Good morning. My name is Steven, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the UPS conference call. All lines have been placed on mute to prevent any background noise, and after the speaker's remarks, there will be a question and answer period. It is now my pleasure to turn the floor over to your host, Mr. Scott Childress, Investor Relations Officer. Sir, the floor is yours.
Good morning, everyone, and thank you for joining the webcast. Before we begin, remarks of today's call will be made by taking advantage of the safe harbor provisions of the Private Securities Litigation Reform Act. UPS, like all U.S. companies, is required to adopt accounting standards released by the Financial Accounting Standards Board, or FASB. They establish financial accounting and reporting standards for companies that follow U.S. generally accepted accounting principles, known as GAAP. FASB is recognized by the Securities and Exchange Commission as the designated accounting standards setter for U.S. public companies. Today's presentation will provide you information on new standards and how it will impact UPS financial reporting. Because our reporting cycle follows the annual calendar, UPS will report financial results for first quarter 2018 under the new standards. We also plan to recast several prior periods for you at the next earnings call.
I recommend that you also take advantage of the information provided in the appendix of the presentation, including the estimated quarterly impact of the accounting changes for 2017 and 2018. Following our prepared remarks, we will take questions as time allows. You can submit online questions through the webcast browser. I will now turn the call over to UPS Chief Financial Officer, Richard Peretz. Richard?
Thanks, Scott, good morning, everyone. On the fourth quarter earnings call, we mentioned that there were two new accounting changes UPS is required to adopt as of January 1st, 2018. The changes are not unique to UPS. The following information is a guide on how these changes impact the company's financial reports. With these changes, you can see on this slide, there are a number of items that can influence results within a given period: revenue and expense shifts, discount rates, actual return on assets, and other items listed here. Here is a summary of what we will cover. Two new or updated Accounting Standards Codifications or ASC. The first is related to an update, ASC Topic 715, retirement benefits. The second change is the adoption of a new standard for revenue recognition, ASC 606. Both changes took effect on January 1st of this year for UPS.
ASC 715 pension expense is a geography change on the income statement. There is no change to net income or earnings per share from adopting this change. ASC 606 number 1 is a revenue recognition gross to net. It impacts the supply chain and freight area in certain activities. There is no change to net income or earnings per share from adopting this change. ASC 606 number 2 is revenue recognition deferred entry. It causes financials to shift slightly between periods, but the impact is minimal. Under the old GAAP standards, all components of net pension costs were recorded as operating expense. Under the revised standard, three components of net pension costs will be recorded with the non-operating income and expense. Please note that the expected return of assets is a net reduction to expense.
Operating expense is anticipated to increase because the combined items moving below the line to other income is a net credit to expense. Operating profit and margins will be lower. Other income will increase. Net income and earnings per share are not impacted by the change. Under the revised standard, only service costs will remain an operating expense. We have recast the 2017 income statement based on adopting ASC 715. We estimate the following results. Adjusted operating expense will increase by $789 million. The combined items relocating to other income are a net reduction in expense. Adjusted other income will increase by $789 million. There's no change in underlying performance in the business segments. As you can see, there's no change to adjusted pre-tax income, adjusted net income, and adjusted diluted earnings per share by adopting ASC 715. Looking at the revenue recognition changes.
ASC 606 number 1 involves a recognition of gross rather than net revenue. Adopting the new standard is expected to increase 2017 revenue by around $709 million and increase expense by the same amount. It has minimal impact on operating results. Operating profit is not impacted, and operating margin will compress slightly. ASC 606 number 2 is a recognition of revenue and expense for packages in transit at the end of the quarter. Packages not yet delivered will be recognized based on the % of service rendered. The adoption of the standard is expected to shift revenue and expense among some periods, but will have minimal impact on the company's financial reporting. To sum it up, 2017 combined impact of these three accounting changes is estimated as follows: Revenue will increase by $712 million, driven by ASC 606. Adjusted operating profit will go down. Adjusted other income goes up.
