MANAGEMENT DISCUSSION & ANALYSIS: OUTLOOK

2001 proved to be a very challenging year for the Postal Service. A softening economy and inflationary increases in our costs put severe pressures on our financial performance. Even our extraordinary productivity performance, which limited cost growth, was insufficient to offset these negative forces. We expect 2002 to be even more challenging. There is greater economic uncertainty today, and we face the challenges of maintaining service and improving productivity in the wake of terrorist attacks that use the mail as a delivery mechanism.

The U.S. economy had entered a recession even before the terrorist attacks of September. Over and above their human cost, these atrocities are causing a significant short-term dislocation to the economy, adding still more uncertainty to our view of the future. Layoffs and unemployment are rising, and much of the wealth generated by the long bull market has disappeared. In 2002, we are concerned that even if the recession is short, stagnation or slow economic growth will follow.

An additional hazard that primarily affects the Postal Service is the continued threat from attacks such as those that spread anthrax bacteria late in 2001. In response to these threats, we are working to ensure the safety and security of the mail.

Although inflation is moderating as a result of a weakening economy, it is uncertain whether the Postal Service will experience any substantial benefit. Our labor costs have grown very rapidly in recent years, with increases in salaries and health benefits outpacing the Employment Cost Index (ECI), partly as a result of arbitration decisions that awarded substantial wage increases to some craft employees. This growth has occurred despite the reductions in total work years we achieved in each of the past two years. Health benefits expenses have grown at double-digit rates. With three more arbitration decisions due in the coming year, there is significant uncertainty about labor costs. Also a growing share of Postal Service expense relates to retirement benefits that increase with the passage of time.

Because our price for labor is increasing faster than inflation, we will not be able to meet our goal of keeping rate increases less than inflation in the near term. In each of the last three rate cases (R94-1, R97-1, and R2000-1), the average price increase was less than inflation, with a cumulative price increase of about 21%, compared to inflation of nearly 32%. The proposed rates for the R2001-1 filing, however, represent an average increase of 8.7%, against an expected inflation of less than 4%.

As volume growth slows, it is difficult to keep rate increases below the rate of inflation because the revenue earned from that volume must not only cover the cost of those volumes but must also cover the costs of a growing delivery system. Furthermore, in recent years, mail volume growth has not kept pace with the economy.

Every year we deliver to about 1.7 million new addresses, as the number of addresses we are obligated to serve continues to grow. Neither population growth nor the rate of household formation has slowed. New housing continues to be built, with new addresses that need mail delivery service. As we try to cut costs, annual address growth requires the equivalent of us adding over 3,000 new carrier routes. Operating these routes requires hiring more carriers, purchasing new vehicles and equipment and building new facilities to serve the growing delivery network.

At the same time that labor costs are rising, we face the prospect of slow mail volume growth. The diversion of First-Class and Standard Mail to electronic alternatives is gradually diverting volume from the mail stream, and we expect this to continue. Internet-based bill payment systems are well established, and we expect more consumers to opt for electronic bill payment for at least some of their bills. As electronic bill payment becomes more popular, it seems likely that the number of bills presented to consumers electronically will also grow. We expect First-Class Mail volume growth to remain sluggish, a result of economic conditions and the increasing market share of alternative bill presentment and payment technologies.

The economic slowdown will affect Standard Mail. Most observers see declining growth in the ad market in the near future, an effect of generally poor economic conditions. Since Standard Mail is frequently part of a multifaceted advertising campaign, shrinking advertising budgets will impact volume and revenue. In the long term, the prospects for Standard Mail volume growth are favorable. The fact that Standard Mail is a highly targetable medium works in its favor, because resources can be used to reach a very specific audience, rather than having a message broadcast to many uninterested parties.

The end result of slowing volume growth and continuing network expansion is a declining number of pieces per delivery and a cost per delivery that rises. To combat this growing inequality, we must continue to manage our costs and use less resources to increase productivity. Over the last two years, we have increased our productivity by streamlining our processes and weeding out costs. Even so, our accumulated losses are growing, and our debt is increasing. In the wake of the anthrax attacks, we are assessing the need to invest in new equipment to ensure the security of the mail. The ultimate cost of this investment remains unclear, but it could be significant, and unless funded by appropriations from Congress, it compounds our problems.

Volume Growth per Delivery Declines...

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...While Resources Costs Keep Rising Despite Controlling Resource Usage

Source: Christensen Associates, Inc. Productivity Data

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In the face of these trends, we have frozen capital spending on facilities and other infrastructure projects not related to safety and security. This freeze will have negative impacts. We need investments in facilities and infrastructure to maintain our network and fulfill our obligations to our customers. We need to purchase new equipment and buildings to service new addresses, and we need to be able to maintain, repair and replace existing infrastructure to continue serving our customers.

Our challenge is to build our business and keep improving productivity through control of our costs, while ensuring our long-term ability to continue providing high-quality service. This may include not only filing rate cases but also seeking a broader reform of the legislation that guides the Postal Service to give it more flexibility in the marketplace and more control over costs.

Our discussion in the MD&A represents our best estimate of the trends we know about, the trends we anticipate and the trends that we think are relevant to our future operations. However, actual results may be different from our estimates.