United Parcel Service, Inc. ( UPS - Analyst Report ) reported second quarter 2012 earnings per share of $1.15, missing the Zacks Consensus Estimate of $1.17. However, earnings per share registered year-over-year growth of 7.5% from adjusted earnings of $1.07.

The growth was aided by higher profitability from U.S. Domestic Package and Supply Chain and Freight segments that compensated for the lackluster International Package business.

Total revenue for the quarter inched up 1.2% year over year to $13,349 million but missed the Zacks Consensus Estimate of $13,732 million. Consolidated volume grew 2.7% year over year while average revenue per piece fell 0.8% year over year.

Total operating profit increased 4.6% year over year to $1,790 million from adjusted operating profit $1,712 million. Operating margin rose 40 basis points (bps) to 13.4% from 13.0% adjusted operating margin in the year-ago quarter. The growth was primarily backed by higher profits from the U.S. Domestic segment.

Revenue Segments

US Domestic Package revenue rose 4.1% year over year to $8,058 million in the reported quarter. Operating profit leaped 12.1% year over year to $1,134 million from adjusted operating profit of $1,012 million. Operating margin grew 100 bps to 14.1% from 13.1% adjusted operating margin in the year-ago quarter.

The margin expansion was driven by solid volume growth and improved network efficiencies, higher base rates and fuel surcharges. Average daily volume increased 3.5% on growth in online shopping. Revenue per piece improved 0.6% year over year driven by higher rates.

International Package revenue dropped 4% year over year to $3,014 million due to uncertainties in the global economy and poor exports from Asia. Additionally, negative currency translation also impacted the segment’s revenue performance.

Operating profit fell 10.1% year over year to $454 million in the reported quarter and operating margin contracted to 15.1% from 16.1% in the year-ago quarter. Average daily volume declined 1.6% year over year on a 3.2% drop in non-U.S. domestic average daily volumes offsetting 0.8% growth in export average daily volumes. Revenue per piece was also down 2.4% from the year-ago quarter.

Supply Chain and Freight segment revenue was down 1.6% to $2,277 million given a lower demand in International Air Freight and lower rates. Operating profit increased 3.6% to $202 million from $195 million adjusted operating profit in the year-ago quarter driven by efficiency in cost and revenue management. Operating margin expanded 50 bps year over year to 8.9% from adjusted operating margin of 8.4%.

Liquidity

At the end of the second quarter, UPS generated free cash flow of $3 billion and spent $949 million. The company repurchased 11.3 million shares for approximately $870 million.

Guidance

Given the poor economic backdrop because of the European debt crisis and lower Asian business, UPS provided a more conservative outlook. The company reduced its adjusted earnings guidance to $4.50–$4.70 from previous projection of $4.75–$5.00 per share for fiscal 2012. The current projection represents a growth of 3–8% over fiscal 2011 adjusted earnings, down from 9–15% projected previously.

Our Analysis

We believe that healthy performance in the Supply Chain and Freight segment and improved profitability in Domestic Package will fuel future profitability. Additionally, the proposed acquisition of TNT Express slated for completion by the year-end will also be accretive to the company growth goals.

However, the company’s lower earnings projection and forestalled international business given economic uncertainties keep us on the sidelines. Further, labor unionization, large European exposure and competitive threats, in particular from FedEx Corporation ( FDX - Analyst Report ) remain significant concerns for the company.

Currently, we have a long-term Neutral rating on UPS. For the short term (1–3 months), the stock retains a Zacks #4 Rank (Sell).