United Parcel Service Inc
NYSE:UPS
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United Parcel Service Inc
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Good morning. My name is Stephen, and I will be your conference facilitator today. At this time, we would like to welcome everyone to the UPS Investor Relations fourth quarter 2017 (sic) [first quarter 2018] earnings conference call. All lines have been placed on mute to prevent any background noise. And after the speakers' 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.
Welcome to the UPS first quarter 2018 earnings call. Joining me today are David Abney, our CEO; Richard Peretz, our CFO; along with Chief Operating Officer, Jim Barber; Kate Gutmann, our Chief Sales and Solutions Officer; our Chief Information Officer, Juan Perez; and Scott Price, our Chief Strategy and Transformation Officer.
Before we begin, I want to review the Safe Harbor language. Some of the comments we'll make today are forward-looking statements and address our expectation for the future performance and results of operations of our company. These statements are subject to risks and uncertainties, which are described in detail in our 2017 Form 10-K and first quarter 2018 Form 10-Q. These reports are available on the UPS Investor Relations website and from the Securities and Exchange Commission.
The webcast of today's call, along with the reconciliation of GAAP and non-GAAP financial measures, are available on the UPS Investor Relations website. Unless stated otherwise, discussions today regarding full year financials will refer to adjusted results. Webcast users can submit live questions during today's call. We will attempt to answer questions of a long-term strategic nature. Callers are asked to submit only one question, so that we may allow as many as possible to participate.
Now, I will turn the call over to David.
Thanks, Scott, and good morning, everyone. UPS achieved first quarter earnings per share of $1.55, up 17%. Demand for our services remained strong, with total revenue up more than 10%. The International and Supply Chain units maintained a strong pace, producing double-digit growth in operating profit. These gains helped offset headwinds, including severe weather conditions that weighed on bottom line results in the U.S. Top-line results in the U.S. were strong, with revenue up over 7%.
While we're making progress on the strategies we've shared with you, there's more opportunity for greater returns to shareowners. To capture this potential, we've embarked on a broad transformation of our company. Every part of our business is in scope, and we're moving quickly into a new phase of transformation. We will create greater efficiency throughout our back office and administrative areas, and generate savings through Global Procurement. We're streamlining internal systems and processes and driving improved performance throughout the organization. We will also better align resources to new and emerging growth opportunities.
Yesterday, we announced a voluntary retirement program for eligible U.S. employees. This is the first of many initiatives to reduce cost and improve efficiency in our business. To accelerate our transformation, Scott Price joined UPS as Chief Strategy and Transformation Officer. We also recently announced several senior management changes. Jim Barber was named Chief Operating Officer, with broad responsibility for the operations of the business. We know the secret to our success is in coordination and alignment across our business as we move deeper into transformation. The timing was right for Jim's new position, and he will play a critical role, along with Scott, in ensuring we take full advantage of all the benefits from transformation. Following my remarks, I've asked Jim to comment on his new role.
In addition, during the quarter, we appointed Nando Cesarone as President of International Small Package and George Willis President of U.S. Operations. We are also advancing our global smart logistics network. In fact, we're bringing online additional network capabilities around the world, including more than 400,000 pieces per hour of highly efficient sort capacity this year.
In coming weeks, we'll open new hubs in London and Paris, and this summer, two large regional hubs in Salt Lake City and Atlanta. Operating leverage in our business will improve as we significantly expand our capabilities this year and beyond. Our superior network and operating strategies are enabling UPS customers to take advantage of free trade around the world. UPS supports fair trade agreements like the modernization of NAFTA and other pacts that will make cross-border trade more predictable and easier for businesses of all sizes.
We continue to believe there is a win, win, win for all three countries in an updated NAFTA agreement, and we're encouraged by recent events. Other headlines about trade agreements with South Korea, the reemergence of TPP and trade with China, provide real opportunities to the global economy and to improve standards of living.
Now turning to recent economic forecast. The overall economy is expected to remain strong throughout 2018, with consumer spending and business investment driving economic growth in most markets. Global GDP is projected at about 3.5% in 2018, the fastest expansion since 2010. Strong growth is expected in both Europe and Asia. In addition, worldwide exports are anticipated to grow more than 4.5%. In the U.S., expanding industrial production and retail sales growth is being driven by healthy fundamentals and competitive tax policy. UPS is well-positioned to benefit from this positive outlook.
Before I turn it over to Jim, I want to take a moment and recognize the amazing accomplishments of some extraordinary UPSers. In February, we published our annual list of drivers, who've joined the UPS Circle of Honor. For the first time, we have more than 10,000 drivers around the world who've remained accident-free for 25 or more consecutive years.
In addition, I want to take a moment to recognize a true UPS partner, Myron Gray, for his many years of valued leadership. Myron has made a material impact on UPS during his 40 years, and we wish him the best in his retirement. As we look at the rest of the year, our key transformation initiatives are moving forward. The economic outlook remains positive, and we're sharply focused on executing our growth strategies. Considering the scope of our transformation, we now plan to host a conference in the next several months to give you more details on our new multiyear initiatives and their financial benefits.
