MANAGEMENT DISCUSSION & ANALYSIS: OPERATIONS

FINANCIAL REVIEW

The financial bottom line for 2001 is a net loss of $1.7 billion. This follows the loss of $199 million in 2000. The trend and its implication, though, is clear: our cash flow from operations is declining.

Net Cash Provided By Operations

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This trend has two component parts: first, a declining growth rate for revenue and volume, and second, a trend of increasing labor cost per hour. Each of these components is discussed in the following sections. The graph above shows the result of this trend: a decline in the net cash provided by operations. This cash is critical to financing our capital expenditures, those necessary to substitute capital for labor as well as those expenditures we need to make to maintain universal delivery service. Declining cash flow makes it harder for us to provide the infrastructure that supports our universal service mandate, as well as to increase productivity. Our financing of those investments is discussed later in our Capital Investment and Financing section.

When we prepared our 2001 financial plan in the summer of 2000, we projected revenue would increase in 2001 by $4.0 billion. We later reduced it by $630 million, recognizing the trends that emerged at the end of 2000. Our forecast expense then exceeded our revenue, and a net loss of $480 million was projected. The growth in expenses was fueled by an increase in cost per labor hour of almost 6%. It was driven by rising Cost of Living Adjustments (COLA) tied to the Consumer Price Index (CPI), higher level pay for letter carriers, and inflation of 11% in health benefits. Several other factors occurred after this plan was set that changed the actual outcome even more dramatically.

The first was the Postal Rate Commission's (PRC) recommended decision to reduce the contingency amount in our rate request. This contingency is to cover unforeseen events. The total effect of the PRC decision was to reduce revenue generated by recommended rates and fees by approximately $1 billion. Effective July 1, the Governors modified the rates recommended by the Postal Rate Commission, but the delay in implementing rates reduced revenue by $400 million.

The second factor was the economic slowdown and competition, which restrained volume late in 2000. In early 2001, based on new forecasts and projected costs, we were facing a loss of between $2 and 3 billion. We immediately acted to reduce expenses and accelerated the work year reduction begun in 2000. In addition, we established a headquarters-hiring freeze, removed an additional $300 million from program budgets and implemented a capital spending freeze due to cash flow concerns.

In the Last Two Years, We Reduced Our Cumulative Work Years...

...Even As We Delivered 6 Billion More Mail Pieces and Added 3.6 Million Delivery Points

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The third factor was the terrorist attacks of September 11, which dramatically reduced mail volume in the last days of the fiscal year and cut revenue by approximately $200 million. We did accomplish our objective of work hour reductions, a record-setting 23 million hours below 2000. We controlled expense growth in spite of higher labor costs, higher fuel and utility prices and rising health benefits costs. Without these actions, our loss for the year would have been greater.

OPERATING REVENUE

In last year's report we projected a 5% growth in revenue for 2001, anticipating the requested rate increase and a forecast of modest volume growth. However, the entire process for this rate request - starting with preparing the necessary documentation to support the rate proposals and ending with implementing the new rates - took two years. During that time, economic conditions began to change for the worse. Revenue grew by only $1.3 billion from 2000 to 2001. This was $2.1 billion less than we planned. The slowdown in the economy and the September 11 attacks accounted for $1.5 billion of this difference, while $400 million was a result of the Postal Rate Commission's recommended decision, and $200 million resulted from shortfalls in our revenue initiatives.

The changing characteristics of the mail also affects our revenue. Across almost all classes of mail, average weight per piece was down in 2001. This trend is most pronounced in Periodicals, Express Mail and Parcel Post. All of these classes declined well over 5% in weight per piece since the rate change in January 2001. In the case of Periodicals Mail, the weight decline is largely due to the economic slowdown and consequent weakness in the advertising market. For Express Mail and Parcel Post, however, the decline is likely due to rate increases that hit the higher weight steps especially hard, as well as actions by our competitors to secure some of the volume in the wake of the rate increases. At the same time, differences in growth rates between classes of mail are changing the mail mix. More and more mailers are taking advantage of presort and drop-shipping discounts, which affect our revenue and workload.

Overall, total mail volume declined by 420 million pieces, or 0.2% from last year. First-Class Mail grew only 0.1% in 2001, the lowest growth since the recession of 1991. Growth in the presort categories did not offset a 2.7% decline in single piece First-Class volume. Standard Mail lost 0.1% or 119 million pieces this year. Mail continues to move into the automation presort from the nonautomation categories.

Priority Mail volume fell 8.6% this year, driven primarily by a 15% average price increase beginning in January. Priority Mail is part of the extremely competitive expedited package market and is also affected by economic conditions. Total Package Services declined by 3.1%, although the Parcel Post component grew strongly, at 9.4%. Most of this growth came from bulk-entry products, with some retail Priority Mail moving down to Parcel Post. Also declining this year were Periodicals, down by 2.8% and International Mail by 1.5%.

In past years, we have presented forecasts for the various classes of mail in this section. However, economic and operational uncertainties as to the full effect of the terrorist attacks precludes that this year.

