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UNITED PARCEL SERVICE INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Overview U.S. economic growth, retail sales and industrial production accelerated in the second quarter of 2014, in comparison to the weather-related declines experienced earlier in the year, which resulted in growth in the small package delivery market. Continued strong growth in e-commerce and omni-channel retail sales has driven package volume increases in both commercial and residential volume. Given these trends, overall volume growth was strong during the second quarter, and products most aligned with business-to-consumer and retail industry shipments experienced the fastest growth. Economic growth in Europe has continued at a slow, stable pace, as growth in several larger countries (including the U.K. and Germany) has offset slower growth in some of the smaller countries. Economic growth in Asia has continued, though growth in China has moderated. The uneven nature of economic growth worldwide, combined with a trend towards more regional international trade, has led to shifting trade patterns and resulted in overcapacity in certain trade lanes. These factors have created an environment in which customers are more likely to trade-down from premium express products to standard delivery products in both Europe and Asia. As a result of these circumstances, we have adjusted our air capacity and cost structure in our transportation network to better match the prevailing volume mix levels. Our broad portfolio of product offerings and the flexibilities inherent in our transportation network have helped us adapt to these changing trends. While the worldwide economic environment has remained challenging in 2014, we have continued to undertake several initiatives in the U.S. and internationally to (1) improve the flexibility and capacity in our delivery network; (2) improve yield management; and (3) increase operational efficiency and contain costs across all segments. Most notably, the continued deployment of technology improvements (including several facility automation projects and the accelerated deployment of our On Road Integrated Optimization and Navigation system - "ORION") should increase our network capacity, and improve operational efficiency, flexibility and reliability. Additionally, we have continued to adjust our transportation network and utilize newly expanded operating facilities (including the $200 million recently completed expansion of our Cologne air hub) to improve time-in-transit for shipments in each region. Our consolidated results are presented in the table below: Three Months Ended Six Months Ended June 30, Change June 30, Change 2014 2013 % 2014 2013 % Revenue (in millions) $ 14,268 $ 13,507 5.6 % $ 28,047 $ 26,941 4.1 % Operating Expenses (in millions) 13,521 11,765 14.9 % 25,787 23,619 9.2 % Operating Profit (in millions) $ 747 $ 1,742 (57.1 )% $ 2,260 $ 3,322 (32.0 )% Operating Margin 5.2 % 12.9 % 8.1 % 12.3 % Average Daily Package Volume (in thousands) 16,859 15,722 7.2 % 16,929 15,971 6.0 % Average Revenue Per Piece $ 10.91 $ 11.08 (1.5 )% $ 10.81 $ 10.97 (1.5 )% Net Income (in millions) $ 454 $ 1,071 (57.6 )% $ 1,365 $ 2,108 (35.2 )% Basic Earnings Per Share $ 0.49 $ 1.14 (57.0 )% $ 1.48 $ 2.22 (33.3 )% Diluted Earnings Per Share $ 0.49 $ 1.13 (56.6 )% $ 1.47 $ 2.21 (33.5 )% Items Affecting Comparability The year-over-year comparisons of our financial results were affected by the following items (amounts in millions): Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 Operating Expenses: Health and Welfare Plan Charges $ 1,066 $ - $ 1,066 $ - TNT Termination Fee and Related Expenses - - - 284 Gain Upon Liquidation of Foreign Subsidiary - - - (245 ) Income Tax Expense: Income Tax Expense (Benefit) from the Items Above (401 ) - (401 ) (75 ) 32-------------------------------------------------------------------------------- Table of Contents UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS These items have been excluded from comparisons of "adjusted" operating expenses, operating profit and operating margin in the discussion that follows. Health and Welfare Plan Charges In connection with the ratification of our national master agreement with the International Brotherhood of Teamsters ("Teamsters") in the second quarter of 2014, we incurred pre-tax charges totaling $1.066 billion ($665 million after-tax) associated with changes in the delivery of healthcare benefits to certain active and retired union employees. These charges are discussed in further detail in the "Collective Bargaining Agreements" section. These charges impacted our U.S. Domestic Package segment ($957 million), International Package segment ($27 million) and Supply Chain & Freight segment ($82 million). TNT Termination Fee and Related Expenses On January 30, 2013, the European Commission issued a formal decision prohibiting our proposed acquisition of TNT Express N.V. ("TNT Express"). As a result of the prohibition by the European Commission, the condition of our offer requiring European Union competition clearance was not fulfilled, and our proposed acquisition of TNT Express could not be completed. Given this outcome, UPS and TNT Express entered a separate agreement to terminate the merger protocol, and we withdrew our formal offer for TNT Express. We paid a termination fee to TNT Express of €200 million ($268 million) under this agreement, and also incurred transaction-related expenses of $16 million during the first quarter of 2013. The combination of these items resulted in a pre-tax charge of $284 million ($177 million after-tax), which impacted our International Package segment. Gain upon the Liquidation of a Foreign Subsidiary Subsequent to the termination of the merger protocol, we liquidated a foreign subsidiary that would have been used to acquire the outstanding shares of TNT Express in connection with the proposed acquisition. Upon the liquidation of this subsidiary in the first quarter of 2013, we realized a pre-tax foreign currency gain of $245 million ($213 million after-tax), which impacted our International Package segment. Results of Operations-Segment Review The results and discussions that follow are reflective of how our executive management monitors the performance of our reporting segments. From time to time, we supplement the reporting of our financial information determined under generally accepted accounting principles ("GAAP") with certain non-GAAP financial measures, including operating profit, operating margin, pre-tax income, effective tax rate, net income and earnings per share adjusted for the non-comparable items discussed above. We believe that these adjusted measures provide meaningful information to assist investors and analysts in understanding our financial results and assessing our prospects for future performance. We believe these adjusted financial measures are important indicators of our results of operations because they exclude items that may not be indicative of, or are unrelated to, our core operating results, and provide a better baseline for analyzing trends in our underlying businesses. Certain operating expenses are allocated between our reporting segments based on activity-based costing methods. These activity-based costing methods require us to make estimates that impact the amount of each expense category that is attributed to each segment. Changes in these estimates will directly impact the amount of expense allocated to each segment, and therefore the operating profit of each reporting segment. There were no significant changes in our expense allocation methodology during 2014 or 2013. 33-------------------------------------------------------------------------------- Table of Contents UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS U.S. Domestic Package Operations Three Months Ended Six Months Ended June 30, Change June 30, Change 2014 2013 % 2014 2013 % Average Daily Package Volume (in thousands): Next Day Air 1,233 1,213 1.6 % 1,242 1,224 1.5 % Deferred 988 937 5.4 % 1,036 978 5.9 % Ground 12,085 11,176 8.1 % 12,082 11,373 6.2 % Total Avg. Daily Package Volume 14,306 13,326 7.4 % 14,360 13,575 5.8 % Average Revenue Per Piece: Next Day Air $ 20.73 $ 20.52 1.0 % $ 20.45 $ 20.32 0.6 % Deferred 13.05 13.31 (2.0 )% 12.77 12.96 (1.5 )% Ground 8.03 8.18 (1.8 )% 7.98 8.13 (1.8 )% Total Avg. Revenue Per Piece $ 9.47 $ 9.66 (2.0 )% $ 9.41 $ 9.58 (1.8 )% Operating Days in Period 64 64 127 127 Revenue (in millions): Next Day Air $ 1,636 $ 1,593 2.7 % $ 3,226 $ 3,159 2.1 % Deferred 825 798 3.4 % 1,680 1,610 4.3 % Ground 6,207 5,850 6.1 % 12,250 11,743 4.3 % Total Revenue $ 8,668 $ 8,241 5.2 % $ 17,156 $ 16,512 3.9 % Operating Expenses (in millions): Operating Expenses $ 8,459 $ 7,109 19.0 % $ 16,020 $ 14,295 12.1 % Health and Welfare Plan Charges (957 ) - (957 ) - Adjusted Operating Expenses $ 7,502 $ 7,109 5.5 % $ 15,063 $ 14,295 5.4 % Operating Profit (in millions) and Margin: Operating Profit $ 209 $ 1,132 (81.5 )% $ 1,136 $ 2,217 (48.8 )% Adjusted Operating Profit $ 1,166 $ 1,132 3.0 % $ 2,093 $ 2,217 (5.6 )% Operating Margin 2.4 % 13.7 % 6.6 % 13.4 % Adjusted Operating Margin 13.5 % 13.7 % 12.2 % 13.4 % Revenue The change in overall revenue was impacted by the following factors for the second quarter and year-to-date periods of 2014 compared with the corresponding periods of 2013: Total Rates / Fuel Revenue Volume Product Mix Surcharge ChangeNet Revenue Change Drivers: Second quarter 2014 vs. 2013 7.4 % (2.2 )% - % 5.2 % Year-to-date 2014 vs. 2013 5.8 % (1.8 )% (0.1 )% 3.9 % Volume Our overall volume increased in the second quarter and year-to-date periods of 2014 compared with 2013, largely due to continued solid growth in e-commerce and overall retail sales. Business-to-consumer shipments, which represent approximately 43% of total U.S. Domestic Package volume, grew 14% for the quarter and drove increases in both air and ground shipments. UPS SurePost volume increased more than 60% in the second quarter, and accounted for approximately half of the overall volume growth for the segment. The growth rate of business-to-business volume also accelerated in the second quarter of 2014, largely due to increased volume from the retail industry, including the use of our solutions for omni-channel (including ship-from-store and ship-to-store models) and returns shipping; additionally, business-to-business volume was positively impacted by growth in shipments from the industrial and manufacturing sectors. 