Thanks for your time today. Jim?
Thanks, David. I'm absolutely excited about my new role, and it's good to reconnect with the U.S. operations. I spent the first half of my career learning, leading and executing in the U.S. and have had the great opportunity to integrate those lessons across the globe over the last 15 years working internationally. More specifically, let me take a moment to review the International and Supply Chain segments, where we're generating great returns for our shareowners.
The results this quarter were robust, double-digit growth in revenue and operating profit. Clearly, this is not where we started in 2014. We've made long strides, and it has taken a lot of hard work and execution by the entire team. Last year, we finished at over $3.2 billion of operating profit, up significantly over where we started, even with the currency headwind, and we're enjoying the benefits from our continued momentum. These results are based on straightforward plans: build sustainable foundations; make the business models more efficient and flexible; and focus on the right growth strategies.
As we look ahead, the pace of business is accelerating, and we are transforming our entire business to connect global buyers and sellers in new ways. We are advancing the capabilities of our global smart logistics network, and this year marks a major step up. We start bringing online new regional hubs, and begin the initial rollout of dynamic ORION as well as Network Planning Tools. We also continue to implement technology projects within the EDGE program. All of these items will drive greater operational efficiency.
Additionally, we're identifying new multiyear transformation projects that bend the cost curve further, making us even more efficient. While all segments will benefit from the new initiatives, the U.S. Domestic segment will enjoy the largest gains as we move faster with transformation.
The future of UPS is being designed to create a more flexible and agile company, and at the same time, enhance our ability to better serve customers. But make no mistake about it, our plans are built on better managing our customer value proposition based on how buyers and sellers consume our integrated networks and our services. We can take the best lessons learned from our International and Supply Chain segments to speed the pace of improvement in all parts of our business.
At a high level, we will continue to follow a straightforward approach to drive execution. Already, many actions are underway, and I look forward to helping drive strategic plans across all of the business units.
Thanks for your time today, and now I will turn it over to Richard.
Thanks, Jim, and good morning.
As we look across the enterprise, revenue increased more than 10%. Volume growth was strong and product yields expanded. We made $1.55 earnings per share in the quarter, about where we expected. We had strong performance in both the International and Supply Chain & Freight segments, while the U.S. Domestic underperformed, primarily due to difficult weather conditions and some expected headwinds.
Also this quarter, UPS adopted the new FASB accounting standards that shifted items on our income statement. A presentation of the changes can be found in our IR website. We've also added a new section in the web schedules to give investors clarity on the pension changes. For the quarter, the pension accounting change resulted in $285 million of net benefit moving from operating profit to non-operating profit.
Now for the segment detail, in the U.S., revenue was $10.2 billion, an increase of 7.2%. Revenue for all products grew in the quarter, with air expanding faster than ground. High demand for UPS Next Day Air and Deferred Air services was in part driven by e-commerce shippers seeking faster delivery option.
Average daily shipment volume was up 4.6%, with improvements across multiple industry segments, including retail, healthcare, and manufacturing. Reported average revenue per piece increased 2.6%. Base rates increased over 2.5%, with improving trends through the quarter. We continue to identify opportunities to better align pricing to reflect the value creation and cost to serve. As planned, we are implementing additional pricing action on packages with unfavorable characteristics later this year.
Also in the quarter, winter storm activity made working conditions difficult in parts of the U.S. In fact, we experienced weather disruptions in parts of our network during 10 of 13 weeks this quarter. And as a result, we incurred additional operating expense as well as lost revenue. We estimate the impact from weather was a drag on operating profit of about $85 million.
There were also three expected headwinds: first, the continued deployment of Saturday operations; second, the network project yet to come online; and finally, pension expense related to the lower discount rate this year.
In 2018, we are in the first year of a three-year peak capital phase. While we are incurring startup costs today, not all the network benefits will be realized this year, as most of the buildings come online in the second half of the year.
Now looking at the International segment, we are executing unique revenue and growth strategy, leveraging our portfolio to extract the most value. Reported results were outstanding. Revenue and operating profit grew at 15%. On a currency adjusted basis, this is the 13th consecutive quarter of double-digit operating profit growth. Global export shipments per day increased about 12%, with the strongest growth in pan-European cross-border and Europe-to-U.S. and U.S.-to-Europe trade lines.
Also two less days due to the timing of Easter in the local countries impeded export and domestic shipments, and growth was impacted by about 250 basis points. International revenue per package remains firm, with good growth in both export and domestic products. It's due to our superior portfolio and network enhancements that we've invested in. Operating profit increased 15% to $594 million, with all regions contributing to the gain. We had our highest first quarter operating profit, with industry-leading margins at almost 17%, another proof point of the potential upside and momentum in our strategy.
