United Parcel Service, Inc.

Good morning. My name is Steven, and I will be your facilitator today. I would like to welcome everyone to the UPS Investor Relations fourth 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 fourth 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 security laws and address our expectation for the future performance or operating results of our company. These statements are subject to risk and uncertainties, 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. For the fourth quarter of 2020, GAAP results included a non-cash, after-tax, mark-to-market pension charge of $4.9 billion, an after-tax transformation charge of $114 million, and an after-tax impairment charge of $545 million related to the company's decision to sell UPS Freight. The after-tax total for these items is $5.6 billion, an impact to the fourth quarter of 2020 EPS of $6.38 per diluted share. The mark-to-market pension charge of $4.9 billion included a benefit from higher than anticipated asset returns, which did not fully offset the negative impact of lower discount rates. It also included the remainder of our current best estimate of potential central states coordinating benefits as of December 31, 2020. Additional details regarding the year-end pension charges will be available in a presentation posted to our investor relations website later today. Unless stated otherwise, our comments will refer to adjusted results, which exclude the year-end pension charges, transformation cost, and non-cash impairment charge. The webcast of today's call, along with the reconciliation of non-GAAP financial measures, are available on UPS investor relations website. Following our prepared remarks, We will take questions from those joining us 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 have a lot to cover with you this morning. We were very busy in the fourth quarter. I will review our peak season and then provide an update on our strategic progress. Brian will cover the financial details for the quarter and then finish with an outlook for 2021. Let me begin with a huge thank you to our more than 540,000 UPSers for not only delivering one of the best peaks in our company history, but also for their extraordinary efforts throughout 2020. UPSers are essential workers, and I could not be more proud of the team. In a year unlike any other, they delivered what matters. Looking at the fourth quarter, our results were strong and considerably better than we expected. Consolidated revenue in the quarter rose 21 percent from last year to $24.9 billion. and operating profit grew 26% from last year to $2.9 billion. This is the highest quarterly operating profit in the company's history, with record profit produced in each segment. For the year, UPS generated record revenue of $84.6 billion, with growth in all three segments. We increased operating profit by 7% to $8.7 billion, and we generated diluted earnings per share of $8.23, an increase of 9.3 percent. Turning back to the fourth quarter, let me address our holiday peak performance. The environment was very dynamic, largely due to market demand exceeding market supply, but we were ready. Our early collaboration with customers and a disciplined approach to executing our peak plans proved to be very successful. We delivered industry-leading service levels, which in turn accelerated new customer requests for our services. As peak holiday approached, we saw SMBs, or small and medium-sized businesses, increasingly turn to UPS. In the U.S. in the fourth quarter, SMB volume grew 28.5%, outpacing our larger customers, which grew by 4%. By running the network with more discipline and through the deployment of new tools, we reduced what we refer to as chaos costs, or costs associated with bottlenecks and overtime pay. Additionally, SurePost Redirect reached a new record in December. Nearly 50% of SurePost volume was delivered by UPS drivers, optimizing our network. And just a comment about peak outside of the U.S. It was a very peaky peak with the highest volume in our history delivered with excellent service levels. And while this peak was one of our best, we know that we can do even better. We have identified additional areas for improvement and are including them in our peak 2021 planning. During the height of the peak season, the FDA and other health authorities approved the use of COVID-19 vaccines. We were ready for this. as we had reserved capacity in our network. We've been in the healthcare logistics business for more than 15 years. Our expertise in cold chain logistics positions us well. And thus far, we have provided above 99% service for vaccine delivery. Looking back to 2020, we laid a strong foundation for future success. On my first earnings call in July, I mentioned that we were operationalizing our strategy customer-first, people-led, innovation-driven, through a better, not bigger framework. We are making solid progress. From a customer-first perspective, speed and enabling capabilities are very important. Our goal is to provide the best digital experience powered by our smart global logistics network. And we're targeting our solutions to high-yielding sectors, like SMBs, among others. We've moved the needle on speed. For the year, weekend ground volume was up 93.9% over last year. And SMB volume on our fastest ground ever lanes grew by 40% in the fourth quarter since we improved these lanes. We now have more than 700,000 accounts in DAP, which is our digital access program. And revenue from that program grew more than 360% in 2020. We expect our DAP revenues to reach $1 billion in 2021. People-led focuses on building a better workplace for our people. Over the past several months, we've addressed some of the pain points here, and early feedback has been very positive. In fact, we've seen a 13 percentage point improvement in likelihood to recommend, the primary metric we use to measure progress on our people-led initiative. As Brian will detail, during the quarter we accelerated certain annual bonus awards that were paying out over five years. Going forward, our annual management incentive plan will pay out in one year and will include targets for return on invested capital. Further, we are simplifying our sales incentive programs and incorporating profitability targets into those programs. These changes better align employee performance to the interests of all share owners. People-led also means creating fewer but more impactful jobs and lowering our non-operating costs. Brian will provide you with an update on our transformation activities. Innovation-driven means driving higher returns on the capital we deploy using new tools, processes, and technologies. Driving higher returns starts by improving our revenue quality, and here our efforts are working. In the fourth quarter, U.S. domestic revenue per piece was up 7.8 percent, the highest growth we've seen in more than 10 years. While this year-over-year growth rate reflects peak surcharges, it also reflects a change in mix, as SMBs accounted for 64 percent of U.S. average daily volume growth in the quarter. We also saw solid SMB volume growth outside of the U.S., Lastly, we have tightened the linkage between our investments and returns. As I mentioned back in July, with the exception of our five core principles, everything else is under review. Last week, we announced that we had entered into an agreement to sell UPS Freight, our LTL business unit. UPS Freight is a capital intensive, low returning business. We do not need to own this business to provide an LTL solution for our customers. With the disposition of UPS freight, we will be smaller, but we will be better, as without it, we will see an improvement in our operating margin and return on invested capital. Being better, not bigger, also means de-risking our balance sheet. We will use the proceeds from the sale of UPS freight to pay down long-term debt. Looking ahead, Uncertainty remains. While we are optimistic about the future, we don't know the pace of the vaccine rollout or the impact that a continuing pandemic will have on the global economy. On the other hand, we don't think e-commerce sales as a percentage of retail sales will decline, which means continued supply and demand imbalances. This scenario supports our efforts to improve revenue quality while optimizing our existing network. These efforts, coupled with a relentless focus on productivity and effective capital allocation, should result in both operating margin expansion and higher return on invested capital in 2021. But until we have more certainty with the economic environment, we are not providing revenue or earnings per share guidance. Let me close with a note of reflection. I've been in the CEO chair since June 1st. It has been an honor and a privilege to serve, especially this year, a year the world won't forget. UPS is a purpose-driven company with a proud past and an even brighter future. I'm excited about the opportunities that lie ahead. And with that, I'll turn the call over to Brian.

