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Operator
Good morning; my name is Melissa and I'll be your conference facilitator today.
At this time I would like to welcome everyone to the UPS Investor Relations fourth-quarter 2006 earnings conference call.
All lines have been placed on mute to prevent any background noise.
After the speakers' remarks there will be a question-and-answer period league.
Please note that we will take one question and one follow-up question from each participant. (OPERATOR INSTRUCTIONS).
It is now my pleasure to turn the floor over to your host, Ms. Teresa Finley, Vice President of Investor Relations.
Ma'am, the floor is yours.
Teresa Finley - VP, IR
Good morning, everyone.
In a moment Mike Eskew, our CEO, will share some comments on the most recent quarter, 2006 and some thoughts on 2007.
Then Scott Davis, our Chief Financial Officer, will discuss fourth-quarter segment details and comment on our expectations going forward.
Before I turn the call over to them there are a couple of topics I want to bring to your attention.
UPS adopted FAS 158, accounting for defined benefit pension, and other post retirement plans at year-end 2006.
The standard requires that the funded status of defined benefits and other post retirement plans be shown on the balance sheet rather than represented in footnotes as was the practice in the past.
This has resulted in changes to pension and postretirement benefits, assets and obligations, deferred taxes and shareowner's equity.
Keep in mind, this affects only the balance sheet.
A full description of these changes will be included in our 2006 Form 10-K.
I also want to provide an update on progress with the special voluntary separation opportunity which we offered last quarter to corporate employees.
The registration period for this program is just wrapping up, therefore it's too early to quantify cost or benefit neither of which is built into our guidance for the year.
We anticipate issuing an 8-K in a couple of weeks on the result and will update guidance then if there's any impact.
Now for the Safe Harbor language.
Some of the comments we'll make today are forward-looking statements that address our expectations for the future performance or results of operations of the Company.
These anticipated results are subject to risks and uncertainties which are described in detail in our 2006 Form 10-K and 10-Q reports which are available on the UPS Investor Relations website or from the Securities and Exchange Commission.
Additionally, this conference call is being webcast and will be available on our Investor Relations website.
It's my pleasure now to turn the program over to Mike.
Mike Eskew - Chairman, CEO
Good morning, everyone; thanks for joining us today.
We had a very good fourth quarter, meeting our expectations in almost all areas despite a slowing U.S. economy.
Let me begin with our peak season in the U.S.
The economy caused volume growth to moderate a bit more than we had expected.
However our execution was out standing.
I want to congratulate our people across the globe for a job well done in a very challenging operating period.
Just a few years ago our peak ran from Thanksgiving to Christmas with relatively steady volume through this entire period.
The ongoing trend toward more online shopping is compressing the holiday shipping season.
For the two weeks before Christmas we experienced seven days with volumes exceeding 20 million packages, now two of those days we handled more than 22 million packages.
Superb execution in our operations was necessary to handle so many packages in such a short time and our people performed very well.
Overall 2006 was a very good year for UPS.
We reported the highest revenue, operating profit and earnings per share in our history.
This was a reflection of the strong performance of our small package operations around the world.
Total small package volume at nearly 4 billion packages and letters was also a record.
This translates into almost 15.6 million packages every day.
Let's take a look at what we said 2006 would bring and how we actually performed.
We said that the domestic market would grow faster than GDP and our share would grow at market rates.
We estimate the market did grow faster than GDP and UPS grew even faster than that.
We said that the UPS international export volume would grow at double-digit rates and it did.
We said the global pricing environment would remain rational, which it did.
And our consolidated small package revenue per piece would be in line with its historic average, it was at a 2.7% increase.
We said we intended to balance market growth and margins, which we accomplished.
Record operating profit in our combined U.S. and international small package business produced a record operating margin of 16.8% for the year.
Certainly the global small package business experienced a very strong year in 2006.
I wish I could paint a similar picture for all areas of our business, but unfortunately I can't.
We said that we would double profits in our supply chain and print segment, but we fell short. 2006 was a year of challenging integration in this unit; we learned a lot and we have more work to do.
However, despite the challenges for the full year we came in within the earnings range we established more than a year ago, achieving an 11.2% growth for 2006, or record earnings of $3.86 per share.
Looking at 2007 we anticipate the global small package market will expand moderately.
U.S. economic growth is expected to be in the low to mid 2% range this year, about a percent less than 2006.
Industrial production grew about 4% in 2006 and consensus estimates call for a 2.6% expansion in 2007.
World trade should remain strong supporting a robust international small package market.
We expect the supply chain and freight segment to turn the corner on profitability this year with performance picking up in the second half of the year.
As a result for 2007 we anticipate earnings will improve in the range of 6 to 10% or $4.10 to $4.25 per share.
We remain bullish about overall global dynamics and still expect to achieve the long-term targets for 2010 that we shared with you at our investors' conference last November.
With excellent service, broad portfolio, unique business model and the best people in the industry UPS will continue to provide our customers with innovative solutions that enable global commerce.