Now, let's look at the Supply Chain & Freight segment. Total revenue jumped 16%, with gains across all business units. Operating profit increased more than 14% to $170 million on top of an over 18% increase in profit last year. Forwarding revenue jumped 27%, as pricing strategies and high-quality service, along with positive market conditions, drove significant improvements over the prior year. Tonnage gains were in the mid-single digits in both international and the North American air forwarding units.
Coyote, our asset-light truck brokerage division, continues to produce significant market gains in the U.S. and are making good progress on their global expansion. The segment's focus on profitable middle-market growth and the ability for customers to ship across our portfolio produced great results, and we expect good momentum moving forward.
Now, let's turn to the balance sheet. We produced strong first quarter free cash flow of about $2.6 billion, a hallmark of UPS, and we're well on our plan to meet our target of $4.5 billion to $5 billion in free cash flow this year. The company distributed $840 million in dividends, which represents nearly a 10% increase per share. We also repurchased 2.2 million shares for just over $250 million. Capital investments came in, as expected, at $1.5 billion as we gear up for deployment and bring several major facilities online in the back half of this year. The benefits from these investments, new multiyear transformation efficiencies and expanding pricing actions position UPS well to continue to achieve our return on invested capital targets of 23% to 28%.
Now, let's turn to taxes. Our effective tax rate came in at just over 19%, due to the annual vesting of stock-based compensation that lowered the rate by about 2.5 percentage points. Also in the quarter was the resolution of discrete tax items for just over $25 million. Currently, we expect our tax rate to be between 23% and 24% for the remaining three quarters of 2018.
Additionally, the U.S. Treasury Department is still defining the tax regulations, and our rate is subject to change as items become final. Further, our cash tax rate should be in the mid- to high-teens during the next few years. This year's rate will be pushed even lower, as benefits from the pension funding will put our rate in the mid-single-digits.
Now turning to guidance. As a reminder, the new transformation initiatives are not included in our guidance. We're well on our way to achieving our financial targets for the year, and we are reaffirming our 2018 adjusted earnings per share guidance of $7.03 to $7.37, an increase of 17% to 23% over last year's results.
2018 is a busy year, with several external and internal moving parts. We felt a closer look at the quarters would be helpful to add clarity. Looking across the remainder of 2018, we anticipate earnings per share growth to be the highest in the second and third quarter in the range of 22% to 26%. Performance in the business is anticipated to be good in the fourth quarter, but will be somewhat offset as the U.S. calendar works against us, with two less operating days in December. Prior year tax benefits are not expected to repeat, and as we open new facilities before the peak season. As a result, fourth quarter earnings per share growth is expected to be in the mid-teens.
We're off to a solid start, with great results in both the International and Supply Chain & Freight segments, helping offset the severe weather impact in the U.S. As we look at the rest of the year, our plans are set. We're growing the business and driving initiatives that increase shareowner value. We look forward to meeting with you in the coming months to discuss the transformation initiatives that we've begun to lay out for you today.
Thank you. And now, I'll ask the operator to open the line. Operator?
I will now turn the program back over to our IRO, Mr. Childress, to start the Q&A segment.
Thank you. We're going to take an online question here. We've got a question from Jack Atkins from Stephens. And Jack's question is about the recent management changes. And can we discuss the appointment of the COO in particular how these changes will improve the business in the next three to five years?
In fact, Scott, we had another question that kind of ties into management. You want to give management structure changes, maybe paraphrase that and also who asked the question.
That was from Brian Ossenbeck. And Brian's question was about U.S. operations and Scott Price's appointment from an external standpoint on to the UPS management team.
Okay, so both of these questions are about management structure and changes, so I just thought it made sense to answer them together, this is David Abney, of course. And first, I'll start with Scott Price, we brought him in as outside hire to our management committee in December of this year. We did that for a couple of reasons. We knew that we were going to advance our transformation initiatives and just felt like we wanted someone that had been through this before. Different company, connecting industry that we could gain from his expertise, at the same time, he could gain from ours, so very happy to have hired Scott and got him in place.
And we knew that Alan Gershenhorn was going to be retiring as Chief Commercial Officer, so we added strategy to Scott's transformation responsibilities. And that's how we divided that position. So Alan is Chief Commercial Officer with 38 years with UPS, decided to retire, and Alan did exactly what we had asked him to do, which is really focus on the growth and growing the company. And he's done a great job of that so much so that it has placed some challenges on some of our growth plans. So, we've been able to ramp up those growth plans. But real happy for what Alan has been able to do for us.
And then made the decision, I thought the timing was absolutely right with the way things were going to, I asked Jim Barber to take further responsibilities as most people in this call know Jim had been the President of International for a good four or five years, has just done an excellent job.