Thanks, Carol, and good morning. In my comments today, I will cover four areas, starting with high-level macroeconomic trends, then the results for each of our business segments. Next, I'll review full-year cash and shareowner returns. And lastly, I'll wrap up with some color on our 2021 outlook, including full-year guidance for capital allocation. Let's start with the macro, which can be best described as dynamic. and has created both opportunities and obstacles pushing business activity in multiple directions. Global GDP for the fourth quarter is expected to finish down 1.7%, a slight improvement versus the third quarter. In the U.S., reported consumer sentiment in December was 80.7%, up 3.8 points from November 2017. and consumers continued to shop online with year-over-year growth for non-store retail sales up 24.3% to finish at 20.9% of all U.S. retail sales in the fourth quarter. On the commercial side of the U.S. economy, growth in industrial production during the fourth quarter remained negative at minus 4.7% year-over-year, but improved 180 basis points from the third quarter, Overall, macro conditions are weak. However, the shift in buying patterns generated elevated residential demand. Moving to performance. For the quarter, consolidated revenue, profit, and EPS were all up more than 20%. UPS consolidated revenue increased 21% to $24.9 billion, and operating profit totaled $2.9 billion, higher than last year. The operating margin for the company expanded to 11.5%, which was 40 basis points above last year. And diluted earnings per share was $2.66, up 26.1% from the same period last year. Our strong fourth quarter financial results provide a glimpse into our strategic progress and what is possible. Moving into the segments. In U.S. domestic, our success was driven by our revenue quality efforts and a disciplined approach to executing our peak plans. As expected, average daily volume increased 8.9% year-over-year to a total of 25.2 million packages per day. More importantly, customer mix improved. SMB volume growth accelerated 980 basis points sequentially. going from 18.7% growth in the third quarter to 28.5% in the fourth. Both SMBs and our larger customers grew residential shipments across air and ground products. Overall, B2C shipments increased 19.9% year-over-year and represented 67% of total volume. Conversely, Both SMBs and large customers shipped fewer B2B packages on a year-over-year basis. B2B average daily volume finished down 8.3%. Healthcare and automotive were bright spots and delivered single-digit B2B growth. However, they were unable to offset weakness in retail and high-tech. For the quarter, U.S. domestic generated its highest-ever quarterly revenue. up 17.4% to $15.7 billion, driven by growth in ground products. We are extremely pleased with our revenue quality efforts, which were well above our expectations. More specifically, SMB growth accelerated, and we had higher than anticipated peak season surcharge revenue. As a result, reported revenue per piece grew 7.8% year over year, with ground revenue per piece up 11.2%. Turning to costs, expenses were up 17.7% over the fourth quarter of last year, and cost per piece was up 8.2%. Our expenses grew faster than revenue due to several factors. First, in 2019, we had $150 million in expense reductions from alternative fuel tax credits and lower management incentives that did not repeat. Total delivery stops increased by 15.7% due to high growth in single-piece shipments and lower delivery density increased costs by $185 million. Third, in the quarter, we had higher benefit expenses of $100 million related to the employees hired early in 2020. And finally, as Carol mentioned, in the fourth quarter, we elected to accelerate the vesting of certain previous compensation awards, a one-time expense impact of $129 million. If you ignore the impact of the accelerated vesting of awards, we would have leveraged expense in the quarter. When we look specifically at our peak period, despite the complexities, our operators and engineers executed extremely well. Together with the sales teams, we controlled volume that entered the network, avoiding chaos costs while delivering best-in-class service. As one example, overtime hours in our operations in December went down 7.7% compared to last year. Pulling it all together, in the fourth quarter, the U.S. generated $1.4 billion in operating profit, an increase of 14.3% compared to last year. Moving to international, the segment delivered another quarter of record operating profit, we exceeded our volume expectation with total average daily volume up 21.9%, driven by export and domestic volume growth in all regions. We added 365 flights above our normal schedules to support high market demand for our export services. In fact, total