34-------------------------------------------------------------------------------- Table of Contents UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Among our air products, volume increased in the second quarter of 2014 compared with 2013 for both our Next Day Air and deferred services. Solid air volume growth continued for those products most aligned with business-to-consumer shipping, including our residential Second Day Air package and residential Next Day Air Saver products. This growth was slightly offset by a decline in Next Day Air letter volume, which was negatively impacted by some competitive losses and slowing growth in the financial services industry. Our business-to-business air volume increased slightly, due to growth in the retail and industrial sectors. The growth in premium and deferred air volume continues to be impacted by economic conditions and changes in our customers' supply chain networks; the combination of these factors influences their sensitivity towards the price and speed of shipments, and therefore the use of our premium air services. The increase in ground volume in the second quarter and year-to-date periods of 2014 was driven by our SurePost service offering, which had a volume increase of 62% for the quarter (56% year-to-date). Additionally, we experienced moderate volume growth in our traditional residential ground services. Demand for SurePost and our traditional residential products continues to be driven by business-to-consumer shipping activity from e-commerce retailers and other large customers; additionally, business-to-consumer ground volume benefited from a large, one-time catalog shipment after a customer upgraded their distribution channel. Business-to-business ground volume also increased, primarily from the growth in omni-channel retail volume and the increased use of our returns service offerings. Rates and Product Mix Overall revenue per piece decreased 2.0% for the second quarter of 2014 compared with the same period of 2013 (1.8% year-to-date), and was impacted by changes in base rates, customer and product mix, and fuel surcharge rates. Revenue per piece for our ground and air products was positively impacted by an increase in base rates that took effect on December 30, 2013. We implemented an average 4.9% net increase in base and accessorial rates on UPS Next Day Air, UPS 2nd Day Air and UPS 3 Day Select, and UPS Ground. In the second quarter and year-to-date periods of 2014, revenue per piece increased slightly for our Next Day Air products, largely due to the base rate increase, an increase in the average weight per package, and a shift in product mix from lower-yielding letters towards higher-yielding packages. Revenue per piece declined for our deferred products in the second quarter, as customer and product mix changes more than offset the increase in base rates. Product mix adversely impacted deferred revenue per piece, as we experienced relatively stronger growth in our lighter-weight business-to-consumer shipments, which have lower average yields than our heavier-weight commercial shipments. Customer mix also adversely impacted deferred revenue per piece, due to the faster volume growth among our larger customers, which typically have a lower average yield than our smaller and middle-market customers. Ground revenue per piece decreased in the second quarter and year-to-date periods of 2014, as customer and product mix changes more than offset the impact of the base rate increase. Customer and product mix changes adversely impacted revenue per piece as a greater portion of our overall volume in 2014, relative to 2013, came from lighter-weight shipments (including 62% volume growth in SurePost) and larger customers. Fuel Surcharges UPS applies a fuel surcharge on our domestic air and ground services. The air fuel surcharge is based on the U.S. Department of Energy's ("DOE") Gulf Coast spot price for a gallon of kerosene-type jet fuel, while the ground fuel surcharge is based on the DOE's On-Highway Diesel Fuel price. Based on published rates, the average fuel surcharge for domestic air and ground products were as follows: Three Months Ended Six Months Ended June 30, Change June 30, Change 2014 2013 % Point 2014 2013 % Point Next Day Air / Deferred 10.7 % 11.0 % (0.3 )% 10.6 % 11.0 % (0.4 )% Ground 7.5 % 7.5 % - % 7.3 % 7.4 % (0.1 )% 35-------------------------------------------------------------------------------- Table of Contents UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Total domestic fuel surcharge revenue increased by $2 million in the second quarter of 2014, as strong volume increases more than offset the decline in fuel surcharge rates. On a year-to-date basis, fuel surcharge revenue decreased by $17 million, as the lower fuel surcharge rates more than offset the increase in package volume. These decreased fuel surcharge rates for the quarter and year-to-date periods were due to lower jet and diesel fuel prices in the U.S. during 2014. Operating Expenses Adjusted operating expenses for the segment increased $393 million for the second quarter of 2014 compared with the same period of 2013 ($768 million year-to-date), and were impacted by several factors. This increase was primarily due to pick-up and delivery costs, which grew $199 million, as well as the cost of operating our domestic integrated air and ground network, which increased $146 million for the second quarter ($374 and $273 million, respectively, year-to-date). The growth in pick-up and delivery and network costs was largely due to increased volume and higher employee compensation costs, which were impacted by an increase in average daily driver hours (up 3.9%) and an increase in employee healthcare expenses. Additionally, we incurred higher costs associated with outside contract carriers, due to volume growth as well as issues associated with service performance of rail carriers. The remaining increase in adjusted operating expenses was mostly attributable to the costs of package sorting, which increased $39 million for the second quarter ($92 million year-to-date), largely due to higher package volume. On a year-to-date basis, poor weather conditions early in 2014 also increased operating expenses through higher overtime hours in our operations, reduced productivity, higher snow removal and utility costs, as well as the additional use of outside contract carriers. Outside of the adverse weather impact, cost increases have been mitigated as we adjust our air and ground networks to better match higher volume levels and utilize technology to increase package sorting and delivery efficiency. Improved pick-up and delivery densities, particularly for our residential products, have also contained increases in cost. These network efficiency improvements allowed us to process increased volume (up 7.4%) at a faster rate than the increase in average daily aircraft block hours (no change for the quarter), vehicle miles driven (up 4.0%) and average daily union labor hours (up 6.0%) in the second quarter of 2014 compared with the same period of 2013. The total adjusted cost per piece decreased 1.7% for the second quarter of 2014 compared with the second quarter of 2013 (0.4% year-to-date). Operating Profit and Margin Adjusted operating profit increased $34 million for the second quarter of 2014 compared with 2013. Overall volume growth allowed us to better leverage our transportation network, resulting in better pick-up and delivery density; however, these factors were partially offset by changes in customer and product mix, which combined to pressure our revenue per piece. The adjusted operating margin declined by 20 basis points, as we incurred additional operating costs associated with rail service performance and investments made to enhance operational capabilities and expand network capacity. On a year-to-date basis, adjusted operating profit declined $124 million in 2014 compared with 2013, as adverse weather conditions early in 2014 and lower yields more than offset the volume growth and productivity improvements discussed previously. The unfavorable weather conditions in the U.S. reduced operating profit approximately $200 million in 2014, including the estimated loss in package volume, increased guaranteed service refunds to customers, and higher operating expenses. 36-------------------------------------------------------------------------------- Table of Contents UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS International Package Operations Three Months Ended Six Months Ended June 30, Change June 30, Change 2014 2013 % 2014 2013 % Average Daily Package Volume (in thousands): Domestic 1,496 1,427 4.8 % 1,513 1,422 6.4 % Export 1,057 969 9.1 % 1,056 974 8.4 % Total Avg. Daily Package Volume 2,553 2,396 6.6 % 2,569 2,396 7.2 % Average Revenue Per Piece: Domestic $ 7.23 $ 7.06 2.4 % $ 7.18 $ 7.12 0.8 % Export 35.60 36.51 (2.5 )% 35.10 35.97 (2.4 )% Total Avg. Revenue Per Piece $ 18.97 $ 18.97 - % $ 18.66 $ 18.85 (1.0 )% Operating Days in Period 64 64 127 127 Revenue (in millions): Domestic $ 692 $ 645 7.3 % $ 1,380 $ 1,286 7.3 % Export 2,408 2,264 6.4 % 4,707 4,450 5.8 % Cargo 152 153 (0.7 )% 292 304 (3.9 )% Total Revenue $ 3,252 $ 3,062 6.2 % $ 6,379 $ 6,040 5.6 % Operating Expenses (in millions): Operating Expenses $ 2,808 $ 2,611 7.5 % $ 5,497 $ 5,237 5.0 % Health and Welfare Plan Charges (27 ) - (27 ) - TNT Termination Fee and Related Expenses - - - (284 ) Gain Upon Liquidation of Foreign Subsidiary - - - 245 Adjusted Operating Expenses $ 2,781 $ 2,611 6.5 % $ 5,470 $ 5,198 5.2 % Operating Profit (in millions) and Operating Margin: Operating Profit $ 444 $ 451 (1.6 )% $ 882 $ 803 9.8 % Adjusted Operating Profit $ 471 $ 451 4.4 % $ 909 $ 842 8.0 % Operating Margin 13.7 % 14.7 % 13.8 % 13.3 % Adjusted Operating Margin 14.5 % 14.7 % 14.2 % 13.9 % Currency Translation Benefit / (Cost)-(in millions)*: $ $ Revenue $ 49 $ 68 Operating Expenses (26 ) (29 ) Operating Profit $ 23 $ 39 ___________________* Net