. So of course we're going to be growing to service that growth. But right now it's all about value share.

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

Thanks very much. Good morning. I want to focus a little bit on international. Very strong in the quarter acceleration export volume growth, third quarter from second quarter. Just want to discuss kind of the trends through year end, you think, and maybe beyond how sustainable is this strength in international. And Brian, I missed what you said about, you said high teens. I didn't know if that was profit growth. or margin in fourth quarter. But if you could elaborate a little bit on sustainability and margin in that segment. Thanks.

Thanks, Scott, for the question. So from an international perspective, very happy with the Q3 performance. They continue to post double-digit top line and profit growth. and the real strength is coming out of Asia and Europe in particular. I was referencing operating profit growth in the high teens, Scott, was what I had commented on, and the operating margin has come in about 23% for the last two quarters. A lot in the international side depends on the international backdrop, so obviously we're watching that very closely, but the overall business is sound. Carol, I don't know if you have anything to add.

Well, the one comment I would make on the margin, which was outstanding, and the profit growth in the third quarter, we did have surcharge in the third quarter because the capacity is just so tight. So we've had about $120 million of surcharges in our international business in the third quarter. Whether or not that sustains is really a subject of market demand. Hopefully that's helpful to you.

We have a question from the line of Ravi Shankar of Morgan Stanley. Please go ahead.

Thanks. Good morning, everyone. Carol, you highlighted big capex cuts coming next year. How do you make sure that you are kind of keeping pace with others who are investing significantly to grow their capacity and kind of going back to what you just mentioned about value share and Is that something UPS can do by themselves if the rest of the industry is going to try to, you know, take share and kind of aggressively grow capacity and pursue that growth?

So this is all about our better but not bigger framework, which is a start of pivoting the business to position us for success in the future. Sweating the existing investments that we've made is a really good thing next year. then we'll look at where we want to grow and how we want to grow. But for next year, we're going to sweat the investments that we've made. Brian, you might want to talk about that.

Yeah, Ravi, it's a good question. If we look backwards first, we put over $15 billion in the capacity in the U.S. over the last several years, and that was needed, but now 85% or so of our ground volume is going through some sort of automated capacity and hub. So as we're looking at that and those investments, I've watched the ROIC actually trend down. A real focus going forward is going to say, how do we lower CapEx, ensure it's driving shorter-term paybacks to get better benefit? And I talked about where we're going to shift to in terms of health care, some specific to international markets, thinking about digital. So it's a different type of spend going forward, but I don't want to front-run the investor conference next year. We'll unpack that in more detail.

And I would comment just on the technology front, because that's such an important area of investment for us, well, for everybody, actually. the customer wants a digital experience. And so we can't move off of that digital experience. In fact, we need to lean into that. But that isn't necessarily a capital expenditure because software as a service, as you know, is paid through a license fee. So we're moving away from internally developed IT solutions to software as a service. So you'll see line item differences happening. The other thing I would ask you to remember is as we grow outside of the United States, our international business tends to have an asset-light profile in most areas of the rest of the world. And that asset-light profile will certainly help spur growth and generate higher returns.

Great. Thank you.

Jordan Oligar of Goldman Sachs, please go ahead.

Yeah, hi, morning, everyone. I just wanted to come back to the fourth quarter for a second. Obviously, you mentioned some puts and takes on the expense side, you know, balanced against sort of the revenue quality and then highlighted the normal sequential domestic decline of a couple hundred basis points. I mean, should we be thinking then in terms of the fourth quarter domestic margin at a base level, you know, sort of holding on to that first half margin of around 6.6, 6.7%. I mean, when you put all the puts and takes together, is that the baseline you should be thinking about?

Jordan, it's Brian. Thanks for the question. That's a fair baseline. We had some pressures in the third quarter, which we discussed. But as you go forward, thinking about the 8.6 that we posted in the third quarter, The first half of the year was 6.6. So as you look to the back half of the year, assuming a baseline of 6.6 is a fair assumption. And we're going to do everything we can to beat that. We're seeing improvement on the pricing and the revenue quality side. The challenge are the headwinds I outlined for the fourth quarter. So balancing those two is going to dictate where we land.

Okay. Thanks very much.

Thanks, Jordan.

Jack Atkins of Stevens, please go ahead.

Good morning, and thank you for taking my question. Just curious if you could comment for a moment, given the surge in the virus that we've been seeing in Europe over the last several weeks, if that's had any impact on business trends there, or just if you could comment broadly on if that's had an impact on the market in Europe.

So our business trends continue to be very strong coming out of our international business. There's a big watch out, though, because of COVID. You know, we see cases spiking. It's concerning, right? Because if we were to have disruption, let's say, in our pilots, that would be a real problem. Now, we haven't seen that, but we're just watching this very, very closely.

Tom Waterwitz, UBS. Please go ahead. Mr. Waterwitz, your line is open.

Steven, you want to move to the next caller?