exports grew 27.8% on a year-over-year basis, led by Asia exports up 45%, and Europe exports up 30.7%. B2C average daily volume grew 104.1%, while B2B was up 2%, the first quarterly B2B growth in 2020. For the quarter, international revenue was up 26.8% to $4.8 billion. Revenue per piece was up 3.8%, and cost per piece was up 0.3% year over year, which generated positive operating leverage in the quarter. For the fourth quarter, International delivered operating profit of $1.2 billion, an increase of 43.4%, and operating margin expanded 280 basis points to 24.3%. Operating profit and margin are both record highs for the segment. Looking at supply chain and freight, the segment results were excellent. with revenue up 29% to $4.4 billion. Strong market demand drove revenue and profit growth in almost all business units. Forwarding had another great quarter, led by elevated demand out of Asia. Our LTL business grew operating profit by focusing on revenue quality efforts, and healthcare had its best quarterly top-line and bottom-line growth ever, driven by outbound direct-to-patient shipments all while providing near perfect service in late December for COVID-19 vaccine deliveries. Overall, in supply chain and freight, operating profit was $331 million, an increase of 26.3% year over year. Walking down our income statement, we had $175 million of interest expense. Other pension income was $327 million. And lastly, our effective tax rate came in at 23.2%. Now let's turn to cash and share on our returns. Our cash flow was strong throughout the year. We generated $10.5 billion in cash from operations, which included a benefit of $1.1 billion related to the CARES Act federal payroll tax deferral, offset by pension contributions totaling $3.1 billion. Capital investments totaled $5.6 billion, which includes 16 new aircraft, 16,000 new vehicles, and 18 facilities added to our smart global logistics network, all of which resulted in free cash flow for 2020 of $5.1 billion. In 2020, UPS distributed $3.6 billion in dividends, which represents a 5.2% increase on a per-share basis over 2019. Moving to our outlook for 2021. As Carol mentioned, due to the continuing economic uncertainty, we are not providing revenue or diluted earnings per share guidance at this time. But I do want to give you some color as you think about 2021. First, let me update you on what we have been calling Transformation 2.0. Through a combination of various programs, we plan to reduce our non-operating expenses by more than $500 million in 2021. As Carol mentioned, we are focused on creating fewer but more impactful jobs. Second, we expect the sale of UPS freight will close during the second quarter of 2021, so you will want to adjust your models accordingly. Third, we are gaining traction on our revenue quality initiatives. As a result, we would expect our small package revenue in 2021 to grow faster than our average daily volume. As we further evaluate the year, one of our wildly important initiatives is to review our network design and look at alternatives for how we expand capacity. And finally, because of our revenue quality initiatives, along with our actions to drive higher levels of productivity and take costs out, we expect operating margin and return on invested capital to expand. And just a comment on the first half of the year. we will face more difficult comps in the second quarter of 2021 than in the first quarter. As a result, we anticipate much stronger year-over-year financial results in the first quarter relative to the second quarter. While it is early in the quarter now, we are pleased with how the year has begun. Looking at a full-year capital allocation in 2021, we expect capital expenditures to be about $4 billion, with 40 percent allocated to maintenance capex, 50% for both technology initiatives and network capabilities in 2021, with over half of this investment being deployed to international and healthcare, and the remaining 10% for growth projects that will come online after 2021. Dividends are expected to grow, subject to board approval. And to further strengthen the balance sheet, we will pay off $2.5 billion of funded debt. We have no plans to repurchase shares or access the debt capital markets. And lastly, our effective tax rate is expected to be approximately 23.5 percent. Before I wrap up, I would like to confirm that we will host an investor meeting on June 9th where we will share multi-year financial targets and our specific plans for how we will achieve those targets. In closing, we are laser focused on executing our strategy and leaning into the best market opportunities to improve the financial performance of the company, provide the best customer experience, and benefit our shareholders. Thank you. And operator, please open the lines.

