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WESCO ANNUAL LETTER 1983, 1984
WESCO 1983 ANNAUL LETTER
Consolidated ordinary operating income (i.e., before all net gains from sales of securities, mortgages, and important fixed assets) for the calendar year 1983 increased to $8,507,000 ($1.20 per share) from $7,221,000 ($1.02 per share) in the previous year.
Consolidated net income (i.e., after net gains from sales of securities, mortgages, and important fixed assets) decreased to $10,553,000 ($1.48 per share) from $11,502,000 ($1.62 per share) in the previous year.
Wesco has two major subsidiaries, Mutual Savings, in Pasadena, and Precision Steel, headquartered in Chicago and engaged in the steel warehousing and specialty metal products business. Consolidated net income for the two years just ended breaks down as follows (in 000s except for per-share amounts):
...
Mutual Savings
Mutual Savings' ordinary net operating income of $3,046,000 in 1983, represented a decrease of 12.5% from the $3,482,000 figure the previous year. In both years such ordinary net operating income, while economically real and probably of at least average quality as reported savings and loan industry incomes go, was below the top quality possible because such earnings came from income tax savings obtained through inclusion of Mutual Savings in the consolidated income tax return of a parent corporation. Earnings so derived from income tax savings are not of the top quality possible because they have less cushion in reserve against future adversity than earnings from ordinary operating income on which income taxes have been paid in full in cash at the highest corporate rate and are recoverable from the I.R.S. in the event of future operating losses.
Separate balance sheets of Mutual Savings at yearend 1982 and 1983 are set forth at the end of this this annual report. They show (1) total savings accounts rising to $203 million from $168 million the year before, (2) a very high ratio of shareholders' equity to savings account liabilities (probably the highest for any mature U.S. savings and loan association), (3) a substantial portion of savings account liabilities offset by cash equivalents and marketable securities, and (4) a mortgage loan portfolio of about $106 million at the end of 1983, down 12% from the $121 million at the end of 1982. The mortgage loan portfolio at the end of 1983 bore a fixed average interest rate of only 7.48%, probably the lowest for any U.S. savings and loan association and far below the average interest rate which now must be paid to hold savings accounts.
The capital-rich, mortgage-loan-interest-rate-poor position of Mutual Savings came from (1) success many years ago as a construction lender at above-average interest rates, plus (2) sale in 1980 by Mutual Savings of all branch offices (except for one satellite office in a major shopping center across the street from the Pasadena headquarters) under terms where only the lowest-yielding mortgage loans from its large portfolio were retained, plus (3) drastic curtailment by Mutual Savings of mortgage lending following the sale of its branch offices.
Mutual Savings has remained profitable because the adverse effects from its low-yielding, fixed-rate mortgage loan portfolio are more than offset by favorable effects from its large shareholders' equity and a tax-equivalent yield on its marketable securities (utility preferred stocks, tax-exempt bonds, and common stocks) considerable higher than that prevailing on the mortgage loan portfolio of a typical savings and loan association. The low-yielding, fixed-rate mortgage loan portfolio has shrunk form pay-backs at 8.5% per year over the last three years, and the shrinkage is expected to continue at about the same rate.
Mutual Savings has adapted in its own way to the dramatic changes which have occurred in recent years in interest rates and the regulatory structure of the banking and savings and loan industries. At Mutual Savings, as well as the rest of the savings and loan industry, the standard practice used to be to borrow short from savers while lending long on fixed-rate mortgages, to have high financial leverage for shareholders' equity and to grant mortgagors easy prepayment terms. The practice was profitable for decades but always involved something like a "hurricane risk," and the equivalent of a hurricane came in 1981-82 as interest rates rose to unprecedented levels and caused widespread losses. Results were good for shareholders before 1981-82 only because interest rates were stable or rose slowly as mortgage-loan portfolios steadily and rapidly expanded under a regulatory structure which both fostered growth and protected operating margins by requiring that on all insured savings accounts fixed rates be paid that were slightly higher than the low rates specified for banks. Thus a small deposit-attracting rate advantage over banks was given to savings and loan associations, while competitive pressure was dampened for both types of institution.
Although interest rates have subsided from the 1981-82 peak, the low and slowly changing interest rates of former years are plainly gone with the wind, as are the former government-decreed limits on interest rate competition for savings accounts and the favoritism for savings and loan associations over banks. But an agency of the U.S. government (F.S.L.I.C.) continues to insure savings accounts in the savings and loan industry, just as it did before. The result may well be bolder and bolder conduct by many savings and loan associations. A sort of Gresham's Law ("bad loan practice drives out good") may take effect for fully competitive but deposit-insured institutions, through increased copying by cautious institutions of whatever apparent-high-yield loan and investment strategies seem to allow competitors to bid away their savings accounts and yet report substantial earnings. If so, if "bold conduct drives out conservative conduct," there eventually could be widespread insolvencies caused by bold credit extensions come to grief.
And if serious credit-quality troubles come to the savings and loan industry, they will merely add to troubles from the borrowed-short, lent-long-at-fixed-rates problem, which is far from completely removed, and which destroys shareholder wealth at startling speed whenever interest rates are rising rapidly, even when the credit quality of mortgagors or other borrowers is excellent.