Now for comments on business segment performance for the fourth quarter and some more insight into our 2007 expectations I'll turn the program over to Scott.
Scott Davis - CFO, Vice Chairman
Thanks, Mike.
We're pleased with the fourth-quarter performance of our global small package business.
UPS faced a tough comparison with the fourth quarter in 2005 when we achieved an 8% increase in total worldwide small package volume.
In the domestic operation volume growth moderated a bit due to the slowing U.S. economy.
Ground volume increased by the same 3.6% as in the third quarter, but Next Day Air was up 1% and deferred volume was flat for the quarter, somewhat below our expectations.
The decline in volume in our higher margin next day products resulted in some pressure on profits and operating margin.
Revenue per piece showed strength again in the quarter.
In fact, ground revenue per piece increased nearly 2% with no benefit from fuel surcharge.
All in all we operated well in the U.S. during the quarter and improved margins over last year by 10 basis points.
In the international operations quarterly operating profit exceeded $0.5 billion for the first time ever.
This business posted an 11% gain in export volume with double-digit growth in Europe, Asia and U.S. export.
Non-U.S. domestic volume growth returned to more normal trends of 4% as we overlapped the LYNX acquisition in the quarter.
International revenue per piece, adjusted for currency, was down slightly due to the continued mix shift in the export products.
Our integrated model in Europe is performing extremely well; the transporter business is growing and continues to create leverage in our network there.
Operating profit in international segment increased over 19% and operating margin was outstanding at 21%, a 160 basis point gain.
Turning now to supply chain and freight.
This segment reached breakeven in profitability, as we had expected it would.
The LTL operation experienced declines in revenue during the quarter due to a general slowing in the LTL market.
We believe the improvements we've undertaken over the course of 2006 helped mitigate the impact of that declining market on our operations.
The forwarding and logistics business improved from the third quarter.
Non operating cost reductions are on track; over 90% of the planned 1200 person reduction has been completed at an expense of a little over $10 million in the quarter.
The remaining reductions will occur this year.
Before I get to our outlook for 2007 I want to summarize UPS' financial position at year-end.
Strong cash generation remains a defining characteristic of the Company.
UPS continued to generate exceptional cash flow from operations, $5.7 billion for the year.
Our CapEx for 2006 totaled $3.1 billion.
We paid $1.6 billion in dividends and spent $2.5 billion to repurchase shares.
In 2006 UPS repurchased 32.6 million shares reducing shares outstanding by 2.5%.
And we had $940 million authorized for additional share repurchase as of year-end.
UPS' return on invested capital increased to 21.9%.
Clearly 2006 was another year in which we generated excellent economic profit.
Turning now to our outlook for this year.
The U.S. small package business tends to perform slightly better than the economy.
Therefore we expect growth in U.S. domestic volume of about 2.5 to 3% in 2007.
We also expect some margin pressure from a declining mix of air products.
The air market saw above trend volume growth during 2005 and in the first half of 2006, but flattened in the second half.
This market should remain flat to slightly positive in 2007 before improving in 2008.
We expect our growth in air products to outpace market growth, as we have done in the past.
Growth in revenue per piece should remain within our historical range.
And we continue to see a firm pricing environment.
Operating margin in the domestic small package business should continue to lead the industry as we target 15% or better.
On the international front we anticipate strong growth trends will continue with about a 10% export volume gain.
In both the non-U.S. domestic and export businesses we expect a firm pricing environment.
Operating margin should improve in 2007 with operating profit growth in the mid teens.
Now for the supply chain and freight segment.
In the forwarding and logistics business our focus is on improving margins.
We are confident we'll see savings from the staff reductions and cost synergies from optimizing the airfreight network.
As for the LTL operations, we're challenged by a slowing market while we continue to invest in improving service and quality.
With our focus on the long-term these investments are necessary for us to become a leading industry player.
During the first half of the year these investments will put pressure on margins but the situation should improve in the second half as revenue increases.
We are confident that we will outperform the overall LTL market.
For 2007 we expect to achieve a 2 to 3% operating margin in the supply chain and freight segment with steadily improving performance as the year progresses.
Now a few financial metrics.
Our CapEx budget for 2007 is projected to be $3.1 billion or about 6% of revenue, similar to the last few years.
And we should have a tax rate of 36.25%.
Return on invested capital should increase again this year as we begin to see some of the benefits from our heavy airfreight and LTL acquisitions which will improve economic profit.
To summarize, 2007 will be a challenging year for the domestic operations.
We expect another great year in the international business and steady improvement in the supply chain and freight segment.
For the first quarter earnings per share should be in the range of $0.94 to $0.98 compared with the $0.89 we reported for last year's first quarter.
And remember, we achieved very strong results in that quarter.
I know we've just shared a lot of details, so you must have many questions.
Let's stop here and we'll be happy to respond.
Operator
(OPERATOR INSTRUCTIONS).