Adjusted net income will decrease slightly, driven by ASC number 2, which shifts results between time periods. Adjusted recast diluted earnings per share will be $6, again driven by ASC 606 number 2. The impact of net income and diluted earnings per share is minimal. The combined impact of adopting ASC 715 and 606 will be different across the segments. The main driver here is the adoption of ASC 715. The changes relocate UPS net reductions of pension expense into other income. Adjusted segment operating expense will increase, and segment operating profit will be lower. Segments with more employees kept under company-sponsored pension plans and plans with the highest asset base will see a larger shift in expense. As expected, the overall impact of the accounting change has a larger impact on the U.S. domestic segment because it has the largest pension plans.
For your benefit, we are providing a projection for 2018 under the new accounting standard. The impact this year is larger than the prior year because the pension asset base has grown, which increased the net reduction to expense. Actual results in 2017 were strong, and we made material discretionary contributions last year. UPS also reduced the expected rate of return for U.S. pension assets from 8.75% in prior years to 7.75% in 2018. As I mentioned on the last call, adopting these accounting changes shifts items on the income statement mainly between operating and non-operating categories. As a result, estimated operating margins in the U.S. could move lower from 125 to 250 basis points, depending on the period. You can see around 40 to 70 basis point movement lower in the international segment, and in the supply chain and freight, between 100 and 150 basis point change.
As a reminder, the comparisons among periods will be more complex under the new standard. The accounting changes do not impact the underlying operation of the business. Let me make a quick comment on the total year-over-year pension expense. It's relatively flat when combining all pension-related items after considering the interest expense from the debt issuance for the discretionary pension funding. Service costs, which remains within operating expense, is sensitive to changes in the discount rate. Lower discount rates at the end of 2017 impacted costs by approximately $235 million in 2018. While UPS has taken action to mitigate this, including making discretionary contributions, offsets are now located below the line in other income. I also mentioned the impact of lower discount rates on our 2018 financial targets during the last earnings call. This slide illustrates how discount rates have declined in recent years.
The impact to segment operating expense will be greater for the U.S. domestic segment, as it has the largest pension plans. At the end of 2017, rates fell to historical lows, increasing service costs and meeting our 2018 projections by about $0.18 per share. If we use today's discount rate as if it was the end of the year, the 2018 headwind would be much smaller. UPS is one of many companies impacted by the new and updated accounting changes. All U.S. public companies are required to adopt these changes. The pension accounting changes have no impact on net income or earnings per share results. It's a geography shift on the income statement. The revenue recognition for ASC 606 changes will result in some movement of revenue and profit between reporting periods, but the effects are minimal.
The key point to remember is that these accounting standards do not change the core performance of the company. Thanks. Now we'll ask the operator to open the line for questions. Operator?
Our first question will come from the line of Mr. Tom Wadewitz of UBS. Please go ahead.
Yeah, good morning. Thank you for hosting the call and providing the information on the accounting changes. Wanted to see if you could just review what's your pension contributions and, I guess, what's happening with pensions this year. Some of the accounting changes are affecting that, but can you go through the contributions and you mentioned some of the, I guess, the headwind on the expense, but if you could just give us a little more perspective on how we think about changes on your contributions and what your contributions are this year and cash flow perspective.
Yeah. Hey, Tom, it's Scott. Thanks for the question. A couple of things on pension in general. What we've said is, currently, we have no plans to make pension contributions for 2018 and 2019. To your point, that's going to impact the cash flow. That's really why we came out and said we expect cash flow this year to be between $4.5 billion-$5 billion. The other, I think, interesting fact to make sure that you've got is that the discount rates that are impacting us by about $235 million this year, they've started to move up in the current time frame. They're about 40 basis points higher than what we closed at the end of the year. If we were to revalue the plans with today's rates as of December 31st, we would see a material change in the drag on the business.
