USPS FINANCES: UNDERSTANDING THE CURRENT DIFFICULTY

(paper copy of presentation in USPS company library file – paper copy includes tables and other exhibits not available here)
USPS FINANCES:
UNDERSTANDING THE CURRENT DIFFICULTY
BY ALAN M. ROBINSON
February 9, 2001
The United States Postal Service has just completed a difficult first four accounting periods. Through this period, the Postal Service reported a loss of $87.3 million, which is $419.9 million worse than plan. These results explain the rapidly declining official projections of the Postal Service's financial performance. In four months, the Postal Service's public pronouncements about this year's prospects have changed from a surplus of $150 million to a deficit of $2 billion. The actions taken yesterday by the Postal Service Board of Governors indicated that deficits of this size cold pose significant financial consequences for the Postal Service.
In responding to the financial difficulties, the Board of Governors ordered the Postal Service to
1) begin preparing a rate case as soon as possible;
2) review all programs and projects and curtail or eliminate all nonessential activities;
3) evaluate the Postal Service's long term ratemaking needs;
4) review all management tools to aggressively improve the Postal Service's financial integrity; and
5) cut capital spending by $1 billion.
These orders indicate that the Board of Governor's immediate concern is that the Postal Service may not have sufficient cash or borrowing capabilities to cover both the current projections for losses and the Postal Service's current capital investment plans. Clearly, the Postal Service now faces its most difficult period since the early 1990's when the Postal Service was burdened with additional pension and retiree costs mandated by the Omnibus Budget Reconciliation Acts of 1990 and 1993.
The last review of Postal Finances outlined how the Postal Service arrived at its current financial difficulties. That report identified six challenges that the USPS faced as it entered fiscal year 2001.
 rate level uncertainty;
 growing fixed expenses,
 restructuring costs beginning with the Emery – Priority Mail Settlement,
 increasing debt service;
 deferred capital expenditures, and
 declining volumes and revenue.
In addition to the challenges noted in October, the Postal Service now faces an economy that has slowed substantially more than anticipated by any forecaster last fall. Each of these challenges worsened the Postal Service's financial prospects from projections made at the beginning of the fiscal year. This update discusses each of these challenges and shows how they contributed to the Postal Service's current financial difficulty.
RATE LEVEL UNCERTAINTY
The Postal Rate Commission's decision last November eliminated the uncertainty about rates that existed at the beginning of the fiscal year. However, the recommended rates, which the Postal Service implemented under protest, will generate less revenue than the rates that the Postal Service originally proposed. The revenue difference is comparable to the revenue requirement reductions made by the Postal Rate Commission in R97-1 as noted in the early review of postal finances.
Unfortunately, the Postal Service's budget assumed that the Postal Rate Commission would approve the Postal Service's full revenue requirement. Revenue budgets from accounting period 5 on overestimate revenue by the difference. By using an optimistic revenue forecast, the Postal Service must now adjust its revenue budget downward by $500 million.
GROWING FIXED EXPENSES
In fiscal year 2001, the fastest growing expenses continue to be those that are independent of changes in postal volumes. These costs include CSRS pension, retiree COLA's, workers compensation, retiree health benefit, and interest expenses mostly associated with postal pensions. So far this year these expenses have grown by 9.4%, double the increase in salary and benefit costs. The projections contained in Exhibit 1 indicates that for the year these costs will be at least 8.6% over last year and $116.8 million more than what the Postal Service put in its revenue requirement presentations in R2000-1.

The Postal Service anticipated the growth in fixed expenses in the current budget. Therefore the Postal Service's financial projections, made at the beginning of the fiscal year, included all of the increases noted here. These expenses could change adversely if the Postal Service needs to increase its debt prior to the regular borrowing period at the end of the fiscal year. The Federal Reserve's efforts to reduce interest rates should have some beneficial budgetary effects as the Postal Service adjusts its debt portfolio to take advantage of lower long-term interest rates.
RESTURCTURING COSTS
Restructuring costs include all costs associated with making significant changes in business operations. These costs include those associated with downsizing and restructuring the business, abandoning product lines, settling lawsuits and other legal actions, writing off damaged and impaired assets, introducing new management information and operating systems and changing accounting methods. The Postal Service faces substantial restructuring costs due to lawsuits, early retirement offers, discontinuing operations, new contractual agreements and introduction of new operating and information systems
The Postal Service will have to pay a restructuring cost to Emery to cover a final agreement on rates due Emery under the recently ended Priority Mail center contract. Additional restructuring costs will come from shifting the Express Mail and Priority Mail air networks to Federal Express from Emery and other air carriers. The Postal Service will face increased unemployment compensation as it shrinks its workforce. In accounting Period 4 unemployment compensation costs increased by 85.7% over last year. Other restructuring costs would come from early retirement incentives, and decisions to shrink transportation and other contracted services. Restructuring costs from closing the Emery contracts could cost the Postal Service $200 million or more. In addition, the Postal Service has start up costs for switching their air service to FedEx. At this point, a reasonable estimate of unbudgeted fiscal year 2001 restructuring costs would be around $500 million.