William Greene, Morgan Stanley.
William Greene - Analyst
Good morning.
I'm wondering if you can just up us understand a little bit more.
If your UPS forecast is 6 to 10%, I thought you would see more leverage from what is a very strong pricing environment.
Is it just the mix that's shifting the margins down or why aren't you kidding more leverage from price?
Scott Davis - CFO, Vice Chairman
I think that if you look at 2007 -- I really do think it's going to be primarily a mix issue.
If you look back at 2006, we had a real strong first half of the year in the express next day package market, first quarter growing almost 10% package volume and a strong second quarter.
I think as you get into 2007 with, as Mike talked about, the industrial production numbers expected to be much less than a year ago, we would expect express products to be somewhat flat first half of the year.
That's primarily driving the margin pressure on the domestic side.
You're still going to see a very good operating profit growth, good margin improvement internationally.
You're going to see margin improvement on the supply chain side of the business.
But it's primarily the premium products not growing the first half of the year that's putting pressure on domestic.
William Greene - Analyst
Okay.
And then, as a second question can you just give us an update on the Teamsters?
We saw that the kind of put out something that said, hey look, if we don't come to an agreement on health and welfare issues here in the next few weeks we're going to stop talking I think as I understood it, but can you just give us some color on that?
Mike Eskew - Chairman, CEO
Bill, we've -- our contract expires the middle of next year, but we did start negotiations and we've been with it a couple of weeks.
I think the tenure is right;
I think both parties would like to do something there and we're very optimist.
Scott Davis - CFO, Vice Chairman
And the Teamsters are actually saying that their goal would be to get done by the end of March.
We'd love to see something like that but that's an ambitious goal.
But part of that statement was the fact that their objective was to try to get these issues resolved by March of 2007 which is a year or four to five months ahead of contract expirations.
We're way ahead of where we had been in the past.
Mike Eskew - Chairman, CEO
They're at the table, we're just a little -- both parties stay at the table.
Operator
Jason Seidl, Credit Suisse.
Jason Seidl - Analyst
A couple quick ones.
When I look at the guidance for the first quarter it's about the same thing as it is for the year, 6 to 10%.
But to your own admission you have tougher comps in the first half of the year.
Are you anticipating the economy to be at pretty much steady-state growth throughout the year?
Scott Davis - CFO, Vice Chairman
I think that for us -- obviously we had the great first quarter last year with the strong express product growth.
Again, we're not a leading indicator so we rely a lot on consensus estimates.
And I think most people think the first two or three quarters this year are going to show moderate growth, low to mid 2%, and there's some hope that you'll see a little bit of improvement fourth quarter.
So as we look out to the year I would say that you'll see quarters will be pretty steady, the growth over last year with the annual guidance.
Other than the third quarter maybe a little light because of some of the workers' comp benefit we had a year ago.
Jason Seidl - Analyst
Fair enough.
As I look at the LTL portion, obviously you noted there are some challenges there.
I know you guys are rolling out more of a bundled product between LTL and package.
Does the slower market hamper your ability to bundle the product or does it actually help you in this case?
Mike Eskew - Chairman, CEO
We don't think so.
We think that overall industry, the LTL industry, is going to be slower, but we believe we'll do -- we'll outperform the industry.
And in terms of bundling that, the same customers that have been pleased with UPS service in small package are also going to be pleased with it.
Those service levels have never been higher in LTL and we're delighted.
We think we're building something special here.
Scott Davis - CFO, Vice Chairman
As we talked about at the investor conference, Jason, we spent a lot of last year making the investments, improving the technology, improving the service and really didn't start heavily selling to our customer base until fourth quarter.
So that is really I think as that customer base takes this LTL offering that's what is going to allow us to outperform the market overall.
Operator
Tom Wadewitz, JPMorgan.
Tom Wadewitz - Analyst
Good morning.
Let's see, I wanted to ask you a little bit about the cost pressures in '07.
During '06 you had a number of cost pressures that you highlighted -- I think pension was one which worked against you in terms of a discount rate; rail cost pressures were pretty meaningful.
And is that something where you see some of the cost pressures could actually abate in 2007 or are some of those cost pressures from '06 likely to continue and that perhaps works against -- limit the growth rate and is within the guidance?
Scott Davis - CFO, Vice Chairman
We certainly had the headwinds last year we talked about with the pension and rail cost.
Some of that was offset again by the worker's comp benefit that we had in the third quarter.
As we moved to 2007, rail costs are still going United Parcel, but I don't think -- not as dramatically as a year ago.
A lot of that's going to be the fuel surcharge side of things -- which also impacted our surcharge revenue for UPS.
Pension costs -- we're going to have about a 6% discount rate for 2007 versus 5.75 for 2006.
Last year the 5.75 cost us $120 million, 2007 we'll save $60 million from this discount rate change.
Tom Wadewitz - Analyst
Okay.
