Avoiding Financial Armageddon at the Post Office

Now it seems strange
How we used to wait for letters to arrive
But what’s stranger still
Is how something so small can keep you alive
—Arcade Fire, We Used to Wait

It’s election season.  And since Candy didn’t use my question in the second debate, I thought I’d ask it here: “President Obama and Governor Romney, the United States Parcel Service is forecasted to lose $5.5 billion in 2012, and also has defaulted on scheduled payments of $11 billion.  What would you do to fix it?”

Since the debates are now over, let me take a shot at answering it.

We have a thesis at Andreessen Horowitz that “software is eating the world”, such that analog businesses in a wide variety of sectors are being crushed by rapid digitization.  In my last blog post, I discussed how this was playing out in retail, where market share gains by online retailers at the expense of offline retailers are threatening the long-term viability of many offline merchants due to their high operating leverage.  This same dynamic is playing out in communications.  The USPS is an analog business being rapidly consumed by digitization.

According to the Postmaster General, “The core function of the Postal Service is the physical delivery of mail and packages…to every address in America.”  Physical = analog.  Here is the USPS product mix in 2008, just four years ago:

It was an analog cornucopia.  Half of their revenue (and even more of their profits) came from first class mail, but this personal and business correspondence is being rapidly replaced by digital email, texts, social networks, and online statements and bill-pay.  Similarly, catalogs, magazines and newspapers are being replaced by commerce and content websites, supported by email marketing.  I had a front row seat at eBay as money orders started getting replaced by PayPal.  The only growth business that USPS has is packages due to the explosion of e-commerce.  But unfortunately, this business has been relatively small for them (representing only about 14% of 2008 revenue) and highly competitive vis-a-vis UPS and FedEx.

So what has happened to the volume of USPS deliveries?  It’s been decimated:

I have to give the USPS management credit—they saw pretty early on that a freight train was coming right at them.  When I was managing eBay in the early 2000’s, the USPS management team organized a session with select Valley executives on what they could do to mitigate potential disruptions to their business due to digitization (I was likely invited because the eBay community in aggregate was one of their largest customers).

Any business that encounters disruption on this scale needs to respond decisively to remain viable.  And the Postal Service is essentially a business: They are “an independent establishment of the executive branch that does not receive tax dollars for its operations.”  But unlike privately owned businesses, “…the Postal Service is nevertheless restricted by laws that limit its ability to control costs and grow revenue in the way a business would.” (2011 Annual Report)

What are some of these restrictions?  The USPS…

Has a “universal service” obligation that mandates the delivery six days per week to a national footprint of 151 million homes and businesses

Has labor agreements that specify cost-of-living wage increases and contractual benefit plans for employees and retirees

Faces limits in raising prices

Is “restricted by law from taking certain steps, such as entering new lines of business that might generate additional revenue…”

USPS management has attempted to navigate these restrictions to mitigate the financial impacts of digitization.  They have been trying to control the costs they can, rapidly consolidating mail-processing facilities and adjusting their employee counts down in line with falling mail volumes.  And they have raised prices.  Unfortunately, the biggest price increases have been in packages and shipping, their most competitive market:

So what’s the net outcome of these actions?  Massive and growing losses.  Revenue is eroding rapidly as the price increases have only partially compensated for plummeting volume.  And they’ve made very modest progress on lowering expenses:

And unfortunately, their situation is even worse than this.  The USPS historically has not accrued for the cost of retiree health benefits; they’ve booked them on an as-spent basis (governmental entities are allowed to do this, unlike the private sector).  And the costs they were spending paled compared to the costs they should have been accruing.  Congress in 2006 mandated that USPS catch up on these obligations over a 10-year period, a process called “RHB Pre-Funding” (RHB stands for Retiree Health Benefits).  They were able to make these Pre-Funding payments between 2007 and 2010, but their economic meltdown has caused them default on their recent obligations (Josh Barro of Bloomberg provides an excellent explanation of this issue here).  The $11 billion in defaults, combined with their operating loss of $5.5 billion, is resulting in the disastrous $16.5 billion 2012 deficit.

USPS management has presented a plan for how they potentially can navigate their way out of this mess (USPS “Plan to Profitability”).  It involves significant savings from changes in benefit plans, decreased service levels (e.g., moving from six to five-day delivery), some post office closures, and continued headcount reductions.  It also involves continued price increases and identifies some revenue-boosting initiatives.  It’s an ambitious plan, but it has a few big issues:

1. About half of the financial improvements require require “significant legislative change”, and Washington hasn’t been very good lately on that front.

2. It ignores the issue of the under-funded retiree health benefit costs.

3. Most importantly, it assumes that their revenue erosion moderates significantly going forward.  This just won’t happen; that digital “genie” is out of the bottle.