of currency hedging; amount represents the change compared to the prior year. 37 -------------------------------------------------------------------------------- Table of Contents UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Revenue The change in overall revenue was impacted by the following factors for the second quarter and year-to-date periods of 2014 compared with the corresponding periods of 2013: Total Rates / Fuel Revenue Volume Product Mix Surcharge Currency Change Net Revenue Change Drivers: Second quarter 2014 vs. 2013 6.6 % (2.1 )% 0.1 % 1.6 % 6.2 % Year-to-date 2014 vs. 2013 7.2 % (2.7 )% - % 1.1 % 5.6 % Volume Our overall average daily volume increased in the second quarter and year-to-date periods of 2014, largely due to strong demand from several industries (including retail, healthcare, industrial and automotive). The export volume increase in the second quarter and year-to-date periods of 2014 was driven by Europe, which experienced a solid increase in volume to all regions of the world. Volume in the intra-European trade lanes was particularly strong, and increased over 14% for the quarter. We also experienced solid export volume growth in the Americas (largely in the Canada-to-U.S. and Mexico-to-U.S. trade lanes) and in Asia (particularly in the Asia-to-Europe and Asia-to-U.S. trade lanes); however, Asian export growth was restrained by fewer technology product launches and fewer shipments from several key customers. Export volume continued to shift towards our standard products, such as Transborder Standard and Worldwide Standard, as compared with our premium express products, such as Worldwide Express. Our international customers continue to be impacted by economic pressures and changes in their supply chain networks, and the combination of these factors influences their sensitivity towards the price and speed of shipments. The strong increase in domestic volume in the second quarter and year-to-date periods of 2014 was driven by solid volume growth throughout Europe, as well as in Canada and Mexico. Rates and Product Mix Total average revenue per piece decreased 1.7% for the second quarter of 2014 on a currency-adjusted basis (2.2% year-to-date), and was impacted by changes in base rates as well as product mix. On December 30, 2013, we implemented an average 4.9% net increase in base and accessorial rates for international shipments originating in the United States (Worldwide Express, Worldwide Saver, UPS Worldwide Expedited and UPS International Standard service). Rate changes for shipments originating outside the U.S. are made throughout the year and vary by geographic market. Currency-adjusted export revenue per piece decreased 4.0% for the second quarter (3.7% year-to-date), as the shift in product mix from our premium express products to our standard products more than offset the increase in base rates (volume for our standard products increased 13%, while volume for our premium express products increased 4%). Additionally, currency-adjusted export revenue per piece was adversely impacted by shorter average trade lanes (due to faster growth in intra-regional shipments) and a reduction in fuel surcharge rates. Changes in customer mix had a small negative impact on revenue per piece in the second quarter, as export volume growth for larger customers exceeded the volume growth for higher-yielding middle market customers. Currency-adjusted domestic revenue per piece was relatively flat for the second quarter and year-to-date periods (increased 0.4% for the quarter and declined 0.1% year-to-date). Domestic revenue per piece was impacted by base rate increases, as well as changes in product mix and fuel surcharge rates. 38-------------------------------------------------------------------------------- Table of Contents UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Fuel Surcharges We maintain fuel surcharges on our international air and ground services. The fuel surcharges for international air products originating inside or outside the United States are indexed to the DOE's Gulf Coast spot price for a gallon of kerosene-type jet fuel, while the fuel surcharges for ground products originating outside the United States are indexed to fuel prices in the international region or country where the shipment takes place. Total international fuel surcharge revenue increased by $2 million for the second quarter of 2014 when compared with the same period of 2013 ($3 million year-to-date), primarily due to increased international domestic and export volume; however, this was partially offset by reduced fuel surcharge rates caused by declining fuel prices. Operating Expenses Overall adjusted operating expenses for the segment increased $170 million for the second quarter of 2014 compared with the same period in 2013 ($272 million year-to-date). This increase was driven by the cost of pick-up and delivery, which increased $69 million for the second quarter ($135 million year-to-date), as well as the cost of operating our international integrated air and ground network, which increased $76 million for the second quarter ($126 million year-to-date). The increase in pick-up and delivery and network costs were largely driven by higher package volume; however, network costs were mitigated by a 2.3% reduction in average daily aircraft block hours (1.6% year-to-date) resulting from ongoing modifications to our air network. This reduction in block hours was achieved even with a 9.1% increase in second quarter international export volume (8.4% year-to-date) and several air product service enhancements. The remaining increase in adjusted operating expenses for the quarter were largely due to the costs of package sorting, which increased $14 million for the second quarter ($23 million year-to-date), and was impacted by volume growth. Indirect operating costs increased for the quarter, but decreased year-to-date, and were affected by various factors, including currency remeasurement gains, legal contingency accruals, bad debt expense, and several other factors. Excluding the impact of currency exchange rate changes, the total adjusted cost per piece for the segment decreased 1.0% for the second quarter of 2014 compared with the same period of 2013 (2.4% year-to-date). Operating Profit and Margin Adjusted operating profit increased by $20 million in the second quarter of 2014 ($67 million year-to-date). The adjusted operating margin declined by 20 basis points in the second quarter, due to increased indirect operating costs and higher expense for outside transportation carriers (which was impacted by network capacity constraints in Europe). On a year-to-date basis, the adjusted operating margin increased 30 basis points, as moderate revenue growth combined with the mitigation of expenses through increased productivity, led to the expansion in the operating margin. In addition to the aforementioned factors, the net impact of fuel (fuel expense decreased at a faster rate than fuel surcharge revenue) and the net impact of currency (remeasurement and translation gains) resulted in a favorable impact on operating profit of $57 million when comparing the second quarter of 2014 with 2013 ($87 million year-to-date). 39-------------------------------------------------------------------------------- Table of Contents UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Supply Chain & Freight Operations Three Months Ended Six Months Ended June 30, Change June 30, Change 2014 2013 % 2014 2013 % Freight LTL Statistics: Revenue (in millions) $ 672 $ 635 5.8 % $ 1,275 $ 1,231 3.6 % Revenue Per Hundredweight $ 22.50 $ 21.61 4.1 % $ 22.51 $ 21.73 3.6 % Shipments (in thousands) 2,736 2,717 0.7 % 5,223 5,235 (0.2 )% Shipments Per Day (in thousands) 42.7 42.5 0.7 % 41.1 41.2 (0.2 )% Gross Weight Hauled (in millions of lbs) 2,985 2,939 1.6 % 5,663 5,668 (0.1 )% Weight Per Shipment (in lbs) 1,091 1,082 0.8 % 1,084 1,083 0.1 % Operating Days in Period 64 64 127 127 Revenue (in millions): Forwarding and Logistics $ 1,432 $ 1,333 7.4 % $ 2,765 $ 2,693 2.7 % Freight 771 731 5.5 % 1,465 1,419 3.2 % Other 145 140 3.6 % 282 277 1.8 % Total Revenue $ 2,348 $ 2,204 6.5 % $ 4,512 $ 4,389 2.8 % Operating Expenses (in millions): Operating Expenses $ 2,254 $ 2,045 10.2 % $ 4,270 $ 4,087 4.5 % Health and Welfare Plan Charges (82 ) - (82 ) - Adjusted Operating Expenses $ 2,172 $ 2,045 6.2 % $ 4,188 $ 4,087 2.5 % Operating Profit (in millions) and Margin: Operating Profit $ 94 $ 159 (40.9 )% $ 242 $ 302 (19.9 )% Adjusted Operating Profit $ 176 $ 159 10.7 % $ 324 $ 302 7.3 % Operating Margin 4.0 % 7.2 % 5.4 % 6.9 % Adjusted Operating Margin 7.5 % 7.2 % 7.2 % 6.9 % Currency Translation Benefit / (Cost) - (in millions)*: $ $ Revenue $ (3 ) $ (15 ) Operating Expenses 1 11 Operating Profit $ (2 ) $ (4 ) ___________________* Amount represents the change compared to the prior year. Revenue Forwarding and logistics revenue increased $99 million in the second quarter of 2014 compared with the corresponding period in 2013 ($72 million year-to-date). Forwarding revenue increased in the second quarter and year-to-date periods, primarily due to volume and tonnage growth in our international air freight, North American air freight and ocean freight businesses, which were impacted by improving overall market demand. This was partially offset, however, by lower rates charged to our customers in our international air forwarding business, which was largely due to industry overcapacity in key trade lanes, particularly the Asia-outbound market. Revenue for our logistics products increased in the second quarter and year-to-date periods of 2014 compared with 2013, as we experienced solid growth in our mail services, healthcare and retail distribution solutions; however, this was partially offset by revenue declines among our technology customers. 