Letter from Roy A. Wehe (San Francisco) to Edward C. Renwick (Los Angeles), November 23, 1951

ROY A. WEHE CONSULTING ENGINEER PACIFIC MUTUAL BUILDING 660 MARKET STREET SAN FRANCISCO CALIFORNIA November 23, 1951 Mr. Edward C. Renwick Assistant General Solicitor Union Pacific Railroad Company Re: File 4705-11-22 422 West Sixth Street Los Angeles 14, California Dear Mr. Renwick: I was pleased to receive your letter of November 15 and thus be brought up to date on the progress of the work and your thinking. I have been pondering over the suggestion raised by you as to the possible advantages and disadvantages if the Water Company owned and operated both the production and distribution facilit- ies as an independent company. If the assets of the Production Company, as represented by its water production and transmission facilities, were transferred to the Distribution Company and the latter divorced from its other corporate activities and reorganized, the ownership, through se- curities to be issued, would necessarily have to be held by Union Pacific. I say "necessarily" for the reason that I do not believe there would be any public market at the present time for two prin- cipal reasons, namely because of: 1. The present and recent past unsatisfactory earn- ings. 2. The critical water supply situation. The most urgent condition to follow up on is item (1), that is, to keep at the task of securing the necessary earnings through higher rates for water service. The question then arises, is there any advantage in changing the corporate set-up, even though the ownership in effect remains unchanged and because of that, the regulatory authority and many of the water customers are not too much concerned if the "rich" Union Pacific does not earn the generally accepted rate of return. Before examining some of the considerations that management would undoubtedly weigh in making a decision, I desire to briefly outline how the new water company would function. Assuming that a clean break is contemplated, looking for- ward to the time that the properties may be disposed of and sold, then in my opinion, strong consideration should be giv- en to setting up a management and operation in Las Vegas that would be practically self-sufficient except for matters in- volving comparatively large capital expenditures and where corporate matters arose requiring legal assistance above that required for normal operations. This would mean the maintaining of an executive head with full authority to run the company at Las Vegas along with the services of an accountant to keep all the primary records in Las Vegas. Both the production and distribution operation and and maintenance would be under a general foreman or superin- tendent. All work would be performed by the water company and none should be hired and performed by any of the Railroad per- sonnel. The company being a utility would necessarily file an an- nual report with the local commission and be under its juris- diction in accordance with the Nevada law. Having thus briefly presented the manner in which the re- organized company would function, let us now consider some of the results that might be expected to follow. These may be set down as follows: 1. Costs of doing business would be reduced. Through ^ union controls and the many departmentalized break-downs of work functions, production expense is now believed to be high. Production of water and its delivery to distribution is a relatively simple function, as it is performed in Las Vegas. With rising costs and the problems faced, all ec- onomies possible should be instituted. Many and most medium size water companies "get by" on services less than might be considered necessary if funds were present. Through a unified organization under a sin- gle control, the man hours performed would, in my opinion, be greatly reduced. Similarly the overhead burden would be even more greatly reduced. There would be no saving, in my opinion, on accounting, as the charges assigned from the Omaha office appear low. 2. Public acceptance of the water company and higher rates would be greatly enhanced as its operation would be viewed as more a part of the city. 3. Due to the issue of bonds and stocks, the Water Company would have definite financial obligations to meet. These could be used effectively as pointing to earnings and return required. At the present time with practically no financial structures, as that is normally looked upon, there is nothing that can be pointed to in setting up the earning requirements of the Water Company. Even on the open account, no interest is paid. Where the situation exists, in which the funds of the water company become intermingled with the parent company, it lays the parent company open to criticism. It is only necessary for the "champion" of the public to point to the "inner workings" of the top company and its creature to create in the minds of the public that the water company is being bled for the benefit of the big corporation. If the banking is done locally and all dol- lars are accounted for and reported to the Commission, this situation will in large measure be cleared up, even though the securities are held by the Union Pacific. 