And then I guess if you compare 2007 to your longer-term growth range, I think you said 9 to 14% at the analyst meeting.
You're a bit below that, what do you need to be back in that range?
Is it a 3.5% GDP economy versus the 2 to 2.5 that you're talking about?
Is it a little bit less cost pressure?
What's the biggest difference in '07 versus what you believe you can do longer-term?
Mike Eskew - Chairman, CEO
I think if the economy gets back to trend growth which is probably in the low 3% area.
With industrial production growing at least at GDP, I think we're very comfortable that UPS can put up the historical numbers that we normally do.
If we grow 12 to 13% in 2008 to 2010 we'll get back to the middle of that 9 to 14% range.
We're very comfortable we can do that and historically we've averaged 13 to 14% growth over the last 30 to 40 years.
Operator
Edward Wolfe, Bear Stearns.
Edward Wolfe - Analyst
Good morning.
Just a little more visibility if you could on the guidance -- because you've given 6 to 10% EPS guidance, but we're going to have lower fuel it looks like and you just talked about a $60 million pension benefit.
Have you assumed in the back end some diversion in front of the Teamster contract or is that not in the guidance?
And if it's not, then why such below historical guidance into what feels like two real benefits, fuel and the pension?
Scott Davis - CFO, Vice Chairman
I think that fuel in general should not change the P&L very much.
In other words, we've said many times the fuel cost and the fuel surcharge revenue over a 12-month period should offset each other.
We talked about if it spikes real quickly you may have a benefit or you may have a penalty.
But over a 12-month period I don't see the lower fuel costs having a dramatic impact on the profit and loss.
So I think that that -- the biggest issue for us really is the product mix and the fact that we're not growing the next day product as dramatically as we did a year ago.
Edward Wolfe - Analyst
Have you assumed no diversion in those estimates?
Scott Davis - CFO, Vice Chairman
We're assuming no diversion in 2007.
We do not expect any diversion.
Historically we've talked about it, you start seeing it two to three months, maybe four months before that contact expiration.
Obviously we're hopeful we can get this thing resolved early in 2007, but do not expect any diversion this year.
Operator
Jordan Alliger, Deutsche Bank.
Jordan Alliger - Analyst
Competitively during the Christmas peak how do you think you guys sort of stacked up?
Were there any -- I know over time you expect to sort of grow within the market on the ground and what have you;
I'm just sort of wondering as you sort of looked out there competitively were there any changes versus what you expect to do from a long-term standpoint?
Scott Davis - CFO, Vice Chairman
No, I think that we performed very well during peak season.
I think we certainly grew the domestic product at the market levels.
The thing that happens every year as it get more compressed, as Mike talked about, you have a -- if you look back between Thanksgiving and Christmas I think we were a little disappointed with the volume levels the first couple of weeks of December.
That seemed to be -- the whole transportation industry saw a slower peak at that point in time.
The last two weeks before Christmas we saw real strong volume with seven days over 20 million pieces which made up really for the first couple of weeks.
So I think overall that we performed very well -- certainly held market for that peak season.
Jordan Alliger - Analyst
And then just implicit in sort of your supply chain outlook which I think you said 2 to 3% margin for the year, does that imply that we stay above breakeven for each of the quarters or do we dip down in the first half and then really accelerate in the back half?
Scott Davis - CFO, Vice Chairman
Are you talking about consolidated profits?
Jordan Alliger - Analyst
Yes, consolidated, yes.
Scott Davis - CFO, Vice Chairman
Supply chain and freight?
Jordan Alliger - Analyst
Yes, supply chain --
Scott Davis - CFO, Vice Chairman
I think supply chain and freight will get better as the year goes on.
We expect to be profitable every quarter.
It will get better each quarter throughout the year, but we do not expect to post any losses in supply chain and freight in any quarter in 2007.
Operator
Jon Langenfeld, Robert W. Baird.
Jon Langenfeld - Analyst
On the international side, any signs of slowing in terms of the export product out of Asia or Europe?
Scott Davis - CFO, Vice Chairman
Obviously by the numbers you saw in the fourth quarter we're continually posing very strong growth around the world in, again, all three major regions.
Asia, Europe and U.S. export all posted double-digits.
We had 11% export volume growth.
Asia is still growing the strongest of all the regions.
We see nothing that's going to change that as we head into 2007 and 2008.
Still should be the largest volume growing region in the world.
Jon Langenfeld - Analyst
Good.
And then on the domestic side, domestic express specifically, how much of the slower growth -- both in the fourth quarter and anticipated for '07 -- how much of that is due to the economy versus FedEx you know -- done with the culling of their business?
Because I'm assuming that that also has an impact on your growth rate.
Scott Davis - CFO, Vice Chairman
I think that you've seen over the last 10 and 20 years that UPS has outperformed the market in domestic express and I expect that to continue as we move forward.
So I think it's primarily the market, it's primarily industrial production, it's primarily manufacturing which we're big users of next day air services not growing as fast a pace as we saw a year ago.
