United Parcel Service Inc Q2 FY2023 Earnings Call

Good morning. My name is Stephen, and I will be your facilitator today. I would like to welcome everyone to the UPS Investor Relations Second Quarter 2023 Earnings Conference Call. It is now my pleasure to turn the floor over to your host, Mr. Ken Cook, Investor Relations Officer. Sir, the floor is yours.

Good morning and welcome to the UPS Second Quarter 2023 Earnings Call. Joining me today are Carol Tomé, our CEO; Brian Newman, our CFO; and a few additional members of our executive leadership team. Before we begin, I want to remind you that some of the comments we’ll make today are forward-looking statements and address our expectations for the future performance or operating results of our company. These statements are subject to risks and uncertainties, which are described in our 2022 Form 10-K and other reports we filed with or furnished to the Securities and Exchange Commission. These reports, when filed, are available on the UPS Investor Relations website and from the SEC. Unless stated otherwise, our discussion refers to adjusted results. For the second quarter of 2023, GAAP results include after-tax transformation and other charges of $106 million or $0.12 per diluted share. A reconciliation to GAAP financial results is available on the UPS Investor Relations website, along with the webcast of today's call. Following our prepared remarks, we will take questions from those joining us via the teleconference. And now I'll turn the call over to Carol.

Thank you, Ken, and good morning. Let me begin by commenting on our agreement with the Teamsters. We believe this contract is a win-win-win. Together, we reached agreements on the issues that were important to Teamster leadership, to our employees, and to UPS. We have the best people, and our new contract continues to reward our employees with the best pay and benefits in our industry. I'll share some highlights of the new contract in a moment. The second quarter was challenging, and I'd like to recognize the more than 500,000 UPSers around the world for their hard work and effort and for doing what they do better than anyone, and that's to deliver industry-leading service. I'd also like to give a special shout-out to our sales people for their dedication to our customers. Most importantly, I want to thank our customers for putting their trust and business with us during our labor negotiations. For those customers who diverted, we look forward to bringing you back to our network. Moving to our second quarter results, we expected negotiations with the Teamsters to be late and loud, and they were. As the noise level increased throughout the second quarter, we experienced more volume diversion than we anticipated. Now in pace with volume declines, some companies might go off strategy or chase unprofitable business, but that is not today's UPS. Today's UPS is focused on the long-term. During the quarter, we stayed on strategy and continued to invest in the business. We also maintained our pricing discipline. Further, the investments we've made in our automated facilities and technology, like network planning tools or NPT, have enabled greater agility than ever before. As volume levels declined, we demonstrated that agility by quickly adjusting our integrated network and maintaining high levels of productivity. Looking at our second quarter results versus last year, consolidated revenue declined 10.9% to $22.1 billion, under our expectations due to lower volume. By controlling what we could control, we quickly took cost out of the network and delivered $2.9 billion of operating profit, in line with our expectations. Consolidated operating margin was 13.2%, which exceeded our expectations. Over the past three years, we've executed several initiatives in support of our Customer First, People Led, Innovation Driven strategy. Let me highlight some recent accomplishments. Starting with customer first. During the labor negotiation, communication and transparency with customers was a top priority. During the quarter, over 500 UPS executives had regular contact with customers. Our approach with these customers was to keep volume from diverting or if it diverted, win it back after the labor negotiation was settled. This approach brought us closer to our customers, and we gained an even better understanding of their end-to-end supply chain, which will allow us to better serve them. We are now laser focused on executing our win-back initiatives and pulling through the more than $7 billion of opportunity in our sales pipeline. To do so, we will leverage our superior service and capability and the investments we've made in the digital customer experience. While win-back and new volume won't happen immediately, we are already seeing some volume return. On the digital front, our digital access program, or DAP, continues to grow. We've introduced new plug-and-play technology to make it even easier for e-commerce platforms to connect. In the second quarter, we added 7 new platforms to DAP, including 4 international platforms. In the