4. The Regulatory Commission will look not only with favor on the change, since it places all operations under its control, but likewise it will take credit for bringing the change about. In a state where political Influence with the party in control is not to be disregarded, there should be indirect benefits that would follow any such merger. The net result should be the eventual obtaining of reasonable earnings and with service to the public at minimum costs. 5. Due to improved and reasonable earnings the com- pany will be in a better position to (a) Finance and raise additional capital through a local public offering. (b) Command a higher price for the properties on sale. (c) Work out a lease agreement with the city and receive a reasonable income from the properties if such should be desired. Disadvantages 1. Lose income tax credit under a consolidate fil- ing if earnings are poor on the water operations. 2. Cost of Railroad operations raised in Las Vegas Division because water production no longer available to absorb part of man hours and overhead. 3. Costs for water purchased from Water Company may be higher (or possibly less) than under its own op- eration. 4. Cost involved in making the corporate change. 5. Less direct control of the water operation. Inasmuch as it is believed there is no intention of bur- dening the water operations?and since such are now a burden on the Railway, none of the disadvantages given are of much moment. The objective is to improve earnings and not operate to take "advantage" of losses. If the steps taken will result in better earnings (and/or make possible a higher sales price) and improved public rela- tions, then such must be viewed as justified. Financial Structure The securities issued should be fully covered by property assets. Since the regulatory practice uses a net capital base (investment less depreciation reserve) that should be the standard, in my opinion. On the Distribution Company, as it now stands, there is the bothersome item of plant amortizations of $160,483 and Customer Advances in aid of construction of possibly some $400,000 as of the end of this year. After allowing for a 5% overhead, which was estimated as not capitalized in plant and for the portion not estimated to be refunded, a figure of $280,000 was used as a deduction from the fixed capital in setting up the Rate Base in the case before the Commission. The approximate net capital structure rounded off as of the end of this year would be: Water Production Company $ 755,000 Water Distribution Company 585,000 1,340,000 Corporate Surplus 60,000 Total $1,400,000 The ?1,400,000 is viewed as the capital structure that might be suitable for the issue of securities. Securities to be issued probably should be limited en- tirely to bonds and common stock. There would be no justi- fication for a preferred stock issue on a company as small as this one. The bonds should not exceed 50% and in this case prob- ably a 40 or 45% issue would be better. Under all the conditions obtaining it would appear to me that the bonds should carry a 4% coupon rate and issued at par. Earnings on the common stock equity will necessarily de- pend on what is left after paying bond interest (and all other operating expenses). A minimum dividend rate of 8% would prob- ably be required to be attractive to outside purchasers. In- itially something less would probably be paid to the Union Pacific. The following simple financial structure calling for earning requirements are as follows: Bonds 45% $ 630,000 <3 4% $25,200 Stock 55% 770.000 @ 8% 61.600 $1,400,000 6.2 $86,800 If 7% is paid instead of 8%, then 5.6% would be earned and if only 6% is paid, but 5.1% would be earned over all. In our Exhibit "S" under integrated operations, a 63-% return called for net revenue of $86,837 on an investment base of ?1,389,400. If net additions to plant were equal to or exceeded the growth in the depreciation reserve, there would be no lessen- ing in the net plant value underlying the bonds. To the ex- tent that earnings exceeded dividends paid, the net worth would increase and the earnings in dollars on the common stock equity would increase from year to year. On any reorganization in the capital structure and the bringing in of the Production Company, the accounting practice would undoubtedly be changed to "retirement accounting". This would mean that upon replacement of a 4-inch main that stood on the books at, say, $1.50 per foot, the new 4-inch main would be capitalized at its present day cost of, say, $3.00 per foot. Under present ICC railroad requirements the $1.50 per foot in- crease is an expense charge. Similarly under group deprecia- tion practices, the whole original cost is charged to the res- serve, whether fully accrued or not, along with the cost of renewal. Any salvage is a credit to the reserve. The gen- eral effect of this will be to reduce operating expenses and increase the capital base. Likewise, the over-all effect is to reduce the earning requirement and hence, the increase required. Similarly, all service pipes should be capitalized. It may be possible as a condition of bringing about the merger, that the Commission will agree to give some recognition to a capital amount for service pipes. If this is set up on the books and future service extensions are capitalized, when it comes to sell the properties, the likelihood of receiving payment for this item of plant will be greatly enhanced, in my opinion. This has been a long review, but I trust it may prove helpful in providing some thoughts on the matter. Very truly yours, Roy A. Wehe RAW:mw