Thank you. We will now begin the question and answer session. As a reminder, for those that have not queued up, if you have a question, please depress the zero followed by the one on your touchtone pad. Our first question will come from the line of Amit Mahotra of Deutsche Bank. Please go ahead.

Thanks, operator. Good morning, everybody. Congrats on the good results. Brian, just on your margin comment, just wondering if you can clarify on the second quarter if you expect margins to be up year over year in the second quarter. I understand the tougher comp is just trying to get a sense of how you're thinking about it on a year over year basis. And then I was just hoping also you can help us think about yield and cost per package as we progress through 2021. Yield progress has been great, but just wondering if that's something you can continue to sustain or build upon in 2021. Thank you.

Yeah, I'm happy to take that. So from a yield perspective, very happy with the progress, particularly in the U.S. business. You know, we went from Q2 yield was minus 4%, 4.4. We were flat in Q3 and up 7.8 in Q4. So I think you've heard us talk about the revenue quality actions we've been implementing. It's a combination of mix. It's a combination of surcharges and customer action. So I think the progress speaks for itself. In terms of op margins for 2021, As I mentioned, we're committed to expanding our domestic op margin in the year. I won't get into Q1 versus Q2. We'll certainly give you some more guidance and clarity when we get together in June to talk about the second half of the year. But suffice it to say, the combination of revenue quality and cost actions will expand domestic margins in the year.

But just one quick related to that, you know, The cost per package inflation was pretty high in the quarter, and you obviously called out some specific items. As we look at the progression over this year, the yield dynamics look sticky. Maybe cost per package can come down, at least the inflation and cost per package can come down, especially as you get B2B recovery. Is that a fair way to think about the spread between cost price and cost per piece as we progress through the year relative to obviously what it was in the fourth quarter?

Yeah, I mean, I think we talked in the last quarter about some of the headwinds we were walking into in the fourth quarter of 20. You know, we had 40,000 employees coming on, which was about a $100 million headwind. We were investing in fastest ground ever. I guess what I would call your attention to, if you're looking for margin progression and progress, we made an intentional decision, as Carol mentioned, to accelerate the investing of some awards programs. And if you back that out, that was worth about 80 basis points. So we would have actually generated positive leverage in Q4. So as you think about that relationship, we would have seen positive leverage if we chose not to pull that forward. Hopefully that answers.

Yeah, got it. Thank you very much. Appreciate it.

Our next question comes from the line of Tom Wadowitz of UBS. Please go ahead, sir.

Yeah, good morning. I wanted to give you, I guess, another angle on the domestic package margin. Congratulations on the strong results as well. I should say that first. How do you think about the kind of key factors that maybe drive stronger or weaker performance in domestic package margin improvement as you kind of look on 2021? Is it how well B2B recovers? Is it kind of, you know, your cost initiatives? And do we think about kind of a building as you look out in quarters and even look further out in the pace of margin improvement? So I guess just a couple things trying to get more of a sense, not a number, I know you don't want to give that, but, you know, how we think about the levers and whether that improvement is something that accelerates, you know, maybe beyond the second quarter comment you gave.

Maybe I'll start, Brian, and then turn it to you. We look at Q4 as a turning point in our company where our revenue grew faster than our ADB, and that was driven really by three factors in the U.S. We beat our U.S. expectations on the top line by nearly $850 million, and it was driven by higher peak surcharges. It was driven by a change in mix, as we called out, with that increase in SMB, almost 29%. And it was driven by the actions that we started last year to optimize our network all along the better, not bigger framework. And we think this is proof positive that better, not bigger will work. And in the face of the demand capacity constraints, we believe that will continue. So as we look forward to 2021, we expect our revenue to grow faster than our ADV, which provides leveraging opportunities. But it doesn't stop at the top line. It also means continued productivity on the bottom line. So Brian called out our actions to take out $500 million of cost. That's cost that's being eliminated from our company. And then we are driving productivity in our operations expense lines as well. So it's a combination of better revenue quality and productivity that will lead to margin expansion, not just in 2021, but beyond. Now, we're going to lay this out for you in great detail at our investor conference in June. So I hate to kick the can to June, but we're going to kick the can to June a bit because we've got some more work to do. Brian, anything you want to add to that?

Just, Tom, on the Q4, the inflection cow reference. I think if you look back the last decade or so, we're used to seeing peak and Q4 margins actually decelerate, go down from Q3. This was actually an inflection point where we actually saw an 8.6 go to an 8.8 on a sequential quarter-over-quarter basis. So I think the levers we're pulling on revenue, the levers we're pulling on cost that Carol referenced, we're looking for the right glide path, but we'll give you more clarity on that. Great. Thank you. Thank you.

We have a question from the line of Brian Asenbeck of JP Morgan. Please go ahead, sir.

Good morning. Thanks for taking my question. I just wanted to ask you about the capital intensity of growth. I think, Brian, you mentioned you're looking at network design and expanding some capacity. So maybe you can clarify if that's in the U.S. domestic or, more broadly speaking, across the whole network. And then just when you think about automation, How much more investment do you think you need to do there to sort of get this sort of leverage that you're talking about if we still see a pretty big step up in B2C and e-commerce throughout the next year?

Well, I'll take the automation question. By the end of 2021, we expect that 88% of our packages will go through an automated sort. So we're reaching sort of where we want it to be in that regard. That doesn't, though, talk about robots. and what we are doing with robot application inside of our domestic business. We've got some interesting pilots underway that are actually starting to take traction, particularly as it relates to label applications, and we'll be happy to share with you more information in that regard too. It's pretty exciting when I think about what we can do from that perspective longer term. In terms of how we're spending our capital this year, Brian, you might want to talk about that.

