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a return of 4.6 percent. It should be borne in mind in this connection that the Pennsylvania Railroad accounts for almost 10 percent of the industry, and since there were other railroad companies whose return was equally or even more inadequate, it can be readily observed that a substantial portion of the railroad industry's earnings are highly marginal.
The basic causes behind the meager earnings of the railroad industry are manifold, but probably the most important are :
1. Restrictive and outmoded regulatory procedures by various governmental bodies at local, State, and National levels.
2. Both direct and indirect subsidies to all other forms of transportation, with the exception of the pipelines. These have had the effect of preventing each segment of the transportation industry from finding its proper place in the industry as dictated by sound economics. At the same time subsidies have also tended to hold down, across the board, rates of all transportation agencies, since those whose operations are cushioned by subsidies have not felt the same necessity for raising them as they otherwise might have with costs spiraling.
The figures appearing in table 4 clearly indicate how rates in the transportation field have thus been held down artificially. In this table a comparison is made between the years 1929 and 1955. These 2 years have been selected because I believe everyone will agree that in 1929 the transportation industry was generally considered to be in a healthy and prosperous condition in this country and maintaining its relative economic position in our free-enterprise system; and 1955 represents the latest figures available. During this period the physical production, as measured by gross national product in constant dollars, has increased 116 percent. Intercity ton-miles handled by all transport agencies during the same period have increased 113 percent, so that in terms of physical volume the transportation industry has held its own during the last 26 years. However, if we examine corporate sales or revenues for industries other than transportation, we find that during this period they increased 314 percent as compared to an increase of only 142 percent in the revenues of the transportation industry. This clearly indicates how the price level in the transportation industry has been artificially held down. As a consequence, naturally enough, this has seriously affected profits. During this 26-year period corporate profits of the transportation industry showed an actual decrease of 27 percent as compared to an increase of 178 percent for industry other than transportation. If transportation sales had gone up to the same extent as other corporate sales, in the year 1955 alone it would have received an additional $16 billion of revenues. And if it had been able to maintain its relative position with other industries with respect to profits, it would have realized an additional $1,850,000,000. If these additional profits are divided on the basis of traffic volume, approximately half, or $900 million would have flowed to the railroads. Needless to say, such a substantial addition to net income would have materially aided the railroads to strengthen their existing weak position.
3. In the postwar inflationary economy it has been most difficult for the railroads even to obtain such rate increases as have been considered absolutely mandatory to offset increased costs, and in every instance even those increases that have been obtained have lagged far behind the cost increases from the standpoint of time. Of course wage costs are the largest factor by far in the operating expenses of the railroad industry.
Whatever the causes back of the situation, it appears perfectly obvious that the railroads have not received an adequate return. It seems also perfectly clear that the railroads' position has been severely damaged, possibly irreparably, by this failure, and my testimony will now deal with this aspect of the situation.
Let us examine for a moment chart C, entitled “Class I Railroads and Lessors Funded Debt Outstanding.” In 1940 the total debt of the class I railroads amounted to $11.3 billion, and since that time this debt has decreased to $9.7 billion, which is all to the good. However, there has been a very substantial change in the composition of this indebtedness. In 1940, only roughly 4 percent of this debt was in the form of equipment obligations. However, equipment debt jumped about 5 times to $2.5 billion by 1955 and as of that date represented just over 25 percent of total debt. The important difference in the character of this debt stems from the fact that equipment obligations mature serially, generally over a 10 to 15 year period, and cannot be refunded. Bonded debt, on the other hand, is generally susceptible to a refinancing operation. This means that whereas in 1940 serial maturities of equipment debt were negligible, by 1955 they were substantial and definitely represented a major drain on the cash drawer of the industry. This can be seen by the fact that such maturities are now running on an annual basis at the rate of about $350 million a year. This is just about equivalent to 75 percent of total equipment debt outstanding in 1940.
Turning to chart D, this again deals with funded debt outstanding due within 20 years of calss I railroads. The amounts shown of total debt outstanding in 1940 and 1955 are naturally the same as in the previous chart. Total debt went down gradually from $11.3 billion to $9.3 billion in 1945, and since that time the trend has been upward, but not in a material amount. However, if we examine the composition of the debt from another standpoint, in 1940 we find that of the total debt outstanding as of that date, 43 percent would mature within 20 years. This figure again is little changed in 1955, and as of the end of the year 1955, 44.5 percent of the debt was scheduled to mature in 20 years. The important change again is with respect to equipments. Less than 10 percent of the debt maturing in 20 years in 1940, or 9.8 percent to be exact, was in the form of equipments, whereas in 1955 of the debt maturing in 20 years 58.5 percent was in the form of equipment obligations. To clarify this, it means that at the end of 1955 almost half the debt outstanding would mature in 20 years. With respect to bonded debt this is not too serious provided the credit of the industry and of the individual companies is such that it can be refinanced. It is sifinicant, howa ever, that of this debt maturing in 20 years, 58.5 percent is in the form of equipments, which are nonrefundable and therefore must come out of the industry's cash. For reasons which I will explain later, unfortunately we believe that the amount of equipment obligations outstanding is going to continue to rise markedly to the extent that the market will absorb them, and we estimate, assuming this premise, that by 1965 the amount of equipments outstanding will increase by 20 percent or $500 million. This in turn will increase the year to year cash drain on the companies involved, will make their debt service larger and more rigid, and will make each company more susceptible to receivership or bankruptcy in the event of a decline in business.