The rate of growth of our revenue continues to decline.

For the first time since 1991, our mail volume declined, jeopardizing our ability to fund our universal service mandate.

RATE-MAKING ACTIVITY

Until 1971, Congress set postage rates through legislation, and the relationship between the revenue from those rates and the actual cost of operating the postal system varied greatly. Since 1971, however, the Postal Reorganization Act has required the Postal Service to establish postal rates that cover the costs of operating the postal system.

The rate-making process is lengthy and complicated and begins when management determines that current rates will not be adequate to meet our mandate of "covering costs" in the future. The Postal Service, with approval of the Board of Governors, submits a request for a recommended decision on rate and fee changes to the Postal Rate Commission (PRC), an independent establishment of the executive branch of the government. The submission is accompanied by detailed rate proposals supported by extensive testimony and lengthy documentation.

The Commission's proceedings take up to 10 months. It holds public hearings, during which interested parties such as mailers, competitors and consumer representatives are authorized to challenge the Postal Service's proposals and submit their own testimony and proposals. At the conclusion of the hearings, the Commission sends its recommended decision to the Governors. The Governors may approve, reject, allow under protest, or, under certain limited circumstances after more proceedings, modify the Commission's recommendations.

CLASSIFICATION AND RATE CHANGES

In November 2000, the Postal Rate Commission (PRC) issued its first Recommended Decision for R2000-1, reducing many of the rates requested. In the opinion of our Governors, the rates and fees that the PRC recommended would have resulted in a revenue shortfall of approximately $1 billion. After considering their statutory options, the Governors decided to allow the PRC recommendations to take effect "under protest" and to return the case to the PRC for reconsideration. As a result, we implemented the PRC's recommended average increase of 4.6% on January 7, 2001. In its second Recommended Decision, the PRC recommended limited changes that did not correct the projected revenue shortfall. Therefore, the Governors rejected this Decision and returned the case to the PRC for reconsideration once again.

When the PRC's third Recommended Decision did not correct the projected revenue shortfall, the Governors chose to "modify" the decision. Under the Postal Reorganization Act, the Governors must ensure that postal revenue is sufficient to cover total estimated costs. If the PRC recommends rates that are insufficient, the Governors may change or "modify" those rates to correct the revenue imbalance. Any decision by the Governors to modify a PRC decision must be unanimous. This is an unusual step, and for only the second time in 30 years the Governors found it necessary to modify a PRC recommended decision in an omnibus rate case. We implemented the modified rate increase of 1.6% on July 1, 2001.

Following an evaluation of the Postal Service's financial position, the Governors decided to file a new rate request with the PRC in September 2001. The proposed rate increase averages 8.7%. In light of the Postal Service's current financial requirements, the Governors requested that the PRC expeditiously act on the rate request and return a Recommended Decision in less than the 10 month maximum set by law.

EXPENSES

COMPENSATION AND BENEFITS

Our personnel compensation and benefits costs, including interest on deferred retirement, grew over $1.8 billion or 3.6% over 2000. This year's growth was due to contractual payments and health benefits, even though labor use was reduced by over 11,500 work years. This compares to growth of 4.4% in 2000 and 3.7% in 1999.

However, labor rates increased by 5.8% on a cost per hour basis. Base salaries alone increased more than $713 million in 2001. Contractual lump sum payments increased by $495 million. Our health benefits expenses were $244 million greater than last year, driven mainly by premium increases per participant in January 2001 of 11% for active employees and 9% for annuitants and our increasing number of retirees. Due to the high cost of prescription drugs, advances in medical procedures, and the aging of the American population, we expect our health benefits expense to continue to grow.

Growth in Compensation and Benefits

2001	2000	1999
3.6%	4.4%	3.7%

The September 1999 National Association of Letter Carriers (NALC) arbitration award provided for the upgrade of all letter carrier craft employees from their current Grade 5 classification to Grade 6 while maintaining the salary differential between Grade 5 and 6. The effective date of the upgrade was November 18, 2000, resulting in a cost of $267 million.

Collective bargaining agreements with three of the four major postal unions expired in November 2000. Negotiations for new agreements were unsuccessful. The Postal Service and the American Postal Workers Union bypassed the fact finding and mediation phases of the dispute resolution process and began arbitration on August 27, 2001. The Postal Service and the National Rural Letter Carriers Association went through all three phases of the dispute resolution process, beginning with the fact finding on April 30, moving to mediation in June and, finally, arbitration on July 16, 2001. Negotiations continue with the National Postal Mailhandlers Union. And, for the National Association of Letter Carriers, whose contract expires in November 2001, negotiations are under way.