On the current course, we’re destined to see ever-larger losses as revenue continues to fall and expenses are only tweaked. The Postal Service is effectively becoming a taxpayer-supported entity, with ever-growing losses subsidized to maintain the “common good” of physical mail delivery.

But there are alternatives to mitigate the pain of this digital transformation:

Stem the Bleeding:

There are some very highly leveraged ways that you could improve USPS economics.  But all require political will, so they’re not likely to happen any time soon:

Re-invent the post office.  Operating and staffing 36,000 physical post offices is hugely expensive.  And these post offices are being hollowed out, as volume going through the average post office is down 19% in the past four years alone.  USPS needs to steal pages from the UPS and FedEx playbooks.  Most physical post offices should be closed and replaced with self-service kiosks, supported by proven technology tools.  These kiosks could be located in retailers, who would gladly trade a little space in exchange for foot traffic and possibly a revenue share. Closing post offices would save a fortune in operating and staffing costs, and the proceeds from selling the real estate could fund the benefits shortfall.

Deliver mail less often.  Your local mail person is delivering 23% less mail to an average location today than four years ago.  It doesn’t make sense to keep delivering progressively less mail with the same frequency.  Cutting delivery down to three days a week, say Mondays, Wednesdays and Fridays, would halve delivery trips, but the average time to deliver something would increase by only a half day.

Restructure comp and benefits.  Postal Service employees and retirees are expensive.  I calculate current USPS manpower costs at $84k per employee (excluding those RBH pre-funding costs), compared to $67k and $70k respectively for UPS and FedEx workers (who have a higher proportion of skilled jobs like airline pilots and mechanics).  It’s not intuitive to me why USPS labor deserve a 21-25% premium over their private sector counterparts.  An enormous 80% of USPS costs are labor-related.  If they paid the same labor rates as UPS (and that of course is a BIG “if”), their current $5.5 billion operating loss would swing to a multi-billion dollar profit.

Selectively raise prices.  The cost of mailing a first-class letter was in the U.S. was $0.44 in 2011; comparable figures in other countries include Great Britain at $0.74, Germany at $0.77, Japan at $1.06 and Norway at $1.63.  Giving the USPS more flexibility to raise selective prices could mitigate near-term financial pain.

Compete:

Package delivery is the only one of USPS’s market segments that is growing.  But the packages business is very competitive, and USPS is getting its clock cleaned by UPS and FedEx.  In my experience, many businesses start out using USPS given its ubiquity and low rates, but switch to UPS and FedEx as they grow due to their volume discounts and superior service.  USPS needs to focus on packages, improving their service and having the latitude to offer volume discounts.  They actually should have a cost advantage competing for an incremental package since they already make a trip to each destination each day.

Innovate:

A few private sector companies have in recent years explored trying to digitize your mailbox, providing consumers with a website that serves as a secure virtual mailbox to which mailers could send digital versions of the mail. Physical mail is very expensive for businesses—in addition to billions in postage costs, there are even larger costs in paper, printing and processing.  As a business, I’d be willing to pay a fee to deliver electronic correspondence at scale if it saved me big bucks in physical production and delivery.  And as a consumer, I would dramatically prefer to check a website for my mail than make the daily trek to the mailbox.

The challenge in building this service is the classic chicken and egg problem—it’s only interesting to consumers if many businesses use it, and it’s only interesting to businesses if many consumers use it.  USPS may be uniquely positioned to solve this chicken and egg problem with their scale, universal reach, and relationships with both consumers and businesses.  They could charge much lower “postage” rates for this service, but at higher margins as they replace the costs of physical distribution.  And they could provide related services like integrated bill payment, archiving and the like.  In the process, they also save about a zillion trees!

Privatize:

UPS and FedEx currently deliver packages to every home and business in the U.S., just like USPS.  They don’t currently go to every one of these everyday, but they are in every neighborhood every day.  And both of these businesses are operated significantly more efficiently than the Postal Service and turn a profit.  It feels like there would be massive efficiencies from combining USPS operations into one of these companies.  Alternatively, there’s a war that’s starting to brew around delivery to your home from players including Amazon and Wal-Mart, and both are world-class at logistics.  Amazon alone spent a stunning $4 billion in 2011 on outbound shipping costs; they now spend more on shipping than marketing!  Might they be interested in owning delivery to the home?

Software is eating the world, leading to the rapid destruction of many legacy analog business models.  It’s a foregone conclusion that the post office will go the way of record and book stores, as bits don’t require physical buildings to be delivered.  The Postal Service as we know it is well along the path of being obsolete.  Acting on this reality sooner rather than later will save taxpayers very many billions of dollars.