Keith Schoonmaker: Hello. I'm Keith Schoonmaker, Morningstar's Transportation Analyst. We are here today with Mike Jones with Investor Relations of UPS. Mike thanks for coming.
Mike Jones: It's my pleasure to be here, Keith.
Schoonmaker: At Morningstar, we look for companies that have the ability to persistently out earn their cost to capital for years to come. We consider these economic moats. Wide-moat UPS has earned nearly double its cost to capital for years in the past. The firm's competitive advantage is principally its barriers to entry, which are staggering from its massive network of trucks, aircrafts, sorting facilities, information technology and know how.
I'd like to hear from Mike a little bit about how the company has evolved over the years. Mike, as we're entering the 103rd year of UPS operations, what can you tell me about the Company at this point in its life?
Jones: Yeah. As you say, Keith, we have been around for over 100 years now, and I think that really is a big contributor to it. If you look at the network that we've built, we are constantly focused on improving the operational efficiencies within our network. And you look at the other things as we continue to reinvent ourselves. And I think that's the most exciting thing of working at UPS. I have been here for over 20 years and that's really the exciting things we continue to reinvent ourselves.
For example, when we opened up and started to do business in Europe in the mid-'70s, built out our airline, became a largest airlines in the world in the mid-'80s and we just continued to go from there and really start to build out into other transportation modes including distribution, logistics, freight forwarding, ocean, air, trucks. So, again, that's one of the exciting things. As we continue to do that, that really enables us to continue to generate these operating margins and returns that are well in excess of our cost to capital.
Schoonmaker: Mike, I've heard the CEO, Scott Davis, say all freight onboard, an expression he has used before, and as you mentioned, the company now has not only expressed in ground, but has entered other avenues like logistics.
We at Morningstar are big fans of logistics models since these are very asset-light businesses in general and produce sky high returns on invested capital, sort of the opposite end of the spectrum where we would traditionally think of an airline operating. UPS's current ad campaign emphasizes this aspect of the company. Can you tell me more about why the company is placing such an emphasis on logistics?
Jones: Yeah. We are. It really goes back to a few things when you look at it, in all products onboard, or packages onboard that Scott likes to talk about. I think when you think about that, that gives you more of that economies of scale. But then when you start to think about logistics and really how that expands out, that starts to drive the economies of scope, and again, those are the things that continue to allow us to drive the high returns that we come to expect.
So when we look at logistics, we did launch our new brand campaign and that's our first one that's actually a global advertising campaign that we've had, it talks about logistics. And really what it is, is to start to get customers of all sizes to think about logistics. I think the typical thing that investors and companies would think of it first is, is warehousing when you think of logistics.
But if you think about it and step back, logistics really begins at manufacturing and actually can continue beyond post sales. So for example, like a company like Toshiba, where we actually helped them with their laptop returns, so from a supply chain perspective, we've been able to go in and really reduce their overall cost to be able to provide excellent service to their customers. And that's the way that we really focus on distribution and logistics as just a part of this broader portfolio.
Schoonmaker: These supply chain solutions you mentioned is a little bit different than the way most consumers would consider UPS. We on the street know UPS for the ubiquitous presence of brown trucks, they simply blink at the streets of Chicago here, you can't miss a UPS truck on any street. So has tremendous network density in this area, but how material is the logistics operation for UPS and I am thinking just of the supply chain. You've mentioned that basically UPS is all logistics company, all of the parcel handling can be considered logistics. But in just supply chain sort of efforts, what sort of portion of the business is this?
Jones: We've started to really focus on as we really have built out our distribution and logistics capability. It's been a controlled growth environment and that's been our strategy as we've gone forward. Because when you look at distribution and logistics we didn't want to go in and be all things to everybody because we still want to make sure we continue to generate the returns that we expect.
It is typically an asset – more asset-light than the traditional transportation when you think about it. But we are able to really start to generate higher and higher margins, especially compared to our other customers. We've seen our distribution and logistics group through this controlled growth environment. As we bring customers in we ensure that each customer hits a certain return level. It has continued to grow. So as we look at it, supply chain and freight part of our business, which is what distribution and logistics continues roll up under, has just grown over the past 10 years.
We've probably made 40 plus acquisitions that roll up under the supply chain and freight, and that gives us those capabilities. But as we look at distribution and logistics, I mean that really excite us because we start to see the margins actually approaching the high single digits. Which again, as you look at other people that are pure logistics plays, they don't have margins near that.
Schoonmaker: Yeah. That's almost doubled, yeah, double…
Jones: So that's why it goes back to the controlled growth. It goes to focusing on key verticals. So we focus on health care, we focus on high-tech and retail as well. But really, if you look at where the growth is coming from, that's really in health care and high-tech.
Schoonmaker: I understand that UPS makes a tremendous investment every year in information technology. Can you give me an idea of the scope of this, and also some of the fruits of this type of investment? Is this kind of investment required indefinitely into the future?
Jones: When you look at it – I mean, if we go back over at least the last 10 years, we've invested $1 billion or more in technology related expenditures. Because one of the things is when you look at it, one, it continues to raise the level of acceptance for customers, both here in the U.S. and around the world. That's one of the keys that enable us to continue to have that wide moat because we continue to push basically the level of acceptance and the bar higher for other competitors. That again raises another barrier of entry, but we also invest for operational efficiencies.