40-------------------------------------------------------------------------------- Table of Contents UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Freight revenue increased $40 million for the second quarter of 2014 ($46 million year-to-date), driven by an increase in LTL revenue per hundredweight, as well as smaller increases in tonnage and average daily LTL shipments. The increase in LTL revenue per hundredweight was largely due to our focus on yield management, as well as general rate increases averaging 4.4% and 5.9% that took effect in March 2014 and June 2013, respectively, covering non-contractual shipments in the United States, Canada and Mexico. The increases in tonnage and average daily LTL shipments for the second quarter were impacted by overall U.S. economic growth and improving LTL market conditions; however the adverse weather conditions in the U.S. during the first quarter of 2014 resulted in year-to-date declines in both tonnage and shipments. LTL fuel surcharge revenue increased by $9 million in the second quarter of 2014 compared with the corresponding period of the prior year ($7 million year-to-date), due to changes in diesel fuel prices and overall LTL shipment volume. Revenue for the other businesses within Supply Chain & Freight increased $5 million in the second quarter and year-to-date periods of 2014, due to revenue growth at The UPS Store, UPS Capital and UPS Customer Solutions; however, this was partially offset by a decline in revenue from our contract to provide domestic air transportation services for the U.S. Postal Service. Operating Expenses Forwarding and logistics adjusted operating expenses increased $95 million for the second quarter of 2014 compared with the same period of 2013 ($62 million year-to-date), largely due to higher purchased transportation and employee compensation expenses. Purchased transportation expense increased by $73 million in the second quarter ($50 million year-to-date), primarily due to higher volume and tonnage in our international air freight forwarding business, but partially offset by lower rates charged to us by third-party transportation carriers. The remaining increase in expense was impacted by higher employee compensation costs for both management and hourly employees, due to merit salary and wage increases along with an increase in the overall size of the workforce. Freight adjusted operating expenses increased $28 million in the second quarter of 2014 ($38 million year-to-date), while the total adjusted cost per LTL shipment increased 3.2% (3.0% year-to-date). The increase in adjusted operating expenses was largely due to pick-up and delivery expenses and the costs associated with operating our linehaul network, which increased $20 and $18 million, respectively, in the second quarter ($39 and $20 million year-to-date, respectively). The increases in pick-up and delivery and network costs were primarily due to contractual wage increases, higher LTL volume and increased costs associated with outside contract and rail carriers. Partially offsetting these cost increases were reductions in indirect operating expenses, including lower auto liability and worker's compensation costs, which were impacted by operational safety and claims management initiatives, as well as lower pension expense. Operating expenses for the other businesses within Supply Chain & Freight increased $4 million in the second quarter of 2014 compared with 2013 ($1 million year-to-date). Operating Profit and Margin Adjusted operating profit for the forwarding and logistics unit increased by $4 million in the second quarter of 2014 compared to the same period in 2013 ($10 million year-to-date), largely driven by strong results in ocean freight, North American air freight, brokerage and mail services. These products were impacted by improving market demand, cost controls and solid operating margin increases. The operating profit improvements in these businesses were partially offset by reduced profitability in our international air forwarding business. Continued excess capacity in key trade lanes pressured the rates we charge to our customers, which more than offset the reduced rates we incur from third-party transportation carriers, and thereby led to a decline in our international air freight operating margin. Adjusted operating profit for our freight unit increased $12 million in the second quarter of 2014 compared to the same period in 2013 ($8 million year-to-date), as increased yields and higher productivity more than offset contractual union wage increases. The combined operating profit for all of our other businesses in this segment increased $1 million during the second quarter ($4 million year-to-date), primarily due to higher operating profit at UPS Capital and UPS Customer Solutions. 41-------------------------------------------------------------------------------- Table of Contents UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Consolidated Operating Expenses Three Months Ended Six Months Ended June 30, Change June 30, Change 2014 2013 % 2014 2013 % Operating Expenses (in millions): Compensation and Benefits $ 8,375 $ 6,981 20.0 % $ 15,640 $ 13,949 12.1 % Health and Welfare Plan Charges (1,066 ) - (1,066 ) - Adjusted Compensation and Benefits 7,309 6,981 4.7 % 14,574 13,949 4.5 % Repairs and Maintenance 341 309 10.4 % 670 618 8.4 % Depreciation and Amortization 473 466 1.5 % 941 940 0.1 % Purchased Transportation 1,988 1,731 14.8 % 3,896 3,511 11.0 % Fuel 980 992 (1.2 )% 1,952 1,998 (2.3 )% Other Occupancy 241 225 7.1 % 538 478 12.6 % Other Expenses: 1,123 1,061 5.8 % 2,150 2,125 1.2 % TNT Termination Fee and Related Expenses - - - (284 ) Gain Upon Liquidation of Foreign Subsidiary - - - 245 Adjusted Other Expenses 1,123 1,061 5.8 % 2,150 2,086 3.1 % Total Operating Expenses $ 13,521 $ 11,765 14.9 % $ 25,787 $ 23,619 9.2 % Adjusted Total Operating Expenses $ 12,455 $ 11,765 5.9 % $ 24,721 $ 23,580 4.8 % $ $ Currency Translation (Benefit) Cost $ 25 $ 18 Compensation and Benefits Employee payroll costs increased $238 million for the second quarter of 2014 compared with 2013 ($469 million year-to-date), largely due to contractual union wage rate increases, a 6.0% increase in average daily union labor hours, and a merit salary increase for management employees. The increase in average daily union labor hours was impacted by volume growth in the second quarter and year-to-date periods of 2014; additionally, adverse weather conditions in the early part of 2014 also contributed to an increase in labor hours in the year-to-date comparison. Adjusted benefits expense increased $90 million for the second quarter of 2014 compared with 2013 ($156 million year-to-date), primarily due to increased health and welfare costs, payroll taxes and vacation, holiday and excused absence expenses. These factors are discussed further as follows: • Adjusted health and welfare costs increased $62 million for the second quarter of 2014 compared with 2013 ($116 million year-to-date), largely due to higher medical claims in company-sponsored plans, increased contributions to multiemployer plans and the impact of several provisions of the Patient Protection and Affordable Care Act of 2010. The growth in multiemployer plan contributions was impacted by contractual contribution rate increases and higher union labor hours. • Payroll taxes increased $13 million in the second quarter of 2014 compared with 2013 ($29 million year-to-date), primarily as a result of union wage increases and the timing of management incentive compensation payments. • Vacation, holiday and excused absence expense increased $6 million in the second quarter of 2014 compared with 2013 ($21 million year-to-date), due to increased vacation entitlements earned based on employees' years of service. 42-------------------------------------------------------------------------------- Table of Contents UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Repairs and Maintenance The increase in repairs and maintenance expense for the second quarter and year-to-date periods was primarily due to higher aircraft engine repair and component replacement costs, largely in our Boeing 747 and 767 aircraft fleets. Depreciation and Amortization The slight increase in depreciation and amortization expense in the second quarter and year-to-date periods of 2014 was primarily due to higher depreciation expense on vehicles, due to the replacement of older, fully-depreciated vehicles, technology upgrades on new vehicles and an overall increase in the size of our vehicle fleet in our U.S. Domestic Package and UPS Freight operations. This increase was largely offset by lower amortization expense on capitalized software and a reduction in building and facility depreciation (as certain assets became fully depreciated). Purchased Transportation The $257 million increase in purchased transportation expense charged to us by third-party air, ocean and truck carriers for the second quarter of 2014 ($385 million year-to-date), was driven by several factors: • Our U.S. Domestic Package segment incurred a $116 million increase in expense for the second quarter ($224 million year-to-date), primarily due to (1) higher fees paid to the U.S. Postal Service associated with the volume growth in our SurePost product; (2) the increased use of, and higher rates passed to us from, rail carriers; and (3) the increased use of outside contract carriers, which was impacted by volume growth and rail carrier service issues; additionally, adverse weather conditions in the early months of 2014 resulted in the additional use of outside contract carriers in the year-to-date period. • Our International Package segment incurred a $46 million increase in expense for the second quarter ($84 million year-to-date), primarily due to higher costs incurred for the use of outside transportation providers, which was impacted by strong international volume growth. • Our UPS Freight business incurred a $22 million increase in expense for the second quarter ($27 million year-to-date), largely due to the increased use of, and higher rates passed to us from, rail carriers. • The purchased transportation expense for our forwarding & logistics business increased $73 million for the second quarter ($50 million year-to-date), largely due to increased volume and tonnage in our international air freight forwarding business, but partially offset by reduced rates charged to us by third-party transportation carriers. Fuel The $12 million decrease in fuel expense for the second quarter of 2014 ($46 million year-to-date) was primarily due to the decline in fuel prices, which decreased expense by $9 million for the quarter, net of hedging ($43 million year-to-date). We also incurred a slight decline in fuel usage during the second quarter and year-to-date periods, as a reduction in aircraft block hours more than offset an increase in vehicle miles driven. Other Occupancy The $16 million increase in other occupancy expense in the second quarter of 2014 ($60 million year-to-date) was primarily due to a $6 million increase in facility rent expense ($10 million year-to-date) and a $5 million increase in natural gas and electric utility expenses ($22 million year-to-date). The year-to-date increase was also impacted by the adverse weather conditions in the U.S. in the early months of 2014, which resulted in higher snow removal costs at our operating facilities ($19 million year-to-date) and increased natural gas and electric utility costs. Other Expenses The $62 million increase in adjusted other expenses in the second quarter of 2014 ($64 million year-to-date) was impacted by a number of factors. Transportation equipment rentals increased $12 million for the quarter ($26 million year-to-date), and were affected by the growth in package volume. We also incurred increases in several other expense categories, including transportation security costs, bad debt expense, warehouse and office equipment rentals, and legal contingency costs. These increases were partially offset by business interruption insurance claim reimbursements from previous weather-related events. 