The Citigroup Analysis of the Amazon – USPS Relationship

Steve Hutkins of Save the Post Office blog also reviewed the WSJ/Citigroup analysis of the Amazon – USPS agreement in the second half of his article, “Fake News, Flawed Analysis, and Bogus Tweets,” April 8 on Angry Bear. As noted in the first half on Steve’s article presented at Angry Bear; Trump’s tweet about the Postal Service undercharging Amazon by $1.50 per parcel is based on a July 2017 Wall Street Journal article undercharging Amazon was based on an April 2017 report by Citigroup.

Citigroup is bullish on UPS and FedEx because, it says, they will enjoy “a better pricing environment in the future” since the Postal Service is soon going to need “to raise rates meaningfully to capture its true costs.” (Of course, if USPS shipping rates were to go up, UPS and FedEx would need to pay more for “last mile” deliveries by the Postal Service, but with higher rates or a bigger market share for their own deliveries, the net result would be to their advantage.)

If these “true costs” are not eventually covered by higher rates, says Citigroup, the taxpayer is going to be on hook for the Postal Service’s financial problems and, by extension, for the “free shipping” Amazon is offering.

In order to identify these “true costs,” the Citi analysts outline two scenarios that illustrate how the Postal Service is charging below market prices for shipping services.

Scenario #1: Paying off the prefunding

In the first scenario, Citigroup focuses on the so-called “prefunding mandate” established in 2006 by Congress with the Postal Accountability and Enhancement Act. Under PAEA, the Postal Service was required to pay $5.5 billion a year, for ten years, into a fund to cover the costs of retiree health care for decades down the road.

How this Retiree Healthcare Benefit Fund (RHBF) came to be is a long story, as discussed in this previous post. Much of the story remains shrouded in mystery, though, because the U.S. Senate decided to withhold publication of the Committee report that described its rationales for the Act’s provisions. But the long and short of it is that the decision to mandate annual contributions of $5.5 billion turned out to be a disaster.

In 2006, the Postal Service was doing great and coming up with over $5 billion a year didn’t seem like a big problem, but then the Great Recession hit, postal revenues took a dive, and it wasn’t long before the Postal Service had to start borrowing from the Treasury to make the payments. When it reached the borrowing limit, the Postal Service just started defaulting on the payments.

This prefunding mandate is responsible for almost all the deficits you read about in the news every time a USPS fiscal report is published. Were it not for the prefunding requirement, the Postal Service would be doing just fine over the past few years, usually breaking even or showing a relatively small profit or loss. According to the FY 2017 10-K report (p. 17), if one looks solely at “controllable” costs and income (i.e., excluding the RHBF payments and other actuarial issues), the Postal Service lost $814 million in 2017 and made a profit of $610 million in 2016 and $1.188 billion in 2015.

In any case, for their first scenario, the Citigroup analysis assumes that “a day of reckoning is approaching” when the Postal Service “must resume making annual prefunding payments to the PSRHBF as well as meeting the amortization schedule on the accumulated $33.9B it owes, as laid out in its FY16 annual report to Congress.”

In addition, says Citi, the Postal Service will need to contend with rising operating costs and declining Market Dominant revenues. According to Citigroup, in fiscal year 2017 the Postal Service will therefore need to bring in an additional $8.3 billion, growing to $9.6 billion in 2019.

For some reason, the Citi analysts then assume that parcel mail would need to cover all of this additional revenue. This, they estimate, would require a 50 percent hike in the price of an average parcel, an increase from $3.50 to $5.25 — or about $1.75 per piece.

The problems with Scenario #1

This scenario is seriously flawed for several reasons. First of all, there’s no reason to believe that such “a day of reckoning” is coming. If anything, we’re heading for a day when Congress recognizes the mess it created with the prefunding mandate and does something to fix it.

As reported by Government Executive, there’s currently a bill in Congress (the text isn’t available yet) under which “Outstanding payments [to the PSRHBF] would be wiped clean and USPS would make actuarial payments toward the remaining liabilities over the next 40 years.”

A 40-year amortization schedule was actually being recommended back in 2006, but the Bush administration pushed for the 10-year schedule that caused all the problems. Such a relaxed schedule would mean annual payments on the order of $1 billion rather than $6 billion, and essentially eliminate the premise on which Citi’s Scenario #1 is based.

A second problem with this scenario is that it assumes the entire $8 billion in increased revenue would have to come from shipping services. But if the Postal Service had to bring in an additional $8.3 billion, it would surely spread the hurt out over all types of mail and not put it all on parcel shippers.

Annual revenues in 2017 were about $70 billion. To bring in another $8.3 billion would require an across-the-board rate increase of about 12 percent. Since such an increase exceeds the price cap on Market Dominant products, the Postal Service would need to request what’s called an exigent rate increase from the PRC due to the “extraordinary” circumstances of being required to pay off the prefunding mandate. That’s happened once before. In 2013, the PRC granted a 4.3 percent increase for about two years to help the Postal Service make up losses due to the Great Recession.