Operator
Gary Chase, Lehman Brothers.
Gary Chase - Analyst
Just a couple quick ones for you to have you maybe clarify.
Scott, you noted that there were a lot of people out there kind of forecasting better economic conditions in the second half of the year, but it wasn't clear -- it kind of sounded like that wasn't part of what you're thinking in terms of the guidance.
Should we view that as the upside potential if that happens or is that kind of captured in the range that you're thinking?
Scott Davis - CFO, Vice Chairman
No, I think that the upside for us is if industrial production performs better than what we're seeing right now.
We basically have been somewhat cautious as we move forward and, again, we're relying on consensus estimates, we're not a leading indicator.
But the upside for us would be if industrial production and manufacturing improved a little bit better in the second half of the year.
Gary Chase - Analyst
So if we see that pick up that would the upside to at least what you're staring at here?
Scott Davis - CFO, Vice Chairman
You would expect to see better performance out of UPS, correct.
Gary Chase - Analyst
And on the express side, could you just give a little bit more color on sort of what you're seeing there?
Is pricing an issue or is it just truly kind of end market stuff with tech, financial services kind of not generating the same kind of growth contribution that they had previously?
Do the price changes play at all in the volume forecasts that you've got out there?
Scott Davis - CFO, Vice Chairman
Frankly it should -- with the fuel prices coming down and there's a much larger fuel surcharge on the express products, if it's just price alone I think you would see that business growing.
I think it's primarily the manufacturing area slowing down somewhat in the fourth quarter and projected to stay slow for the next few quarters.
So I think it's not pricing -- actually pricing is almost a benefit to the consumer at this point in time because of the lower fuel costs.
Teresa Finley - VP, IR
Maybe to help on that question a little bit, if you look at the market performance over a much longer period of time you'll go back to April of 2003 when we really started the recovery on industrial production.
The ground business came back very strong in 2004 and in 2005 the air market followed that ground market strength.
So 2005 and 2006 were unusually strong air market period and we're just really just adjusting back to normal growth.
And couple that with big slowing in the economy and a slower IT you get a little bit more muted growth in 2007.
But it should pick up again, the next day market again in 2008.
Operator
Scott Flower, Banc of America Securities.
Scott Flower - Analyst
I want to get a sense -- I mean, and I know there are differences in each cycle.
But if you go back to '95, and maybe the answer is that Next Day Air was a less mature product in your portfolio in terms of your marketshares, etc., but you were still able to grow net income 10, 10.5% in what was a midcycle economy.
And I'm just wondering is this more of a reflection that as you've sort of gotten a little more normalized share in Next Day Air that on a trendline basis that's going to impact your longer-term domestic growth rate with some cyclicality within there?
Scott Davis - CFO, Vice Chairman
Well, I think clearly that between '95 and 2007 our share of the air market has grown tremendously.
So without a doubt that there's more of an impact on UPS' results when that market slows down than there would have been in 1995.
Again, even though we're growing it an awful lot we still anticipate we'll grow that business faster than the overall market going forward.
Clearly, Scott, there's probably more impact now than there would have been in '95.
Teresa Finley - VP, IR
Yes Scott, I'd also add that in '95 your next day letter market, your letter market was more robust of a market in general.
That has been a much lower growing market than your next day package.
The next day boxes basically trend pretty well to the commercial ground business or the B2B dynamics which is industrial production.
They do have some differences between the letter market and the package market in the express business from '95 to current trends.
Scott Flower - Analyst
And then I was wondering maybe, Scott, if you could give us some sense of domestically how did the volume feel in the months through the fourth quarter and perhaps give us some sense, is January sluggish, is it okay?
Just give us some sense of how the domestic volumes broadly have played out during the quarter and in January?
Scott Davis - CFO, Vice Chairman
I think the domestic volumes in the fourth quarter were pretty steady.
As I mentioned earlier, we were a little disappointed with the first couple weeks of December because we thought the peak would start a little quicker than it did.
But clearly the last two weeks before Christmas made up for that shortfall, so we pretty much hit the numbers, outside of Next Day Air, that we thought we would hit in the quarter.
January started off somewhat slow, frankly.
I think the first week having a holiday on Monday and then the day of mourning for President Ford on Tuesday seemed to impact business and commerce a little bit.
So the first week at January was slow, it's picked up over the last couple weeks to moderate growth, but still below the levels we've been seeing.
Some of that's economy, some of that's comparing against the 8% consolidated volume growth we saw last year's first quarter.
So we had an extremely strong first quarter a year ago.
If you remember, GDP was over 5% first quarter a year ago.
We grew our air products 10%, ground 6% -- so very tough comps also.
Operator
Adam Thalhimer, BB&T Capital Markets.
Adam Thalhimer - Analyst
Thanks for taking my question.
On the international side you guys had a phenomenal quarter, 21% margin.
What do you view as the key margin drivers in that business?