With transformation going to be a part of the future, just felt like that needed someone that was going to accelerate the implementation of our operating initiatives. We needed to I thought better coordinate and align across our business units because more and more of our business is crossing those business units. And I wanted to make sure we didn't have any silos and felt that this was a way to do it. And I also expected Jim from the operations side to play a big role with Scott in this transformation of UPS.
And then because we promoted Jim, that left us with the International position open, we promoted Nando Cesarone, a Canadian that we've worked throughout the world, and has worked closely with myself and Jim for many years. And then, we also had Myron Gray retire, which just did an excellent job for us. And we had George Willis, who is a very experienced UPSer that not only has worked throughout the U.S., but he's worked in the corporate office, he's worked in the UK, a wide, wide range of experience. So, those are the moves that we have made. They're all geared towards the future, all towards the focus.
And Jim, I'd like to turn it over to you, just talk a little bit about how you see your new role.
Okay, I'd be happy to, David. Thanks. So, let me, I guess, reinforce a couple of points. First, extremely excited about this new role. Also, with George and Nando to come into their places, it just continues to talk about the depth of the partnership at UPS. So, really excited to have them in their new roles as well. David just mentioned the great job Alan has done in growing the business, and it really kind of points me back to the international piece of my background.
I think there's a couple of points that we've gone through the last four or five years. Many of you would recall that we were on the verge of a merger with TNT that actually kind of held up our capital expenditure plans for a number of years, then we announced in 2014, the $2 billion expansion. That piece of work aligns very nicely to what's going on in the U.S. for us right now. At the same time, we had to re-gear the network in Asia, and the intra and intercontinental air networks in the international business for the last couple of years. That seems to be very much correlated to, obviously, our U.S. So, those type of learning specifically is where I see us coming back to the U.S. and adding that into the COO role going forward.
I guess three or four quick points to punctuate David's comments of coordination and alignment, because I do see that job as very much about that. First, across the business units, is very key today. Intermodal and how products move and supply chains crosses business units, we think we can do a better job in the years to come to harmonize and align those. The other thing obviously is we start to transform the announcements we've had yesterday and today and will continue to talk about as it gets you to the place of getting the right people and structures in place to really drive maximum value creation. And I'll be involved in helping coordinate that which Scott and the rest of the team launch going forward.
I did make the point about value creation in my opening talk that needs to be reinforced, because that is key, especially in the U.S. business, for us to drive continued value. And ultimately, I think you could boil it down to the fact that my job will be to help say yes and no to the right value creation growth opportunities within the units and across the units in the years to come. So I appreciate that, David, the opportunity.
We're going to take another question here. This question, we've got three questions in. Brandon Oglenski from Barclays, Keith Schoonmaker from Morningstar, and then, JPMorgan, Brian Ossenbeck. And the question is, we've seen some of your early indications of the company's transformation initiatives. And what are the areas of focus for the company and is there any timeline that you can share with us?
So, thanks for the question, and let me start by saying that I'm very excited to be part of UPS and part of this transformation. And we've focused our initial work across two categories, foundational and modernization initiatives. We continue to rapidly evaluate and benchmark all aspects of our business and organization. This is not just focused on operations as David said. This is a very broad program. We're identifying a lot of opportunities that are going to create multiyear value, and they're both cost reduction programs, but as well sources of growth moving forward. We started fast, we started with cost, as David mentioned. Yesterday, we announced our first foundational cost initiative, which was a voluntary retirement program, a VRP. It's a cost action that's focused on increasing efficiency and reducing cost through addressing initially span and layer opportunities in the organization. And David also mentioned a second foundational program, which is to drive procurement value through the scale of UPS.
These are really just the beginning of what is going to be a very extensive program. We believe transformation will benefit all aspects in all segments of the business. UPS Domestic will also experience, if not many, maybe potentially even most of the greatest gains. We're moving fast, building broad support within the company. And as Richard mentioned, we'll be sharing more details at an upcoming conference. Thank you.
This is David. Great job explaining that, Scott. Really, the reason that it's driving the pace of transformation is just the fact that the pace of change in business is accelerating so quickly. And we feel like that we have to respond and we have to respond with a sense of urgency.
This transformation that Scott talked about is going to generate efficiencies throughout the business. It's going to accelerate growth and it's going to create shareholder value, which is what this is all about. So we're very excited about the start of this. We've got some very good initiatives that's going to make a difference, and there's more to come. And as mentioned earlier, we will have a conference in a few months, and we'll be able to give you a lot more of the details at that time. So thank you for the question.
Our first online question will come from the line of Ken Hoexter of Bank of America Merrill Lynch. Please go ahead.
Great, good morning. David, or maybe it's for Richard, if we could dig into that a little bit when you detailed the transformation initiatives large picture, I just want to understand. Is there a dollar value you can talk about? Are you talking about just automation? Is that the reason for the voluntary head count reduction? Is that just part of the upgrades to automate, or can you talk about scale or put a dollar value on it? Can you give us some parameters of what you're doing there?