Developing a short-term operating plan for Mutual Savings which would sharply increase its reported earnings next year would be a near-absolute cinch. For instance, savings accounts could be expanded greatly by paying a high rate of interest on "jumbo" deposits in $100,000 multiples, and proceeds plus cash equivalents on hand could be placed in long-term mortgages at a substantial current interest spread while, in addition, some origination fees could be "front-ended" into income. However, taking long-term risks into account, it is much harder to find a sound operating plan. Money is the ultimate fungible commodity. In the new order of things, an association is not only in a tough, competitive, commodity-type business on the lending side but also finds that, with decontrol of government-insured rates paid savers, every competitive association has virtually unlimited credit to fund increased lending, by paying premiums over interest rates generally prevailing on savings accounts. Under such conditions, when all risks are considered, including those created by that portion of competitors motivated primarily by short-term effects, it is quite naturally difficult to earn over a long period an attractive return on shareholders' equity. How could it be otherwise?
A few years ago, about the same time Mutual Savings reacted to new conditions by curtailing lending, most other associations decided instead to keep lending aggressively but under new adjustable-rate mortgages under which some portion (but far from all) of the interest rate-fluctuation risk is shifted to the homeowner. Despite widespread use of these new adjustable-rate mortgages, savings and loan industry earnings remain dependent to a material extent, as they always were, on an interest rate spread attributable to: (1) borrowing short while lending long, and/or (2) making loans which can be priced high enough to provide a profit only because they involve very material credit risk, compared to the risk of owning government-backed securities of comparable maturity.
Under present conditions of strong competition from bold competitors accompanied by high interest-rate-fluctuation risk, the results tend to be that each year of reported attractive earnings occurs only in the absence of two now much more likely events: (1) sharply rising interest rates, and (2) widespread credit losses. Thus, each good year reported is a lot like the year when a Texas hurricane insurer reports satisfactory earnings because there have been no hurricanes. Mutual Savings has considerable share of this uncomfortable position and will continue to have it. It has not yet developed a long-term operating strategy with which it is satisfied, and continues to seek one. Just as Mutual Savings has been idiosyncratic in the past as it sold branch offices in 1980 (a practice now being adopted to some extent by other savings and loan associations and major banks), it will probably be idiosyncratic in the future. It will seek some non-standard way of rendering socially constructive service while operating with acceptable profits accompanied by an acceptable level of risk for shareholders' capital, likely gains considered.
Eventually, by maintaining unusual capital strength and liquidity, and by having a parent corporation which does likewise, Mutual Savings hopes to stand in particular favor with federal and state regulatory authorities and be in a position soundly to expand again, perhaps dramatically, and perhaps involving additional shareholder investment in Mutual Savings by the parent corporation.
As part of a program for the anticipated eventual sound expansion of the savings and loan business, Mutual Savings in 1983, without heaving promotion or advertising, consistently paid about 1/2% per annum more than most competitors on so-called "money market rate accounts" of moderate size. This type of savings account is repayable on demand without penalty and allows up to three withdrawals by check each month. Most of Mutual Savings' "money market rate accounts" are in the range of $10,000 to $100,000. Mutual Savings' practice of bidding up slightly for this one type of account penalized 1983 earnings to a small extent and caused the bulk of the reported $36 million growth in savings.
Precision Steel
Wesco's Precision Steel subsidiary, located in the outskirts of Chicago at Franklin Park, Illinois, was acquired for approximately $15 million on February 28, 1979. The price was roughly book value for a company which carried its inventories on a conservative LIFO account basis and which contained significant cash balances. More important, it had reached its position from a modest beginning through maintenance of sound, customer-oriented business values inculcated over a long time by a gifted founder and his successors. Precision Steel owns a well-established steel service center business and a subsidiary engaged in the manufacture and distribution of tool room supplies and other specialty metal products.
Precision Steel's business contributed $1,622,000 to ordinary net operating income in 1983, up 396% compared with $327,000 in 1982. Most of the increase was caused by (1) generally improved conditions in the cold-rolled strip steel market, and (2) absence in 1983 of an unusual loss which occurred in 1982 from correction of a business mistake (in which the present chairman of Wesco personally participated), namely a venture in the measuring tool distribution business which with better judgment would not have been authorized.
Under the leadership of David Hillstrom, Precision Steel's businesses are now satisfactory, taking into account the financial leverage put into Wesco's consolidated picture incident to their acquisition. The improvement from disappointing performance in 1982 is welcome. No dramatic change is expected in 1984 in either direction.
Shortly after Wesco's purchase of Precision Steel, a substantial physical expansion of steel warehousing facilities was authorized involving a new building in Charlotte, North Carolina. The new building and the whole North Carolina operation are now successful, contributing $7,605,000 to sales in 1983 at a profit percentage higher than has prevailed in the long-established Chicago headquarters' facility.