Non-bargaining Postal Service employees only receive increases in compensation through annual merit reviews. Unlike the rest of the federal government, these employees do not receive automatic salary increases, nor do they receive COLAs or locality pay. Additionally, lump-sum payments are made from the Pay for Performance program, a group incentive program covering over 84,000 supervisors, managers, postmasters, executives and staff throughout the Postal Service. To spur greater levels of performance in core areas, this incentive program sets measurable performance goals for the organization and for each organizational unit within the Postal Service at the beginning of each year. Participants in the program earn incentive credits through performance to these goals and as financial performance measures indicate that economic value has been added to the organization. Each year, employees earn incentive credits that are placed in a reserve account. One third of the total amount is paid, and the remainder is held in reserve and is placed "at risk," pending future performance. The objective of this approach is to promote continuous improvement and long-term value creation.

The Workforce is Decreasing...

...But Labor Cost Per Work Year Accelerates Faster Than Inflation

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HEALTH BENEFITS

Our health benefits expenses were $244 million greater than last year. The cost of retiree health benefits now represents 27% of our total health benefits costs.

RETIREMENT EXPENSES

Virtually all of our employees participate in one of three retirement programs, under the auspices of the federal government's Office of Personnel Management (OPM). (Please see Note 6 of the Notes to Financial Statements for details.) These three programs are the Civil Service Retirement System (CSRS), the Dual CSRS/Social Security System (Dual) and the Federal Employees Retirement System (FERS). Both the CSRS and the Dual systems are now closed to new participants, and all employees hired since 1983 participate in FERS.

Total retirement expense this year was $8.9 billion, an increase of $356 million or 4.2% compared to 2000. This follows increases of $428 million in 2000 and $405 million in 1999. Over $141 million of this year's increase is related to the FERS. Approximately $131 million of this year's increase was due to the Cost of Living Adjustments (COLA) for annuitants, increasing their benefits based on the Consumer Price Index (CPI) increases.

Global Bargain

	Price of First-Class Stamp
Australia	$ 0.24
Mexico	0.33
United States	0.34
Canada	0.36
Great Britain	0.38
France	0.41
Germany	0.50
Switzerland	0.54
Italy	0.55
Japan	0.65

WORKERS' COMPENSATION

Our employees are covered by the Federal Employees' Compensation Act (FECA), which is administered by the Department of Labor's Office of Workers' Compensation Programs. This office makes all decisions regarding eligibility for benefits for injured workers. Our bottom line is directly affected every time an employee is injured.

We record as a liability the present value of all the future payments we expect to make to those employees receiving workers' compensation. At the end of 2001, we estimate our total liability for future workers' compensation costs at $5,804 million, an increase of $244 million or 4.4% over 2000. For this year we had planned on workers' compensation costs of $998 million, basing our budget on trends that we expected to continue. In 2001, we recorded $970 million in workers' compensation expense, compared to the $911 million we recorded in 2000. (See Note 3 of the Notes to Financial Statements for details.)

PRODUCTIVITY

Productivity is a measure of our efficiency. While Total Factor Productivity (TFP) growth may fluctuate from year to year, over the long run, our goal is to have positive growth in productivity. During 2001, our TFP improved by 1.3%, which is equivalent to reducing expenses by nearly $900 million. Our two-year cumulative TFP growth of 3.7% is comparable to an expense reduction of more than $2.5 billion. Not since 1978 have we achieved TFP growth of this magnitude.

TRANSPORTATION

Transportation expenses increased by $347 million in 2001, driven by increased fuel prices and a change in how we report processing and transportation expenses associated with the Priority Mail Processing Centers (PMPC). In previous years this expense was included in the Other category. During the year, we terminated our contract with Emery Worldwide Airlines for the transportation of mail within the PMPC network and the operation of the PMPCs. The operations were brought in-house, and new transportation contracts were initiated.

We made a number of changes that have saved money while improving our efficiency. Our Highway Contract Route reviews, which made our truck routes more efficient, and other efforts lowered our transportation costs by approximately $135 million.

We think that transportation costs for 2002 will remain in line with our costs for 2001, subject to adjustments required following the September 11 terrorist attacks.

Growth in Transportation Expenses

2001	2000	1999
7.4%	10.4%	1.4%

EXPENSE GROWTH IN 2002

We expect the cost pressures that made a major impact on our 2001 bottom line to continue. In 2001, we estimated that our total expenses would increase $3.1 billion in 2002. However, we intend to improve productivity by $900 million, reducing our estimated expense increase to $2.2 billion. Of this amount, $1.8 billion is for growth in personnel expenses, and $400 million is for non-personnel expenses.

Aside from pay increases, personnel costs will increase due to health benefits and retirement funding. Our planned reduction of 26 million work hours in 2002 will mark the third year in a row we will have reduced work hours compared to the prior year. In the nonpersonnel category, expense growth will be due mainly to increasing depreciation and interest expense.

The trends driving expense growth will continue. Therefore, our focus in 2002 will be on continuing to manage costs. As the chart below shows, our costs, adjusted for inflation, have risen more slowly than volume over the last five years because of our cost control measures. Not only has volume grown 13% cumulatively since 1996, but delivery points have increased by 5% as well, adding to the workload and cost of delivering the increased volume.

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Cumulative Growth in Volume and Inflation - Adjusted Cost