INCREASING DEBT SERVICE
The Postal Service now holds $2.3 billion in debt more than it held at the same point last year. (Exhibit 2) In the current accounting period, the Postal Service shifted one half of this increase in debt from short term to long term debt, most likely taking advantage of interest rates more favorable than those that were available in October when it took on the additional debt. Given the current interest rate environment, the Postal Service will likely shift an additional debt from short term to long term instruments as the forecasts of operating deficits makes the prospect of the Postal Service paying off its $3.8 billion in short term debt this year extremely unlikely.
Based on trends in the past three years, the Postal observers should expect the Postal Service to attempt to pay off an additional $650 to $750 million in short term debt to cover Fiscal Year 2000's end of the year expenses. This will leave the Postal Service with $3.1 billion in short term debt, half of which was generated over the past two years when the Postal Service was not able to pay off all of its end-of -the year borrowing during the subsequent year.
The ability of the Postal Service to pay off debt generated to cover end of the year expenses this year could be compromised by the projected operating deficits. Over the past few years, the Postal Service has paid off all or nearly all of its end-of-the year debt in years in which it generated operating profits. Last year, with a $199 million loss, the Postal Service could not pay $1.3 billion of the debt it accrued at the end of the prior year to cover end of the year obligations. The larger projected deficit suggests that in this year even less of this debt will be paid this year.

DEFERRED CAPITAL EXPENDITURES
One method that corporations use to adjust cash outlays in response to slowing business prospects is cutting capital expenditures. Through accounting period 4, capital expenditures are 5% below last year and 11% below plan. Now the Postal Service's plan to cut $1 billion more will reduce capital expenditures 44% for the rest of the year. With these cuts, the Postal Service will be reducing capital expenditures for two years in a row with the reductions much larger now. Postal stakeholders need to know specifically how the cuts now proposed will affect the ability of the Postal Service to manage its business and improve efficiency.
Deferring capital expenditures have minimal impact on operating surpluses or losses. Capital expenditures enter the budget as depreciation and therefore only a small portion of the expenditures enters the budget as a cost in the year in which they are spent. Reducing capital expenditures conserves cash. If deficits are large, the Postal Service cannot invest in the business but needs the cash operations or borrowing can generate to cover losses.
DECLINING VOLUMES AND REVENUE
Accounting period 4 showed a 1.1% reduction in volume and 2.4% reduction in revenue. This follows a first quarter in which mail volume rose 3.3% and revenue increased 1.3%. While troubling, AP 4 figures are deceiving because they are compared with a period last year in which mail volumes grew exceptionally fast and then slid in the next period. Some First, Periodical, and Standard Mail mailers may have accelerated their mailing schedules into Accounting Period 4 last year to avoid potential Y2K problems. Also last year, private parcel carriers did not have sufficient delivery capacity to meet all of their customer's needs and the excess demand sparked rapid growth in Express, Priority, and Standard B (parcel post) products. This year both United Parcel Service and Federal Express made substantial expansions in their sortation and delivery capabilities that both have admitted were greater than shipper demand required. This excess capacity among private sector carriers most likely drained business from the Postal Service in accounting period 4 this fiscal year. Postal observers will need to wait till the next accounting period's volume and revenue reports are out to fully comprehend the extent that volume growth ended.
What is more disturbing about the volume statistics provided to date is the decline in the Postal Service's primary parcel products. The Postal Service is clearly losing market share among parcel carriers whom all experienced limited volume growth during the same period. The loss of one-quarter of Special Standard Mail (video and audio recordings and other media) raises questions about where that business went. The 16% increase in Priority Mail rates that just went into effect should only exacerbate this trend.
In the October review of Postal Finances, a review of accounting period revenue forecasts since 1998 indicated that the Postal Service's revenue budget consistently overestimated actual revenues. Adding an additional four accounting periods did not change this conclusion. Based on this additional data, the Postal Service's revenue budget most likely will overestimate commercial revenue every by 1.3% and retail revenue by 1.8%. With its current revenue forecast, and before taking into account the change in rates, the Postal Service will likely report a revenue shortfall in Fiscal year 2001 nearing $1 billion just from the upward bias in its revenue budget. Figures 3 and 4 depict the forecasting error data since 1998.