Precision Steel's businesses, despite their mundane nomenclature, are steps advanced on the quality scale from mere commodity-type businesses. Many customers of Precision Steel, needing dependable supply on short notice of specialized grades of high quality, cold-rolled strip steel, reasonable prices, technical excellence in cutting to order, and remembrance when suppliers are short, rightly believe that they have no fully comparable alternative in Precision Steel's market area. Indeed, many customers at locations remote from Chigago and Charlotte (for instance, Los Angeles) seek out Precision Steel's service.
Wesco remains interested in logical expansion of Precision Steel's businesses, using liquid assets.
All Other Ordinary Net Operating Income
All other ordinary net operating income, net of interest paid and general corporate expenses, rose to $3,839,000 in 1983 from $3,412,000 in 1982. Sources were rents ($2,609,000 gross, including rent form Mutual Savings) from Wesco's Pasadena office building block (predominately leased to outsiders although Mutual Savings is the ground floor tenant) and interest and dividends from cash equivalents and marketable securities held by Precision Steel and its subsidiaries at the parent company level.
Net Gains on Sales of Securities, Mortgages and Important Fixed Assets
Wesco's consolidated balance sheet retains a strength befitting a company whose consolidate net worth supports large outstanding promises to others. As indicated in note 2 to the accompanying financial statements, the aggregate market value of Wesco's marketable securities was higher than their aggregate cost at December 31, 1983 by about $29 million. In addition, Wesco's Pasadena office building block (containing about 155,000 net rentable square feet including Mutual Savings' space) has a market value substantially in excess of carrying value. The mortgage debt ($5,166,000 at 9.25% fixed against this real property now exceeds its depreciated carrying value ($3,077,000) in Wesco's balance sheet at December 31, 1983. Wesco remains in a prudent position when total debt is compared to total shareholders' equity and total liquid assets. Wesco's practice has been to do a certain amount of long-term borrowing in advance of specific need, in order to have maximum financial flexibility to face both hazards and opportunities.
It is expected that the balance sheet strength of the consolidated enterprise will in due course be used in one or more business extensions. The extension activity, however, requires some patience, as suitable opportunities are not always present.
As indicated in Schedule I accompanying Wesco's financial statements, common stock investments, both those in the savings and loan subsidiary and those held temporarily elsewhere pending sale to fund business extension, tend to be concentrated in very few companies. Through this concentration practice better understanding is sought with respect to the few decisions made.
The ratio of Wesco's annual consolidated net income to consolidated shareholders' equity, about 9% in 1982-83, is not yet attractive from the Wesco shareholders' point of view. Wesco, started as a savings and loan holding company in what became a very tough business, has been proceeding slowly under shortened sail instead of trying to make fast time by getting all canvas aloft. However, progress ultimately helpful to shareholders is not restricted to what shows up in the income account. Recent increases in balance sheet strength are expected to be useful in the future.
On January 26, 1984, Wesco increased its regular quarterly dividend from 131/2 cents per share to 141/2 cents per share, payable March 7, 1984 to shareholders of record as of the close of business on February 14, 1984.
This annual report contains Form 10-K, a report filed with the Securities and Exchange Commission, and includes detailed information about Wesco and its subsidiaries as well as audited financial statements bearing extensive footnotes. We invite your careful attention to these items.
Retirement of Louis Vincenti
Late in 1983 Louis Vincenti retire from Wesco on account of health. He had served 28 years, the last 10 as Chief Executive Officer. Before joining Wesco, as a partner in Hahn and Hahn, he was one of Southern California's great attorneys. Before practicing law he had starred spectacularly as both student and athlete at Stanford.
Wesco had a net worth of about $5 million when he joined it in 1955. As he retires the net worth of Wesco is about $124 million, and, in addition, cash dividends of about $26 million have been paid out to shareholders over the years. The consolidated enterprise first made extraordinary profits as a construction lender, then went through the 1981-82 criss period ... the savings and loan industry reporting steady profits, paying dividends which increased each year, and piling up more capital outside the troubled savings and loan business as a start was made at diversifying sources of operating income.
The entire record was accompanied by much philanthropic and public service and service to the savings and loan industry by Mr. Vincenti. All who know him admire him, in whom generosity, acuity, diligence and a totally forthright manner as so happily joined. In a career of extraordinary length as well as distinction, he came to work before 7:30 each morning until very shortly before he retired at age 77.
There are not many men in the world like Louis Vincenti. Wesco has been a very fortunate corporation to be guided so long by such a man.
Mr. Vincenti's colleagues who replaced him are Charles T. Munger as Chairman and Chief Executive Officer of Wesco and Mutual Savings and Harold R. Dettmann as President of Mutual Savings. Mr. Munger is also Vice Chairman of Berkshire Hathaway Inc., 80% owner of Wesco. Mr. Dettmann for many years served as operating manager next in line to Mr. Vincenti.
February 3, 1984
Consolidated "normal" operating income (i.e., before all unusual operating income and all net gains from sales of securities) for the calendar year 1984 increased to $10,060,000 ($1.42 per share) from $8,507,000 ($1.20 per share) in the previous year.
Consolidated net income (i.e., after unusual operations income and all net gains from sales of securities), increased to $23,656,000 ($3.32 per share) from $10,553,000 ($1.48 per share) in the previous year.