first 6 months of this year, DAP generated more than $1.4 billion in revenue, putting us on our way to achieving our 2023 DAP revenue targets of around $3 billion. One of our strategic objectives is to become the number one complex health care logistics provider in the world. In the second quarter, we further expanded our European footprint by opening our first dedicated health care distribution facility in Ireland, giving us certified health care facilities in 35 countries. For the first 6 months of 2023, revenue from our health care portfolio reached $4.7 billion. For the full year, we expect to generate $10 billion in health care revenue. On the international small package front, we've been quickly expanding in India, which is one of the fastest-growing economies in the world. In May of last year, we launched MOVIN, our asset-light domestic joint venture. We recently expanded from 3 studies to 49 of the largest cities in India, now covering approximately 90% of the B2B market opportunity. Turning to People Led. We expect our new labor contract to be ratified in 2 weeks. Today, I'll just share some highlights, and we will provide more details after ratification. Let's start with weekend delivery. The new contract converts all 22.4 employees, our weekend delivery drivers, to regular full-time packaged car drivers. This gives us the flexibility we need to schedule delivery drivers Tuesday through Saturday and provides more work-life balance for our drivers. Further, we kept our Sunday delivery service by maintaining our SurePost product. Moving to working conditions. We will be improving the working conditions for all employees, including air conditioning in every new U.S. packaged car starting in January 2024. We retained our ability to introduce new technology and the flexibility to use seasonal support during the peak holiday season. For our Teamster employees, this contract further strengthens the industry-leading pay and benefits they already enjoy. When you look at total compensation, by the end of the new contract, the average UPS full-time driver will make about $170,000 annually in pay and benefits. For all part-time union employees already working at UPS, by the end of this contract, they will be making at least $25.75 per hour while receiving full health care and pension benefits. In fact, our part-timers are among only 7% of all U.S. part-time workers in the private sector to enjoy these benefits. There's much more, but the last point I want to highlight is the addition of a new paid holiday on Martin Luther King Junior Day, which will be a benefit for all U.S. employees. UPS has a long history of honoring Dr. King. This additional paid holiday aligns with our values. All of this and more helps to make UPS the best place to work, which brings me to Innovation Driven. We run the most efficient integrated network in the world powered by technology developed by UPS engineers. In the quarter, we leveraged the agility of our network to match capacity with volume levels. Key to this agility was NPT, which is a set of technologies that use AI and machine learning to harness the value of our data to quickly make changes to low planning, scheduling, and volume flows across the network. This technology is powerful. In fact, NPT can do in an afternoon what used to take a team of engineers months to do. By using NPT with our total service plan, we quickly matched the network to volume levels. This resulted in a nearly 10% reduction in hours in the U.S., in line with the decline in volume. Additionally, NPT enabled us to further reduce semi-variable and fixed costs, which Brian will detail in a moment. Importantly, we did all of this while continuing to provide industry-leading service to our customers. There is no finish line when it comes to driving efficiency. For example, we've made great progress in rolling out smart package smart facility, our RFID initiative. At the end of the second quarter, almost 50% of our U.S. buildings were operating with this technology, and we expect to complete the U.S. deployment by the end of October. Quickly touching on our outlook. Now that labor negotiations are behind us, we've updated our guidance for the full year, primarily to reflect the volume impact from labor negotiations and the costs associated with the tentative agreement. Brian will share more detail in a moment. Let me close by talking about our future. Customer First, People Led, Innovation Driven under our better and bolder framework is a winning strategy. We are winning in the best parts of the market and making our integrated network even more agile and efficient. Now for the People Led part of our strategy, our new contract establishes a platform for the future. Our company is stronger than ever, and we will move even faster to execute our strategy and continue delivering industry-leading service for our customers. I'm excited about what the future holds and what UPSers will accomplish together. I truly believe our best days are ahead. And with that, thank you for listening. And now I'll turn the call over to Brian.

