Financial Section Part II

Additionally, in 2006, we implemented a new transportation strategy, which balances the use of air and surface transportation to reduce cost and improve service performance. We began implementing a national preferential surface transportation network by activating surface transfer centers (STC) in Salt Lake City, Phoenix and Memphis. The STC network reduces cost by shifting mail from costly air transportation to less costly more reliable surface transportation. We have extended our contracts with select commercial air carriers, United Parcel Service and Federal Express enabling improved service at competitive rates.

We will continue to invest in new equipment, consolidate operations and optimize transportation to keep our network service responsive and affordable.

Global Business

In 2006, we created the Global Business organization to manage our worldwide trade to take advantage of opening markets.

Outlook

The economy in 2006 showed trouble signs that are expected to carry forward to 2007 and adversely affect mail volume and revenue growth in the year ahead. We began 2006 with the Hurricane Katrina recovery which led to a spike in energy prices. This spike receded but was eventually followed by a long run up in prices through August 2006 when the world price of oil reached record levels of just over $78 per barrel. While energy prices were rising, housing sales, particularly on the east and west coast were dropping after interest rates increased.

The current omnibus rate case includes a request for an increase in rates of approximately 8.5%. The Postal Rate Commission is expected to issue its recommendations on the request in late 2006 or early 2007. We have assumed for planning purposes that the new rates will be accepted by the Board of Governors and implemented in early May 2007. Any delay will result in missed revenue opportunities of approximately $450 million per month to us.

The demand for all postal products will be reduced in 2007 by three factors. First, the widely expected slowdown in the economy will impact nearly every class of mail negatively. Growth in retail sales, investment spending and employment, all drivers of mail demand, is expected to decline in 2007. Second, in May, the new rate increase will further suppress demand for mailing services. Third, the widespread availability and ease of use of electronic alternatives to mail will continue to depress First-Class Mail volume.

We project Standard Mail volume growth to plateau at 1.9%, despite a rebound in Standard Regular Rate and Nonprofit Enhanced Carrier Route Mail volume. Standard Regular Rate Mail volume should increase approximately 4.6%. Nonprofit Enhanced Carrier Route Mail will benefit from additional election related volume. In quarter four of 2007, the volume in all subclasses of Standard Mail is expected to decline by 2.2% as the presumed May rate increase takes effect.

Although the demand for First-Class Mail is not particularly price sensitive, it is not immune from rate effects. Therefore the back-to-back rate increases are expected to adversely affect volume growth. First-Class Mail single-piece letters are expected to continue to decline due to electronic diversion and rate increases. Workshare letter volume is expected to decline 1.5%, for the first time since 2003. Workshare letters are affected by electronic diversion but to a lesser extent than single-piece letters. However, the slowdown in retail sales will contribute to the softness in workshare letter demand.

In both 2005 and 2006 Priority Mail volume had rebounded from several years of declines. Priority Mail competes in a very competitive market and is considerably more price sensitive than First-Class Mail. We expect Priority Mail volume to be affected by the back-to-back rate increases and decline by 3.9% in 2007. Express Mail has higher price sensitivity than Priority Mail and is expected to decrease by 7.8% in 2007. The demand for these two products is dependent on competitors’ prices that include fuel surcharges. Therefore uncertainty with regard to future fuel prices contributes an added degree of uncertainty to the projection of Priority Mail and Express Mail volume.

Package Services volume is expected to decline 13 million pieces or 1.1% in 2007. Retail Parcel Post is expected to increase 1.2% but Parcel Select is expected to decline 3.1% as retail Parcel Post is much less price sensitive than Parcel Select. Projected Bound Printed Matter volume increases of 1.3% are expected to be offset by an 8.1% volume loss in Media and Library mail. Growing our business to exceed these forecasts is a major priority in 2007.

Periodicals mail volume is projected to decline 2.7% in 2007. In addition to being affected by the factors mentioned above, Periodicals mail is driven by the changing reading habits of many Americans.

We project revenue to increase by $2.5 billion, or 3.4% to $75.3 billion in 2007. Most of this increase is due to the anticipated rate increase. Even though mail volume will be lower, revenue will increase.

Network Growth

Historically, First-Class Mail volume and the growth in contribution it has produced have financed the cost of operating and expanding our universal delivery network. During the last several years however, the volume of First-Class Mail has declined while the number of delivery points in our network has continued to increase. Since its peak in 2001, First-Class Mail volume has decreased by 6.1 billion pieces while our delivery network has expanded through the addition of over 8 million new delivery points. Furthermore, we operate a retail network anchored by almost 37,000 Post Offices, stations, branches and contract units.

Delivering mail to individual delivery points six days a week is a major part of our work. Each year, we add almost 2 million delivery points to our network. We expect the number of delivery points to continue to grow for the indefinite future as a result of population growth and continuing demand for new housing.