Ken, this is Richard. I'll start and then I'm going to pass it to David. There is no change to guidance right now. But as Scott and David mentioned a minute ago, this is a multiyear, multi-phased approach. And as this is finalized, you saw the first action. We'll come together and talk about it in the next several months. But at this point, it's really not just about this year. It's really about the future as well.
Okay. And, Scott, do you want to add to it?
I think, Ken, that we're being very thoughtful in how we're going to sequence initiatives that will both be an opportunity for just foundationally reducing cost like our voluntary retirement program, but also future investments that will help create modernization of our overall process. So the combination of those two, we'll be able to share a little bit more detail at the upcoming conference.
Our next question will come from the line of Mr. David Vernon of Bernstein. Please go ahead.
Hey, good morning, guys, and thanks for taking the question. Richard, I wanted to ask you a little bit of a bigger picture question on cash available for return to shareholders. If you look at the business the last five or so years, not a lot of growth CapEx going in, but about $15 billion going into the pension. As you think about the outlook going forward, assuming no dramatic shift in economic activity, assuming no dramatic shift in the interest rate environment, do you think that the burden on cash from operations from pension contribution is still going to be high?
And I guess I'm wondering. Should we be expecting that the cash that's available for distribution to shareholders, even with higher spending, is that going to be at a higher run rate level than we've seen in the past five years or a lower run rate level? I'm just trying to get a sense for how investors should be expecting the cash returns from UPS to change as the pension requirement and funding goes down and the CapEx goes up in the business.
Sure, David. I think the first thing to remember here is that UPS has always had a philosophy of making sure we give a good return to our shareholders. We increased our dividend this year almost 10%, and we're almost 50 years of increasing or seeing the dividend grow. And so that's an important hallmark of UPS. Another hallmark of UPS is investing in the business, and you've heard some of our plans both for the aircraft and the buildings, and that's really about the growth. And we've had such good growth in revenue on an almost $65 billion to $70 billion company.
That being said, what's going on with pensions today, we did make a decision last year to fund a very large contribution, and it was opportunistic. And it was opportunistic because we took a tax deduction at 35%. Given the current environment today, we don't expect that we'll have more contributions in 2018. And if discount rate changes, that also changes our need to think about funding. And I can tell you right now, we also have – the discount rate impact is up 50 basis points since the end of the year. And that 50 basis points changes the liability or decreases the liability by a few billion dollars. So we don't expect that we'll continue to fund pension in the way that we have. But Congress made it easier for us to think about funding versus paying the PBGC premiums.
And that does bring you to the free cash flow, and you can see that for the quarter, we were at about just over $2.5 billion of free cash flow on a plan of $4.5 billion to $5 billion, and we're well on our way. And we recognize that part of the benefit we got was getting the refund at 35%. But we still see free cash flow growing over the next few years as all of the initiatives that we've talked about around transformation, the smart logistics network, and then the improving yield that we'll continue to drive will all create better or more free cash flow. Thank you.
All right, thanks. And maybe just as a very short follow-up, is there a chance that there could be some asset monetization as part of the transformation initiatives? Is there going to be any review of the asset base looking for opportunities to maybe reduce some surplus real estate, things like that?
So historically, we've always looked at that. It's not just about transformation. But we tend to buy assets based on what we need and not really inventory excess assets. So I don't see that as a big piece of transformation, but as I said, annually we're going through that process every year, really in the springtime, to think about it and see if there is anything there.
All right. Thanks a lot for the time, guys.
We're going to take an online question. This question comes from Scott Schneeberger. And we got a number of questions on the topic. Please discuss how UPS strategically views balancing volume and price over the next two to three years and the potential to exceed the 2% to 3% base rate that we've talked about.
Thank you for the question, Scott. It's important to clarify that we don't have a ceiling of 2% to 3%, but rather have a strategy of continuously looking for pricing initiatives which align our revenue to our cost to serve and as well as the value we create for our customers. As an example of that, international currency-neutral revenue per piece increased 3.6%, and U.S. in the two-year stack is up 6% with multiple months above 3%.
We also address characteristic changes and the cost to serve them. Large Packages, for instance, have had an 18.5% increase over the two years and Over Max which are the packages outside of our weight and size limits but still get into our network increased 350% over those two years. So we will continue to work on base rates and increase throughout the year as planned. Thanks so much.
Our next question is coming from Keith Schoonmaker from Morningstar. And basically, we've got a couple of questions here about the performance of international. Keith's question specifically is the firm announced strong investment in Europe over the last few years of $2 billion. What have you really accomplished to date and what remains?
This Jim. I'll take that one obviously. I think a point I'd like to start with is that while Europe is obviously performing very well for us, one of the points we've continued to make over the last couple quarters is that probably the biggest benefit to how international is performing today is the balance in it. So it is growing everywhere. It's very balanced and the network is continuing to create additional flywheels as we go forward.