Despite the high numbers reported, 1984 was a so-so year in terms of real gain in strength. While "normal" net operating income increased satisfactorily, total net income was swollen in a major way only because of an unusual item of operating income and the cashing in of some unrealized appreciation in marketable securities which had occurred in the earlier years.
Wesco has two major subsidiaries, Mutual Savings, in Pasadena, and Precision Steel, headquartered in Chicago and engaged in the steel warehousing and specialty metal products businesses. Consolidated net income for the two years just ended breaks down as follows (in 000s except for per-share amounts):
...
The foregoing breakdown (of the same aggregate earnings) differs somewhat from that used in audited financial statements, which follow standard accounting convention as interpreted from time to tome by Wesco's outside auditor. The supplementary breakdown of earnings is furnished because it is considered useful to shareholders.
Much of this letter is a word-for-word repeat of last year's letter with updated numbers. The repetition of wording occurs because it is believed (1) that the duplicated material remains correct and is worth repeating, and (2) that in Wesco's case any time and money required to change wording would be better spent elsewhere.
Parsimony, however, does not wholly predominate. So much kidding occurred concerning the 1960s automobiles in the old photograph of the Mutual Savings' building, which was used in last year's annual report to avoid incurring the cost of a new photograph, that the purse has been opened a little. Shareholders comparing the new photograph (on the inside front cover of this report) with the old will note that the trees have grown a lot in the intervening years. Fortunately, so has the value of the building. See the last section of this letter. The building, which works very well and attracts high quality tenants regarded as friends, is a constant reminder of the good sense of Louis R. Vincenti and Richard D. Aston, the Wesco executives responsible for its creation.
Mutual Savings
Mutual Savings' "normal" net operating income of $3,476,000 in 1984, represented an increase of 14.1% from the $3,046,000 figure the previous year. In both years such "normal" net operating income, while economically real and probably of at least average quality as reported savings and loan industry incomes go, was below the top quality possible because such earnings came entirely or partly from income tax savings obtained through inclusion of Mutual Savings in the consolidated income tax return of a parent corporation. Earnings so derived from income tax savings are not of the top quality possible because they can be impaired by future changes in tax laws and have less cushion in reserve against future adversity than earnings from ordinary operating income on which income taxes have been paid in full cash at the highest corporate rate and are recoverable from the I.R.S. in the event of future operating losses.
Separate balance sheets of Mutual Savings at yearend 1983 and 1984 are set forth at the end of this annual report. They show (1) total savings accounts rising to $228 million from $203 million the year before, (2) a very high ratio of shareholders' equity to savings account liabilities (probably the highest for any mature U.S. savings and loan association), (3) a substantial portion of savings account liabilities offset by cash equivalents and marketable securities, and (4) a loan portfolio (mostly real estate mortgages) of about $95 million at the end of 1984, down 11% from the $107 million at the end of 1983. The loan portfolio at the end of 1984 bore a fixed average interest rate of only 7.63% probably the lowest for any U.S. savings and loan association and far below the average interest rate which now must be paid to hold savings accounts.
The capital-rich, mortgage-loan-interest-rate-poor position of Mutual Savings came from (1) success many years ago as a construction lender at above-average interest rates, plus (2) sale in 1980 by Mutual Savings of all bran offices (expect for one satellite office in a major shopping center across the street from the Pasadena headquarters) under terms where only the lowest-yielding mortgage loans from its large portfolio were retained, plus (3) drastic curtailment by Mutual Savings of mortgage lending following the sale of its branch offices, plus (4) profits in every recent year, no matter how high interest rates went.
Mutual Savings has remained profitable because the adverse effects from its old low yielding, fixed-rate mortgage loan portfolio are more than offset by favorable effects from its large shareholders' equity and a tax-equivalent yield on its marketable securities (utility preferred stocks, tax-exempt bonds and common stocks) considerable higher than that prevailing on the mortgage loan portfolio of a typical savings and loan association. The old low-yielding, fixed rate mortgage loan portfolio has shrunk from pay backs at 9.8% per year over the last three years, and the shrinkage is expected to continue at about the same rate. With portfolio shrinkage, loan credit quality problems have been reduced to a meaningless trace, because the old mortgages have large real estate equities supporting secured credit extended. And the foreclosed property on hand (mostly 22 vacant, largely oceanfront, acres in Santa Barbara) over a long holding period has plainly become worth considerably most than its $2 million balance sheet carrying cost.
It should be noted, however, that Mutual Savings' total mortgage loan portfolio did not, in substance as distinguished from accounting form, decrease in 1984 by the 11% mentioned above, determined by comparing audited year end balance sheet totals for loans. Mutual Savings has agreed to buy in 1986 U.S. Government guaranteed mortgage equivalents (GNMA certificates) at a price of about $19 million and has pre-funded this forward commitment by buying U.S. Treasury Notes maturing near the time the certificates will be purchased. After taking into account this forward commitment to purchase GNMA certificates, Mutual Savings' total mortgage loan portfolio has, in substance, increased by about 7% in 1984.