43-------------------------------------------------------------------------------- Table of Contents UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Investment Income and Interest Expense Three Months Ended Six Months Ended June 30, Change June 30, Change 2014 2013 % 2014 2013 % (in millions) Investment Income $ 25 $ 3 N/A $ 25 $ 8 N/A Interest Expense $ (89 ) $ (98 ) (9.2 )% $ (179 ) $ (194 ) (7.7 )% Investment Income The increase in investment income for the second quarter of 2014 was primarily due to a $9 million increase in realized gains on the sales of investments ($8 million year-to-date) and an $10 million decrease in losses from fair value adjustments on real estate partnerships ($12 million year-to-date). These increases were partially offset by a decline in the average balance of invested assets. Interest Expense Interest expense decreased in the second quarter and year-to-date periods of 2014, largely due to a lower average balance of debt outstanding. In addition, interest expense declined due to having a larger proportion of our debt swapped to lower variable rates in the second quarter and year-to-date periods of 2014 compared with 2013. Income Tax Expense Three Months Ended Six Months Ended June 30, Change June 30, Change 2014 2013 % 2014 2013 % (in millions) Income Tax Expense $ 229 $ 576 (60.2 )% $ 741 $ 1,028 (27.9 )%Health and Welfare Plan Charges 401 - 401 - TNT Termination Fee and Related Expenses - - - 107 Gain Upon Liquidation of Foreign Subsidiary - - - (32 ) Adjusted Income Tax Expense $ 630 $ 576 9.4 % $ 1,142 $ 1,103 3.5 % Effective Tax Rate 33.5 % 35.0 % 35.2 % 32.8 % Adjusted Effective Tax Rate 36.0 % 35.0 % 36.0 % 34.7 % Our adjusted effective tax rate increased to 36.0% in the second quarter of 2014 from 35.0% in the same period of 2013 (36.0% and 34.7% year-to-date, respectively) due to a decrease in U.S. Federal and state tax credits relative to total pre-tax income. Our effective tax rate decreased to 33.5% in the second quarter of 2014 compared with 35.0% in the same period of 2013 primarily due to the $1.066 billion pre-tax charge associated with certain health and welfare benefit plan changes, which generated a tax benefit at a rate higher than the effective tax rate. On a year-to-date basis, our effective tax rate increased to 35.2% in 2014 from 32.8% in 2013 due to prior year results including a gain from liquidating a foreign subsidiary which was non-taxable, in addition to the aforementioned trends with U.S. Federal and state tax credits. 44-------------------------------------------------------------------------------- Table of Contents UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources Net Cash From Operating Activities The following is a summary of the significant sources (uses) of cash from operating activities (amounts in millions): Six Months Ended June 30, 2014 2013 Net income $ 1,365 $ 2,108 Non-cash operating activities (a) 2,645 1,414 Pension and postretirement plan contributions (UPS-sponsored plans) (115 ) (114 ) Settlement of postretirement benefit obligation (1,995 ) - Income tax receivables and payables 69 (176 ) Changes in working capital and other non-current assets and liabilities (144 ) 298 Other sources (uses) of cash from operating activities 7 (99 ) Net cash from operating activities $ 1,832 $ 3,431 ___________________ (a) Represents depreciation and amortization, gains and losses on derivative transactions and foreign exchange, deferred income taxes, provisions for uncollectible accounts, pension and postretirement benefit expense, stock compensation expense, impairment charges and other non-cash items. Operating cash flow was adversely impacted by $2.062 billion due to certain transactions resulting from the ratification of our collective bargaining agreement with the Teamsters in 2014: • We paid $1.995 billion to settle postretirement benefit obligations for certain Teamster employees, and paid an additional $276 million that has been accounted for as a deposit until the ratification of certain other collective bargaining agreements. • We paid $204 million in 2014 for retroactive economic benefits under the collective bargaining agreement that were related to the period between August through December of 2013. • As of June 30, 2014, we have received cash tax benefits of $413 million from the payments described above (through reduced U.S. Federal and state quarterly income tax payments). Operating cash flow was adversely impacted by $246 million in 2013, due to certain TNT Express transaction-related charges. We paid a termination fee to TNT Express of €200 million ($268 million) under the agreement to terminate the merger protocol, and also incurred additional transaction-related expenses of $16 million. As of June 30, 2013, we had received net cash tax benefits of $38 million from these TNT Express transaction-related items. Apart from the transactions described above, operating cash flow increased approximately $217 million in 2014 compared with 2013, largely due to improvements in our working capital position and changes in income tax payables and receivables. In 2014, our working capital position experienced a relatively greater seasonal improvement, as the compressed holiday shipping season in the fourth quarter of 2013 resulted in an increase in working capital at year-end. The cash payments for income taxes decreased in 2014 compared with 2013, and were impacted by the timing of current tax deductions. As of June 30, 2014, the total of our worldwide holdings of cash and cash equivalents was $3.056 billion, of which $1.634 billion was held by foreign subsidiaries. The amount of cash held by our U.S. and foreign subsidiaries fluctuates throughout the year due to a variety of factors, including the timing of cash receipts and disbursements in the normal course of business. Cash provided by operating activities in the United States continues to be our primary source of funds to finance domestic operating needs, capital expenditures, share repurchases and dividend payments to shareowners. To the extent that such amounts represent previously untaxed earnings, the cash held by foreign subsidiaries would be subject to tax if such amounts were repatriated in the form of dividends; however, not all international cash balances would have to be repatriated in the form of a dividend if returned to the U.S. When amounts earned by foreign subsidiaries are expected to be indefinitely reinvested, no accrual for taxes is provided. 45-------------------------------------------------------------------------------- Table of Contents UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Net Cash Used In Investing Activities Our primary sources (uses) of cash for investing activities were as follows (amounts in millions): Six Months Ended June 30, 2014 2013 Net cash used in investing activities $ (1,802 ) $ (1,853 ) Capital Expenditures: Buildings and facilities $ (207 ) $ (183 ) Aircraft and parts (25 ) (274 ) Vehicles (385 ) (281 ) Information technology (196 ) (252 ) $ (813 ) $ (990 ) Capital Expenditures as a % of Revenue 2.9 % 3.7 % Other Investing Activities: Proceeds from disposals of property, plant and equipment $ 10 $ 24 Net decrease in finance receivables $ 13 $ 19 Net sales (purchases) of marketable securities $ (959 ) $ (898 ) Cash paid for business acquisitions $ (22 ) $ - Other sources (uses) of cash for investing activities $ (31 ) $ (8 ) We have commitments for the purchase of vehicles, equipment and real estate to provide for the replacement of existing capacity and anticipated future growth. We generally fund our capital expenditures with our cash from operations. Capital spending on buildings and facilities increased in the first six months of 2014 compared with 2013, due to several facility automation and capacity expansion projects. Capital spending on aircraft declined due to the completion of our Boeing 767-300 order in 2013 (we no longer have any open aircraft orders in 2014). Capital spending on vehicles increased in the first six months of 2014 in our U.S. and international package businesses, due to vehicle replacements, technology enhancements and new vehicle orders to support volume growth. Capital spending on technology decreased in the first six months of 2014, largely due to fewer new capitalized software projects. Future capital spending for anticipated growth and replacement assets will depend on a variety of factors, including economic and industry conditions. We anticipate that our capital expenditures for 2014 will be approximately $2.5 billion. The net decrease in finance receivables was primarily due to loan sales in our business credit and leasing portfolios. The purchases and sales of marketable securities are largely determined by liquidity needs and the periodic rebalancing of investment types, and will therefore fluctuate from period to period. The cash paid for business acquisitions in 2014 was primarily related to our acquisition of Polar Speed Distribution Limited in the U.K. Other investing activities include the cash settlement of derivative contracts used in our currency and commodity hedging programs, as well as capital contributions into certain investment partnerships. We received (paid) cash of ($14) and $21 million in the first six months of 2014 and 2013, respectively, for the settlement of derivative contracts. 