Sure. So, you know, we've We've pivoted a little bit. The buildings and auto piece is going to represent about $2 billion of the four. We do have about $1.6 billion of maintenance that we need to continue to invest in the business, and we're reserving the balance for growth. I think the shift towards higher return, we're going for shorter-term paybacks in areas like international and health care and technology. Those are areas that we're pivoting to to capture the growth in high-return areas.

Maybe a little bit more specificity here. We'll expand or retrofit about seven buildings in 2021. It's about 2 million square feet that will be added, 130,000 packages per hour. We are adding 11 new aircraft, which will certainly help support the demand that we're seeing outside of the United States. So we're planning to grow, but we're planning to grow smartly. It's about being better, not bigger.

Okay. Thank you very much. Our next question will come from the line of Allison Landry of Credit Suisse. Please go ahead, ma'am.

Thanks. Good morning. So I just sort of wanted to ask another question about domestic revenues growing faster than volume. Obviously, you're focusing on SMBs and other high margin sectors, but how do we think about just broadly growth at the largest customers? Are you taking any specific action, price or otherwise, to materially reduce exposure We have some of the low margin but high volume business. And then lastly, if you could just speak to your thoughts on the sustainability of the SMB growth rate. Thanks.

So let's just address the elephant in the room, which is our largest customer. We have over 19 million customers. Amazon is our largest customer. We enjoyed growth with that customer in 2020. If you look at total revenues for our company in 20, Amazon now makes up about 13.3% of our total revenues up from 11.6% last year. But we had growth in other customers as well. As we look at our large enterprise customers in the fourth quarter alone, we had enterprise customers who were growing at 80% year-on-year. Full year, we had enterprise customers who were growing 100% year-on-year. So we see growth across the board. To your question, Alison, about the stickiness of the SMB customer, we are laser-focused here. because this is such an important customer to us and one we think values our end-to-end network. So we have 16 customer journeys that we are investing into to improve the customer experience. Now, it started with our Fastest Ground Ever initiative, and we made good progress in that regard, but we're not done. We know there's more we can do to invest in that experience, because speed really matters for this customer. But it's also about a frictionless digital experience, And I'll just give you one example of our 16 customer journeys. That's our billing system. If you look at our billing system for our SMB customers compared to our competitors, and if you did a Harvey Ball comparison, you would see that many of our Harvey Balls are empty, which means our capabilities are at a competitive disadvantage. This is a system that was built by UPS years ago. Gosh, I don't know how long ago, but years ago. We are replacing that system with a new SAS-provided software application. And when you do the capability comparison against what we will have against our competitors, well, we're best in class. That matters to this customer because the billing system can be personalized for their experience. And every SMB customer is different. Now, we can't have this in every country around the world because some countries require paper still today. But in many countries, we can install this billing system, and we believe that will result in stickiness. It's also about the solutions that we provide. When we provide solutions to our customers, we see they stick with us. And the numbers are quite impressive in terms of the stickiness if they have a solution and don't have a solution. So we continue to invest in that. And at our June 9th investor conference, we're going to unpack this in pretty good detail for you so you can get a sense of what we're talking about. The one other data point that I will share with you is churn. And I think we talked about churn on my first earnings call, didn't we? And we've got a laser focus on SMB churn. What we saw in December is our churn improved for the company year over year, the first month this year. And we think that's really in large part because of the customer journeys we're investing in and our fastest ground ever. And as a reminder, every point of churn improvement in the United States is about $170 million of revenue.

Our next question will come from the line of Allison Poliniak of Wells Fargo. Please go ahead, ma'am.

Hi, good morning. Just turning back to the commercial customer within that B2B segment, clearly the industrial production has been on a positive trend line. Is that something you're seeing within your business as well? Any thoughts from your customers in that segment in terms of how they're thinking about 2021? Any color on that segment?

Well, to your point, Allison, the trends are certainly encouraging in terms of what we're seeing from a production perspective. Our largest commercial account is actually retail, and it's related to stores and how product flows to stores. So until we see more store openings, we think our commercial business could be under some pressure. But we did see some growth signs. Brian, you called out some signs of growth, didn't you?

Yeah, we saw in the industrial side, Allison, healthcare and auto were positive. Also, if we look internationally, we actually saw Asia and Europe contribute with the high-tech international in particular. We saw 2% positive B2B growth in the quarter in international. That was the first positive sign in 2020. So hopefully the B2B trend stayed about the same, down 8% in the U.S., but hopefully as the sectors come back, and as Carol mentioned, as retail opens back up, we can grow that as well.

There's just still so much uncertainty, isn't there? Because until we get this pandemic under control, it's a little, we're just a little bit walking on jello.

Understood. Thank you. Thank you.

We have a question from the line of Ken Hexter, Bank of America. Please go ahead, sir.

Hey, great. Good morning and solid results. Just, Brian, can you clarify that margin comment? That was just domestic or were you talking overall? And then I guess my question would be on the $500 million transformation issue. Is that the employee reductions that you've already done, or are there other projects in the Transformation 2.0? I don't know if you also want to detail what was in the charges that you had this quarter. Thanks.