The 1984 increase in substance of mortgages owned reflects Mutual Savings' intention to keep at least 60% of assets in mortgages or mortgage equivalents, exactly as the Federal Home Loan Bank Board wisely exhorts the savings and loan industry to do if it expects to remain under a regulatory system separate from that of banks. And as a result of anticipated steady shrinkage through repayment of remaining old 7.63% mortgages, combined with purchases of new mortgages or mortgage equivalents bearing much higher interest rates, Mutual Savings expects in due course significantly to raise the average rate of interest on the entire mortgage loan portfolio, thus improving earnings so long as interest rates on savings accounts do not greatly increase. The GNMA certificates purchased for 1986 delivery at a price of about $19 million are expected to yield about 15% on such price, getting under way the process "blending" the mortgage loan portfolio yield to a higher average level.
Mutual Savings has adapted in its own way to the dramatic changes which have occurred in recent years in interest rates and the regulatory structure of the banking and savings and loan industries. At Mutual Savings, as well as the rest of the savings and loan industry, the standard practice used to be to borrow short from savers while lending long on fixed-rate mortgages, to have high financial leverage for shareholders' equity and to grant mortgagors easy prepayment terms. The practice was profitable for decades but always involved something like a "hurricane risk," and the equivalent of a hurricane came in 1981-82 only because interest rates were stable or rose slowly as mortgage-loan portfolios steadily and rapidly expanded under a regulatory structure which both fostered growth and protected operating margins by requiring that on all insured savings accounts fixed rates be paid that were slightly higher than the low rates specified for banks. Thus a small deposit-attracting rate advantage over banks was given to savings and loan associations, while competitive pressure was dampened for both types of institutions.
Although interest rates have subsided from the 1981-82 peak, the low and slowly changing interest rates of former years are plainly gone with the wind, as are the former government0decreed limits on interest rate competition for savings accounts and the favoritism for savings and loan associations over banks. But an agency of the U.S. Government (...) continues to insure savings accounts in the savings and loan industry, just as it did before. The result may well be bolder and bolder conduct by many savings and loan associations. A sort of Gresham's Law ("bad loan practice drives out good") may take effect for fully competitive but deposit-insured institutions, through increased copying by cautions institutions of whatever apparent-high-yield loan and investment strategies seem to allow competitors to bid away their savings accounts and yet report substantial earnings. If so, if "bold conduct drives our conservative conduct," there eventually could be widespread insolvencies caused by bold credit extensions come to grief.
And if serious credit-quality troubles come to the savings and loan industry, they will merely add to troubles from the borrowed-short, lent-long-at-fixed-rates problem, which is far from completely removed, and which destroys shareholder wealth at startling speed whenever interest rates are rising rapidly, even when the credit quality of mortgagors or other borrowers is excellent.
The Federal Home Loan Bank Board, under its current Chairman Edwin R. Gray shares Wesco's concerns. Wesco approves its attempts by regulation and by "jaw-boning" to limit follies to come from (1) sharing the U.S. Government's credit with optimistic new entrants to the savings and loan business, often coming from the real estate development and stock brokerage businesses, given ample scope to venture under widened investment authority, and (2) high financial leverage throughout the savings and loan industry, combined with continuing maturity mismatch of fixed rate assets and liabilities. Logic and history would suggest that Mr. Gray is right to pull on the reins, but this is an unpopular task since many powerful activity-cravers feel the bit and create political heat in opposition to even limited (and almost surely inadequate) financial discipline which would protect the federal deposit-insurance system by demanding a significant margin-of-safety factor in financial institutions, just as in bridges. Wesco is not optimistic either that the present rules of the savings and loan game will stand the test of time or that drastic changes in the rules will occur until huge future trouble comes, sooner or later.
Developing a short-term operating plan for Mutual Savings which would sharply increase its reported earnings next year would be a near-absolute cinch. For instance, savings accounts could be expanded greatly by paying a high rate of interest on "jumbo" deposits in $100,000 multiples, and proceeds plus cash equivalents on hand could be placed in long-term mortgages at substantial current interest spread while, in addition, some origination fees could be "front-ended" into income. However, taking long-term risks into account, it is much harder to find a sound operating plan. Money is the ultimate fungible commodity. In the new order of things, an association is not only in a tough, competitive, commodity-type business on the lending side but also finds that, with decontrol of government-insured rates paid savers, every competitive association has virtually unlimited credit to fund increased lending, by playing premiums over interest rates generally prevailing on savings accounts. Under such conditions when all risks are considered, including those created by that portion of competitors motivated primarily by short-term effects, it is quite naturally difficult to earn over a long period an attractive return on shareholders' equity. How could it be otherwise?
A few years ago, about the time Mutual Savings reacted to new conditions by curtailing lending and financial leverage, most other associations decided instead to keep lending aggressively but under new adjustable-rate mortgages under which some portion (but far from all) of the interest-rate-fluctuation risk is shifted to the homeowner. Despite widespread use of these new adjustable-rate-mortgages, savings and loan industry earnings remain dependent to a material extent, as they always were, on an interest rate spread attributable to: (1) borrowing short while lending long, and/or (2) making loans which can be priced high enough to provide a profit only because they involve a very material credit risk, compared to the risk of owning government-backed securities of comparable maturity.