Thanks, Carol, and good morning. Let me begin by echoing Carol's comments on how pleased we are to achieve a win-win-win labor agreement covering our more than 300,000 Teamster employees. This contract provides UPS a significant measure of certainty around labor, gives us operational flexibility to increase productivity and continue providing industry-leading service to our customers, and it will help us attract and retain the best employees in the industry. Now in my comments today, I'll cover 4 areas. I'll start with the macro, followed by our second quarter results. Next, I'll cover cash and shareholder returns. Lastly, I'll provide some comments on the second half of the year. In the second quarter, the overall macro conditions in the U.S. were in line with our expectations. Internationally, conditions were a little worse than we expected due to lower growth in both real exports and industrial production. Moving to our financial results. For the quarter, consolidated revenue was $22.1 billion, down 10.9% from last year. All 3 of our segments demonstrated agility and on a combined basis, drove down total expense by $2.1 billion in the second quarter year-over-year. This enabled us to deliver $2.9 billion in operating profit, which is the target we communicated to you last quarter and was a decrease of 18.4% compared to last year. Consolidated operating margin was 13.2%, a decline of 120 basis points compared to the same period last year, with all 3 segments achieving double-digit operating margins. For the second quarter, diluted earnings per share was $2.54, down 22.8% from the same period last year. Now let's look at our business segments. In U.S. domestic, our disciplined approach to revenue quality partially offset the decrease in volume. As volume declined throughout the quarter, the team did an excellent job adjusting the network to match demand and drive out costs in real-time, all while maintaining industry-leading service levels. We expected volumes to decline in the second quarter, and it did, but we saw more volume diversion than anticipated as noise levels around our labor negotiations increased. We estimate the impact of volume diversion, combined with a slowdown in our sales pipeline pull-through, reduced volume in the second quarter by approximately 1.2 million packages per day. For the quarter, total average daily volume was down 9.9%, with June down 12.2%. Moving to mix. In the second quarter, we saw lower volumes across all industry sectors with the largest declines from retail and high tech. B2C average daily volume declined 11.5% compared to last year, and B2B average daily volume was down 7.7%. In the second quarter, B2B represented 43.7% of our volume, which was an increase of 100 basis points from a year ago. Also in the second quarter, we continued to see customers shift volumes out of the air and onto the ground. Total air average daily volume was down 16.5% year-over-year, and ground average daily volume declined 8.6%. In terms of customer mix, in the second quarter, SMB average daily volumes declined less than volumes from our enterprise customers. U.S. domestic generated revenue of $14.4 billion, down 6.9%. Revenue per piece increased 3.3%, partially offsetting the decline in volume. The combination of strong base rates and improved customer mix increased the revenue per piece growth rate by 670 basis points. Changes in fuel prices decreased the revenue per piece growth rate by 220 basis points. The remaining 120 basis point decline was due to multiple factors, including package characteristics and product mix. Turning to costs. The U.S. domestic team took out $889 million of expense year-over-year, which is the largest year-over-year cost reduction in our history. How did we do it? We leveraged our technology and the agility of our integrated network. Let me walk you through some of the levers we've pulled. We continued to execute our total service plan and reduced labor hours by nearly 10% to maintain our high levels of productivity. We leveraged the power of our network planning tools to optimize package flows and pull volume out of smaller non-automated buildings and flow it into our larger automated facilities. While total volume was down 9.9%, we reduced the volume in our non-automated building by 18%. This enabled us to close doors and reduce operations headcount by 7% compared to last year. We reduced feeder movements by continuing to manage cube utilization in our trailers and brought on more UPS feeder drivers to support our fastest ground-ever lane. Looking at air volumes, we pulled more activity into WorldPort, our global AirHub in Louisville. This enabled us to move more volume via our next day flight and reduced second day flights. As a result, domestic block hours were lower by 6.5% versus last year, and we exited the second quarter with block hours down more than 10%. Lastly, we reduced management headcount by over 2,500 positions year-over-year. All these actions helped us reduce U.S. domestic expenses in the second quarter. Specifically, compensation and benefits was down $205 million year-over-year, despite a 6.5% increase in average union wage rates. Purchase transportation declined $207 million. Fuel expenses were lower by $394 million, and multiple factors drove the remaining $83 million reduction in expense. Our results are proof of our agility. In the second quarter, we took out a record amount of cost and held the cost per piece growth rate to 3.7%, while volume was down nearly 10%. The U.S. Domestic segment delivered $1.7 billion in operating profit, in line with our expectations and down 9.4% compared to the second quarter of 2022. Operating margin was 11.7%, an increase of 180 basis points from the first quarter of this year. Moving to our International segment. Macro conditions remained sluggish in the second quarter. In Europe, persistent high inflation and tight financial conditions weighed on the consumer. In Asia, the slow recovery we experienced in the first quarter stalled in the second quarter. In the quarter, International total average daily volume was down 6.6% year-over-year. About 2/3 of the decline came from lower domestic average daily volume, which was down 8.7%, driven primarily by declines in Europe. On the export side, average daily volume declined 4.5% on a year-over-year basis. In the second quarter, International revenue was $4.4 billion, which was down 13% from last year due to the decline in