Yeah, so on those two, Ken, the margin comment I was referring to was domestic, where we're looking to expand that on a year-over-year basis and committing to do that. The Transformation 2.0, I called out $500 million of benefit in 2021. That's related specifically to what we call Transformation 2.0, the non-operating spend. The gross number on it was actually $750 million. So net of some investments, it was $500 for the year. But please remember, when we talked about transformation, this was a non-op initiative. We're reducing our non-op spend by about 8%. So that's a good first step. We're going to move into Transformation 3.0 and get after the operating costs inside the business, which is the next wave. And I think we'll provide more detail and clarity on that as we get to June.

Just to clarify, so you're commenting on domestic, but you're not setting any target for international, right? Or would you commit to it being up as well?

So from a margin perspective, my reference was the domestic would expand. We're going to talk to you about the full-year margins when we get to June 9th, Ken. So there's a lot of volatility going on right now, Asia, Europe, et cetera. So more clarity to come on that.

If you're trying to build a model, I think we could help you if you're trying to build a model that you should plan for operating profit to grow outside of the United States. The margin question is highly dependent on supply and demand and whether or not surcharges will be maintained. They're holding today. The question is, will they hold for the balance of the year? We'll have much more clarity on that in June.

Thank you, Karen Bryant. Appreciate the time.

Yep. Thanks, Ken. Next up, we have David Vernon of Bernstein. Please go ahead, sir.

Hey, good morning. A question for you on that topic around surcharges and the holding of surcharges. As you're looking out at renegotiating contracts and talking to your customers given the tightness of last year's market, can you give us some color on the receptivity of customers to be working with you either through taking rate increases or working to help drive efficiencies at the edges of the network that would help kind of make the customer base either a little bit stickier or more profitable as we get into 21 and 22?

We're very pleased with the relationships that we have with our good customers. This has been a challenging year for all of us. We have all enjoyed this unprecedented demand, which has put candidly pressure, but as we've worked through it, we've been able to land really, I think, very favorable contracts for us and for our customers. It's really about optimizing the network, leaning into the customer segment that values our end-to-end network.

And are those surcharges going to be re-based into base rates, or how do we see that playing out?

The way you should think about it is very different than in the past. We're moving to more personalized pricing. Thank you. You're welcome.

We have a question from the line of Jordan Allager of Goldman Sachs. Please go ahead, sir.

Yeah, hi. Just a quick follow-up on some of the density and productivity around the domestic front. I know that may still be to come on transformation, but can you maybe talk a little bit, assuming e-commerce obviously remains elevated, residential remains elevated. There are a couple of things you could point to that maybe improve like stops per house or improve that delivery density, which you mentioned was a financial impact in the fourth quarter. And then, secondly, just a quick follow-up. When you mentioned the financial outlook for the first quarter being better than the second quarter, I'm assuming you're talking about year-over-year profit growth on that front. Thanks.

Let me take a second. So yes, Jordan, you're right. On a year-over-year profit growth, certainly the margins, we're lapping lower domestic margins in the U.S. Those ramp up to about 9.3% in the second quarter. So I was referring to profit growth on that.

If we look at our productivity results, I'm pleased with what I'm seeing in our feed. I'm pleased with what I'm seeing in our sort. I'm pleased what I've seen in our hubs. I'm not pleased what I've seen in our preload. And Nando and team are really looking at how they can drive productivity in our preload. And clearly, we've got some density opportunities. Now, we've been trying to drive synthetic density through our access points in our UPS stores. We have 22,000 access points in UPS stores that we are trying to utilize to drive delivery density. It's not working as well as we thought, quite candidly. So as a team, we've taken this as a strategic imperative. And we're going to talk about other ideas we have to improve density, given that you can't really change the demand pattern. But there are things that we can do internally, we believe, to drive productivity. So more to come. This will certainly be something that we unpack on June 9th.

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

Thanks. Good morning. Carol, you said in your prepared remarks that you do not expect e-commerce as a percentage of retail sales to decline in 2021. Can you just unpack that comment a little more for us? What are your large retail customers telling you if and when hopefully stores reopen again in a post-pandemic world back off of the year? Do they expect traffic to return to stores or not? And what does that do to your e-commerce volumes?

So they're all hoping that their stores will reopen because they've got a huge investment in that real estate, of course. But from a demand perspective, there's no one out there that thinks that the demand is going to change. We're in a new normal. Even my relatives who are older are shopping online before they would never do that. So they're all telling us they don't expect the demand to go back. There's been a step change in the demand patterns. which then translates into a capacity shortfall, candidly. So if you think about what happened in peak of this year, there was about a 3 million ADV shortfall in terms of the demand. And if you look forward into 2021, you would expect that shortfall to consist, which just gives us an opportunity to continue to optimize our network.

Thank you. David Ross of Stiefel. Please go ahead, sir.