46-------------------------------------------------------------------------------- Table of Contents UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Net Cash Used in Financing Activities Our primary sources (uses) of cash for financing activities are as follows (amounts in millions, except per share data): Six Months Ended June 30, 2014 2013 Net cash used in financing activities $ (1,632 ) $ (4,041 ) Share Repurchases: Cash expended for shares repurchased $ (1,379 ) $ (1,867 ) Number of shares repurchased (13.7 ) (21.8 ) Shares outstanding at period end 914 938 Percent reduction in shares outstanding (1.0 )% (1.6 )% Dividends: Dividends declared per share $ 1.34 $ 1.24 Cash expended for dividend payments $ (1,192 ) $ (1,140 ) Borrowings: Net borrowings (repayment) of debt principal $ 840 $ (716 ) Other Financing Activities: Cash received for common stock issuances $ 149 $ 293 Other sources (uses) of cash for financing activities $ (50 ) $ (611 ) Capitalization (as of June 30 each year): Total debt outstanding at period end $ 11,842 $ 11,923 Total shareowners' equity at period end 5,585 3,630 Total capitalization $ 17,427 $ 15,553 Debt to Total Capitalization % 68.0 % 76.7 % We repurchased a total of 13.7 million shares of class A and class B common stock for $1.363 billion in the first six months ended June 30, 2014, and 21.8 million shares for $1.836 billion for the first six months ended June 30, 2013 ($1.379 and $1.867 billion in repurchases for 2014 and 2013, respectively, are reported on the cash flow statement due to the timing of settlements). In February 2013, the Board of Directors approved a new share repurchase authorization of $10.0 billion, which has no expiration date. As of June 30, 2014, we had $5.451 billion of this share repurchase authorization available. Share repurchases may take the form of accelerated share repurchases, open market purchases, or other such methods as we deem appropriate. The timing of our share repurchases will depend upon market conditions. Unless terminated earlier by the resolution of our Board, the program will expire when we have purchased all shares authorized for repurchase under the program. We anticipate repurchasing a total of approximately $2.7 billion of shares in 2014. The declaration of dividends is subject to the discretion of the Board of Directors and will depend on various factors, including our net income, financial condition, cash requirements, future prospects and other relevant factors. We increased our quarterly cash dividend payment to $0.67 per share in 2014, compared with the previous $0.62 quarterly dividend rate in 2013. We expect to continue the practice of paying regular cash dividends. Issuances of debt in the first six months of 2014 and 2013 consisted primarily of commercial paper. Repayments of debt in 2014 consisted primarily of the $1.0 billion 3.875% senior notes that matured in April 2014, while repayments in 2013 consisted primarily of the $1.75 billion 4.5% senior notes that matured in January 2013. We consider the overall fixed and floating interest rate mix of our portfolio and the related overall cost of borrowing when planning for future issuances and non-scheduled repayments of debt. 47-------------------------------------------------------------------------------- Table of Contents UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The cash outflows in other financing activities were primarily due to premiums paid and received on capped call options for the purchase of UPS class B shares, the purchase of noncontrolling interests, and tax withholdings on vested employee stock awards. We received (paid) net premiums of $102 and ($399) million during the first six months of 2014 and 2013, respectively, related to entering into and settling capped call options for the purchase of class B shares. We paid $70 million in 2013 to purchase the noncontrolling interest in a joint venture that operates in the Middle East, Turkey and portions of the Central Asia region. Cash paid to settle the tax withholdings on vested employee stock awards was $154 and $138 million during the first six months of 2014 and 2013, respectively. Sources of Credit We are authorized to borrow up to $10.0 billion under the U.S. commercial paper program we maintain. We had $1.860 billion outstanding under this program as of June 30, 2014, with an average interest rate of 0.10%. We also maintain a European commercial paper program under which we are authorized to borrow up to €5.0 billion in a variety of currencies. As of June 30, 2014, there were no amounts outstanding under this program. We maintain two credit agreements with a consortium of banks. One of these agreements provides revolving credit facilities of $1.5 billion, and expires on March 27, 2015. Generally, amounts outstanding under this facility bear interest at a periodic fixed rate equal to LIBOR for the applicable interest period and currency denomination, plus an applicable margin. Alternatively, a fluctuating rate of interest equal to the highest of (1) JPMorgan Chase Bank's publicly announced prime rate; (2) the Federal Funds effective rate plus 0.50%; and (3) LIBOR for a one month interest period plus 1.00%, plus an applicable margin, may be used at our discretion. In each case, the applicable margin for advances bearing interest based on LIBOR is a percentage determined by quotations from Markit Group Ltd. for our 1-year credit default swap spread, subject to a minimum rate of 0.10% and a maximum rate of 0.75%. The applicable margin for advances bearing interest based on the prime rate is 1.00% below the applicable margin for LIBOR advances (but not lower than 0.00%). We are also able to request advances under this facility based on competitive bids for the applicable interest rate. There were no amounts outstanding under this facility as of June 30, 2014. The second agreement provides revolving credit facilities of $1.0 billion, and expires on March 28, 2019. Generally, amounts outstanding under this facility bear interest at a periodic fixed rate equal to LIBOR for the applicable interest period and currency denomination, plus an applicable margin. Alternatively, a fluctuating rate of interest equal to the highest of (1) JPMorgan Chase Bank's publicly announced prime rate; (2) the Federal Funds effective rate plus 0.50%; and (3) LIBOR for a one month interest period plus 1.00%, plus an applicable margin, may be used at our discretion. In each case, the applicable margin for advances bearing interest based on LIBOR is a percentage determined by quotations from Markit Group Ltd. for our credit default swap spread, interpolated for a period from the date of determination of such credit default swap spread in connection with a new interest period until the latest maturity date of this facility then in effect (but not less than a period of one year). The minimum applicable margin rate is 0.10% and the maximum applicable margin rate is 0.75% per annum. The applicable margin for advances bearing interest based on the prime rate is 1.00% below the applicable margin for LIBOR advances (but not less than 0.00%). We are also able to request advances under this facility based on competitive bids. There were no amounts outstanding under this facility as of June 30, 2014. Our Moody's and Standard & Poor's short-term credit ratings are P-1 and A-1, respectively. Our Moody's and Standard & Poor's long-term credit ratings are Aa3 and A+, respectively. We currently have a negative outlook from Standard & Poor's and a stable outlook from Moody's. Our existing debt instruments and credit facilities subject us to certain financial covenants. As of June 30, 2014 and for all prior periods, we have satisfied these financial covenants. These covenants limit the amount of secured indebtedness that we may incur, and limit the amount of attributable debt in sale-leaseback transactions, to 10% of net tangible assets. As of June 30, 2014, 10% of net tangible assets was equivalent to $2.349 billion; however, we have no covered sale-leaseback transactions or secured indebtedness outstanding. We do not expect these covenants to have a material impact on our financial condition or liquidity. Except as described in this quarterly report, the nature and amounts of our payment obligations under our debt, capital and operating lease agreements, purchase commitments, and other liabilities as of June 30, 2014 have not materially changed from those described in our Annual Report on Form 10-K for the year ended December 31, 2013. We believe that funds from operations and borrowing programs will provide adequate sources of liquidity and capital resources to meet our expected long-term needs for the operation of our business, including anticipated capital expenditures, for the foreseeable future. 