Financial Section Part I

Item 1 – Business

Overview

The United States Postal Service (we) commenced operations on July 1, 1971, as an “independent establishment of the executive branch of the Government of the United States.” We are governed by an eleven-member Board of Governors. The Board is composed of nine Governors appointed by the President of the United States with the advice and consent of the Senate, the Postmaster General and the Deputy Postmaster General. Under the Postal Reorganization Act, and its successor, the Postal Accountability and Enhancement Act, Public Law 109-435 ( P.L.109-435), we have a legal mandate to offer a “fundamental service” to the American people, “at fair and reasonable rates.” We fulfill this legal mandate to provide universal service at a fair price by offering a variety of classes of mail services without undue discrimination among our many customers. This means that within each class of mail our price does not unreasonably vary by customer for the levels of service we provide.

We serve individual and commercial customers throughout the nation. We compete for business in the communications, distribution, delivery, advertising, and retail markets.

Our mailing services are sold through our almost 37,000 Post Offices, stations, branches, contract postal units, our website www.usps.com, and a large network of consignees. We deliver mail to about 148 million city, rural, Post Office box, and highway delivery points. We conduct our operations primarily in the domestic market, with international operations representing less than 3% of our total revenue.

All references to years, unless otherwise stated, refer to our fiscal year beginning October 1 and ending September 30. All references to quarters, unless otherwise stated, refer to fiscal quarters within 2007.

We are not a reporting company under the Securities Exchange Act of 1934, as amended, and we are not subject to regulation by the Securities and Exchange Commission (SEC). However, effective for reporting periods ending after September 30, 2007, we are required under P.L.109-435 to file with the Postal Regulatory Commission (PRC) certain financial reports containing information prescribed by the SEC under section 13 of the Securities Exchange Act of 1934. These reports are further described on the following page.

Additional disclosures on our organization and finances, including our Cost and Revenue Analysis reports; Revenue, Pieces, and Weight reports; Strategic Transformation Plan 2006–2010; and the Comprehensive Statement on Postal Operations may be found on our website at www.usps.com. Information on our website is not incorporated by reference in this document.

Postal Accountability and Enhancement Act, Public Law 109-435 (P.L.109-435)

This new postal law was signed by President Bush on December 20, 2006. It revises a number of provisions of the Postal Service’s governing statute, codified in Title 39, United States Code.

The new law, once fully implemented, will divide our services into two broad categories: market-dominant and competitive. Market-dominant services include, but are not limited to, First-Class Mail, Standard Mail, and Periodicals. Future rate increases for these services will be subject to a price cap based on the Consumer Price Index - All Urban Consumers (CPI-U). Competitive services, such as Priority Mail, Express Mail, Bulk Parcel Post, and Bulk International Mail will have greater pricing flexibility.

For our retail customers, the new law anticipates that universal service can be preserved at affordable rates. For commercial mailers, the law is intended to provide rate predictability. For employees, ratepayers, and taxpayers, the new law is designed to provide assurance that the employer portion of the Postal Service’s health and retirement benefits funding obligations becomes fully funded.

P.L.109-435 also directs the U.S. Treasury to resume financial responsibility for the portion of the Civil Service Retirement System (CSRS) pensions of postal employees attributable to military service. This takes the financial burden added by P.L.108-18, estimated in 2003 at approximately $27 billion by the Office of Personnel Management (OPM), off of the Postal Service. Our CSRS obligations are now estimated by OPM to be fully funded as of September 30, 2006, pending future actuarial revaluations. P.L.109-435 also abolished a federally-mandated escrow requirement and directed that the money previously held in escrow be placed into a new Postal Service Retiree Health Benefits Fund (PSRHBF). During the next ten years we are required to make payments into the PSRHBF that average $5.6 billion per year. By 2017, we expect our retiree health benefits obligations will be substantially funded.