Yes, thank you very much. Carol, I just want to talk a little bit about the labor issues. You know, fourth quarter and the peak, you guys handled exceedingly well and were able to demonstrate profitability. How much of a headwind was managing through this period of absences and rescheduling, pilots calling out sick, that kind of stuff that normally doesn't happen during peak. If you actually had a normal environment where somebody just didn't call up and say, I'm out for the next two weeks at last minute, how much would that have helped?

Well, you're right in that this is a very difficult environment, one that we've never been faced with before. But the team did a masterful job of managing through it. A few things were different this peak than last peak. One was the use of PBDs, or personal vehicle drivers. We've used them in the past, but this year we really leaned into it. So in the United States, this year we had 39,000 PBD drivers, and they delivered 69 million packages. That, we believe, drove $92 million of benefit in the quarter. So this is something that really worked very well, and we're going to lean into this as we think about peaks of the future. We were also able to use our dream tool, which is a dispatch tool, to give our Teamster drivers who work so hard, give them some time with their families, which hasn't been the case in prior seasons. So we were happy to be able to deliver that. We were also pleased with our ability to redirect our SurePost volume back into our networks. We saw in December alone 50% of the SharePost volume was redirected back into the network delivered by our UPS drivers. That resulted in productivity savings as well of about $44 million. Now, was there money left on the table? Sure. We had disruption with pilots in part of the world like Shanghai. For sure, we had some money left on the table, but I would say we had more good news than bad news coming out of the challenges in the fourth quarter.

That's excellent. Thank you.

Our next question will come from the line of Vascon Major of Susquehanna. Please go ahead, sir.

Good morning, and thank you for taking my question. Carol, you've made a lot of progress very fast here. One thing that comes to mind is dealing with organized labor, which really wasn't an issue at your prior employer. I mean, you have a change in Washington that should be more labor sympathetic. You're going to have a change at the head of the Teamsters union this year. Can you talk about your strategy for that relationship and finding a happy medium that takes care of your employees, the union, and your shareholders over the next three to five years?

Yeah. Well, as you know, we employ more Teamsters than any other company, and We love our Teamsters employees. Our UPSers first, Teamsters second. As we think about labor, our contract comes due in the United States. It comes due in 2023. And we think about, you know, mutually beneficial outcome for both our Teamsters and UPS as we prepare for that contract. We're viewing labor as a strategic imperative. We want to keep those jobs. We want to grow jobs. So we're going to be speaking with the union representation about how we do that going forward. We're also candidly excited about what new administration could mean for pension reform. And pension reform would be good for us and it would be good for our teamsters. So we will continue to work that agenda because we think it's in the best interest of all parties.

Thank you. Our next question will come from the line of Scott Group of Wolf Research. Please go ahead, sir.

Hey, thanks, Morning. So I want to ask on balance sheet cash flow, Carol, do you think this is the new sort of new normal for CapEx? How much do you want to improve the balance sheet before you start buying back stock? If we're at this inflection in margins, why not buy back stock now? And maybe just any thoughts around pension contributions for this year and pension impact. Thank you.

Thank you, Scott. Brian, why don't you take that question?

Yeah, sure, Scott. So, look, we're focused on strengthening the balance sheet. I think in my prepared remarks I talked about for modeling purposes, assume no buybacks in 2021. We think by reinvesting in the business in areas that are driving higher cash returns, strengthening the balance sheet, Scott, will end up with one of Carol's five imperatives. a strong credit rating as we go forward, which gives us optionality to evaluate opportunities, organic and inorganic.

From my perspective, we have ample room to allocate capital back into the business and back to the shareholders. We just want to make sure that we generate the right return on that. And to your point, I haven't been in this seat for that long, and it's a big company to try to get your hands around, but as we look at the opportunities to invest, We're going to have opportunities to invest. We just want to make sure that every dollar that we invest generates a higher return on capital. That's our goal. And the share buybacks will come. We thought for modeling purposes, it was just helpful to say no buybacks. If we change our mind on that, we'll tell you what we're doing, and you can put it into your model.

Our next question will come from the line of Scott Schneeberger of Oppenheimer. Please go ahead.

Thanks. Good morning. Carol, in decisive move with the sale of UPS Freight, just would love to hear in this forum just some puts and takes in the decision-making process. And then just to get a little more granular, could you discuss the UPS Freight ground with Freight Pricing Program, where TFR will act as a reseller? And then some thoughts on how the divestiture will impact the ability to serve the e-commerce market for heavier goods. Thanks.

So the question was a bit muffled, but I think it was on UPS Freight and the rationale, the decision behind UPS Freight, and then the go-forward commercial agreement. So as I mentioned back in July, my first earnings call, other than our five core principles, everything in the business was under review. And I immediately looked at UPS Freight. You know, I was on the UPS board for a long time. I went on the UPS board in 2003. So I was on the board when we acquired overnight back in 2005. I have been laser-focused on this asset because we had to impair it shortly after we bought it. And it's never turned out to be what we thought it would be. It's a capital-intensive, low-margin business that we don't need to own to offer this solution. So we're like, if we can get a price where this asset is worth more to someone else than it is to us, shouldn't we move on that asset? But keep the commercial agreement so that we can serve our customers. And that's where we landed. We couldn't be happier with this announced acquisition that should close, I think, the beginning of the second quarter. I'm thrilled for our freight UPSers because they're going to be now part of a big freight company. So from a career perspective, I think the opportunities for personal growth will be better for them. I'm thrilled for our shareholders, and I'm thrilled for our customers because the commercial agreement will be a great agreement And, oh, by the way, there's margin on that that's going to flow to our U.S. small PAC business as well. So I think it's a win-win-win. Anything else, Brian?