48-------------------------------------------------------------------------------- Table of Contents UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Guarantees and Other Off-Balance Sheet Arrangements We do not have guarantees or other off-balance sheet financing arrangements, including variable interest entities, which we believe could have a material impact on our financial condition or liquidity. Contingencies We are involved in a number of judicial proceedings and other matters arising from the conduct of our business activities. Although there can be no assurance as to the ultimate outcome, we have generally denied, or believe we have a meritorious defense and will deny, liability in all litigation pending against us, including (except as otherwise noted herein) the matters described below, and we intend to defend vigorously each case. We have accrued for legal claims when, and to the extent that, amounts associated with the claims become probable and can be reasonably estimated. The actual costs of resolving legal claims may be substantially higher or lower than the amounts accrued for those claims. For those matters as to which we are not able to estimate a possible loss or range of loss, we are not able to determine whether the loss will have a material adverse effect on our business, financial condition or results of operations or liquidity. For matters in this category, we have indicated in the descriptions that follow the reasons that we are unable to estimate the possible loss or range of loss. Judicial Proceedings We are a defendant in a number of lawsuits filed in state and federal courts containing various class action allegations under state wage-and-hour laws. At this time, we do not believe that any loss associated with these matters would have a material adverse effect on our financial condition, results of operations or liquidity. UPS and our subsidiary Mail Boxes Etc., Inc. are defendants in a lawsuit in California Superior Court about the rebranding of The UPS Store franchises. In the Morgate case, the plaintiffs are (1) 125 individual franchisees who did not rebrand to The UPS Store; and (2) a certified class of all franchisees who did rebrand. With respect to the 125 individual franchisees described in (1) above, the trial court entered judgment against a bellwether individual plaintiff, which was affirmed in January 2012. In March 2013, we reached a settlement with the remaining individual plaintiffs who did not rebrand; this settlement did not have a material adverse effect on our financial condition, results of operations or liquidity. The trial court granted our motion for summary judgment against the certified class described in (2) above, which was reversed in January 2012. We have not reached a settlement with this class of franchisees, and the claims of the class remain pending. The trial is scheduled for February 2015. There are multiple factors that prevent us from being able to estimate the amount of loss, if any, that may result from the remaining aspects of this case, including: (1) we are vigorously defending ourselves and believe we have a number of meritorious legal defenses; and (2) it remains uncertain what evidence of damages, if any, plaintiffs will be able to present. Accordingly, at this time, we are not able to estimate a possible loss or range of loss that may result from this matter or to determine whether such loss, if any, would have a material adverse effect on our financial condition, results of operations or liquidity. In AFMS LLC v. UPS and FedEx Corporation, a lawsuit filed in federal court in the Central District of California in August 2010, the plaintiff asserts that UPS and FedEx violated U.S. antitrust law by conspiring to refuse to negotiate with third-party negotiators retained by shippers and by individually imposing policies that prevent shippers from using such negotiators. UPS and FedEx have moved for summary judgment. There has been no ruling on those motions. The case does not have a trial date scheduled. The Antitrust Division of the U.S. Department of Justice ("DOJ") has an ongoing civil investigation of our policies and practices for dealing with third-party negotiators. We are cooperating with this investigation. We deny any liability with respect to these matters and intend to vigorously defend ourselves. There are multiple factors that prevent us from being able to estimate the amount of loss, if any, that may result from these matters including: (1) we believe that we have a number of meritorious defenses; (2) the Court has not ruled on the pending dispositive motions; and (3) the DOJ investigation is pending. Accordingly, at this time, we are not able to estimate a possible loss or range of loss that may result from these matters or to determine whether such loss, if any, would have a material adverse effect on our financial condition, results of operations or liquidity. 49-------------------------------------------------------------------------------- Table of Contents UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS In Canada, four purported class-action cases were filed against us in British Columbia (2006); Ontario (2007) and Québec (2006 and 2013). The cases each allege inadequate disclosure concerning the existence and cost of brokerage services provided by us under applicable provincial consumer protection legislation and infringement of interest restriction provisions under the Criminal Code of Canada. The British Columbia class action was declared inappropriate for certification and dismissed by the trial judge. That decision was upheld by the British Columbia Court of Appeal in March 2010, which ended the case in our favor. The Ontario class action was certified in September 2011. Partial summary judgment was granted to us and the plaintiffs by the Ontario motions court. The complaint under the Criminal Code was dismissed. No appeal is being taken from that decision. The allegations of inadequate disclosure were granted and we are appealing that decision. The motion to authorize the 2006 Québec litigation as a class action was dismissed by the motions judge in October 2012; there was no appeal, which ended that case in our favor. The 2013 Québec litigation also has been dismissed. We deny all liability and are vigorously defending the one outstanding case in Ontario. There are multiple factors that prevent us from being able to estimate the amount of loss, if any, that may result from this matter, including: (1) we are vigorously defending ourselves and believe that we have a number of meritorious legal defenses; and (2) there are unresolved questions of law and fact that could be important to the ultimate resolution of this matter. Accordingly, at this time, we are not able to estimate a possible loss or range of loss that may result from this matter or to determine whether such loss, if any, would have a material adverse effect on our financial condition, results of operations or liquidity. Other Matters On March 29, 2013, we entered into a Non-Prosecution Agreement ("NPA") with the United States Attorney's Office in the Northern District of California in connection with an investigation by the Drug Enforcement Administration of shipments by illicit online pharmacies. Under the NPA, we forfeited $40 million to the government, admitted to a Statement of Facts describing the conduct leading to the agreement, and agreed to implement an online pharmacy compliance program. The term of the NPA is two years. We have petitioned the government to shorten that term in its discretion to a lesser period pursuant to the terms of the NPA. The NPA did not have a material impact on our financial condition, results of operations or liquidity in 2013. In August 2010, competition authorities in Brazil opened an administrative proceeding to investigate alleged anticompetitive behavior in the freight forwarding industry. Approximately 45 freight forwarding companies and individuals are named in the proceeding, including UPS, UPS SCS Transportes (Brasil) S.A., and a former employee in Brazil. UPS submitted its written defenses to these allegations in April 2014. In November 2012, the Commerce Commission of Singapore initiated an investigation with respect to similar matters. We are cooperating with each of these investigations, and intend to continue to vigorously defend ourselves. There are multiple factors that prevent us from being able to estimate the amount of loss, if any, that may result from these matters including: (1) we are vigorously defending each matter and believe that we have a number of meritorious legal defenses; (2) there are unresolved questions of law that could be of importance to the ultimate resolutions of these matters, including the calculation of any potential fine; and (3) there is uncertainty about the time period that is the subject of the investigations. Accordingly, at this time, we are not able to estimate a possible loss or range of loss that may result from these matters or to determine whether such loss, if any, would have a material adverse effect on our financial condition, results of operations or liquidity. In January 2008, a class action complaint was filed in the United States District Court for the Eastern District of New York alleging price-fixing activities relating to the provision of freight forwarding services. UPS was not named in this case. In July 2009, the plaintiffs filed a First Amended Complaint naming numerous global freight forwarders as defendants. UPS and UPS Supply Chain Solutions are among the 60 defendants named in the amended complaint. The plaintiffs filed a Second Amended Complaint in October 2010, which we moved to dismiss. In August 2012, the Court granted our motion to dismiss all claims relevant to UPS in the Second Amended Complaint, with leave to amend. The plaintiffs filed a Third Amended Complaint in November 2012. We filed another motion to dismiss. In January 2014, the Court dismissed UPS from one of the claims in the Third Amended Complaint with prejudice, but denied UPS's motion to dismiss with respect to the other claims asserted against UPS. In June 2014, UPS entered into an agreement in principle with the plaintiffs to settle the remaining claims asserted against UPS for an immaterial amount. This agreement in principle is subject to the negotiation of final settlement documents and court approval of the settlement. 