And I'm trying to get a sense of how sustainable they are in 2007.
Scott Davis - CFO, Vice Chairman
I think you've seen, first of all, margin strength the last several years and we've always said we're not going backwards on margins, but I think that international lots of economies of scale that go with our fantastic global network that we have today.
I think one of the keys for us is we have real balanced growth around the world.
Asia is obviously growing very fast but Europe has been a wonderful market for us.
Our transporter business in Europe is performing extremely well.
We've talked about it in the past that we've grown cross-border volumes double digits pretty much every quarter since 1997.
U.S. export still performing double-digits.
So I think it's balanced growth around the world enabled by our wonderful -- we think the best network in the world.
Adam Thalhimer - Analyst
Okay.
And then I just wanted to clarify something that Teresa said at the beginning of the call.
I think you said that you may increase your 2007 EPS guidance once you have clarity into the voluntary termination offers.
And if that is the case can you give some clarity on the timing there?
Teresa Finley - VP, IR
What I said is that we would adjust the guidance if required once we computated the results from the separation voluntary opportunity that we offered employees.
And we anticipate having an 8-K out in the next couple of weeks that would detail that.
Operator
Ken Hoexter, Merrill Lynch.
Ken Hoexter - Analyst
Good morning.
If we could just delve into the margin pressure, I just want to understand -- I understand the Next Day Air is declining, but it sounded like, Scott, you're still getting a little bit of domestic volume growth.
As long as we're not going negative here, is there not more leverage gain just from continuing to expand the domestic volumes?
Scott Davis - CFO, Vice Chairman
I think that clearly we are going to grow domestic volumes in 2007.
Also clearly our best margin products are the -- as they should be -- the Next Day Air products because they drive assets in airplanes.
And when you don't have much growth in those products it puts more overall pressure on the margins than it would on the ground side.
But we're going to grow -- clearly we're going to grow ground above GDP I think through the year.
We're going to grow air, but more so in the second half of the year than the first half of the year, but certainly not the base we saw in 2006.
Ken Hoexter - Analyst
Great.
And then a follow-up just on the supply chain.
I guess can you break that out at all?
I guess we're still seeing profits at overnight.
Is the core supply chain of Fritz & Menlo forwarding the heavy lift, is that starting to turn or get close to breakeven yet?
And can you kind of delve into that portion of the supply chain?
Scott Davis - CFO, Vice Chairman
Yes.
Clearly the LTL business has been profitable, will continue to be profitable.
As we said before, the industry will be challenged in 2007, but we'll improve profitability in the LTL business over 2006 I think with the investments we made in 2006.
Supply chain and freight -- or supply chain itself, freight forwarding and logistics is close to breakeven at this point in time, will be profitable throughout 2007 each quarter, but each quarter will get better.
Due to the things we've talked about -- the 1200 person reduction is going to help drive $100 million in cost savings.
We have the cost synergies from the domestic freight network which will add at least another $100 million in 2007.
So you'll see steady improvement in both the freight and the logistics and forwarding business as we move forward throughout 2007.
Operator
David Ross, Stifel Nicolaus.
David Ross - Analyst
Good morning, everyone.
The question I had was on the peak season again just to go back through that.
Scott, I know you said that basically it was a wash with the contracted peak being higher in the middle.
But did that have any margin pressure associated with it in terms of handling all those packages in a shorter amount of time?
Because it didn't seem like as much, even though it was a contracted peak, move through the air as you may have thought in that scenario.
Scott Davis - CFO, Vice Chairman
Well, I think in the fourth quarter historically you see less leverage than in any other quarters, primarily because of that huge increase in volume over a short period of time.
So we have to go out and charter air craft and lease vehicles for that additional 5 to 6 million packages to get over that short period of time.
So it does have an impact, but it does pretty much every peak season.
You have to go out and commit early; you can't wait until December 22nd to make those commitments.
You have to make those commitments several months in advance to have the capacity.
So it's always a situation that you're expecting the volume to be there, if the volume is not there it would put pressure on the margins.
But overall I think we came in pretty close to where we thought we'd be outside of the express business which was lighter than we expected.
David Ross - Analyst
Okay.
And then the last question is just back to UPS freight.
Tonnage was down about 6.8%.
I just wanted to know you have been in the process since acquiring overnight of culling a lot of the unprofitable freight and improving your mix.
How much of that was the overall economy and were there still any mix shift issues?
Scott Davis - CFO, Vice Chairman
I think certainly some of the business we pruned earlier in the year showed up obviously in fourth-quarter comparisons versus fourth-quarter '06 versus fourth-quarter '05, but still had an impact.
I think it was a combination of the business we pruned earlier in the year and obviously the LTL industry itself not really experiencing the peak of this year.
So partly the market, partly what we've done in pruning business.
As you get into 2007 you'll see better comparisons.
The market may take awhile to get back, but the efforts we've put in improving the service and selling that service to our customer base will show improvements.