P.L.109-435 also reconstitutes the former Postal Rate Commission into a regulatory body, renamed the Postal Regulatory Commission (PRC). The PRC released the final regulations pertaining to the new price-setting process on October 29, 2007. The regulations consist of three parts: (1) regulations related to rate adjustments for market dominant products, including the formula for the calculation of the price cap; (2) regulations related to competitive products; and (3) establishment of a Mail Classification Schedule, which categorizes our products as either market dominant or competitive. The PRC will need to issue additional regulations pertaining to several areas, including the complaint process, reporting requirements, and commercially sensitive materials.

The Mail Classification Schedule divides mail into market-dominant (herein after referred to as “mailing services”) or competitive categories (herein after referred to as “shipping services”), establishes which types of mail constitute separate products, and presents a brief description of each product. The new regulations allow us to make certain classification changes much more easily than under the previous system, which enhances overall ratemaking flexibility.

The regulations for mailing services, currently constituting approximately 90% of all postal revenue, allow rate changes every year with limited prior review, as long as the average increase for each class of mail is no greater than the rate of inflation as measured by CPI-U. The regulations permit rate increases above the price cap in the event of extraordinary or exceptional circumstances.

The regulations for shipping services place no upper limit on rate changes, and the Governors of the Postal Service can adjust rates as necessary with the requirements that each competitive product must cover its attributable costs and no competitive product may be cross-subsidized by mailing services. In addition, shipping services are required to cover 5.5% of the Postal Service’s total institutional cost burden.

We are allowed by P.L.109-435 to file one last rate case under the current rules, to be filed not later than December 19, 2007.

On November 15, 2007, our Governors announced that future prices will be adjusted using regulations issued by the PRC for any future rate changes.

The PRC now has its own Office of Inspector General (OIG). The Postal Service will continue to be required to provide the funding for our OIG, the PRC, and the PRC’s OIG.

Additionally, P.L.109-435 requires us, beginning in 2008, to file with the PRC a number of financial reports not previously required. These include quarterly reports containing information required by the SEC to be filed on Form 10-Q within 40 days after the end of each fiscal quarter, an annual report containing information required by the SEC on Form 10-K within 60 days after the end of each fiscal year, and current reports containing information required by the SEC on Form 8-K within the prescribed time frame. Further, P.L.109-435 requires the Postal Service to comply with the rules prescribed by the SEC implementing Section 404 of the Sarbanes-Oxley Act of 2002, which pertain to reporting on the effectiveness of our financial internal controls. The requirement to comply with the requirements of Section 404 is effective beginning with the 2010 annual report.

Since the law’s enactment, we have been working to ensure that we are ready to meet its requirements. Our goal is to work with the mailing community, the PRC, and our unions and management associations to make the transition as smooth as possible for all stakeholders. To achieve this goal we have:

• sought additional input through a Federal Register notice.
• worked with mailers on developing modern service standards and performance measurement systems.
• received input on service standards from a number of other stakeholders.
• met with the PRC and provided extensive comments to help them develop the new rules for the mailing services and shipping services rate-setting process to ensure a smooth transition for everyone involved.
• continued to work internally to prepare our systems to be ready to meet the new reporting requirements both for price-setting and regulatory reporting.

Strategy

The Strategic Transformation Plan provides focus and direction for all Postal Service business and operating activities. It defines our vision and establishes strategies for revenue, service, efficiency, customer-focused culture, and sustainability.

The strategic transformation process is dynamic and adaptable. The Plan is substantially revised every three years, and is updated annually to accommodate ongoing changes in our business environment. This annual planning process incorporates an ongoing assessment of performance, refinement of strategic goals, and prioritization of programs and budgets to optimize results. Strategic targets and specific functional objectives are then deployed throughout the Postal Service.

Clearly, the most significant event to occur this year was the enactment of the Postal Accountability and Enhancement Act. Although the law did not change our fundamental mission, it did change many aspects of how we will manage our business. Many of these changes will be reflected in a revision to the Strategic Transformation Plan, which will be published in December 2007.