An across-the-board increase of 12 percent would be a serious matter, and mailers, large and small, would go ballistic. One of the effects would be that the rates Citigroup pays to send credit card bills and solicitations would also go up, which would cost the corporation millions of dollars. Maybe that’s why the Citi analysts assume that parcels would need to bear the entire burden of producing the additional revenue.

Anyway, a 12 percent increase on an average piece of Parcel Select ($2) might mean about 24 cents more on a typical Amazon package — not the kind of thing to generate headlines or presidential tweets.

Citigroup actually acknowledges the problems with this scenario later in its report. It notes that the Postal Service could increase postage on other types of mail, Congress might permit the partial reinstatement of the exigent surcharges previously approved by the PRC, and Congress could also provide relief from statutory obligations to prefund certain benefits obligations. Plus, if the Postal Service were to increase parcel pricing significantly, it would do so gradually.

Citigroup calls these “caveats” but they are really much more. Each of these possibilities is much more likely to happen than a 50 percent increase on parcel rates just to cover the costs of retiree health care. Scenario #1 is never going to happen.

Scenario #2: Changing the contribution to institutional costs

In the second scenario, Citigroup notes that when PAEA became law in 2006, Competitive products were assigned a 5.5% share of institutional costs. At the time, parcels represented a relatively small part of the Postal Service’s business, but with the boom in e-Commerce, parcels have become a much larger part. Competitive products now account for about a third of the Postal Service’s revenues.

Over the past few years, UPS has filed several analytic studies and legal briefs with the PRC arguing that Competitive products are not paying their “appropriate share” of institutional costs. According to UPS, the appropriate share would be 24.6% (or even more), as opposed to the 5.5% determined over a decade ago. UPS’ motives are not ambiguous. An increase in contribution to institutional costs would mean an increase in the Postal Service’s parcel prices, which would improve UPS’ position in the market — it could raise its own rates and/or grab a larger piece of the pie.

For its Scenario #2, the Citigroup analysts “work through the impact if the UPS’s suggested 24.6% estimate is instituted.” To do this, they “calculate competitive products’ share at both the current understated 5.5% rate and the updated 24.6% rate proposed by UPS. The difference between the two rates represents the incremental institutional costs that need to be allocated to competitive products.” Here’s how that works out.

For 2017, total USPS operating expenses (i.e., not including the retiree health care expense) were about $70 billion, about half of which were categorized as variable (attributable) costs and half were fixed (institutional) costs. Figured at the 5.5 percent set by PAEA and Citigroup’s estimate of institutional costs (52 percent of total costs), the appropriate share for Competitive products would come to about $2 billion (that’s $70 billion x 52% x 5.5%).

Citi then looks at what would happen if Competitive products had to cover their appropriate share of the fixed costs by using the 24.5 percent figure. The result would be that Competitive products would have to contribute about $9 billion (i.e., $70 billion x 52% x 24.3%).

According to Scenario #2, Competitive products would therefore need to pay $7 billion more for Institutional costs. That would require a rate increase on shipping services comparable to the one determined by Scenario #1 — almost 50 percent. Average parcel rates would go from $3.51 to $4.97, an increase of $1.46. That is the origin of the claim made in the WSJ article, and it’s the basis of Trump’s tweets.

The fatal flaw in Scenario #2

The fatal flaw in Scenario #2 is the assumption that competitive products are currently contributing only 5.5 percent to institutional costs. This 5.5 percent share is actually just the floor set after PAEA was enacted back in 2006, when the PRC determined (as stated in the ACDR) “that if Competitive products contribute at least 5.5 percent toward the Postal Service’s total institutional costs, then, as a whole, they will cover an appropriate share of the Postal Service’s total institutional costs” (p.92).

But competitive products contribute much more than 5.5 percent. According to the 2017 Compliance report, “In FY 2017, the total institutional costs of the Postal Service were $29.700 billion. To comply with 39 U.S.C. § 3633(a)(3) for FY 2017, Competitive products must have contributed at least $1.634 billion toward the Postal Service’s institutional costs. In FY 2017, the total Competitive products contribution was $6.806 billion (approximately 23 percent), which exceeds the minimum contribution requirement.” (italics added, p. 92).

While the numbers differ slightly from Citigroup’s estimates for 2017, the point is clear enough. Competitive products are not contributing 5.5 percent to institutional costs; they are contributing more than four times that amount, and they are contributing almost exactly what Citigroup and UPS say they should be contributing, about 23 or 24 percent.

The Citigroup report observes in a footnote that UPS has subsequently argued that competitive products’ appropriate share should be even higher, like 29 percent. Even at that level, the impact on the prices of Competitive products would be modest compared to what Scenario #2 envisions.

For the past couple of years, there’s been a lively debate at the PRC about how much Competitive products should contribute to institutional costs. (See, for example, PRC Docket No. RM2017-1 on “Institutional Cost Contribution Requirement for Competitive Products.”) While UPS has argued for a higher minimum floor, others have argued that there doesn’t need to be a minimum at all. In its comments on the issue (January 23, 2017), for example, Amazon states this:

“Competitive products are covering almost are four times the share of the Postal Service’s institutional costs that the Commission mandated five years ago. The contribution and cost coverage of competitive products are now far too high to support any credible allegation that a binding minimum contribution requirement is needed to preserve a ‘level playing field’ for the Postal Service’s competitors, let alone to avoid cross-subsidy, predatory pricing, or any other alleged form of unfair price competition, or provide a margin of safety.”