Under present conditions of strong competition from bold competitors accompanied by high interest-rate-fluctuation risk, the result tends to be that each year of reported attractive earnings in the savings and loan industry occurs only in the absence of two now much more likely events: (1) sharply rising interest rates, and (2) widespread credit losses. Thus, each good year reported is a lot like the year when a Texas hurricane insurer reports satisfactory earnings because there have been no hurricanes. Mutual Savings has a considerable share of this uncomfortably position and will continue to have it. It has not yet developed a long-term operating strategy with which it is satisfied and it continues to seek one. Just as Mutual Savings has been idiosyncratic in the past as it sold branch offices in 1980 (a practice since adopted to some extent by other savings and loan associations and major banks), it will probably be idiosyncratic in the future. It will seek some non-standard way of rendering socially constructive service operating with acceptable profits accompanied by an acceptable level or risk for shareholders' capital, likely gains considered.
Eventually, by maintaining unusual capital strength and liquidity, and by having a parent corporation which does likewise, Mutual Savings hopes to stand in particular favor with federal and state regulatory authorities and be in a position soundly to expand again, perhaps dramatically, and perhaps involving additional shareholder investment in Mutual savings by the parent corporation.
Recent growth in savings accounts, considered on an incremental-effects basis, constitutes loss business, because Mutual Savings has incurred in interest and other expense more than it has received from employing proceeds in short-term interest-bearing investments far above regulatory requirements for liquidity. Moreover, some of the attendant expense may not have hit the books. In due course (starting in 1985) Mutual Savings, which with its large ratio of shareholders' equity to total liabilities imposes a virtually zero risk on FSLIC (the U.S. agency which insures safety of accounts in savings and loan associations), will be required to pay FSLIC extra insurance premiums, based on Mutual Savings' gross size, to help fund FSLIC's protection of account holders in other savings and loan associations finally recognized as insolvent. In this process Mutual Savings, in effect, will retroactively pay extra interest-equivalent expense by reason of having attracted new savings. Mutual Savings' position at the moment is like that of a sober and careful automobile driver of 2000 miles per year, disadvantaged by his limited activity, yet forced to pay mutualized, standardized insurance premiums so long as he lives based on inclusion in a liability insurance pool (1) which is composed almost entirely of much worse risks, (2) which contains a considerable number of traveling salesmen previously convicted of drunk driving, and (3) which discovers liabilities, partly through institutional design, long after their occurrence. Deliberate growth in savings, under such conditions, reflects considerable optimism, perhaps Micawberish, that Mutual Savings will eventually have better ideas and opportunities and that its officers (including the Chairman) will make fewer of the sort of mistakes in which they participated in the past, leading to difficulties now decried.
The forgoing comments, designed to communicate reality for Wesco shareholders as it appears to Wesco management, should not be taken as criticism of the FSLIC management. In recent years FSLIC management has bordered on heroic, considering economic and legal changes, political pressures, extraordinary work burden, novel problems, and limited resources.
Precision Steel
Wesco's Precision Steel subsidiary, located in the outskirts of Chicago at Franklin Park, Illinois, was acquired for approximately $15 million on February 28, 1979. The price was roughly book value for a company which carried its inventories on a conservative LIFO accounting basis and which contained significant cash balances. More important, it has reached its position from a modest beginning through maintenance of sound, customer-oriented business values inculcated over a long time by a gifted found and his successors. Precision Steel owns a well-established steel service center business and a subsidiary engaged in the manufacture and distribution of tool room supplies and other specialty metal products.
Precision Steel's businesses contributed $2,034,000 to "normal" net operating income in 1984, up 25% compared with $1,622,000 in 1983. Such a sharp increase in 1984 profit was not anticipated and was largely attributable to (1) increased sales (up 20% to $55, 098,000) and (2) some favorable quantity-order prices on steel purchased.
Under the leadership of David Hillstrom, Precision Steel's businesses are now quite satisfactory, taking into account the financial leverage put into Wesco's consolidated picture incident to their acquisition. The 1984 year could be a hard act to follow.
Shortly after Wesco's purchase of Precision Steel, a substantial physical expansion of steel warehousing facilities was authorized, involving a new building in Charlotte, North Carolina. The new building and the whole North Carolina operation are now very successful, contributing $8,589,000 to sales in 1984 at a profit percentage higher than has prevailed in the long-established Chicago headquarters' facility.
Precision Steel's businesses, despite their mundane nomenclature, are steps advanced on the quality scale from mere commodity-type businesses. Many customers of Precision Steel, needing dependable supply on short notice of specialized grades of high quality, cold-rolled strip steel, reasonable prices, technical excellence in cutting to order, and remembrance when suppliers are short, rightly believe that they have no fully comparable alternative in Precision Steel's market area. Indeed, many customers at locations remote from Chicago and Charlotte (for instance, Los Angeles) seek out Precision Steel's service.
Wesco remains interested in logical expansion of Precision Steel's businesses, using liquid assets available.