volume and a 5.7% reduction in revenue per piece. The decline in revenue per piece was primarily driven by a 570 basis point decrease from fuel surcharge revenue. Additionally, a reduction in demand-related surcharge revenue contributed 240 basis points to the decline. There was an 80-basis point decline in revenue per piece due to a stronger U.S. dollar. Partially offsetting the decline, multiple factors increased the revenue per piece growth rate by 320 basis points, including strong base rates and favorable volume mix as export volume outperformed domestic volume. Moving to costs. In the second quarter, total international costs were down $356 million, primarily driven by lower fuel expenses. We leveraged the agility of our integrated network to match capacity with demand and focused on controlling what we could control. These actions included flight reductions, which drove international block hours down 9.4% compared to last year, including a 15.5% block hour reduction on Asia-outbound transcontinental flights. We also reduced headcount in operations and overhead functions by a total of more than 1,700 positions, and we did all of this while continuing to deliver excellent service to our customers. Operating profit in the International segment was $902 million, down $302 million year-over-year, which included a $123 million reduction in demand-related surcharge revenue. Operating margin in the second quarter was 20.4%, in line with our expectations. Now looking at Supply Chain Solutions. Our teams continued to navigate a challenging macro environment and executed our plans to reduce costs. In the second quarter, revenue was $3.2 billion, down $990 million year-over-year. Looking at the key drivers. Forwarding continued to be impacted by softer global demand, especially out of Asia, which drove market rates and volume lower. This resulted in a decline in revenue and operating profit. In response, we cut operating costs and continued to manage buy-sell spreads. Logistics delivered revenue and operating profit growth, including gains in our health care business. In the second quarter, Supply Chain Solutions generated operating profit of $336 million and an operating margin of 10.4%. Walking through the rest of the income statement, we had $190 million of interest expense, our other pension income was $66 million, and our effective tax rate for the second quarter was 23.5%. Now let's turn to cash and shareholder returns. Year-to-date, we generated $5.6 billion in cash from operations, and free cash flow was $3.8 billion, including our annual pension contribution of $1.2 billion that we made in the first quarter. Also this year, in the first quarter, we issued $2.5 billion in long-term debt. We've used $1.6 billion to pay off debt maturities in the second quarter and plan to use $900 million to pay off debt maturities in the second half of this year. In the first half of 2023, UPS paid $2.7 billion in dividends. We also completed $1.5 billion in share buybacks at an average price of around $178 per share. Now I'll share a few comments about our outlook. As Carol mentioned, with the contract out for ratification, we have updated our consolidated revenue and adjusted operating margin guidance. For the full year 2023, we expect consolidated revenues of about $93 billion and consolidated operating margin of around 11.8%. Let me provide some color to help you update your models for the second half of the year. The U.S. Domestic segment is navigating a couple of unique factors in the back half of the year. First, in the second quarter and into July, we experienced more volume diversion than we anticipated. Because of this, our volume ramp-up for the second half of the year is starting from a lower base. We're already executing our initiatives to win back diverted volume and accelerate the pull-through from our sales pipeline while remaining disciplined on revenue quality. As a result of our efforts, we're expecting average daily volume levels to be about even with December of last year by the end of the year. Overall, for the second half of 2023, we expect U.S. average daily volume to be down by a mid-single-digit percentage year-over-year. Secondly, looking at expenses in the U.S. Domestic segment, the union wage rate increases included in our new labor agreement for the first year are higher than we originally planned. We started to accrue for the terms of the tentative agreement on August 1, while the contract is out for ratification. Further, we will address wage compression that resulted from the new labor contract. These additional labor costs in the back half of the year will be partially offset by the network adjustments we made in the second quarter. Turning to the International segment. In the second half of the year, we expect the year-over-year volume growth rate to be similar to what we saw in the second quarter and revenue per piece growth to be flattish compared to the same period last year. In Supply Chain Solutions, we expect second half revenue to be down by a high single-digit percentage year-over-year, with full-year revenue approaching $14 billion. Moving on to capital allocation. Our 2023 full-year targets have not changed. We will continue to stay on strategy and invest in both efficiency and growth opportunities. Capital expenditures are still expected to be about $5.3 billion, which includes completing the deployment of the first phase of Smart Package Marketability in the U.S., continuing to expand our health care logistics footprint globally, expanding DAP internationally, and investing in our Logistics-as-a-Service platform. We're still planning to pay out around $5.4 billion in dividends in 2023, subject to Board approval. For the full year, we still plan to buy back around $3 billion of our shares. With negotiations behind us, we are moving our business forward. For our people, we have a platform for the future that continues to reward our employees, which helps us deliver industry-leading service to our customers and enables us to win that volume and drive revenue quality. We will control what we can control, which means continuing to manage costs as we scale up the network with volume. We are staying on strategy and investing through this cycle, which will enable us to grow in the most attractive parts of the market, make our integrated network even more efficient, and continue to reward our shareholders. Thank you, and operator, please open the line.