50-------------------------------------------------------------------------------- Table of Contents UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS In January 2014, we received a Civil Investigative Demand from the Department of Justice seeking documents related to possible violations of the False Claims Act ("FCA") in connection with delivery services provided to government customers where guaranteed commitment times allegedly were not met. The General Services Administration - Office of Inspector General had previously sought similar documents. We have been contacted by several states requesting similar information. The Company has been cooperating with these inquiries. It is not possible to predict the potential outcome of these matters at this stage, or to reasonably estimate the range or amount of possible loss, if any, that may result from these investigations based on a number of factors, including: (1) the investigations are not complete; (2) these matters are at an early stage and there are unresolved questions of law and fact that could be of importance to the ultimate resolution of these matters; (3) the scope and size of potentially affected government customers and the time period covered by potential claims remains uncertain; and (4) our current intention to vigorously defend any claims of FCA violations. Accordingly, at this time, we are not able to estimate a possible loss or range of loss that may result from these matters or to determine whether such loss, if any, would have a material adverse effect on our financial condition, results of operations or liquidity. We are a defendant in various other lawsuits that arose in the normal course of business. We do not believe that the eventual resolution of these other lawsuits (either individually or in the aggregate), including any reasonably possible losses in excess of current accruals, will have a material adverse effect on our financial condition, results of operations or liquidity. Collective Bargaining Agreements Status of Collective Bargaining Agreements As of December 31, 2013, we had approximately 253,000 employees employed under a national master agreement and various supplemental agreements with local unions affiliated with the International Brotherhood of Teamsters ("Teamsters"). These agreements ran through July 31, 2013, but had been indefinitely extended pending the ratification of a new agreement with the Teamsters. On April 24, 2014, the Teamsters ratified a new national master agreement with UPS that will expire on July 31, 2018 (discussed further below). We have approximately 2,600 pilots who are employed under a collective bargaining agreement with the Independent Pilots Association ("IPA"), which became amendable at the end of 2011. In February 2014, UPS and the IPA requested mediation by the National Mediation Board for the ongoing contract negotiations. Our airline mechanics are covered by a collective bargaining agreement with Teamsters Local 2727, which became amendable November 1, 2013. In addition, approximately 3,100 of our auto and maintenance mechanics who are not employed under agreements with the Teamsters are employed under collective bargaining agreements with the International Association of Machinists and Aerospace Workers ("IAM"). Our previous agreements with the IAM ran through July 31, 2014; on July 28, 2014, the IAM ratified new collective bargaining agreements that will expire on July 31, 2019. Ratification of New Collective Bargaining Agreements On April 24, 2014, the Teamsters ratified a new national master agreement ("NMA") with UPS that will expire on July 31, 2018. The UPS Freight business unit ratified its national master agreement in January 2014. The economic provisions in the NMA include wage rate increases, as well as increased contribution rates for healthcare and pension benefits. Most of these economic provisions are retroactive to August 1, 2013, which is the effective date of the NMA. In the second quarter of 2014, we remitted $278 million for these retroactive economic benefits; this payment had an immaterial impact on net income, as these retroactive economic benefits had been accrued since the July 31, 2013 expiration of the prior agreement. In addition to the retroactive economic provisions of the NMA, there are certain changes to the delivery of healthcare benefits that are effective at various dates. These changes impact approximately 36,000 full-time and 73,000 part-time active employees covered by the NMA and the UPS Freight collective bargaining agreement (collectively referred to as the "NMA Group"), as well as approximately 16,000 employees covered by other collective bargaining agreements (the "Non-NMA Group"). These provisions are discussed further below. 51-------------------------------------------------------------------------------- Table of Contents UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Changes to the Delivery of Active and Postretirement Healthcare Benefits Prior to ratification, the NMA Group and Non-NMA Group employees received their healthcare benefits through UPS-sponsored active and postretirement health and welfare benefit plans. Effective June 1, 2014, we ceased providing healthcare benefits to active NMA Group employees through these UPS-sponsored benefit plans, and the responsibility for providing healthcare benefits for active employees was assumed by three separate multiemployer healthcare funds (the "Funds"). The responsibility for providing healthcare benefits for the active Non-NMA Group employees will also be assumed by the Funds on dates ranging from October 1, 2014 through January 1, 2015, depending on the ratification date of the applicable collective bargaining agreement. We will make contributions to the Funds based on negotiated fixed hourly or monthly contribution rates for the duration of the NMA and other applicable collective bargaining agreements. Additionally, the Funds assumed the obligation to provide postretirement healthcare benefits to the employees in the NMA Group who retire on or after January 1, 2014. The postretirement healthcare benefit obligation for the employees in the Non-NMA Group will be assumed by the Funds for employees retiring on or after January 1, 2014 or January 1, 2015, depending on the applicable collective bargaining agreement. In exchange for the assumption of the obligation to provide postretirement healthcare benefits to the NMA Group and Non-NMA Group, we transferred cash totaling $2.271 billion to the Funds in the second quarter of 2014. UPS-sponsored health and welfare benefit plans retained responsibility for providing postretirement healthcare coverage for employees in the NMA Group who retired from UPS prior to January 1, 2014, and for employees in the Non-NMA Group who retire from UPS prior to the January 1, 2014 or January 1, 2015 effective date in the applicable collective bargaining agreement. Accounting Impact of Health and Welfare Plan Changes Second Quarter 2014 - Income Statement Impact: We recorded a pre-tax charge of $1.066 billion ($665 million after-tax) in the second quarter of 2014 for the health and welfare plan changes described above. The components of this charge, which was included in "Compensation and benefits" expense on the statement of consolidated income, are as follows: • Partial Plan Curtailment: We recorded a $112 million pre-tax curtailment loss due to the elimination of future service benefit accruals. This curtailment loss represents the accelerated recognition of unamortized prior service costs. • Remeasurement of Postretirement Obligation: We recorded a $746 million pre-tax loss due to the remeasurement of the postretirement benefit obligations of the affected UPS-sponsored health and welfare benefit plans. • Settlement: We recorded a $208 million pre-tax settlement loss, which represents the recognition of unamortized actuarial losses associated with the postretirement obligation for the NMA Group. Second Quarter 2014 - Balance Sheet and Cash Flow Impact: During the second quarter of 2014, we transferred cash totaling $2.271 billion to the Funds for the assumption of the postretirement healthcare benefit obligations. Of this cash transfer amount, $1.995 billion was accounted for as a settlement of our postretirement obligation for the NMA Group, while the remaining $276 million was accounted for as a prepaid deposit asset (recorded in "Other Current Assets" on the consolidated balance sheets) until the ratification of the collective bargaining agreements covering the Non-NMA Group. We have received approximately $375 million of cash tax benefits (through reduced U.S. Federal and state quarterly income tax payments) as of June 30, 2014, and we anticipate receiving the remaining cash tax benefits of approximately $479 million resulting from these payments over the remainder of 2014. For NMA Group employees who retired prior to January 1, 2014 and remain with the UPS-sponsored health and welfare plans, the changes to the contributions, benefits and cost sharing provisions in these plans resulted in an increase in the postretirement benefit obligation, and a corresponding decrease in pre-tax accumulated other comprehensive income, of $13 million upon ratification. After the remeasurement and settlement of the obligation for the NMA Group, the total postretirement medical benefit obligation was reduced by $858 million from $3.691 billion at December 31, 2013 to $2.833 billion at June 30, 2014. 52-------------------------------------------------------------------------------- Table of Contents UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Remainder of 2014: Upon ratification of the collective bargaining agreements covering the Non-NMA Group, we plan to record a pre-tax charge of approximately $31 million for the remeasurement and settlement of the postretirement obligation associated with these employees. At the same time, the $276 million prepaid deposit asset, described previously, will be used to settle the postretirement benefit obligation for the Non-NMA Group. We anticipate the ratification of these agreements covering the Non-NMA Group will occur prior to December 31, 2014. Based on the anticipated expense and contribution levels for the remainder of 2014, in addition to the remeasurement and settlement of the obligations, we expect that the total postretirement medical benefit obligation will be reduced by approximately $1.094 billion from $3.691 billion at December 31, 2013 to approximately $2.597 billion at December 31, 2014. The accounting charges and other amounts described above are estimates based on actuarial valuation assumptions, and will be updated as necessary for any changes in discount rates, final collective bargaining agreement details and similar factors for the Non-NMA Group. Anticipated Benefits of Health and Welfare Plan Changes We believe we have obtained several benefits as a result of these health and welfare plan changes, including: |