Yeah, no, there's some CapEx avoidance on a low-margin business, and we expect a positive improvement to our margins in ROIC, which are our core focus. So I think it's a win-win.

We have a question from the line of Jack Atkins of Stevens. Please go ahead.

Great, thank you. And just following up on that point, are there maybe some other non-core businesses, Carol, that maybe have come into the company through acquisitions over the last 10 or 15 years that could also be a target for potential divestitures, or is it just sort of a one-off here with UPS Freight? Thank you.

Well, Chet, as you can appreciate, it wouldn't be appropriate for me to speculate on assets that might be available for sale, but everything's under review.

Brandon Ogulinski of Barclays. Please go ahead, sir.

Hey, good morning. Thanks for taking my question. Brian, could we come back to the pension impact and how that's possibly impacting cash flows this year? And I'm not sure, but did you guys reserve another charge for central states here, too?

Yeah, Brendan, so we had a $6.5 billion mark. There's actually a deck that will provide you the details on it, but the discount rate change was a little over $4 billion, and in central states we took what we believe to be the last reserve for that, which was a little over $2 billion. So those were the two elements that made up the mark. In terms of headwinds for up on the service cost side, if that's what you're asking about from a pension perspective, We have a similar headwind to what we had in 2020. It's about $300 billion related to service costs in the U.S. business.

And, Brian, we made some cash contributions in 2020. We're not planning that in 2021.

Right. So we pulled forward about $1.7 billion in contributions into December of 2020 and don't anticipate having those in 2021, Carol. Thank you.

David Vernon of Bernstein, please go ahead, sir.

Hey, guys, thanks for coming back to me, Brian. I just wanted to clarify that the $500 million non-op expense reduction we're expecting this year, that's a net of cost to implement number. I mean, I just want to make sure there aren't any other sort of non-typical inflationary costs that we should be kind of budgeting for or thinking about when we're building an outlook here for 2021.

No, we've got 750 was the gross program. We reinvested to get to a net 500. We do have transformation charges associated with severance that will show up in the guidance that we give you.

That will be adjusted out of results, though, right?

That will be non-core, so it will adjust it out, and we'll shine a light on that for you. And nothing like... Sorry, but the return on those investments are kind of seven to eight months, so we're looking for better returns. I think you'll find that the investment in the transformation charges non-core are good paybacks.

Okay, and then there's nothing like the investment in the speeding up the network, the faster ground network sort of stuff. Are we going to be recreating any of those sort of like operational investments in the 21 period?

No, so the majority will be related to the Transformation 2.0 programs we talked to you about.

All right, thanks again for the time.

Yep, thanks.

We have Jaram of NAGWA. Please go ahead.

Yeah, hi. Thanks for taking my question. So I just wanted to refer to your CapEx plan, and you talked about 130,000 packages per hour increase. That's, I don't know, at 29 million packages daily volume. It's probably about 7%. And then on top of that, you've got the revenue quality. So is that kind of a run rate capacity increase we should expect and about maybe, I don't know, close to double-digit increase in revenue that is possible, that it's potentially a longer term?

If you're looking for a longer-term answer, we're going to punt to June 9th. Because on June 9th, we're going to lay out a longer-term plan. And we can answer that question in great detail.

Okay. And just if I could follow up, you talked about the $3 million shortage at peak. How do you make sure that you don't attract new entrants into the market with this strategy here? You know, like nature finds always a way. I guess markets also find a way somewhere.

So there are a number of regional players. There are a number of new entrants that are coming in the market. Our job is to provide the best end-to-end experience so the customers that we are bringing into our network are those customers who value what we have to offer. In many ways, it's about leaning into segments like health care, like SMBs, and other high-growth areas that value our end-to-end network. And just on healthcare, if I could make a comment on vaccines, because we haven't talked about it, but thought I just might share what we're doing in the vaccine solution here. As you know, it's a complicated supply chain. There's upstream supply chain where the raw materials are delivered to the manufacturers, and there's a place where we play, which is delivering vaccines from the manufacturers to the dosing locations, and then there's the administration of the vaccines by the dosing locations. As it relates to the space that we play, manufacturers to the dosing locations, we've delivered about 225,000 shipments, about 36.5 million vaccines, at service levels at 99.99%. So our healthcare logistics team is just doing just a really great job of moving these vaccines forward and couldn't be more proud of that team.

Okay. Thank you, Victoria. Thank you.

Well, Stephen, thank you very much for hosting us and introducing. We appreciate all the comments we got and all the investors that joined us today. And that concludes the UPS fourth quarter 2020 earnings call. Thank you.