Our first question will come from David Vernon of Bernstein.

So Brian or Carol, I just want to understand kind of at a high level, what we should be expecting about the shape of inflation over the course of the contract. I know we're probably not going to get into too many of the details today, but I'd love to understand kind of from a CAGR perspective how you're set up for inflation over the life of this contract.

Well, maybe I'll just start with some observations about the contract. Then Brian, you can provide details on the shape of the curve. As we got into the negotiations, David, it became very clear to me that we were negotiating on behalf of a number of stakeholders. We were negotiating on behalf of our people, our customers, our country, our shareholders, and UPS. As I look at the handshake agreement we achieved, I think we have a win-win-win for all stakeholders. Let me make that real for you. First, in terms of our people, they will continue to be paid the highest wage and benefits in the industry. We'll have better work-life balance, and the working conditions will also be improved as we'll be adding air conditioning among package cars starting January. Our customers benefit as well; we avoided a work stoppage that would have been disruptive for them and for their customers. So I think that's a win. For our country, we move 6% of the U.S. GDP every day, and there was no place for this volume to go. So we avoided a disruption to the economy with this handshake agreement. For our shareholders, I would say we also have a win because, as I look at the economic package over the 5 years, the compounded annual growth rate of this economic package is 3.3%. That's a win too. For UPS, we retain the flexibility needed to take care of our customers, provide seasonal health during the holidays, and add technology to drive productivity and efficiency. So I think it's a win-win-win. Maybe, Brian, you can talk about the shape.

Yes, Carol. I'm going to go a bit deeper on it, but it's sort of a barbell effect. We've got a majority of the increase or not majority; over 40% in year one, and then years 2, 3, and 4 quite reasonable from an inflation standpoint, and then with another step-up in year 5. But I'll go into more details on that when we host a call following the ratification.

All right. And thanks for that. And maybe just as a quick follow-up. Can you talk about what you need to do to win back some of the volume that you might have lost during the contract uncertainty? I'm wondering how quickly you guys are expecting that to come back as we look into what's baked into guidance.

It's all hands on deck to win back the volume that was diverted as a result of the labor negotiations. The first thing we did is that we stood up a control tower. This is the same kind of control tower that we use during peak to ensure we can onboard this volume coming back without disruption. So that is up and running, and I'm very pleased with what I'm seeing in that regard. We have, of course, mitigated all the risk that was still remaining because we didn't know the outcome of the contract. Those high-risk customers are now shipping with us without any risk. From a marketing perspective, we're doing several things. The first thing we're doing is amplifying our service message because we do have the best service in the industry. We are also amplifying our SurePost advantage because this is a very attractive product for shipping low-weight packages. Additionally, we are expanding our speed campaign because we outpace our largest competitor in many markets. Furthermore, we are increasing our weekend pickup to four markets. We are also expanding our Saturday delivery by 890 postal codes. Lastly, we are launching new offerings inside Deal Manager, which is the tool we use to win new small- and medium-sized businesses. There's a lot of effort underway to bring back the business we lost and win new business. Now I will tell you, it's not all going to happen at once. We understand that. We're working with our customers to bring it in as smoothly as we can for them as they've diverted. Looking at our volume in July, I will say that it was still down year-on-year, but not as much as the decline that we saw in June.

Our next question will come from the line of Ken Hoexter of Bank of America.

Maybe just a little bit, Carol, your thoughts into the peak season here. Maybe outside of the diversion, what was underlying in your thoughts here? And I think Brian mentioned still expecting negative all the way through the end of December. So maybe just a little bit of thoughts on the backdrop and the differences between the contract and what's going on economically.

Yes. We'll still have a peak even though we're winning back those volumes that were diverted over time; we'll still have a peak. We are collaborating with the top 100 customers who represent 87% of our peak surge. We're already starting to work with them on their operating plans for peak. Peak will be 21 days this year, the same as it was last year. We expect to see a surge in the 60% area this year. So it's still going to pick up; it's just from a different volume level. We're well prepared to handle another peak for us; it's just another day with more volume.

Our next question will come from the line of Amit Mehrotra of Deutsche Bank.

Brian, can you help us on the guidance change? Just attribute that guidance change to volume diversion and then maybe the difference in terms of what you accrued on the wages. And I don't know if you provided this in your prepared remarks, but the monthly cadence of domestic volumes in June and July? And then lastly, Carol, we started the year at 12% margin expectations for domestic. We went down to 11%, now we're probably around 10%. Obviously, we're in a completely different world, and you have a new wage deal. Just provide your thoughts around 3.3% inflation; doesn't seem like an enormous hurdle. Has what happened over the last 7 months changed your view on the return profile of this business from an operating margin perspective in the domestic business? And when can we get back to a positive trajectory in that? Thank you.

Amit, thanks for the question. From a guidance perspective, we went from $97 billion to $93 billion in revenue. That's a $4 billion change. About $1 billion of that is from the softer volume Carol talked about in the second quarter, the higher diversion, and about $3 billion is coming from the second half as we think about volume. Exiting the second quarter, we were down 12%. You'll remember that in March and April, we were down 7%. June exited at minus 12%. So if we take that minus 12 exit and project flat by the end of the year, the glide over the balance of the year is about down mid-single digits—down about 6%. From a profit standpoint, we dropped about $1.4 billion in profit to $11 billion or an 11.8 margin. Most of that came from the domestic side—about $1 billion. That billion is split evenly between wages and the lower volume I just referenced. There was a $400 million piece related to some inconsistent recovery in the euro, inflation, and interest rates. Germany is in a recession, and Asia is facing similar challenges, but the vast majority is really split—half and half between wages and volume.