Operator
David Campbell, Thompson Davis.
David Campbell - Analyst
Thank you.
In the fourth quarter your purchased transportation costs, Scott, were down 16.9%.
That's the smallest decrease in the whole year.
Is that a function of the change in your reporting of the supply chain business?
Is it something that would eventually go to zero as you keep increasing the percentage of your freight on your scheduled network?
What causes that?
Scott Davis - CFO, Vice Chairman
Throughout the year clearly the purchased transportation numbers were grossed up because of the change in accounting for revenue on the freight forwarding side.
Again, we went from a -- we control the network.
We had to treat the revenue gross and purchase transportation as an expense item.
So that kind of distorted the comparison throughout the year.
As we head into 2007 you'll see that number come in much -- come down quite a bit.
But also in the fourth quarter we had some purchased transportation in international that drove about 45 to $50 million of the increase.
And that was primarily due to the volume increases in international and somewhat due to currency impact.
But as you head into 2007 you'll see those numbers come down quite a bit as we compare apples and apples.
David Campbell - Analyst
So the international was a bigger factor there than I thought because of the seasonal surge in business in the fourth quarter?
Scott Davis - CFO, Vice Chairman
Exactly.
And the big volume increase.
And again, currency drove probably 10 or $15 million of that increase, too.
David Campbell - Analyst
Thanks a lot.
All my other questions are answered.
Appreciate to help.
Operator
Helane Becker, Benchmark.
Helane Becker - Analyst
Almost all my questions were asked and answered.
Just one on new security inspection rules for international packages, does that affect you significantly and is that going to cause any expense pressure?
Scott Davis - CFO, Vice Chairman
It's something that we're concerned about.
It does not have a direct impact on UPS, it's actually more geared towards the passenger air planes and cargo that goes on passenger airplanes.
We think that directly it does not have an impact on UPS -- it does have an impact on our freight forwarding business and does put freight on passenger airplanes, so there is some impact there.
We think we're -- we're obviously very much in favor of the security improvements.
We need to do that; we work very closely with TSA, but we're also concerned at how fast and how dramatic this move is for the passenger airlines.
So we'll pay a lot of attention to it.
Helane Becker - Analyst
Okay.
Thanks very much.
Operator
Tom Wadewitz, JPMorgan.
Tom Wadewitz - Analyst
Good morning.
I just had a follow-up for you on the supply chain side.
Let's see, in '06 it appeared that some of the issue was in terms of revenues falling off and I think related to some of the work on IT and so forth and salesforce execution.
Can you give us some thoughts about '07 performance and supply chain, what your revenue assumptions are, whether you need to see that revenue improvement to hit some of your goals and what it would be that would give you confidence that '07 revenue performance might be different from '06?
Scott Davis - CFO, Vice Chairman
I think clearly you're going to see better performance out of UPS on the international airfreight and ocean freight forwarding products.
I think you're going to see growth lately.
The market looks like it's going to grow upper single digits and probably about 8%.
I think we're looking for the ocean freight to grow this year, maybe 6 or so on the airfreight market.
So you'll see UPS performing we think probably about market on ocean, maybe slightly below on air as we're winning back our customer base, but a much better improvement than we saw in 2006.
The domestic airfreight market, again, we talked about it's a space available market for us.
Our objective is not to grow that revenue as much as to get the right revenue on our airplanes and obviously improve profitability.
So I think on domestic airfreight you'll see more of a flat revenue line for us, but obviously better revenue and more profitability coming from that.
Distribution will grow that slightly as we move into -- move ahead, but we expect margins to improve in that business also.
Tom Wadewitz - Analyst
So when you look at your guidance, does that assume pretty good execution in terms of getting the revenues in on supply chain?
Or is that potentially you'll get the cost side and if the revenue really has good execution there would be upside?
Scott Davis - CFO, Vice Chairman
I think clearly that there would be outside if we grow the revenue at a faster pace than we've built-in.
And I think the key for us though is obviously to manage the space available in the domestic side very efficiently and get better yielding products on those airplanes than we have in the past.
And we're making great progress along those lines.
Operator
Edward Wolfe, Bear Stearns.
Edward Wolfe - Analyst
I'm just trying to understand a little bit better on the domestic international side the timing of the LYNX acquisition.
When in the quarter did that grandfather and when does the one in Germany -- I forgot its name -- grandfather as well?
Scott Davis - CFO, Vice Chairman
They've all wrapped now.
The last one was LYNX in the UK and that -- we bought that on October 1, 2005.
So the entire growth in the fourth-quarter was organic.
Mike Eskew - Chairman, CEO
And Stolica in Poland was before that.
Scott Davis - CFO, Vice Chairman
I think it was probably first quarter of '05 I think.
So basically fourth quarter was purely organic on the international.
Edward Wolfe - Analyst
And on the LTL on the freight side, you had talked about at the analyst meeting -- which you had talked about on this call too -- finally kind of turning the salesforce loose.