All Other "Normal" Net Operating Income
All other "normal" net operating income, net of interest paid and general corporate expenses, rose to $4,550,000 in 1984 from $3,839,000 in 1983. Sources were (1) rents ($2,078,000 gross, excluding rent from Mutual Savings) from Wesco's Pasadena office building block (predominately leased to outsiders although mutual savings is the ground floor tenant) and (2) interest and dividends from cash equivalents and marketable securities held by Precision Steel and its subsidiaries and at the parent company level.
Net Gains on Sales of Securities
Wesco's aggregate net gains on sales of securities, combined, after income taxes increased to $13,138,000 in 1984 from $2,046,000 in 1983. The large 1984 gains do not indicate special acumen or good fortune in 1984. It merely happened that in 1984 unrealized appreciation occurring in previous years was cashed in.
A $1,080,000 portion of 1984 securities gains, if a different accounting treatment has been used, would have been both (1) shifted to a different income category and (2) increased by $1,765,000. See next section.
Unusual Income and Certain Accounting Quirks in 1984 Reporting
Wesco's consolidated audited figures for net earnings contained in this Annual Report are lower by $1,328,000 in aggregate ($.19 per share) with respect to the nine months ended September 30, 1984, then the figures contained in Wesco's previously-issued quarterly reports covering such nine months.
The downward restatement of earlier reported earnings occurred because, after the close of the year, Wesco's outside auditor made an unanticipated interpretation of generally accepted accounting principles applicable to an unusual business transaction.
The unusual business transaction was cash paid by General Foods for transfer of General Foods' stock from Wesco to General Foods under a written arrangement with General Foods, specifying intention to create an exact dividend-equivalent, which kept Wesco's percentage ownership of General Foods the same at all times. Under such circumstances, income tax law quite naturally treats all proceeds of the in-form "sale" of General Foods stock as a dividend, which is the I.R.S. view as well as Wesco's view of the underlying economic substance. Last year, in a virtually identical case, Wesco's outside auditor approved, for the consolidated group of which Wesco is a part, financial statements including accounting treatment in conformity with in-substance dividend reporting to the I.R.S. and Wesco's 1984 quarterly reports of earnings followed this precedent with no objection. But, after much deliberation, the outside auditor's opinion early in 1985 came down in favor of treating the 1984 transactions with General Foods as sales instead of dividend-equivalents, except that income tax provision continued to be computed on the in-substance dividend basis.
From the Wesco shareholders' vantage point the result from the outside auditing decision made is that the error, if any, existing in the audited accounts by reason of the Wesco-auditor disagreement is now on the side of underreporting income. Wesco's audited net income for the full year 1984 is now lower by $1.765,000 ($.25 per share) than would have been reported if all proceeds of the 1984 business transaction with General Foods had been reported as unusual dividends or dividend-equivalents, following Wesco's view of substance. Either way, any income from the Wesco-General Foods business transaction is reported as "unusual" or from an irregular source (securities gains), and, either way, the 1984 year end balance sheet is exactly the same, expect that in one case (Wesco's view) the after-tax balance sheet carrying cost would have been $1,765,000 higher for an identical number of General Foods' shares owned with the $1,765,000 increase augmenting book net worth of Wesco.
While Wesco disagrees with its outside auditor on the accounting issues, Wesco can find something to applaud in (1) a de-emphasis of year-to-year consistency in search for an answer best in the auditors latest view and (2) an auditor's favouring of a decision, where is has any doubt, which may err on the side of under-reporting income, considering a common tendency of corporate clients to favor decisions in the opposite direction.
Were Wesco running a national accounting partnership it would want a system where a high-ranked partner, free of business-retaining pressure, could reverse accounting decisions urged by field partners, so Wesco can hardly complain about the inconsistent messages from an audit-management system which forced Wesco in 1984 to change at year end quarterly income figures earlier reported. However, in thesis murky case, where we happen to know that one of the country's most eminent accountants agrees with the Wesco view, we must admit to minor irritation with the fates. Wesco makes special effort aimed at high-quality reporting to shareholders. (For instance, only with respect to competitively proprietary information, such as transactions in marketable securities, does Wesco consciously keep communication with shareholders to the legal minimum.) Thus when the audit quality-control system of its outside C.P.A. firm selects Wesco for forced restatement of numbers previously given shareholders, we feel much as if we were a duty-obsessed engineering system at Brigham Young University accidentally tear-gassed by the national guard in a necessary program to control campus unrest.
The subject of this restatement of a a small part of Wesco's earnings is covered at length here only because, must more often than not, it is a bad sign for shareholders when a full year-end audit decreases income reported as earned in previous quarterly reports. A full explanation is therefore appropriate.
The inconsistency between quarterly and financial income figures is not the only accounting quirk in Wesco's audited 1984 financial statements. It seems odd, as high-lighted above in the unconventional breakdown of earnings, that unrealized appreciation of $458,000 in a forward commitment to buy mortgage-equivalents was taken into Mutual Savings' income in 1984, which happened because the commitment was made in a futures market on a commodities exchange. A forward commitment to buy the same mortgage equivalents, made in some other manner, for instance by simple contract, would not, under the applicable accounting rules, result in the same unrealized appreciation's being reported as income. And, even though the unrealized appreciation is recognized as income in the 1984 earnings statement, shareholders must look deep into a footnote to the audited 1984 financial statements to find the only reference to the mortgage equivalents which produced the appreciation. The balance sheet standing alone discloses only short-term investments (U.S. Treasury Notes in this instance) the proceeds of which will be used in 1986 to close the forward commitment to buy the mortgage equivalents.