On the monthly cadence, we were down 12% in June and down double-digit in July, but better than 12%.

Right. Right.

On your question about margin, as we went into the negotiation with the Teamsters—this is true for any negotiation—there are some things that are very important. One thing that was important for Teamster leadership was to front-load some of the wage inflation. We agreed to do that, which puts a little pressure on the margin, as Brian pointed out. But that doesn't change the destination; it just changes the journey. We'll have a bit of pressure for the next year through August of next year, but then the inflation is very manageable. I see a path back to 12% or higher margins in the U.S. because of all the investments we are making to drive productivity. A good proof point of that is what we did in the second quarter. Let me give you just one example of our initiatives, which is Smart Package, Smart Facility. We're now in over 50% of the buildings in the U.S., and 50% of those buildings have misload improvements from 1 in 400 to now 1 in 1,000. As the buildings mature, they get better and more productive. We're transitioning from where the preloaders are scanning the package to where the cars will scan the packages. Think about the productivity we will achieve. It doesn't change the destination—just the journey. We plan to have an investor conference in the spring of 2024. We haven't landed on a date yet, but during that investor conference, we will lay out 3-year targets, so you can understand the journey to get to a 12%-or-higher margin in the U.S.

Our next question will come from the line of Allison Poliniak of Wells Fargo.

Carol, I just want to see if you can expand a little bit on the productivity efforts in Smart Package, how we should think about that? I know a lot of the investment was going into this year. You're talking about 900 facilities by the end of October. Does that productivity start to accelerate from here? How should we think about that in terms of an offset to some of the wage inflation going forward? Thanks.

Yes. Smart Package, Smart Facility is just one of the levers in our productivity toolkit. Our network planning tools are powerful tools, powered by machine learning and AI. Think about it; we just completed rolling out network planning tools in 2020, and we get better every year because the tools improve. Consider what the tools enabled us to do in the second quarter. When we saw the volume starting to slow down and actually divert, we were able through our tools to move volume away from unautomated hubs to automated hubs. Let me make that real for you. Last year, of the volume started by our hubs in the U.S., about 53% went through an automated hub. This year, 57% of the volume went through an automated hub. The tools are making us more effective, and we're introducing new technology inside of our buildings to boost productivity, like automated label application, automated bagging, and robotic small sort induction. I can go on and on, but it's a complement of tools that will help offset some of the wage pressure we will see over the next year.

Our next question will come from the line of Brian Ossenbeck of JPMorgan.

Just wanted to see if, with the disagreement now behind you and out for ratification, has that changed any of your thinking about the timing and magnitude of GRI or pricing in general? Maybe, Brian, you can give more detail on RPP trends and mix in the U.S. And then, Carol, I wanted to see. You mentioned the SurePost Advantage. Can you give some context around the USPS Ground Advantage product that just launched? Do you see that as a competitive threat now that it's been out there for a month or so, maybe some initial impressions of that service and what they're able to deliver and what it means for you?

Yes, Brian. Thanks for the question. Look, every year we evaluate the GRI to provide the right service at the right price for our customers. This year, we guided to roughly a 500-basis point improvement in rate, and we expected about a 200 basis point headwind in fuel to land at about 3%. We're staying with that guide for this year. Coming up here in the fall, we’ll take a look at next year, but the thing I would leave you with is we remain very disciplined on revenue management, and we'll continue to deliver value for the service we provide.

On our SurePost product, it compares very favorably to the USPS Ground Advantage product, and we're going to continue to invest in that product. We like it a lot because of the delivery density associated with it.

Our next question will come from the line of Ravi Shanker of Morgan Stanley.

Carol, can you give us a little more color on the $7 billion sales pipeline? Kind of what kind of customers, what kind of end markets? I haven't heard you guys talk about a sales pipeline before too often. How is that kind of building up, or how do you expect it to come through over time? Can you also give us an update on your largest customer and any changes to that relationship or volumes there over the course of the potential union negotiations? Thank you.

The sales pipeline is across all customer segments, with a real focus in the commercial area, small and medium-sized businesses, of course, health care, and enterprise. You name it; we're going after it. Our sales team is really excited about selling the value we have to offer, which is just the best service in the industry. We've also identified about 50 customers that are target customers for our new pricing architecture, which we call Architecture of Tomorrow. This new pricing architecture doesn't fit everybody, but for some, based on their shipping needs, we could add pricing modifiers like the day of the week or cube or ZIP code plus 4. These pricing modifiers are very interesting to the targeted customers. It won't be for everybody, but for some, we'll lean into that in a significant way. Regarding our largest customer, we have a very good relationship with them, and the business is operating as we would expect.