We would clean a lot of that up and improve it moving forward.
That's basically some of the commentary around pension. We'll continue to manage pensions aggressively. I think it's very clear to say we moved about $6 billion of liability off of our balance sheet on a year-over-year basis. We'll continue to be aggressive to make sure that we've got the balance sheet in good shape.
Scott, your comment on the 235, that number's not changing. You're just reviewing that discount rate once a year, you're just saying that it's begun to move in your favor. Is that or-
Yeah.
Okay.
Basically, Tom, the way it works is you take that view at December 31st, we're not allowed to basically change that rate for the year. We'll have to wait until the end of this year to be able to revalue the plans. It's just that the rates are moving in the right direction, at this time in the year, we'll have to see where the rest of the market goes for the remainder.
Great. Thank you.
Our next question will come from the line of Mr. David Vernon of Bernstein. Please go ahead, sir.
Hey, good morning, thanks for taking the time to put this out. Richard or Scott, can you give us a little bit more color into the quarterly breakdown of how the adjustments should impact? Should we just take those numbers and sort of treat them quarterly on a flat basis for each of the quarters of 2018? I'm just trying to get a sense for how to better predict the margin fluctuations for the domestic segment from these changes.
Great question, Dave. One of the things we did, because we knew there was going to be some questions around how does it break down over the year, in the appendix, we basically gave you the dollar amounts of the movements, we broke those down by quarter. I think in general, what you're going to see across the period, once you get to the U.S. domestic operating margin, use Richard's commentary around 150-250 basis point movement in the U.S. operating margin because of this relocation, it'll really depend on by period that you're looking at. I think the appendix will help you tremendously in how you set up for the quarter adjustments.
All right. Then maybe just as a quick follow-up, I think you guys have made commentary on this in the past around about not making any pension contributions this year. Is that still kind of the plan, or do you think there might be some cash outflow going into the pension as well in 2018?
Yeah. At this point, we don't have any plans to fund any of the pensions. In your models, I'd recommend you set that to 0 for this year and even into next year. We'll continue to look at the environment, right? We will be opportunistic if conditions change, but at this time, we don't see any indication to be able to fund. Richard?
This is Richard, I just wanted to comment that when you look at what we did last year, we tried to make it clear recently, that we took a lot of thought into what should we do given the changing tax rates, given the increasing PBGC premiums that were continuing. One of the reasons we did fund that $5 billion last year was because it was opportunistic. It made sense for the enterprise, which ultimately makes sense for our investor base. We went through a careful analysis in making sure that as we thought about that decision, and how it informed on 2018. At this time, other than the international plans that have the normal, much smaller impacts, we don't expect in the UPS U.S. plans that we'll really see anything based on what we know today.
Thank you.
Our next question will come from the line of Mr. Ken Hoexter of Merrill Lynch. Please go ahead, sir.
Hey. Great. Hey, Scott, Richard, just a real quick one. Just thinking about the union pension plan shift that moved on to the balance sheet. Is there any changes to these numbers that shift through negotiations or, I guess, as you go forward and your contributions change, as you renew those negotiations for the next contract, or is this just the ongoing plan that's already on the books?
Ken, this is Richard. Obviously, we're in the middle of negotiations. It's still early with the give and take of the different proposals, both directions. Regardless of the negotiations, the pension itself still lives on because it's the pension for the employees currently working. It's really too early to talk about what might happen there on a number of areas, and really today is about this geographic change on the pension and the revenue rec. What we tried to lay out is for the three main plans that the U.S. sponsored plans that were really inside our balance sheet.
Ken, just to add on a commentary there, the union plans are mainly multi-employer pension plans. There is a schedule in the K, call it around page 86 or so, that break down those plans. One of the good news stories is that three of those plans actually improved their status on a year-over-year basis. That's a positive for us, and like I said, we'll continue to manage and look at those.
Great. Appreciate the time. Thanks, guys.