Specifically on Europe to the point, I mentioned it a few minutes ago, we've chosen Europe in late 2013, early 2014 that we needed to and invest in it just like the same way we're looking at the U.S. network right now. We also looked at our capabilities and we saw our Transborder network needed to be upgraded. We did that in waves through 2015, 2016 and 2017, both ground and air. The specific $2 billion investment, we're about 70% of the way through. This first quarter, we've opened a couple of new buildings. On the back of that as we expanded the network, we've introduced new services in Turkey, Express Services, and so we – big buildings and it has been mentioned previously will come online this year in Paris and Canada. Bielefeld is going to have a big one coming on as well as London.
So like I said, about 70% of the way through, all of it continues to create value. You can see it in the growth numbers and the margin numbers. And we feel like a lot of those learnings certainly transport back to the U.S. investments we're making here as well. So appreciate the question.
And we have a question from the line of Chris Wetherbee of Citigroup. Please go ahead.
Hey, thanks. Good morning. Let me come back to pricing for a minute, and maybe sort of mix it in with the transformation initiatives I guess, when you think about the first to pricing and sort of addressing some of the mix shift dynamics between B2B and B2C in the domestic business, how far along do you feel like you are on that process? And then should we expect meaningful sort of changes in your approach to market on the pricing side as part of the transformation initiatives?
Thank you, Chris. This is Kate. And, yes, as part of transformation, as a part of our ongoing strategy, with the characteristic changes in the marketplace, we absolutely are taking a keen focus on aligning even further cost to serve with pricing to make sure that we get compensated for the value we're delivering.
And to that point, we're also creating solutions such as synthetic density with those changing characteristics to convert B2C, for instance, into B2B packages. Access points is a good example of that as well as we are the market leader in returns. And that goes hand-in-hand with B2C and as you know is a high density delivery address. So both through the pricing as well as the solution set, we are addressing the changing characteristics in the marketplace. Thanks for the question.
We've got a question. This question comes from Dave Ross at Stifel. And he's asking for preliminary thoughts on the ongoing Teamsters negotiation, granted they would do you expect to have a contract completed before the termination of the contract July 31?
This is David. I'll take that and then Jim, since you have labor, if you want to add anything to it. Our agreement expires August 1. So far we've held six week-long sessions. There's been progress made on several non-economic matters, and we are confident that we can reach an agreement that would reward our employees but also keep UPS competitive in this changing world that we live in that has both traditional and non-traditional competitors.
So we really don't negotiate through the media. So although incorrect information comes out, we certainly correct that. But we have the right people negotiating on our end. I think that the more successful UPS is, the more that we can hire additional Teamsters and the better jobs that our people will have. So just like any negotiations, there's give-and-take, there's good days and bad days, but overall I feel confident that we certainly can reach an agreement.
This is James. I'd just add a couple of points to reinforce what David said. Remember we have shared objectives here. It's to create jobs and have career opportunities and serve customers, and that's been going on for many decades. I think the uniqueness of what comes into play now as well is the pace of change and the need for continued flexibility to be adaptive. And so working together with the Teamsters that will be some of the highlighted areas we go forward and get done, and hopefully get it done in the short order. But I think David's points are very right on the point about how the negotiation will transpire going forward, so.
Our next question will come from the line of Tom Wadewitz. Please go ahead.
Yes. Good morning and thank you. David, just a question for you. It really from the outside seems that UPS, under your leadership over – I don't know – the past year or maybe longer is taking more aggressive steps than you have in the past. I think we can look at that in terms of the pace of change at the management committee level, a higher CapEx budget, more aggressive investments, you've got the transformation initiatives. So from the outside, it does appear that you're taking a pretty aggressive approach.
My question is, is that something that we should view as driving potential improvements in the longer-term performance of domestic package business that this is offensive and we can see margin improvement looking out? Or is this something that is more a reflection of the big changes that are taking place in your core domestic market and this is really necessary to sustain what's historically been a very strong position for you? So, sorry, that's a bit longwinded, but just trying to get a sense is this – all this change puts you in an offensive position or is it kind of defense versus a rapidly changing market? Thank you.
Okay, Tom. Thanks for the question. I'll take the first part of it, then I'll hand it over to Richard. And I do agree with the way you position the question. And I think the longer we wait to take on some of these challenges, which are also opportunities, the more defensive position we would be in. We made a conscious decision that we needed to take an offensive position, and we needed to readjust our strategic initiatives, and we needed to ramp up our investments and we needed to – I'd call it, supercharge the level of change that we are doing in our company. We have this proud company that's been very successful, and we're all glad to be a part of that.
But we issued a challenge to our people, and that was that if we continue to do business the same way we do today, and this was a year or two ago, that we didn't see as rosy a future for the company or for the shareholders as we would if we took a much more aggressive stand that if we charged into the future and that's what you've been seeing as do the last 1.5 year or so. And that's what we will continue to do. Take ourselves out of our comfort zone, address the opportunities that have been given in front of us. Richard, why don't you give a few examples of what I'm talking about?