Our next question will come from the line of Chris Wetherbee of Citi.

I was wondering if you could comment on the 1.2 million packages per day and how you think that comes back. I guess maybe the bigger question is, does all of it come back, and how long does it take to get there? Are there quarter-to-quarter margin dynamics as we think about getting towards that full year number? Is there anything we should consider for Q3 versus Q4? I know volume volatility will be a little better in the second part of the year, but I'm curious about how that cadence might look.

The 1.2 million packages per day accounts for about 1 million of diverted volume—in other words, volume that we had that diverted elsewhere—and approximately $200 million of sales that we couldn't pull through because of concerns about the outcome of the labor negotiation. As Brian commented, we think by the end of the year, we will pull back everything that diverted. I think we’re also going to win that extra 200,000 packages as well. Of course, it doesn't happen overnight; it's already starting to flow back in. However, we think by the end of the year, we'll win it all back.

And Chris, just regarding the phasing, we're focused on the second half and the full year guide, but I would say both top line and profitability—Q3 will be more challenged than Q4 due to the ADV growth rates and seasonality. We've got some one-time costs in the third quarter. So I would just think of Q4 being a bit stronger than Q3.

You might ask, where does that volume go? While we don't have great intelligence there, we do have some market share intelligence through a tool we use from Nielsen IQ. It indicates that one-third went to the Post Office, one-third to FedEx, and one-third to the regionals, which guides our activities as we think about how to win that volume back.

Our next question will come from the line of Jordan Alliger of Goldman Sachs.

I was wondering if you could give a little more color. I think I have a good sense on the domestic margin. It looks like there's a small piece in your profitability guide that's Supply Chain and International. Can you maybe unpack the margin expectations for the full year on that? If the U.S. margin should be at or around the 10% level, give or take. Thanks.

From a margin perspective, Jordan, we expect International to be 19% to 20% for the full year, and SCS should be at 10%. As you think about the International business, we expect the second half to see ADV growth rate down around 6.5%, while the revenue per piece should be flattish, stemming from the challenging macro situation. We expect weak real export growth; Germany is in recession, and Europe and Asia ADV growth rates should bottom in Q3. Kate and the team are focused on controlling what we can control, both on the air side and the headcount side to protect those margins. You saw that she printed a margin north of 20% in the second quarter. SCS would expect full-year revenue to approach $14 billion with a margin of about 10%. Forwarding rates and volumes are stabilizing but down year-over-year. The team continues to do a good job managing buy-sell spreads.

Our next question will come from the line of Jeff Kauffman of Vertical Research Partners.

I just wanted to ask a little bit about the labor contract economics. I know you said we'll have a call on this after ratification. You noted a number of about 3.3% CAGR on the economic benefits. Just off the wage, we're calculating a little higher than that. Could you break down the components that help us get to that 3.3%?

Jeff, so 3.3% is an all-in number, so it includes wages and benefits of the two netted together. Rather than go into a lot of detail on this call, I'm going to host a call shortly after ratification, and I'll take you through all the details at that point.

We can go line by line and detail it then.

But we want to respect the ratification process.

Our next question comes from the line of Tom Wadewitz of UBS.

I wanted to see if you could help us think about kind of volume versus price. It seems like both are important, but they're kind of related, right? If you go for more price to offset higher inflation, then it could be a headwind to what you do on volume. How do you think about managing between those two? That feeds into—obviously, you've given us a lot to work with for 2023, but there's probably a lack of visibility for 2024. Should earnings be up in 2024? Obviously, we'd like to see that, but you've got through August that headwind. So any broad commentary about how optimistic you might be on 2024 in terms of domestic margin or earnings overall? Thank you.

We run the business as a portfolio. We want both volume and price, but price doesn't necessarily mean price increases. It means moving into segments that value our end-to-end network and have different products. So we run it as a portfolio. We want both. That's the simple answer.

On shaping the multiyear, as Carol mentioned, we'll come back in the spring and give you multiyear targets. Obviously, year one of the labor contract is the most expensive piece; that's in August to August. So the first half of 2024 would expect to be under some pressure, while the back half may have less inflation. We'll walk that for you in the early part of next year.

Our next question will come from the line of Bruce Chan of Stifel.

I appreciate the time here. Carol, the DAP rollout has been very successful this year. I know it's early to start thinking about 2024, but as far as the longer opportunity, does growth start to slow for that channel now that you've reached critical mass? Or do you see quite a bit of opportunity there? Then, Brian, just to follow up broadly on e-commerce demand trends. Have we turned the corner there, or are we still seeing a bit of an air pocket in spending? Thank you.