Whatever the Commission ultimately decides to do about the minimum contribution level, the key point here is that Citigroup’s Scenario #2 is based on the mistaken assumption that Competitive products are currently covering only 5.5 percent of the Postal Service’s institutional costs, when in fact they are contributing more than four times that amount. There’s no shortfall of $7 billion that needs to be made up by a big increase in parcel prices.

Considering how sophisticated the Citigroup analysts are when it comes to making projections, it’s perplexing that they missed this basic fact.

The $2.6 billion in additional costs for Amazon

The other number that Trump has tweeted also comes from the Citigroup report. In this tweet, Trump says, “If the P.O. ‘increased its parcel rates, Amazon’s shipping costs would rise by $2.6 Billion.’ This Post Office scam must stop. Amazon must pay real costs (and taxes) now!”

Here’s where that number $2.6 billion comes from.

The Citi analysts outline a “worst case scenario” in which Amazon must bear a 50 percent increase in its costs with the Postal Service, plus a 20 percent price jump with FedEx and UPS, which will be able to raise their prices thanks to the price hike by their competitor.

The analysis gets pretty complicated, but the bottom line, says Citigroup, is that Amazon would incur an additional $2.6 billion in shipping costs.

Trump’s tweet makes it sound as if the Postal Service itself is missing out on $2.6 billion a year in revenue from Amazon, but that’s not the case, and it’s really misleading, to say the least, to make such a claim.

Cost coverage on the Amazon deal

If you want to get even deeper into the weeds on all this, let’s take a look at the cost coverage for the type of mail Amazon is using.

While the Amazon NSAs are nonpublic, one can get a good sense of just how successfully the products are covering costs by looking at a couple of USPS financial reports.

This USPS report shows that in 2017 Parcel Select brought in $5.67 billion on 2.8 billion pieces. This second USPS report shows the cost coverage for each type of mail. It doesn’t mention Parcel Select, but it provides data for Total Ground mail, which includes Parcel Select, Standard Post, and Parcel Return Service. It shows that in 2017, Ground brought in about $6.2 billion in revenue on about 2.88 billion pieces. Parcel Select thus accounts for almost all Ground mail, so the data on cost coverage for Ground can give us a ballpark view of the cost coverage for Parcel Select and, by extension, the Amazon NSAs.

The second report shows that the average Ground piece brought in $2.148 in revenue. The variable cost was $1.221; the rest — $0.927 — was contribution to institutional costs. The cost coverage was 175.86 percent.

If you compare this to the cost coverage for other types of mail, you’ll see it’s typical. First Class letters, for example, have a cost coverage of 164 percent, and First-Class mail overall has a cost overage of 210 percent.

A few types of mail have a cost coverage below 100 percent. Standard Mail flats, for example, have a cost coverage of about 74 percent, and Periodicals, about 70 percent. While these types of mail do not cover their attributable costs, there are legal and policy reasons why some of that failure may be considered excusable. In any case, the issue is regularly discussed in the PRC’s compliance reviews, and all the stakeholders are well aware of the issues.

If the cost coverage on Amazon’s Parcel Select is anything like 175 percent, there’s clearly no cause for concern that the Postal Service or the taxpayer is somehow subsidizing Amazon delivery.

Perhaps an upside

There are many reasons to criticize Amazon — its success is hurting brick-and-mortar businesses, it exploits its workers with low pay and poor working conditions, and it’s “no fan of labor unions” — and there are plenty of reasons for criticizing the Postal Service as well, like the way it underpays its non-union employees and abuses the emergency suspension provision to close post offices without due process.

There are also reasons to raise questions about the relationship between Amazon and the Postal Service, as we’ve done on this website since the deal to deliver for Amazon on Sundays was first announced in 2013. STPO contributor Mark Jamison’s posts on Amazon and the lack of transparency in the NSAs are still worth reading. (Our Amazon posts are archived here.)

Criticisms aside, there’s little reason to believe that the Postal Service is significantly undercharging Amazon for delivering its parcels. The cost coverage data show that parcels are more than covering both their attributable and institutional costs, the PRC has reviewed the NSAs and found them in compliance with the relevant statutes, and there are serious flaws with the Citi analysis on which the claims for underpaying are based. There’s absolutely no evidence that the Postal Service is losing a fortune on the Amazon deal.

While Trump’s tweets on the post office are bogus, perhaps we should at least be thankful to the President for raising some important questions about the Postal Service. Perhaps his tweets will lead to some thoughtful Congressional hearings on postal topics. Perhaps the pension and health care cost issues will finally get clarified. Perhaps the Postal Service will address public concerns by providing more transparency about the deals it strikes with companies like Amazon. Perhaps, perhaps.

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