Financial Section Part II

Despite the recent slowdown in the housing market, long-term trends for housing can be expected to track long-term trends in population. We expect the number of delivery points to continue to grow in the future. Household growth will translate into a continuing expansion of our delivery network. As the population and delivery network continue to grow, we expect First-Class Mail volume to continue to decline. This combination of trends will continue to challenge us to build all other postal business and increase productivity to continue to finance the nation’s universal delivery system.

Impact of Inflation and Changing Prices

The Postal Reorganization Act requires that we provide universal mail service and set postal rates and fees so that total estimated revenues of our organization equal our total estimated costs. Our primary costs are for labor and the related cost of benefits, transportation, utilities, material costs, and the cost of maintaining, replacing and expanding our retail and distribution network.

The back-to-back rate increases in 2006 and 2007 have two different underlying causes. The January 2006 rate increase was designed only to cover escrow related provisions of P.L.108-18. The 2007 rate increase will be the first rate increase associated with covering postal operating expense increases since 2002. Despite the fact that $1.1 billion of cost reductions are planned for 2007, these productivity improvements alone will not offset the continuing upward cost pressures resulting from resource cost inflation, the continuous expansion of our delivery network, and the loss of First-Class Mail volume and its high level of contribution to institutional costs. Further rate increases will be necessary to fund our expense increases.

Expense Growth

We estimate that total expenses in 2007 will be $73.6 billion, a 2.3% increase over our 2006 expenses of $71.9 billion. We expect personnel costs and our cost per workhour to increase. This increase will be driven primarily by cost-of-living pay adjustments and potential contractual pay increases that may be incurred through collective bargaining with our unions.

We expect non-personnel expenses, excluding transportation and interest expenses, to increase approximately $242 million, or 2.6%. Transportation expenses are expected to grow $214 million, or 3.5% over 2006 due to higher fuel costs.

The 2007 plan reduces workhours by 40 million hours below the 2006 total. Our planned workhour reduction target is equal to approximately 20,000 full-time equivalent employees. This will be the seventh out of the last eight years in which we have reduced workhours. The workhour reductions are a product of process improvements, automation through capital investment programs and a projected volume decline.

Item 7A – Quantitative and Qualitative Disclosures about Market Risk

Market Risk Disclosure

In the normal course of business, we are exposed to market risk from changes in commodity prices, certain foreign currency exchange rate fluctuations and interest rates. With the limited exception explained on the following page, we do not use derivative financial instruments to manage market risks. Additionally, we do not purchase or hold derivative financial instruments for speculative purposes.

Revenue

Revenue is a function of the volume and mix of mail. As noted, mail volume trends have resulted in a lower revenue-per-piece mix. If this accelerates beyond what has been projected it will have a more significant effect on revenue.

Economic Risk

The demand for all postal services is heavily influenced by changes in the economy. The widely expected slowdown in the economy will impact nearly every class of mail negatively in the coming year. Growth in retail sales, investment spending and employment, all drivers of mail demand, is expected to decline in 2007 and may further reduce forecasted results.

General Inflation Risk

Each of our labor contracts with our largest unions currently includes provisions granting COLAs. These agreements expire on November 20, 2006. Under the current contracts, COLA adjustments are generally granted semiannually and are linked to increases in the consumer price index (CPI). Non-bargaining employees do not receive COLAs, but are eligible for pay for performance increases. Because employee compensation represents a significant portion of our annual expenses, and COLAs may be a component of future labor contracts, an increase in the CPI greater than had been incorporated into our financial plans could be a significant risk to our financial results. We estimate that an increase in the CPI of 0.5% would cause an annualized increase in our COLAs of about $100 million.

Fuel Price Risk

Fuel prices are a significant part of our expenses. We are exposed to changes in commodity prices primarily for diesel fuel, unleaded gasoline, aircraft fuel for transportation of the mails and natural gas for heating facilities. A 1% change in fuel and natural gas costs would result in more than a $48 million increase in our expenses on average. We currently do not use derivative commodity instruments to manage the risk of changes in energy prices.