In fact, if you go back over the years, we probably started investing more from an operational perspective because, again, we are so operations-focused when we look at efficiencies, but then we learned that customers is worth something to them, they know where their packages are at all time to give this complete inbound-outbound visibility. So from that we started to really develop our customer-related tools.
Is it required as we go forward? Yeah. We believe that's a key part of our industry is that we want to continue to push the bar, and the fortunate thing is as well as we look at some of the other competitors, the larger competitors, they do as well. They want to continue to push that because as we look at a global market, it's so very fragmented, but as we do that it will become more and more concentrated.
Schoonmaker: Mike, I think when I send a package by UPS, I am not getting the best, absolute best price UPS might offer to some of its major customers, and I don't deserve it, I am only shipping one package. A lot of corporations are going to be sending dozens and hundreds or even thousands of packages every day. Can you tell me about the mix of B2B versus B2C in the UPS, both domestic network, for example. And how is it important that UPS can ship products for both of these types of sender, both B2B and B2C?
Jones: Yeah. When we look at our B2B and B2C mix, it has changed over the years, of course, with really the proliferation of online retail, online shipping. Everyone – every traditional retailer almost now has an online arm and you've seen the expansion of other just pure e-tailers. So that's driven this B2C growth that we've seen. Right now our business is somewhere around probably 33% to 35% of our volumes here in the U.S.
Our B2C, of course, the remainder would be B2B. But really when you look at it, it's serving two different type of customers when you look at it. A B2C, when you look at it typically from a deliver density perspective, it's going to be – it's rare that when I get packages at my house that I get two or three packages, it usually just one package. But what you see is hopefully that there will be one or two houses on my block that get a package. So you see those type of densities that occur. But on the B2B, that really hits our sweet spot because of the fact, as you say, our UPS package cars are everywhere that you see them, and there is a good chance that every business in the U.S. will probably go right by it, or stop there already.
So, if I'm a driver and I'm delivering four packages and now you get that fifth package, there is significant incremental margins associated with that because that delivery piece is one of the highest cost components, so that's really our sweet spot. So when we see that B2B growth that really drives margin expansion.
Schoonmaker: Historically, UPS had a very high credit rating. The firm made some use of debt in order to pay off the pension obligation to exit and move into a better plan for the central states employees. Can you tell me about the Company's long-term target structure, just casually is it a company plan to continue to use debt or return more to the historical model of leverage?
Jones: Yeah. As you know, Keith, a couple of years ago, we rolled out a new metric, which is our funds from operations to total debt. We had targeted that we want to be somewhere in the 50% to 60%. Last year, we ended about 58%. So we are right within that range because we were AAA and we wanted to lever up and have a little more efficient balance sheet. So we went to this new metric because it gives us some guide rails and that's how we look at those as guide rails.
We still are AA in the AA category, AA minus rating, so still very high quality. So we continue to use debt, both short term and over the past couple of years we've had some longer term debt issuances. But you're right, with the very cheap debt that is available, it does open up some interesting scenarios, and those are the things that our treasury group continues to look at to see other opportunities to take advantage of that. But as far as going back to where we were before, we don't really see that. We really continue to expect to manage our balance sheet based off this FFO to debt metric.
Schoonmaker: Yeah. Especially if the debt is so cheap these days, it makes sense. I think of the Asian market as being highly fragmented with many shippers loyal to their domestic provider or even a national provider like a national post office that belongs to the country in which they live. Has the Asian market been more difficult to penetrate for service within countries? How important is Asia to UPS as a whole?
Jones: Asia is very important to us because when you look at the growth and just the potential capabilities. I mean just look at China, 1 billion plus people and the size of their middle class can even grow to 1 million. I guess expectations are as you look out over the next 10 to 15 years, it's expected to grow to that magnitude. So when you look at that, I mean it's definitely, Asia as a whole is a very important market to us.
But you're right, I mean, when you start to look at actually competing in the domestic markets within those countries, it's more challenging. One, it goes back to the fact that we continue to push the level of acceptance higher and what customers expect higher will – and allow these more emerging and developing markets, the level of acceptance is very low, so yields are going to be low. You're going to be competing with a carrier that is not focused on returns on invested capital.
Schoonmaker: Fewer premium products too I think.
Jones: Exactly. So, when you look at the market that you're focusing, so typically what we'll do is we go into those markets, we hit the more express end, like you're saying. So, we'll hit the express end and then start to build that out as we go forward. When we open up a new market, we'll come in, start to focus on import-export and then you start to build out the infrastructure, still supporting import-export. You will start a relationship with an agent or local player, maybe it's a joint venture or some type of affiliation and then start to build that relationship and then we may make the next step of making an acquisition there or actually doing an organic.
Again, we don't use the same approach in all countries, but the challenge as we go forward is really in these truly emerging markets how do we go in and still continue to generate a good return even when yields are low and even when the level of what the customer expects is somewhat low.
For example, like a trackpad technolofy, to go in and have complete visibility, you're not going to be rewarded for that in every market. So those are things that we're looking at is how do we start to maybe pair back on some of the technology that we might put in this. So, as you're well familiar with our DIAD that our drivers have that they can come in and our electronic clipboard, we may not be rewarded for that type of technology in a more emerging market, so we go to cell phone technology, something like that. Those are the things that we're working on as we go forward.
Schoonmaker: I see. Mike thanks a lot for joining us today.
Jones: My pleasure.
Schoonmaker: Thanks for watching. I'm Keith Schoonmaker with Morningstar.