I-C. FINANCES CASH FLOW VERSUS "EARNINGS" The formal bankruptcy of the Penn Central finally occurred in June 1970 after the company was unable to obtain an immediate Government guarantee for a $225 million loan. The company had simply run out of cash and ways of raising cash. To many reasonably informed investors this terminal cash crisis came as a surprise because Penn Central's earnings, while becoming progressively worse, had not seemed to indicate such a critical cash shortage. 117 The results for the transportation company only (the company containing the railroad) were poorer than the consolidated results, but they did not appear to be terminally critical, particularly considering the size of the company. 117 The reported earnings, however bad, did not reflect the truly disastrous performance of the company, particularly with respect to the critical cash flows. The earnings were inflated by transactions and accounting practices which produced reported earnings but little or no cash.118 Additionally, the earnings were presented in a format which tended to conceal the source and the trend of the losses.119 While the moderately adverse earnings figures were being presented to the public, a cash drain of staggering proportions was occurring in Penn Central. The following is a chart of the cash flow at Penn Central, including the railroad but excluding cash flows within individual subsidiaries: 120 118 See Income Management section of this report for further explanation. 119 Management has argued that accounting practices required for reporting to the ICC mandated this presentation. Even if ICC accounting were required for ICC regulation purposes, management was not prevented from supplying additional earnings information to the public. 120 These figures do not include expenditures for equipment which is customarily financed by conditional sales agreements or equipment trust certificates which require little or no cash outlay by the company. Under these financings, the loans are directly secured by the equipment being acquired. (84) The public was unaware of the magnitude of the cash drain. This cash drain was particularly important information about the condition of the company and the direction in which it was headed. The drain cut through the optimistic statements and the inflated earnings because it was a reality which could not be denied even by management. The cash drain also indicated at a very early date that Penn Central was a likely prospect for bankruptcy. Penn Central's ability to borrow was very limited despite its huge corporate size. It could not raise money through long-term debt because most of its property was already encumbered by debt and Penn Central's poor earnings would assure poor reception for long-term debt in the financial markets. Penn Central could meet its cash drain only by short-term borrowing or by a liquidation of assets and these two courses were restricted in their own right. There were few assets that could be liquidated. The real estate holdings in New York City, formerly owned by the New York Central, were heavily mortgaged and would not produce much cash upon sale. The other likely area for salable assets would be the Pennsylvania company, but many of these assets were pledged, and some, like Great Southwest Corp. and Macco Corp., were not what they appeared to be on the surface. Faced with these problems and the poor image that would be reated by trying to liquidate, Penn Central decided to use some of hese assets indirectly by pledging them as collateral for short-term oans. The short-term borrowing had severe limitations, however. The money market was tight and interest rates were high even for a arge "blue chip" such as Penn Central. Then, too, the pledging of assets in connection with borrowings, such as the revolving credit, quickly narrowed any future possibility for financing while the use of unsecured financing such as the commercial paper put out by the Transportation Co. exposed the railroad to an immediate runoff if adverse information about the company became public. Penn Central very quickly painted itself into a corner from which there was no escape short of a very dramatic and immediate reversal in the direction of the railroad earnings. Indeed, such a reversal would be needed simply to meet the interest charges. As described elsewhere, there existed fundamental problems in the merger and in management's ability which precluded such a reversal. The cash drain then, and not the publicly reported earnings, foretold the destination of the merged railroads. SOME CAUSES OF THE CASH Loss Given the apparent differences between stated losses in the financial reports and the actual cash losses a question arises about where the cash went. The following are some of the major areas of cash loss. These descriptions are merely illustrative of some causes of the cash drain and of the efforts of management to conceal the true magnitude and extent of the losses. OPERATIONS LOSSES The principal cash drain was from the operations of the railroad. Losses had been experienced in the premerger period. After the merger these losses turned abruptly worse. The deteriorating condition of the railroad operations was masked because the financial results included income, much of it noncash income, from other sources. When the rail losses are set apart, the deterioration of the rail operations is apparent: (Loss) on rail operations January to March 1970 ($101, 600, 000) | 1966_. 