When we look right now, we know that we're in the first year of a three-year, we call it, peak capital. And what you see in 2018 is you're going to get a lot of capacity that we haven't really seen added to the network. And that's all going to come in the second half of the year. So we've got a lot of the upfront expense in our numbers, with the benefits start layering-in in 2019 and in 2020. And that's one of the reasons that we called out specifically that the op expense and the Saturday capability were investments.
We're now looking right now at about 50% of the population on Saturday. A year ago, we were effectively at probably under 3% or 4% of the population on Saturday. So when you look at the op expense, you kind of see things like that going on along with the step-up costs required as you open a building before the building opens.
When we look at the quarter itself, what we recognize is on an apples-to-apples basis, we do see the business about where it was last year. But understand that it's being masked because you've got about $230 million in the domestic that was a credit that is no longer in the operating margin. You've got discount rate change, the weather, along with all these investments. But underlying or masking all of our underlying performance, are these callouts? And we do have a deliberate strategy over the next few years to continue to see benefits, to improve both the margin and leverage, and I think that's coming through the pricing information Kate talked about, the initiatives, both transformation and the smart logistics network, as well as the efficient use of that capital that's coming in. Thank you.
We're going to take an online question. This question comes from Helane Becker from Cowen. And her question is as you think about the investments you are making for the long-term, are you confident that you're getting ahead of the growth?
Good morning. Thanks for the question. A couple of things that we wanted to mention on that question. First, we're very busy building capacity and capabilities to support growth and continue to build out our smart logistics network. To support that growth, we're building not only regional hubs, but we're also modernizing facilities. We're bringing more automation into play. We're increasing capacity, all with good return on investment. Just to give you an example, in 2018 alone, we will be opening 18 new or modified facilities, and we will also be increasing capacity in our small sorts with the opening of multiple small sorts.
In total this year, we will have an additional new 5 million square feet of sort capacity, and that's not only for the Domestic side. We're also building out for International 1 million square feet in places like Paris, Eindhoven, and Montréal. And I would say here in the U.S., places that definitely need that capacity, like Atlanta, Phoenix, Salt Lake City, Kentucky, Florida, they will all some good necessary capacity. We have more projects coming in line in 2019 and 2020. And we will continue to review trends to make adjustments as needed. Thanks for the question.
I want to add a point. This is Jim. Real quick on the point is that as we build capacity, there are some key priorities that we have to keep in mind, and that is that what goes in the networks have to be right for the network to drive the right ROIC. We've talked about that concept here this morning. And we do think, by the way, as package sizes are changing across global supply chains, it's where some of the unique opportunity exists to start going across business units, and leverage the power of our supply chain business next to our express business, next to the domestic businesses. So yes, it's about capacity, but it's also making sure that the right products are going in the right networks at the right price points to drive the ROICs and our shareholders' return, and we're confident that a lot of this transformation is going to take us there.
Let's take another online question. This question is coming from Jairam Nathan from Daiwa. His question is, do you see Amazon extending its presence in your sector through Ship with Amazon initiatives, and is that a lingering issue for the industry?
This is David. It's very hard to predict what Amazon or any other of our large shippers are going to do. And we make sure that we evaluate any market moves, whatever impact it would have on our business, and then we monitor and we react accordingly.
When it comes to e-commerce, we really feel that we are the vendor of choice. It's a fast-growing opportunity that we're best-in-class and our network is scalable, difficult to match because of the density and our diverse customer base.
And when it comes to the B2B side of the business, we can talk about B2C so much that we sometimes just don't mention the fact that we are the largest shipper of B2B. It is right in our sweet spot. And we work with all customers, large and small, and marketplace and traditional retailers, and we will continue to do so. So we think we have a good relationship, mutually beneficial relationship with Amazon, but we're open for business for all retailers, big and small. And thank you for the question.
We have a question from the line of Matt Reustle of Goldman Sachs. Please go ahead.
Good morning, thanks for taking the question. I just wanted to touch on your guidance for free cash flow in 2018. I know there are some one-time items in there. But when you look at what's coming on in the back half of the year, it seems like you should have some pretty good operating momentum into 2019 and obviously beyond. So is it achievable to hit that $4.5 billion again in 2019 and 2020? Can you talk on a little bit of that, of how much operating momentum you'll have, and how that will translate into free cash flow?
Matt, I think the first thing to remember is that $4.5 billion to $5 billion we did call out that the tax helped us, and that's one of the reasons we've had actually the best free cash flow we've seen in more than a decade for this quarter. That being said, we do see improving impacts from the different initiatives, but the timing is slightly off, and it's just a little too early for me to tell you exactly how 2019 and 2020 will – but I will tell you that if you take 2017 as a reference point and 2018, we'll be closer to 2018. But I just can't give you enough information yet because we're still finalizing some plans on some of the transformation as well as other strategic initiatives we have that we need to vet out before I give the guidance on 2019.