ECONOMIC SLOWDOWN
In the fourth calendar quarter, the U.S economy grew at a 1.4% and the expectation is that the next two quarters will also be slow. Clearly the slowdown has and will continue to affect postal volumes and revenue. The question is how much. Recent reports made by private sector competitors and testimony provided by the Postal Service in R2000-1 provide some indication of how much.
. The private parcel carriers publicly noted the impact of the economic slowdown first. Federal Express noted in its most recent conference call that volumes started to drop in mid October. United Parcel Service indicated that it had geared up for heavy holiday shipping season that it realized would not materialize shortly after Thanksgiving. The Postal Service's parcel and Priority Mail volume trends are somewhat weaker than its competitors. The outlook for parcel products depends greatly on how long the slowdown in retail sales lasts, the impact of the large increase in Priority mail rates, and the increases in rates imposed by parcel consolidators.
Postal Service revenue from periodicals is unlikely to change from trends until the second quarter. The advertising buys for the first quarter of the calendar year were set before the extent of the slowdown was evident. Therefore, reduction in magazine advertising, and related postal revenue, will not likely occur until the second calendar quarter. The Postal Service forecasting model confirms that there is a lag between changes in economic activity and periodical volume
The Postal Service's forecasting model shows that all First Class mail is economically sensitive. First Class presort is more economically sensitive than single piece mail. In an economic slowdown, all First Class Mail volume will decline at a rate somewhat less than the decline in economic activity.
Both Regular and Nonprofit Standard Mail are significantly influenced by changes in spending and economic trends. Regular Standard Mail is also sensitive to changes in the price of newspaper advertising, which will be under pressure in a slow retail sales environment. Finally Regular ECR Standard Mail (Saturation Mail) is highly affected by changes in economic trends.
This cursory review of the factors that influence Postal volumes suggest that the economic slowdown should have the greatest and most immediate effect on the Postal Service's Priority Mail Parcel and Standard Mail products. For all Postal products the decline in volumes will be somewhat less than the decline in economic activity. If one assumes that mail volumes change by one-half of one percent for every one percent change in economic activity, the change in economic growth forecasts from September till now can be expected to reduce mail volumes by 1/2 to 1 1/2 percent.
As the Postal Service's public forecasting models forecast volume and not revenue, it is possible that the slowdown could have a different affect on revenue than volume. Changes in mail piece volume can affect the type of worksharing that mailers can use and increase the revenue per piece. Similarly, changes in weight changes revenue per piece. If one ignores these effects, the assumption of a 1/2 to 1 1/2% reduction in mail volumes could reduce mail revenue for the rest of the year by between $500 million and $1.5 billion.
CONCLUSION
Excluding the economic slowdown, the difficulties identified above explain why the Postal Service is projecting a deficit greater than $2 billion for fiscal year 2001. The examination of difficulties indicates that the deficit could be greater than $2 billion even if the Postal Service makes serious efforts to reduce expenses. The Postal Service has never seen deficits of this magnitude. The largest deficits previously came after the Postal Service was saddled with additional pension and annuitant costs in 1990 and 1993
Deficits of $2 billion or more pose severe strains on the ability of the Postal Service to generate sufficient cash to pay its bills at the end of this fiscal year. Last year when it lost less than $200 million, the Postal Service needed to borrow $2.4 billion to cover its expenses and capital investments. The Postal Service's original plan for fiscal year 2001 involved borrowing $2 billion, but the increase in the potential deficit could double the Postal Service's borrowing requirements. Unfortunately, the Postal Service legally cannot borrow more than $3 billion of which $2 billion can be borrowed for capital expenses and $1 billion for operating expenses. As such, the Board of Governors had no choice but to order the cuts in capital and operating spending. However the cuts announced this week may not be sufficient if the economic slowdown reduces postal revenue beyond what is now anticipated.
The immediate financial crisis suggests that postal stakeholders may not have the time to wait for the results of a Presidential Commission that some have suggested. Postal stakeholders need real information about how the current cash crunch will affect postal operations now and the Postal Service's ability to continue to perform in the future. The cash situation suggests the possibility that the Postal Service needs either an increase in its borrowing limits or specific congressional appropriation to cover cash needs until a long-term plan can be developed.
. In addition to steps employed to cover the immediate crisis, a serious independent assessment of the Postal Service's physical plant, financial viability, and corporate strategy is now required. This assessment would be in addition to the assessment of legal and regulatory structure and is required in order to determine if the Postal Service can remain a self-sustaining ongoing enterprise. The assessment should be similar in scope to the one that the United States Railway Association (USRA) completed on the Penn Central following its bankruptcy. Following that assessment, the USRA guided the Penn Central and other North Eastern railroads successfully out of bankruptcy and a1llowed it to return to private ownership as Conrail. Unfortunately, it appears that the assessment of the Postal Service may come at a point when its financial health is nearly as poor as the Penn Central's was.