(Fortune Magazine) -- The town of Percile, northeast of Rome, has two groceries, a snack bar, and a tourist booth. Medieval houses climb a hill of overlapping archways and cobblestone footpaths. With only 260 residents, most of them retirees, the town hasn't attracted a newsstand, much less a supermarket or a bank. But it does have a post office.

For Poste Italiane, outposts like the one in Percile are at once its greatest liability and its greatest asset. Postal companies are by nature spread thin, and the Italian state monopoly is no exception.

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With 150,000 employees and 14,000 offices, the company says its mail operations lose hundreds of millions of euros a year. But those same offices provide the backbone of a company that offers everything from investment plans to vacuum cleaners.

By diversifying - by moving into logistics, financial services, and mail-order retail - Poste Italiane has turned its once unproductive infrastructure profitable. Last year mail accounted for less than a third of revenues, which grew 14% over 2004, to $19.5 billion.

Net profits jumped too, by 19%, reaching $413 million. "Fifteen percent of our revenues are from services that didn't exist three years ago," says CEO Massimo Sarmi.

It's a remarkable turnaround for a company that in 1997 epitomized government sloth. With losses of $441 million that year, Italy's postal system was one of the most inefficient in Europe, synonymous with long lines, surly clerks, and late delivery.

"When you sent a letter, you didn't know when it would arrive," says Ugo Arrigo, a professor of public finance at the University of Milan-Bicocca. The change came when Corrado Passera, then CEO, invested in infrastructure and worked with unions to cut costs and jobs. His move into banking drove up revenues. By the time he left in 2002, the company had a tiny profit.

Under Sarmi, Poste Italiane's banking arm has continued to capitalize on a penetration that traditional banks can't match. Post offices in remote villages are often the only place for miles offering loans, life insurance, or checking accounts.

"The relation with the customer is direct, almost familial," says Silva Conforto, 35, the postal clerk in Percile. She spends her mornings behind the counter, greeting customers by their first names, depositing a check for one, mailing a package for another.

In the afternoons she brings them their mail. The nearest bank is 15 kilometers away. "The client trusts you," Conforto says. "You already know what he wants when he comes in."

Last year Sarmi invested $756 million in technology he hopes will take his company into the future. Broadband connects 7,800 offices, and the rest run high-speed modems. In Rome a control room monitors 20 million business transactions a day, flagging router failures, patterns of fraud, and ATMs running low on cash.

The investments have spawned new services. The company offers certified e-mails, and the Italian edition of Microsoft (Charts) Word includes a toolbar button that sends a file to Poste Italiane, which prints and mails it.

In March, Poste Italiane used its network of post offices to process applications from half a million immigrants in two hours. Sarmi has even moved into retail. The Percile branch stocks cookbooks, children's books, and calendars. Catalogs offer digital cameras, exercise bikes, and flat-screen TVs.

Sarmi has said Poste Italiane will be ready for privatization by year-end, estimating the company could be worth $13 billion. It's a goal Italy's newly elected government seems set to embrace, spurred by the Netherlands and Germany, where selling the national postal service has not only brought in revenue but also improved performance.

It's not clear, though, whether the government will sell the entire company or break off the profitable banking arm from the delivery service, a move Sarmi opposes. "We are an integrated business," says Sarmi. "If in any small village you separate the financial services from the logistics from the mail, nobody will survive."

Sarmi's critics say the gains have come at the cost of neglecting his core mission. Poste Italiane's mail service lost $924 million last year, a figure the company says reflects the government's requirement that it deliver mail across the country five days a week, even in unprofitable areas.

In exchange it received $472 million - funding seen by many as a subsidy that undercuts incentives to improve. "If the level of efficiency were equal to the European average, they would make a profit instead of needing a subsidy," says Massimo Beccarello, a professor of industrial economics at the University of Milan-Bicocca.

The practice also draws fire from banks, which worry that unless accounts are kept strictly separate, funding for the postal system could constitute government support for a competitor.

"We don't say they aren't separated, but we want to be sure it's a real separation and an effective one," says Domenico Santececca, director for market services of the Italian Bank Association.

This fall the European Commission will consider a proposal to open Europe's postal sector to competition by 2009. Abolishing the company's monopoly on mail weighing less than 50 grams, which includes the lucrative billing market, would allow challengers to pick off high-volume, high-margin urban areas.

The Dutch carrier TNT (Charts), Poste Italiane's largest rival in Italy (it has only 3% of the market, compared with 95% for the state monopoly), declined to predict what gains it might see if the reform goes through.

But in the Netherlands, where TNT is the national carrier, spokesman Pieter Schaffels says it expects to lose up to 30% of the home market over the next ten years and more than make up the losses in other countries. "Liberalization would be an enormous opportunity," Schaffels says.

Italy's scattered population puts most of it out of reach of small competitors, and Sarmi predicts he won't lose more than 10% of the market. "I don't see a radical decrease," he says. But even that loss would drive the mail service deeper into the red, wiping out Sarmi's hard-earned profits.

To find a way out, the company with its eyes on the future may have to tackle its past. In June, Sarmi dropped cheaper, slower deliveries, effectively raising the minimum postage rate.

But mail-order companies and advertisers that turned away during the slothful years have yet to return, and most Romans insist the fastest way to send a letter abroad is to use the Vatican post office.

Italy's postal workers handle about 120 pieces of mail per citizen a year, compared with more than 700 in the U.S. In France and Germany, advertisers send nearly 50% of the mail; in Italy, it's just 28%.

"The Italian advertising world has not understood the power of mail," says Stefano Gori, who left Poste Italiane last December to lead corporate strategy at Pitney Bowes (Charts), a U.S. postal supplier. With this much room to grow, Poste Italiane may find its brightest future lies in delivering the mail.

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