We've got an online question we'll take from Dave Ross. Appreciate the question, Dave. Any impact on cash flow? Obviously with these pension changes, as Richard said, it's really about a geography move more than anything. No impact at all on our cash flow from these changes.
We have a question from the line of Mr. Scott Group of Wolfe Research. Please go ahead.
Hey, thanks. Morning, guys. Richard, a couple of years ago, there was an issue with a pension clawback. Can you just give us an update on where we stand there?
Yeah. What you're specifically talking about is some legislation that changed the pension rules in 2014, around the ability to reduce benefits for retirees. There is no change. We did outline in the K this year an update, but the update really doesn't have an update because at this point, everybody had good returns. At this point, there's no change, and you'll see that in the disclosure that we have. Ultimately, we believe that we continue to not only manage our plans but work with Central States as we had talked about in the past to make sure we find a successful conclusion to protect our employees and the retirees as well. There's nothing really new here to talk about.
Okay. Helpful. Just big picture, if we run through sort of these geographic changes, it takes domestic margins below 10%. Is that a level where you say, "Hey, maybe we need to sort of change what we're managing the business towards higher margins," or is this geographic and has no impact on the way you think about sort of managing the business?
I think that we have laid out specific strategies of where we're headed and that we do expect an improvement in margin. I would also tell you that with this geographic change, with that 150 to 250 basis point change, even in our goal for margin, that would change the goal because of the way it's going to be presented. I would also tell you that we continue to manage and think about pension costs holistically when we're thinking about our total cost to operate. While it has to be separated for the accounting, it's still got to be put back together to look at how do we manage.
If you think about the last two or three years and some of the activities we've done, and even we called it out, our pension expense is relatively flat when you put in the discount rate impact, the benefits from the higher expected return, and then of course, the interest expense from the discretionary funding. Given if some of that wasn't done, our expense actually would've gone up because of the PBGC premium change as well because that's still moving higher. Although it's not a savings, it's a large avoidance. What we have really stepped back, looked at, spent some time studying, is really making sure we're managing the entire pension across all the components in the most efficient way. That's one of the reasons we did the funding late last year as well.
Scott, one of the things that we are excited about 2018 is the capabilities that come online in the back half of the year, and we've called some of that out. We think those efficiencies, bringing those to bear on the business will absolutely be a benefit for us.
Okay. Just one quick, you're not expecting margin improvement this year, correct?
No, I think when you recast the numbers, the way that the new accounting standards are defined, what I think you would say about U.S. margins is they would be down about, call it around 80-90 basis points. However, if you combine all the call-outs we've had, the op penalties, the movement of the pension credit below the line, you basically would say that U.S. operating margins are relatively flat. It's going to be more of an optics than anything else.
Okay. Thank you, guys.
Hey, we've got another question, Ravi Shanker from Morgan Stanley. You qualified the impact of the pension discount rates at $0.18. This was from a conference that we attended. Can you confirm whether this is a cumulative impact or not? One of the things, Ravi, is that $0.18 is basically the discount rate that's sitting on the business. Now, one of the reasons that we called that out is under this new accounting standards, service cost sits up in operating expense. Discount rates, when they change, has the largest impact on service cost. What we wanted to make sure of under the new optics, that we called those impacts out, and that's really why we included it in the schedule.
When you put all the pension pieces back together, like Richard said in his prepared remarks, it's basically a net flat to the business, relatively flat with all the parts put back together. As we look forward, we'll keep pushing and evaluating the pension liability side, and when opportunities present themselves, we'll make sure that we take advantage of them. Appreciate the question.
We have a question from the line of Mr. Brandon Oglenski of Barclays. Please go ahead.
Hey, good morning, guys, and thanks for doing this call. Could you provide us a sensitivity around the change in the discount rate, Scott or Richard?