Thanks for your comments about DAP. We're very pleased with that product, and we see nothing but growth ahead—global growth. We are just scratching the surface regarding DAP outside of the United States. We continue to add new partners here in the U.S., now up to 27 partners. One thing we are doing to continue to grow DAP is make it easier to onboard the platforms. We're introducing widgets, which are pre-programmed applications that a DAP partner can put into its website to avoid user interface and API onboarding that can slow things down. The first widget we introduced is a locator widget, allowing our DAP partner to quickly show the closest UPS store for shipping. We'll continue to make it easier to do business as we continue to grow this important part of our business.

We're observing ESMO improving in the back end of the year. From a macro standpoint, I think the trends are stable to improving in the U.S., obviously under more pressure internationally.

Clearly, what happened with e-commerce was that it blew up during COVID-19. Now everything is reverting back to where it was before COVID. We see that globally, which makes sense. This is a great place to think about growth from here on out.

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

Brian, I believe you said you're expecting a bottoming in Europe and Asia in the third quarter. Just want to get a sense of cadence and your optimism that it will improve in the fourth quarter, just what you're seeing in trajectory there. Then also, if you could put into perspective just the domestic cost per piece and how you see that trajectory on that metric specifically. Thanks.

On the bottoming, we thought we would have seen the bottom in Asia in Q2; it didn't recover, it stalled. In Europe, we think the bottom will be more in Q3, but there could be an elongated period here. So we're not putting in a lot of recovery into the international business going forward. From a cost per piece basis for the U.S., we would project about $11.24, which is about a 1.4% change from the $11.08 we had previously.

Our next question will come from the line of Stephanie Moore of Jefferies.

I wanted to touch on your automation efforts as part of your ongoing productivity tools. You said last year, it was 53% that went through some form of an automated hub; this year, it's at 57%. Do you have sight on where that can go over time?

We do. We're coming back in the spring at our Investor Conference, where we will give you our sense of what we're calling the network of the future. It's an exciting opportunity for us to really automate this business. The good thing is we don't have to integrate our network because we're integrated, but we can improve on automation, so we'll come back and share all that in the spring of next year.

Our next question will come from the line of Brandon Oglenski of Barclays.

This is Eric Morgan on for Brandon. Thanks for taking my question. I just wanted to ask a follow-up on SurePost. Can you give us an update on how much you're redirecting in the network today? Was this a topic during the labor negotiations? If you did need to start insourcing more on an accelerated basis, what kind of potential cost implications or inefficiencies could arise? Any offsets as well would be appreciated. Thank you.

Sure. We were redirecting a little under 40% at the end of the second quarter. It was a point of the negotiations. We had agreed to redirect 50%. There is no concern about cost because the delivery density with SurePost is really, really good.

Our next question will come from the line of Amit Mehrotra of Deutsche Bank.

So I just had a couple of quick ones. Brian, I think you said the labor deal is a $500 million headwind in the back half relative to what you accrued for estimated in earlier guidance. I wasn't sure if that was a gross number or if there was some productivity against that. And then, Carol, I wanted to ask about M&A, because it doesn't get enough attention. I think you guys have done some interesting strategic acquisitions from Delivery Solutions. You also took a stake or a board seat on CommerceHub. These are small but viewed as important deals long-term. Can you talk about what they give you? Is there more in the pipeline? You're generating significant cash flow. Is there an opportunity for more deals, especially in the healthcare vertical that is such a big opportunity? Can you expand on that? Thank you.

The $500 million is a gross number. We had assumed roughly half of that as what we had planned originally.

Regarding the acquisitions we've made, we couldn't be happier because they provide us with enabling capabilities. The Delivery Solutions group is creating cold chain logistics for us in parts of the world that we didn't have. So I couldn't be happier. We’re also pleased with Rhodium and what it's providing for us. As we look ahead, expect us to continue acquiring enabling capabilities, particularly in those areas we want to own. Health care logistics would certainly be one of those. Technology investments that provide platforms for accelerating the digital experience for our customers; expect us to lean into that space. We'll provide updates as we go.

Our last question will come from the line of Jon Chapell of Evercore ISI.

I just want to tie together a couple of things from before. As you think about regaining that 1 million packages that was diverted and your pricing path going forward, will you need to lead with price in the next 6 months to win back the diverted traffic and think about pricing as a new starting point in 2024? Or do you think it's strictly service and relationships, allowing that package flow to come back without adjusting revenue management?

We don't think we have to lead with price. Our customers did what they thought they had to do to protect their customers, but they're very happy with us. So it's about operating plans to ensure they return to us without disruption to their business. It won't happen overnight; it's going to take a while, but we can bring that business back because of the value we provide.

All right. I want to thank everybody for joining us this morning. We look forward to talking to you soon, and that concludes our call.