We recently attended the 2007 National Postal Forum where the Postal Service highlighted a vast array of initiatives it has underway to improve service and grow in the US parcel industry. The key take-away is that the US Postal Service is an entity for investors to watch closely. In the wake of postal reform legislation (recently passed), we're more concerned that the USPS may become a greater competitive threat (to FedEx and UPS) in the parcel segment, especially in the rapidly growing B2C market.


Longer-term, a more nimble, profit-motivated Postal Service is probably not a bad development for the marketplace, if one believed that USPS previously acted in ways that were less about profitability and more about size. However, a Postal Service unshackled from its more restrictive regulations of the past may impact the market in ways we have yet to fully grasp.


Competitive Risks to UPS and FedEx

We should remember that the USPS is the low-price leader in many markets and is putting pressure on private carrier pricing in those lanes where it competes, especially light-weight B2C. Sure, the USPS has recently announced its intent to implement 13.6% average postage increase on Priority Mail shipping. But, we should remember that the USPS hasn't raised prices in the past five years, whereas UPS and FedEx have taken some sizable increases.  In addition, the Postal Service does not charge many of the accessorial surcharges that are implemented by the private carries such as fuel surcharges and residential delivery charges. This means that the Postal Service remains a compelling value to many large shippers.


Over the last several years, due to booming e-commerce growth and products becoming smaller and lighter, the fastest growth in the domestic parcel market is the B2C segment. This is where the USPS has tended to do very well, given that it serves almost every address in the U.S. 5 to 6 days week. In addition, approximately 95% of the USPS' packages are under 5 pounds which is the typical demographic of a B2Cshipment.


Before we delve into the reasons for the USPS' improving competitive position, we should put its size into perspective. The USPS generates $73 billion in annual revenue compared to UPS at $48 billion and FDX at $32 billion. But most of the USPS' revenue is in areas where UPS and FDX aren't allowed to legally compete (first class mail) or in less desirable product lines such as lower valued direct mail (i.e. unsolicited or junk mail). Among its more desirable products that compete directly with DHL, FDX and UPS' ground products, the USPS has Priority Mail, which generates roughly $5 billion of annual revenue, or 20% of the overall domestic ground parcel market. Priority Mail is the USPS' "2-3 day" product that is most comparable with UPS and FDX's ground products (in some instances Priority Mail competes with UPS and FDX's deferred air products).


New Postal Law Could Earn USPS Seat at the Table

The postal reform law is the most significant change to postal regulation in over 35 years. It gives the USPS the ability to compete more effectively with the private carriers as a possible alternative. The new law will allow the USPS to offer customized pricing agreements that cater to specific customer needs and hold the USPS accountable to measurable standards. In addition the new law gives the USPS more flexibility to adjust rates in these contracts (up or down within certain guidelines). The USPS is not permitted to use profits from non-competitive products to subsidize parcel pricing.


On competitive products, like Priority mail, we believe that the new law could transform the Postal Service into a more formidable competitive threat to the private carriers. Under the new law, the USPS will be able to respond to the marketplace and changing parcel environment by creating new products and pricing that better meet customers' needs. Given UPS's tremendous market share in the domestic ground parcel market, this change could represent a real risk. In fact, UPS has generally touted that it has the most extensive ground network of any other carrier, except the USPS. With improving service capabilities, we believe that the USPS may be able to win some business as shippers look for alternative low cost shipping methods. The ability of the postal service to offer volume discounts should allow the postal service to be a better competitor in the parcel industry and possible earn USPS a seat at the table with the private carriers (FedEx, UPS and DHL).


Still Some Way To Go On Service

A common complaint that we have heard about the Postal Service from shippers has been its ability to provide comparable service standards as the private carriers. This includes full tracking and tracing capabilities, improved customer service and money-back guarantees. While the USPS has made tremendous strides in improving its overall service reliability  we believe that the Postal Service still has a way to go to achieve customer perceptions of service (and outright service offerings) that rival UPS and FedEx. Even so, change is underway at the Postal Service and this will alter the competitive landscape. One significant change that came about through postal reform will be that the USPS will no longer be required to operate at a break-even level. Instead, the USPS will be required to generate profits and grow retained earnings in order to reinvest in its businesses. Although the private carriers have suggested that a more rational, profit-motivated USPS is good for them, we can't help but think the private carriers ought to be careful what they wish for. We believe the new law over time will put a greater focus on efficiency and cost improvements at USPS through automation and process streamlining. This will inadvertently push the Postal Service to improve its technology capabilities and operations and therefore more effectively compete with FedEx and UPS.


Postal Service Continues To Improve

The USPS continues to improve its offering by raising its on-time delivery levels as well as what management believes is an improved "overall customer experience." For instance, FedEx has been conducting the air line-haul portion of Priority Mail since the summer of 2001. As such, this product has seen its on-time performance move above 90%. In addition, the USPS has upgraded its technology for better customer tracking and tracing (though there's more work to be done in this area).The USPS will shortly be rolling out with "Intelligent Mail" barcodes, which allow for end-to-end visibility through out the entire USPS network for Express and Priority Mail packages. The USPS currently offers end-to-end visibility of International Express Mail and will soon offer the same capabilities on its International Priority Mail packages. As the Postal Service upgrades its technological capabilities and improves service standards, we could see the USPS start to take share away from the private carriers (though we're not modeling this yet).


USPS Int'l Growth Could be Positive for FDX and UPS Over the past ten years, the postal service has seen its international package and express market shrink as the market has rapidly expanded. Like many of the private carriers, the USPS is beginning to focus on international deliveries to spark growth. As such, the USPS is looking to provide international shipping methods with time definite delivery to the major countries around the world. Although this might initially seem a negative for the private carriers, we view this as positive for FedEx and UPS. The postal service has openly admitted that its greatest strength lies in its ability to provide first and last mile delivery within the domestic U.S. Therefore, just as the postal service does in the U.S, it could also outsource its long haul operations to international countries where the packages will be delivered to the local posts for final destination delivery. We believe that both FedEx and UPS could be very attractive candidates to provide such operations for the USPS and would not be surprised to see them in the bid.


Other tidbits from the National Postal Forum

The USPS is feeling some effect of a moderating US economy, noting that Priority Mail volumes appear to be flat over last year in the current period.  Over 70% of the USPS packages are shipped a distance of under 700 miles. 


USPS is also seeing a significant shift from air to ground products as ground transit times improve and shippers seek out less costly ways to move packages.  The focus for fiscal 2007 is improving the customer service perception at the USPS. This will be one of the keys to winning new business. 


Growth in online postage sales has been tremendous. In 2006, USPS Postage Online generated $1.0 billion in revenue and is projected to rise to $1.5 billion in fiscal 2007.


 UPS is estimated to consume roughly 0.1 gallons of fuel per delivered package, whereas the USPS estimates that it uses only 0.75 gallons of fuel per package ANNUALLY for its deliveries. While this comparison may be a bit of apples and oranges, the point is still valid; the USPS can leverage its tremendous domestic mail delivery network to deliver packages very economically.  USPS views reverse logistics as a tremendous growth opportunity where it can leverage it vast network of drop boxes and post offices to collect packages that consumers wish to return to the manufacturer or retailer.



William J. Greene, CFA. William.Greene@morganstanley.com. +1 (1)212 761 8017.  Heeten H. Doshi, Heeten.Doshi@morganstanley.com +1 (1)212 761 7748

Visit www.morganstanley.com


Important disclosures relating to this article are available at http://www.morganstanley.com/institutional/research/pdf/IAIRNPF200703271.pdf .