Looking at the same figures with respect to the Pennsylvania Railroad, on chart E, the same situation is apparent. Bonded debt between 1940 and 1955 has decreased from $969 million to $683 million, or 30 percent. During the same period equipment debt increased almost 5 times, or about $240 million. Overall there was a minor decrease of $46 million in total debt in the 15-year period, but here again annual equipment maturities which were $6 million in 1940 jumped to $34 million by the end of 1955.
Turning to chart F, which is similar to the industry chart on funded debt outstanding due within 20 years, we find an even more serious situation with respect to the Pennsylvania Railroad as compared to the class I railroads as a whole. In 1910, 41 percent of the debt was due within 20 years and by 1937 this had climbed to 79 percent. In other words, in the next 20 years all but 20 percent of our debt outstanding will have to be met either through refinancing or by cash payments. Of the debt due in 20 years in 1940, only 15 percent was in the form of equipment obligations, which as I said before have to be paid in cash and cannot be refunded, but by 1955, 39 percent of debt due in 20 years definitely will have to be met out of the cash drawer. To put the Pennsylvania Railroad situation a little more concisely, 80 percent of our outstanding debt, or almost $800 million, matures within 20 years, and of this we know that a minimum of $304 million is represented by equipments and therefore must be met out of cash.
Summing up, although the overall debt situation in the case of class I railroads shows a very slight improvement from the standpoint of the aggregate, there has been a substantial deterioration as a result of the change in composition which is going to result in a greater drain on the railroads' cash resources. The same is true in the case of the Pennsylvania Railroad to an even greater extent. The basic reason for this unfavorable situation of course lies in the inadequacy of past earnings.
It now seems appropriate to turn to the working capital position of the railroads to see whether or not they are in a position to stand an additional drain in this respect. The position of the class I railroads in regard to working capital is shown on chart G. On this chart the working capital is compared on an absolute basis with operating revenues, since after all, the volume of business dictates to a large extent the need for working capital. Working capital is the figure which represents the difference between current assets and current liabilities.
In every other industry with which I am familiar, current assets include all those items which can be liquidated or converted into cash within 12 months, and current liabilities include all items which must be paid within 12 months. In the case of the railroads, debt due within 1 year is not included in current liabilities, although debt due in 6 months is reported as a footnote in ICC reports, This is contrary to standard accounting procedure and the practice in other industries, and in my judgment gives a completely false picture, since obviously there is no difference between one type of liability and another if both have to be paid in the same period of time. Therefore, we have included debt due within à year in current liabilities. Working capital as thus defined is represented by the solid red line. The broken line represents working capital reduced by materials and supplies. This is shown because there is a real question in the minds of most informed people whether or not materials and supplies should be included as a current asset. These are entirely different from the inventory of a manufacturing company which is generally converted into a finished product and disposed of in the course of 12 months. In other words, materials and supplies are not, with certain exceptions, liquid assets. However, whether or not they are included, the results in the comparisons are not too different.
Comparing working capital with gross operating revenues, it is noted that there is a fairly parallel trend between working capital and gross revenues from 1940 to 1946. From there on, gross revenues have increased somewhat, primarily as a result of rate increases. Working capital, however, has tended to decline. In other words, an increasing amount of business dollarwise has had to be handled with a decreasing amount of working capital.
As far as the Pennsylvania Railroad is concerned, as indicated in chart H, our working capital did not increase in proportion to the increase in gross revenues during the war years and with the deficit incurred in 1946 and maturities of over $40 million facing us in 1948, our working capital at the close of 1947 reached a low of $46 million. If materials and supplies are eliminated, there was actually a deficit in working capital of $18 million.