We will do. Our next question will come from the line of Scott Group of Wolf Research. Please go ahead.

Hey, thanks. Morning. So you said revenue better than volume in the fourth quarter. Is that a sustained inflection or more of a one-off with the record surcharges? And then, Carol, you made a great line last quarter about the bees and referring to billions of cost savings, just directionally, should we be thinking a billion plus or potentially multiple billions of cost savings here? Thank you.

So, Scott, I'll take the first piece of this in terms of the pricing. If you look at the underlying health of the price and the quality of overall revenue, really, it's more than just pricing. But as you look at the second quarter, you remember, I peeled out Fuel and SurePost to give you a good read at the growth And we were 1.5% positive. That was the first time we saw a positive number there in quite some time. That would equate to 3.6 in the third quarter. So you see that sustained momentum. We'd expect to see continued improvement there. The question then comes down to the balance in terms of B2B, B2C, and SMB and how we flow through. So we're trying to pivot the business as we walk through. But I think you can look for underlying continued improvement in the RPP ex-fuel and sure post. Carol, do you want to comment on the B?

Yeah, so we've got Transformation 1.0 coming to a close. So we'll turn to Transformation 2.0, which the first wave of Transformation 2.0 was the BSAP that we announced this fall. We offered that BSAP in two waves to over 11,000 UPSers. Thus far, we've had about 1,600 people apply. We'll land at something around there or maybe a little less. So you can do the math of what that might translate into savings. That's not a billion. That's several hundred million. But it's the first phase of Transformation 2.0. There are more activities that will come. We're not going to tell you before we tell our people, but there are more activities that will come in Transformation 2.0. When you think about Transformation 2.0, think about that attacking non-operating expense, in other words, general overhead. It's going after spans and layers. It's going after labor arbitrage, that sort of opportunity. The real money, and candidly, our non-operating expense is about $6 billion on an annual basis. So the real opportunity to get billions out is in the operating side of our business. And this is all about productivity and going after those big buckets of cost. that we need to turn down to add up to a billion. We're going to have an investor conference in 2021 when things calm down. I don't know, Brian, what we're thinking about.

Early June.

Early June, okay. So hopefully COVID is settled down. We can do a good conference in June of 2021. And then we'll lay this all out for you. I just don't want to get ahead of my skis. I was a downhill racer for a long, long time, and if you get ahead of your skis, you tumble down the mountain. I just don't want to do that. So we're just going to be very, very thoughtful, very planful about this, and then we'll lay that out for you so that you can hold us accountable to what we said we're going to do.

We have a question from the line of Jerome Nathan of Daiwa. Please go ahead.

Thanks for your question. I wanted to, with a better than bigger team, I wanted to understand how you're changing your incentive compensation to align with that. And just one modeling, your fuel expense was higher sequentially significantly, and was there anything in there that we should consider?

On the fuel side, Jerome, we saw about $60 million in benefit in the quarter, 30 of that coming, roughly half of it coming in domestic and half international. We'd expect that to moderate in the fourth quarter. So it stepped down from Q2 to Q3 by about 50%. We'd expect that to continue to step down in the fourth quarter. Carol, do you want to?

One of the wildly important initiatives is people. And as we look at the people opportunities, incentive compensation is certainly one of those opportunities. The design of our incentive compensation doesn't necessarily tie to the results that we want to achieve. So we're going to be resetting the goals to make that happen, to make them much more return-focused. They were too line-item focused, if that makes any sense. So you get bonus off of revenue per piece. That's an incomplete look at the business, isn't it? Because it doesn't have the cost and it doesn't have the capital. So we'll be re-looking at the elements of both our short-term, which is our annual bonus, as well as our long-term. Our long-term incentives do have a return characteristic to them, so that's good, but I really want to work on the short-term incentives. Also, we're going to redo our sales incentives for our sales team. They're so complicated. I tend to think I can understand math. I have a hard time figuring this out. So we're going to simplify this so it's really easy for people to understand how they get paid and actually tie the incentives to better, not bigger.

Steven, it's Scott. We've got time for one more question, if you would.

The last question will come from the line of Tom Waterwitz of UBS. Please go ahead.

Tom may be stuck on mute.

Is one more question to the next caller, please?

Our next question will come from the line of Brandon Ogulinski of Barclays. Please go ahead.

Hey, everyone, and thanks for sneaking me on here. Carol, I guess, you know, thinking about not wanting to repeat mistakes of the past, if we go back two predecessors ago, you know, CapEx came down a lot. And you do have, you know, independent contractor competition effectively doubling your growth rate right now. So how do you balance the need for productivity and growth as well as achieving that higher value with lower capex?

Right. So to your point, it's a balance. And we're well aware of the changing competitive environment and the changing customer environment and are thinking through how to best attack those opportunities in ways that are different than what we've done in the past. And that's just a hint of what's to come. But we'll be talking more about that next year.

That concludes our call. And I want to thank everyone for participating on today's call. And have a great day. Thank you.