Understood, thank you.
We're going to take an online question. This question comes from Dave Ross of Stifel. His question is, when do you get the 747-8 start entering the fleet? Will they compete in the airfreight market at all or just focus on UPS International Package? And then, how many are growth versus replacement aircraft?
That's from David I think. So it's Jim. Let me field that one. It's a couple of questions in there all together. I'll try and package it. They started entering the fleet late last year in 2017, to this quarter, five. All of them began their life, if you will, out in Asia. But remember, this is all about growth, capacity in a cascading effect all back into the United States to upgrade our aircraft. At this point, they're not taking aircraft out. We have to adjust as life goes forward.
But I can tell you a couple of things. Obviously, we know about the efficiency and the great benefits the 747-8s bring into the network. With five of them in here, now we connect the network, and we've also been able in the first quarter to launch our first direct flight 747 from Louisville to Dubai as part of the addition of the networks, which is great. All of the 747-8s are managing to run at about 95% utilization across this network, so the timing couldn't be better.
Filling out this year, we're all done with this year. Looking forward, we should have nine new ones come into fleet, a mix of 747-8s and 767s. The concept of what you use them for, you use them for the right revenue per plane that makes it work, and that's usually a blend of obviously the Package business. We put some freight on them when it's right, and at other times, we'll put other mix on them. But in general, that very much aligns to the strategy and across the entire global network. It starts in Asia, but really ripples through the whole network. So that's how we are, David?
Jim, you did mention first, daily flight to Dubai. Could you talk a little bit more about that and tie it into this Expo 2020, our plans?
Absolutely. When David asked me to step into the international position a few years ago, one of the white spots we saw on the map was the Middle East. We knew we had just kind of our model, had not really put our brand where it needed to be. So in 2014-2015, we launched the Indian subcontinent, Middle East and Africa piece of the business. It typically now is the fastest growing piece of the network across the globe. At the same time we saw great value and some of the partnership opportunities we signed on with Expo 2020. As the official logistics provider, our partnerships and customer collaboration have continued to grow over the last four or five years.
And we felt like the time was right here in the beginning of 2018, giving the trade connections and our growing U.S. export business to put a direct flight in. And so we picked up a day. Our customers are excited about it. As much as that, the connection inside of the Middle East now expands itself and we are able to actually pull business out of the other geos into the Middle East. So we're really excited about that, and that connection from Louisville direct to Dubai is just the next step as we move towards 2020.
Next question will come from the line of Scott Schneeberger of Oppenheimer. Please go ahead.
Thanks. Good morning, everyone. Supply Chain & Freight is growing very nicely right now. Could you just address some of the strategic moves you're making there to take advantage of the good environment? And also address maybe some of the things you're doing on the expense side to address that specifically? Thanks.
Sure, Scott. This is Jim again. That, with many of the other initiatives started three or four years ago, where we looked at our distribution business, our supply chain business. Coyote was not in the network yet, Marken hadn't come on yet, but we knew that it also needed to be essentially to certain extent transformed. It ties into the work now that Scott, and we've talked about here this morning, but we needed to really start to lower the cost base and be very selective about getting the right mix in those businesses.
Oftentimes, it meant middle market, different geos, different verticals. We always had the health care business as one of our key strategic verticals and we've kind of stuck to our knitting quite frankly. We've continued to add to them. We'll talk about that more perhaps in a couple of months. But the last two points I'd like to reinforce as well as some of the acquisitions that we've made, obviously, David talked about the growth that Alan brought to us the last couple of years.
The acquisition of Coyote you are seeing start to manifest itself on the supply chain. Marken came on a little while ago in the health care space as well. It's doing very, very well for us and the supply chain segment for us, it continues to have different capabilities, very much aligned to the strategy. And they like the International Package business and certainly the U.S. going forward continue to optimize themselves and grow and become more material in the portfolio. So we're excited about that as well, and transformation will continue to fuel the supply chain segment. So, appreciate the question.
I would now like to turn the conference back over to Mr. Childress. Please go ahead, sir. That does conclude our Q&A.
Thank you for joining us. David, I'll turn it over to you for closing comments.
Okay, thanks, Scott. We have, as you can tell, expanded the scope of our transformation. The new multiyear initiatives will make UPS more efficient. And also you can see we made a significant step up in network capabilities. We continue to see strong growth opportunities for UPS across every one of our business units. We're focused on executing our strategies, strategies that will make us more efficient, strategies that will focus on pricing and strategies that will continue to use technology to allow us to grow our business through offerings that we could not do without that technology, and of course, increase our flexibility across the network. So we look forward to sharing with you the benefits from our new transformation initiatives in the coming months. And thank you all for joining us on the call today.
Ladies and gentlemen, that does conclude our conference call for today. We'd like to thank you for your participation. Have a wonderful day. You may now disconnect.