The improvement in our working capital since that time was achieved principally through the liquidation of assets. In the past 10 years and principally since 1948, the Pennsylvania Railroad has raised over $92 million in cash by this means. Included in the sale of assets were such properties as the Hotel Pennsylvania in New York, valuable property in downtown Pittsburgh and Philadelphia together with other miscellaneous real estate holdings, our stock in Pennsylvania Greyhound Lines, 9 water companies, and this past year the Virginia Ferry Corp., in which we had a 50 percent interest, was sold to the State of Virginia. In addition, over $38 million was raised in 1948 through the sale of bonds of our leased lines held in our treasury. This procedure is obviously cannibalistić, unhealthy, and can only be justified on the basis of our stringent need for money to carry on our railroad operations. I might also add that we have virtually exhausted our resources along this line, and the raising of cash from these sources cannot be repeated.
In chart I, with working capital expressed as a percentage of gross revenues, a comparison is made as between class I railroads as a whole and the Pennsyl vania Railroad. It clearly indicates that we have been able to maintain a working capital position comparable to class I railroads as a group in the postwar years, only through the sale of capital assets or by increasing system bonded debt which, as pointed out above, cannot be repeated. It also shows that in the generally prosperous period following the war an increasing dollar volume of business has had to be handled with a decreasing amount of working capital.
The question may be rightly posed as to whether or not this in itself is serious because there is always the possibility that any individual company or any individual industry may have an excess of working capital.
On chart J, a comparison is made of the percentage of working capital to the volume of business done by the Pennsylvania Railroad, class I railroads, and other typical industries. It will be noted that Pennsylvania Railroad working capital amounted to only 9 percent and class I railroads 12 percent of the volume of business transacted; working capital of the oil and food products industries was almost twice that of the railroads; steel was twice that of the railroads; and building materials, tire and rubber, chemical, metals and mining, and the agricultural machinery industries were substantially beyond even these figures, ranging all the way up to 48.7 percent in the case of agricultural machinery.
It might be argued that these other industries need more working capital since they have to carry large inventories. On the other hand, it is certainly true that their inventories constitute a better current asset than our materials and supplies which are included in current assets for purposes of comparison. However, if we take out inventories in the case of other industries, and materials and supplies in the case of the railroad industry, you will notice the Pennsylvania Railroad still has the smallest working capital as a percentage
of volume of business done, a shown in chart K, and, with one exception, the class I railroads smaller than any of the other industries with which, a, com parison is made.
ini It may also be contended that the railroads should be able to get along with smaller working capital because they do not have to carry a. large volume of accounts receivable, since the bulk of transportation bills are payable within 48 or 96 hours. There is one exception to this, however, and this is certainly true in the case of the Pennsylvania Railroad. Fairly substantial accounts receiv; able are due by various agencies of the Federal Government, and these are car; ried for longer periods of time. In addition, and as will be shown later on in my testimony, the debt of the railroads represents a higher percentage of their capi. talization than in the case of any of the other industries shown in these charts. Further, as we have seen from the charts on debt, the railroads have a very substantial amount of annual eequipment maturities which are peculiar to this industry, and overall the debt service of the railroads is much higher than in any of the other industries with which comparisons are made.
In any event, the working capital position of the industry, and this is par: ticularly true of the Pennsylvania Railroad, has deteriorated and it now seems clear that the situation has not been eased by what transpired in the past year. From the preliminary figures available, it would appear that the class I railroads lost about $200 million in working capital in 1956, and if we exclude materials and supplies as a current asset, they lost more than $250 million. To put it another way, the railroad industry ended 1956 with working capital of approximately $1 billion and if we exclude materials and supplies, the figure is around $275 million.
To illustrate what this deterioration in the railroads' working capital means from the standpoint of daily operations, the monthly payroll of the railroads, including the current cost arising from the 3-year wage settlement pattern, averages $465 million. Compare this figure with the estimated current working capital of $275 million, excluding materials and supplies since to a great extent they do not constitute a liquid asset, and you will find that working capital is equal to little more than the semimonthly payroll. As of the end of 1955, working capital, excluding materials and supplies, was equal to the payroll for about 40 days, while in 1945 it was equal to 442 months.
As far as the Pennsylvania Railroad is concerned, our working capital at the end of 1956 was $72 million, á loss of $14 million capital for the year. Ëxcluding materials and supplies, working capital was $5 million. Compare the latter amount with our current monthly payroll of about $47 million and you will find that it is equivalent to our payroll for just about 3 days. As of the end of 1955, our working capital, excluding materials and supplies, was equivalent to about 3 weeks' payroll and in 1945, slightly better than 242 months.
Therefore, with inadequate working capital, the railroads are in a position where they must meet their current expenses out of current receipts and in the event of a decline in business, they have no alternative but to reduce expenses promptly and accordingly. Once again it may be said that fundamentally this is also attributable to the past inadequacy of earnings.
