Our opportunity for debt reduction in 2005 will depend upon our ability to operate at close to break even, combined with our ability to control our level of capital investment. Our debt level for 2006 and beyond will be influenced by these same factors and will also be greatly influenced by the yet-to-be-specified requirements of P.L.108-18, which requires that savings attributable to the legislation after 2005 must be held in escrow and can not be obligated or expended until otherwise provided for by law. An additional factor that will affect our 2006 debt level is the uncertain result of any rate case filings with the Postal Rate Commission. In the event that we implement a rate increase and the resulting additional revenues do not cover both the normal projected increases in expenses and also the escrow requirement, then the shortfall will need to be covered by increasing debt, all else remaining constant.

INTEREST EARNING INVESTMENTS

Whenever we determine that we have funds in excess of our current needs, we invest those funds with the U.S. Treasury's Bureau of Public Debt. We invest primarily in overnight securities issued by the U.S. Treasury, but by statute we may invest in any obligation of, or any obligation guaranteed by, the U.S. government, through the Secretary of the Treasury. We favor short-term investments because of the nature of our cash flow patterns, but also to ensure that our investments are not unnecessarily exposed to the price risk associated with increases in interest rates. Investment income was $33 million in 2004, versus $58 million in 2003 and $46 million in 2002.

Cash Flow

NET CASH PROVIDED BY OPERATING ACTIVITIES

During 2004, net cash provided by operating activities was $5.8 billion compared with $6.4 billion in 2003. The decrease of $570 million was due primarily to increased operating expenses resulting from higher benefit costs. The main driver of these benefit increases was a $697 million (11.9%) increase in retirement costs mainly as a result of a full year of funding CSRS retirement contributions at 17.4% as required by P.L.108-18 and a $180 million (15.9%) increase in retiree health benefit costs. These increases were offset by an additional $247 million in accrued payroll and benefit expenses caused by one additional day of accrued payroll at year end.

During 2003, net cash provided by operating activities was $5 billion higher than 2002 mainly due to P.L.108-18 which decreased our pension payments by $3.5 billion.

NET CASH USED IN INVESTING ACTIVITIES

During 2004, 2003 and 2002, net cash used in investing activities was $1.7 billion, $1.3 billion and $1.7 billion respectively. The increase in 2004 from 2003 reflects an increased investment strategy in mail processing and retail equipment as well as increased funds spent on building improvements. The 2003 decrease reflects a reduction of spending on mail processing equipment, building construction and building improvements.

NET CASH USED IN FINANCING ACTIVITIES

In both 2004 and 2003 the net cash used in financing activities of $5.6 billion and $4.0 billion respectively, reflect our desire, and the requirement of P.L.108-18, that any "savings" generated by the enactment of the law be used to pay down debt. Consequently in 2004 we paid down $5.5 billion in debt and in 2003 we paid down a net $3.8 billion in debt. In 2002 the $383 million of cash provided by financing activities reflects the balance of appropriations provided by the President and Congress for emergency preparedness expenses of $583 million and a reduction of debt of $200 million.

Liquidity

Liquidity is the cash that we have in the bank (the Postal Service Fund in the U.S. Treasury) and the amount of money we can borrow on short notice if needed. In recent years we have relied less on the cash we have on hand and more on the readily available cash we can borrow as needed. Our Note Purchase Agreement with the Federal Financing Bank, renewed this year, provides for revolving credit lines of $4 billion. These credit lines enable us to draw up to $3.4 billion with two days' notice and up to $600 million on the same business day the funds are needed. Under this agreement we can also use a series of other notes with varying provisions to draw upon with two days' notice. The notes provide us the flexibility to borrow short-term or long-term, using fixed or floating rate debt, and can be either callable or non-callable. We believe that our arrangement with the Federal Financing Bank provides us with adequate tools to effectively manage our interest expense and risk.

We are limited in the amount of funds we can borrow by the amount of debt authorized by the Board of Governors and by certain statutory limits on our borrowing. First, our total debt outstanding cannot exceed $15 billion. Second, the net increase in debt for any fiscal year cannot exceed $2 billion for capital purposes and $1 billion to defray operating expenses ($3 billion maximum annual limit). For 2005, we do not project an increase in debt, and we have not asked the Governors to authorize an increase.

Our liquidity will be comprised of the cash that we have entering 2005 plus the cash flow that we can generate from operations. We expect cash flow from operations to not only supply enough cash to fund our capital investments, but to generate some additional cash flow that could be applied to further debt reduction. However, the amount of cash and debt that we have at the end of 2005 will be influenced by developments regarding the escrow fund requirement and a potential rate case. A less than favorable outcome for these uncertainties would cause us to favor carrying more cash and debt into 2006 as a liquidity cushion.