It also seems odd, in view of the substantial additional costs FSLIC membership will in the near future impose on Mutual Savings, that prepaid FSLIC premiums amounting to $(illegible) are included in the audited consolidated balance sheet, without offset for anticipated new cost of sharing FSLIC liabilities. We do not object to the accounting convention at work. All complexities and interests considered, the accounting profession is doing all right by the civilization; the FSLIC relationship has long been a valuable asset in the savings and loan industry with its mutualized nature of no practical adverse consequence; and both accounting and public policy considerations disfavor quick invention of new accounting convention to anticipate in current financial statements future increases in burden from FSLIC membership by reason of facts already known.
But quirks (at least as diagnosed by Wesco) required (probably wisely, on balance) by accounting convention, do contribute to causing Wesco to break down and discuss its earnings unconventionally in its management letter and also to call shareholders' attention to audit footnotes. The use of both footnotes and letter is needed for a best-feasible understanding of economic reality as it appears to Wesco management.
It is recognized, of course, by most certified public accountants as well as by Wesco that audited statements alone, unless accompanied by a letter giving managements view of economic reality where inconsistent with the image created by accounting convention, is an improperly incomplete form of annual communication with corporate owners. there is a limit to the communication which properly standardized accounting can create, and Wesco's outside auditors (and its parent company's auditors) over the years have been quite supportive of Wesco's approach to expanding numerate communications in the management letter, even though outside auditor jurisdiction.
Written arrangements creating the issue of unusual dividend-equivalent income, of the type which caused reporting quirks in 1984 as a result of transactions with General Foods, can hardly be expected to be made year after year. However, Wesco does anticipate, based on an agreement already signed, that in 1985 more of the same sort of transactions will occur with General Foods, probably somewhat smaller in aggregate amount than 1984.
Consolidated Balance Sheet and Related Discussion
Wesco's consolidated balance sheet (1) retains a strength befitting a company whose consolidated net worth supports large outstanding promises to others and (2) reflects a continuing failure to acquire additional businesses because none are found available, despite constant search, at prices deemed rational when the interest of Wesco shareholders is taken into account.
As indicated in Note 2 to the accompanying financial statements, the aggregate market value of Wesco's marketable equity securities was higher than their aggregate cost at December 31, 1984 by about $13 million, down sharply from about $29 million one year earlier.
Wesco's Pasadena office building block (containing about 165,000 net rentable square feet including Mutual Savings' space) has a market value substantially in excess of carrying value, demonstrated by (1) mortgage debt ($5,182,000 at 9.25% fixed) against this real property not exceeding its depreciated carrying value ($3,069,000) in Wesco's balance sheet at December 31, 1984, and (2) substantial current net cash flow to Wesco after debt service on the mortgage.
Wesco remains in a prudent position when total debt is compared to total shareholders' equity and total liquid assets. Wesco's practice has been to do a certain amount of long term borrowing in advance of specific need, or order to have maximum financial flexibility to face both hazards and opportunities.
It is expected that the balance sheet strength of the consolidated enterprise will in due course be used in one or more business extensions. The extension activity, however, requires some patience, as suitable opportunities are not always present.
As indicated in Schedlue I accompanying Wesco's financial statements, common stock investments, both those in the savings and loan subsidiary and those held temporarily elsewhere pending sale to fund business extension, tend to be concentrated in very few companies. Through this concentration practice better understanding is sought with respect to the few decisions made.
The ratio of Wesco's annual reported consolidated net income to reported consolidated shareholders' equity, about 13% in 1982-84, (1) was dependent to a considerable extent on securities gains, irregular by nature, and (2) nonetheless leaves something to be desired from the Wesco shareholders' point of view. Wesco began life as a savings and loan holding company in what became a very tough industry in which the real value, as distinguished from the reported book value, of most shareholders' equity became impaired, particularly in 1981-82. Damaged along with the rest of the its industry, Wesco has been proceeding slowly under shortened sail, while it assesses damage and repairs the ship, instead of trying to make fast time by getting all canvas aloft. However, progress ultimately helpful to shareholders has not been restricted to what has shown up neatly in the income account covering this period. Increases over recent years in both (1) aggregate reported shareholders' equity and (2) the percentage of such equity outside Wesco's savings and loan segment are expected to be useful in the future.
On January 24, 1985, Wesco increased its regular quarterly dividend from 141/2 cents per share to 15/1/2 cents per share, payable March 7, 1985 to shareholders of record as of the close on February 19, 1985.
This annual report contains Form 10-K, a report filed with the Securities and Exchange Commission, and includes detailed information about Wesco and its subsidiaries as well as audited financial statements bearing extensive footnotes. As usual, your careful attention is sought with respect to these items.
Charles T. Munger
Chairman of the Board