Next the question arises as to whether or not the maturing debt and working capital situation of the railroads is the result of improvident dividend policies rather than to a lack of earnings. I would like to turn to chart L for a moment. During the entire period 1946 to 1955, or in other words, the postwar era', class I railroads paid of 42 percent of their net income in the form of dividends. Since there is no comparable classification either in the industrial field or the utility field, we next show the amount paid out by the railroad companies making up the so-called low-Jones railroad average. The list of these companies is contained in table 10, and comparisons of these are made with companies in the Dow-Jones utility average and with the Dow-Jones industrial average. The companies comprising the Dow-Jones averages are commonly used as an indicator of trends in market prices, dividend yields and other related data. It will be noted that the companies making up the Dow Jones railroad averages during this period from 1946 to 1955 paid out 43.9 percent of their net income in the form of dividends, the Dow Jones industrial average group 55.9 percent, and the Dow-Jones utility arerage group 68 percent. In the case of the Pennsylvania Railroad we paid out 56.5 percent. The fact that we are obviously out of line with the average payout by the railroads can be best explained by the fact that for years Pennsylvania Railroad stock has been known as a "widows and orphans stock.” In other words, there are large numbers of people who have bought it because of its long unbroken dividend record, and under the circumstances the directors have felt it necessary to continue some payments on the stock, and since our income has
been so low the resulting percentage is naturally higher than that of some of the other roads. In this particular period also the percentage payout figure is distorted somewhat by the fact that in 1946 we had a deficit rather than a profit but still made a modest dividend payment. ? If we examine only the period 1951 to 1955, we can see that the amount paid out by the railroads was likewise substantially lower than in the case of either the industrials or the utilities. Dow Jones railroad average companies paid out 42.8 percent, the industrials 58.8 percent, and the utilities 70.9 percent. For this period the Pennsylvania Railroad was more in line with the amount paid out by all other Class I railroads, although still somewhat more on the liberal side. Again if we take just the year 1955, the same comparisons hold good. In the past year, our dividend payments amounted to 49 percent of net income, which is in line with our payout of earnings in 1955 as well as the 5-year period 1951-55. : From these charts it seems clear that the railroads have been conservative in their dividend payments, particularly when we bear in mind that they paid out a lower percentage than the other two groups, industrials and utilities, even though they did not enjoy the increased earnings during this post-war period that the other two groups did. This dividend policy also reflecs a realization on the part of the railroads that their debt situation was deteriorating, that their working capital position was weakening, and that because of inadequate earn. ings over a long period of years they had a very limited ability to raise money in the market, and I will discuss this in more detail later, and therefore they were more dependent on cash throw-off and retained earnings to meet the cost of capital improvements.
This brings up another serious problem with which the railroads have been struggling and which is going to increase their difficulties as far ahead as we can see. The notorious lack of earning power of the railroad industry has made it extremely unpopular as an outlet for capital seeking investment. There are only about a handful of common stocks of railroad companies today that even to a small degree are being purchased by institutional investors. Naturally with the low earnings of the railroads and with the large number of companies that went through reorganization in the thirties, their basic credit standing has been undermined. To give you some idea of what has transpired, for a moment I think it will be interesting to review how two regulated industries have fared over a period of years.
The utility industry today, I think it can be said without qualification, has popular acceptance as a growth industry, whereas all too frequently the layman considers the railroad busines's a dying industry. For a number of years we have been stringently regulated as a monopoly, despite the fact that today we are, in fact, in a highly competitive industry, and strangely enough, with most of our competitors subsidized. The utility industry, on the other hand, comes inuch closer to being a true monopoly but fortunately has been regulated, in most instances, more liberally. · Today the credit rating of the utility industry is high, generally speaking ours is low. Utility securities running the gamut from mortgage bonds to common stocks are popular and sought after in the market place, whereas most of our securities, with the possible exception of equipment trust obligations ,are looked aşkance by the average investor.
In the postwar period 1946–55, the utilities realized an average return on net assets of 9 percent. As contrasted to this, the average return on net assets for all class I railroads was only 4.7 percent. Aside from all other factors, this difference alone is sufficient to create problems in the railroad industry and to afford the utility industry a comfortable and sound position.
There are nearly $9 billion of railroad bonds and equipment obligations held by the public as of the present time, of which only about one-third are now rated by rating services as being of investment caliber. I might also add that, unfortunately, only the equipment obligations of the Pennsylvania Railroad and a few issues which represent about 12 percent of our system bonded debt are rated as of investment caliber. Furthermore, none of the New York Central's obligations are rated as of investment grade, unless you classify Indiana Harbor Belt or Pittsburgh & Lake Erie obligations as being part of the New York Central System. The latter owns 60 percent of the Indiana Harbor Belt stock and 50 percent of the Pittsburgh & Lake Erie stock. Very few railroad's could raise new money based solely on their unsecured general credit, and a still smaller number by the sale of preferred stock, in today's market. Few, if any, could do it by the common-stock route.