1965_ 2, 559, 000 (15, 636, 000) The causes and the course of the deterioration of the railroad are described elsewhere in this report. It is sufficient to note here that traffic volume decreased while costs soared, mainly because of enormous and continuing drains brought on by the chaotic operation of the merged railroad. It should be noted that most of the cash drain in railroad operations. was a drain from the day-to-day operation of the railroad and not, as management implied in its public statements, expenses associated with improving the road's facilities. The growing cash outflow, therefore, did not principally represent expenditures being incurred for the development of a better railroad in the future; it represented drains caused by the poor operations of the railroad. In fact, while capital needs were very great in the postmerger period, the funds available were limited and expenditures were fairly constant.121 Management also indicated repeatedly that the railroad's poor performance was caused by losses on passenger service. While losses from passenger service were growing 12 and did contribute to the cash drain, management cited the passenger losses in ways which tended to shift attention from the overall losses of the railroad to the losses from passenger service. This accomplished two management goals. First, it made the railroad's problems appear to be the fault of the Government and not the fault of management. Although the Government-mandated passenger service did cause losses, management was able to deflect criticism away from its own ineptness, which was the cause of most of Penn Central's losses.1 The second effect of emphasizing passenger losses was to indicate that if and when the railroad was relieved of that burden by the Government, investors could expect the railroad to operate at a profit. On more than one occasion, management stated publicly that without the passenger service losses, the railroad would be operating in the black.124 Such statements were inaccurate. 121 Penn Central Transportation Co. (includes PRR, Central, and N. Y., N.H. & Hartford) capital expenditures for road and equipment 1964-70. 123 Indeed, when questioned by the staff, many of the directors still cited the passenger losses as the principal cause of Penn Central's financial difficulties. The directors, however, were unable to identify the magnitude of the losses or their relation to overall losses. 124 An example from Dec. 1, 1969, letter to shareholders explaining the cancellation of the dividend: "In this same period (first 9 months of 1969], our railroad had a passenger deficit of $73,000,000 on the basis of fully allocated costs or approximately $47,000,000 in direct costs. But for this, the railroad would have been in the black." [The loss from rail operations exceeded $193,000,000 for all of 1969.] Management used two devices to achieve its goals in setting forth passenger service losses. First, it tended to emphasize the "fully allocated" losses rather than the lower "solely related" costs or the "avoidable" costs. The fully allocated costs include costs shared with freight service. Many of these costs would continue even if passenger service were abandoned. Solely related costs are the costs assigned by accounting to running the passenger service. Avoidable costs are costs which would be avoided by the discontinuance of passenger service.125 When used in the context of savings that might be achieved by relief from passenger service, the fully allocated figures conveyed an inaccurate picture. The second device used by management was to avoid comparing passenger losses with overall railroad operation losses.126 Such a comparison would have shown that the direct losses on passenger service were only a relatively minor portion of the overall operations losses.127 These were losses which would still be incurred even if Penn Central was relieved of all passenger service and they were losses largely related to mismanagement and not Government fiat. DIVIDENDS The Penn Central continued to pay dividends until the fourth quarter of 1969.128 Prior to the abandonment of the dividend Penn Central had been paying dividends of $.60 per share each quarter.129 Although the company had sufficient retained earnings from previous periods (in excess of $500 million) to support a dividend under applicable legal standards, the serious cash drain caused by the performance of the railroad was substantially aggravated by the payment of the cash dividend: 125 Avoidable costs were only computed when Penn Central petitioned for abandonment of a passenger service. 126 See pp. 86 and 87 for loss figures. 127 The rise in passenger service losses themselves was probably caused in part by the same problems afecting freight losses. 128 For a description of the decision to abandon the dividend see the section of this report on the role of the directors. : |