Absolutely. Couple of things and I'll do this on the back of the comments that I just made. A 25 basis points movement in the discount rate on a net basis is about, call it about $50 million or so. That includes two components. One, the service cost, second, the interest expense. The issue is those two items are sitting at different places on the income statement today under the new standards. The service cost is going to be up above in the operating expense. Interest expense drops below the line in non-operating. If you separate those two pieces out, it's about on service cost, call it about a $90 million impact, and on interest expense, it goes the other way by about $40 million. That's the way the pieces break out.
I would hold on to the net impact if you're really looking across the consolidated business.
Okay. Appreciate that. I did want to follow up, since we're talking about pensions here, on the MEP plans, because you guys did mention the disclosure in the K. As we're calculating it, I still think 33% of your contributions into the MEPs are, quote-unquote, "In the red." Can you just discuss to us what future potential liabilities could be contingent on these plans and how you mitigate that?
Sure. This is Richard. I think the first thing is we have to step back and think about the rules and legislation around all plans, whether they're red, yellow, or green, is something that has been created and continues to be maintained through federal legislation. The second is that there are areas where based on whether a plan is in the red or not, the plan trustees in those local areas may be moving wage increases into pension if necessary. The third is, other than the plan that we've disclosed, we don't have any kind of obligation other to continue to contribute the contributions based on the hours worked.
It's not the only one, and we called that out when we talked about Central States, and obviously legislation changed, but we looked at what we did with the Central States back when we did it about 10 years ago and today, and it still is the right decision, but ultimately all the other plans don't have the same kind of complexity or anything that we would be looking at other than the normal cash contributions.
Yeah, for those plans, we have no obligation to pull any of that liability onto our balance sheets.
Okay. Thank you.
We have a question from the line of Allison Landry of Credit Suisse. Please go ahead.
Good morning. Thanks. Scott, when you commented earlier that the U.S. domestic margins would be down on the new reporting basis versus 2017, and you did say it's mainly optics, is this prior to any benefit from the transformation initiative that you called out a couple of weeks ago?
Sure, Allison, this is actually Richard. I'm going to take that question. Everything that we've told you so far and we've labeled is where we are today before any impact from the transformation. One of the things that we are continuing to work through is the evaluation on transformation. It's just a little early for us to comment on it. The only reason we had to talk a little bit about it earlier than most other companies, because we did decide to bring in Scott Price, who's someone who's been through some of this kind of work, worked in the industry, worked in other companies. With that announcement, there was some speculation based on his title. We talked about it, we're probably three, six months early in talking about what that impact is.
As we're ready for that, we will obviously share it as well.
Okay. Just to clarify, you do expect it to have an impact on the 2018 results?
Again, we're putting all those plans together. I don't want to commit to something until we finish the study, we will share it with you in plenty of time for you to get a better picture of that.
Yeah, there's no question it's not in the current guidance numbers today. That is absolutely true, Allison.
Okay, great. Thank you.
Thank you.
I would now like to turn the conference back over to Mr. Childress for any closing remarks. Please go ahead, sir.
Thank you very much for joining, and Richard, if you've got some closing comments.
First, I just want to say that what we're really trying to do is make sure that we were able to give you all the information and how the optics of these two accounting standards will change the reporting going forward after many years of being as consistent as possible. We will continue to be as consistent, but it'll be in this new format that's required it with the adoption. I want to leave everyone with the one thought that overall pension expense is relatively flat. We've spent the last year and a half, looking carefully, diligently at making sure we're managing the pension and in the most efficient way for both the enterprise and the investors.
When you consider the discretionary funding and that expense, which was actually more than 150 basis points lower than the PBGC premiums, along with the lower discount rate and the benefits from the expected return on assets, we believe that when you put it all together, that's one of the reasons that you see the earnings per share remain the same, net income remain the same, and we'll continue to manage that way. Again, thank you for joining us for the call.
Ladies and gentlemen, that concludes our call. Have a wonderful day. You may now disconnect.