Can you give us an update in terms of where you are on that and the applications of rolling the track and trace and so forth out on freight?
Scott Davis - CFO, Vice Chairman
I think we saw really the first signs of winning a lot of that business probably late November/December.
So we really started to see some of the business that we've been out working on starting to come in in December so the comparisons improve an awful lot.
I think this is probably the first month we really saw ourselves clearly outperforming the market.
We think that momentum clearly will carry forward as we head into 2007.
The service levels, as we said earlier, have never been higher.
I think the technology is something our customer base is looking for.
Mike Eskew - Chairman, CEO
And we've got DIAD shipping systems and tracking systems that are transparent to customers just like they're used to at UPS; they're in the hands of an awful lot of those UPS freight drivers.
Scott Davis - CFO, Vice Chairman
The challenge we have this year -- we've got a great product, the challenge is going to be the market.
And like I said, we're very confident we'll outperform the market.
But the market, as you all know, will be challenged in 2007.
Operator
Jon Langenfeld, Robert W. Baird.
Jon Langenfeld - Analyst
I guess in terms of those acquisitions -- LYNX and Stolica specifically -- can you talk about what you've learned both good and bad in terms of having had those in your portfolio for a year?
Scott Davis - CFO, Vice Chairman
First of all, I think that these are both international package acquisitions and the integrations went wonderfully well.
We were very successful in integrations.
We're not surprised -- a much smoother integration than obviously Menlo was.
We feel very happy with what we've done at Stolica and what we've done on LINX.
In Poland with Stolica, I think it's been very successful, it's a fast-growing market.
We've got a large piece of that market at this point in time.
We're profitable.
We think it gives us a foothold in Central and Eastern Europe that is critical as more manufacturing moves in that direction.
In the UK I think LYNX -- we'll see a lot of the benefits with LYNX when we build our new hub which will be completed in 2008.
And we do a job of really combining the existing UK operations with the LYNX operations.
That's when the real synergies and benefits will be seen.
Jon Langenfeld - Analyst
And so does it give you anymore or less -- it sounds like more confidence that those types of acquisitions make a lot of sense?
Scott Davis - CFO, Vice Chairman
I think their clearly are some economies of scale with those acquisitions and I think buying those things will bring down our unit costs which will allow us to be more competitive and improve overall profits in those locations.
Operator
Scott Flower, Bank of America Securities.
Scott Flower - Analyst
Just a couple of quick follow-ups.
I know at the analyst day in November you all talked -- and this is beyond some of the headcount costs and logistics -- about looking at more cost [ex], cost take out and things at the overall corporation that, if I recall, I thought you'd maybe give us some more color today.
But I just wanted to get a sense of what process or progress has been there and if you can give us any sense of what those things may do for the overall corporation.
I'm looking at the overall cost structure.
Scott Davis - CFO, Vice Chairman
Clearly we've got a big focus on shared services throughout the whole entire global operations and I think it's an evolution for us, it's going to take time to work our way through it.
The first step we talked about was really the one corporate office and that's the piece that we're addressing right now with the separation opportunity out there for 650 people.
That's really by combining the corporate operations.
But shared services really starts with consolidations.
And a lot of consolidations that will be moving into the shared services operations.
You'll hear a lot I think throughout 2007 as we make advancements in this area, put together a team right now led by Allen Hill who runs our HR -- our shared services effort.
I think you'll see an awful lot of improvement and it will be in periodic announcements throughout 2007 and 2008.
Scott Flower - Analyst
And then the other question -- and not to come back to something -- I know you get a lot in terms of a question.
But if the market doesn't react particularly well to the slowing growth in the economy and how it affects the market's expectations for your outlook, how might you use your balance sheet perhaps a bit more aggressively relative to the buyback or otherwise in terms of getting returns to shareholders if the market is a little bit more tepid about the outlook?
Scott Davis - CFO, Vice Chairman
Basically our capital allocation -- we've talked a lot about it -- it really hasn't changed from what we talked about in November at our conference.
Clearly our first choice is to reinvest, particularly in international package, see the right opportunities.
But without a doubt we're going to evaluate increasing distributions as we head through 2007 via dividends and/or share repurchase and we'll evaluate that as we go.
But clearly it's something that is on the front burner for us.
We'll be paying attention to it, making the right decisions for the shareowners.
Teresa Finley - VP, IR
Thank you very much for all of your questions.
Before I wrap up I do want to remind you that UPS is hosting an investor conference in Cologne, Germany on March 6th for our European investors.
We'll be updating material we presented at our conference here in Atlanta last November.
This conference will be webcast is part of the event we will tour our major international air hub in Cologne.
If you're planning to attend your invitation provides an electronic link to register or you may do it through the Investor Relations website at UPS.com.
Thank you very much for joining us today and we look forward to seeing you soon.
Operator
Thank you.
This concludes today's UPS Investor Relations fourth quarter 2006 conference call.
You may now disconnect.