To Our Shareholders:
Consolidated "normal" operating income (i.e., before all unusual operating income and all net gains from sales of securilies) for the calendar year 1986 increased to $11,934,000 ($1.68 per share) from $8,347,000 ($1.17 per share) in the previous year.
Consolidated net income (i.e., after unusual operating income and all net gains from sales of securities) decreased to $16,524,000 ($2.32 per share) from $51,541,000 ($7.24 per share) in the previous year.
A highly unusual capital gain, of a not-likely-to-recur type, from disposition of General Foods stock caused most of the net income in 1985. Wesco has three major subsidiaries, Mutual Savings, in Pasadena, Precision Steel, headquartered in Chicago and engaged in the steel warehousing and specialty metal products businesses, and Wesco-financial Insurance Company, headquartered in Omaha and currently engaged in the reinsurance business.
This supplementary breakdown of earnings differs somewhat from that used in audited financial statements which follow standard accounting convention. The supplementary breakdown is furnished because it is considered useful to shareholders.
Mutual Savings
Mutual Savings "normal" net operating income of $2,159,000 in 1986 represented a decrease of 35% from the $3,342,000 figure in the previous year.
Separate balance sheets of Mutual Savings at year-end 1985 and 1986 are set forth at the end of this annual report. They show (1) total savings accounts rising to $282 million from $269 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 liabilites offset by cash equivalents andmarketable securities, (4) a loan portfolio (mostly real estate mortgages) of about $79 million at the end of 1986, down 6% from the $83 million at the end of 1985, and (5) favorable effects or securities gains, which caused net worth to decline only $3 million in 1986 despile payment of a dividend of $7.5 million to the parent corporation.
The loan portfolio at the end of 1986, although containing almost no risk of loss from defaults, bore an average interest rate of only 7.48%, probably the Iowest for any U.S. savings and loan association and about equal to the average interest rate which now must be paid to hold savings accounts. This, of course, leaves no net interest margin to cover operating costs. However, the unrealized depreciation in the loan portfolio is now more than offset by unrealized appreciation in Mutual Savings' interest-bearing securities and preferred stocks. Such unrealized appreciation at December 31, 1986 was about $17 million.
As pointed out in footnote 14 to the accompanying financial statements, the book value of Wesco's equity in Mutual Savings ($54.8 million at December 31, 1986) overstates the amount realizable, after taxes, from sale or liquidation at book value. If all Mutual Savings' assets, net of liabilities, were to be sold, even pursuant to a plan of complete liquidation, for the $54.8 million in book value reported under applicable accounting convention, the parent corporation would receive much less than $54.8 million after substantial income taxation imposed because about $47 million of what is designated shareholders' equily for accounting purposes is considered bad debt reserves for most tax purposes.
There is, however, in Mutual Savings, not only a buried plus value in unrealized appreciation of securities, but also a buried plus value in real estate. The foreclosed propety on hand (mostly 22 largely oceanfront acres in Santa Barbara) has become worth over a long holding period much more than its $1.6 million balance sheet carrying cost. Reasonable, community-sensitive development of this property has been delayed over 11 years in the course of administration of land-use laws. But we are optimistic that the delay will end in 1987 and that the Santa Barbara and Montecello communities will be very pleased with development into 32 houses intersperced with large open areas. Mutual Savings plans to make the development first rate in every respect, and unique in the quality of its landscaping.
The buried plus value in real estate is limited by the small number of houses allowed (32) and by the fact only a minority of such houses (12) will haw any significant ocean view. Additional limitation will come from prospective high cost of private streets, sweage amd utility improvements, connections and landscaping. And, most important of all, various changes and burdens imposed by governmental bodies will drastically reduce our potential recovery from what it would have been had the zoning and development climate of the early 1970's continued into 1987.
Balancing all merits and demerits, Mutual Savings, as it has been managed under present conditions by the writer and others, continues to be a mediocre business from the shareholders' point of view. Mutual Savings' good points are: (1) high asset quality and sound balance sheet; (2) a maturity match of interest-bearing assets and liabilities which makes risk of insolvency near zero, whatever happens to interest rates; and (3) a deserved reputation for high quality service to account holders, achieved at below-average cost to the institution in an efficient one-large-office operation, as distinguished from a many-small-branch-offices operation. Mutual Savings' bad points are: (1) all recent growth in savings accounts, considered on an incremental-effects basis. has been loss business because interest and other costs incurred exceed income obtained by employing prcceeds in short-term interest-bearing assets; (2) a burdensome position under the FSLIC account-insurane system causes payments of ever-higher amounts inio the system to help bail out more venturesome savings and loan associations which become insolvent, with the payments being required despite the fact that Mutual Savings imposes almost no risk on FSLIC; (3) "normal" net operating income is below an acceptable rate of return on present book value of shareholders' equity, with such return reaching an acceptable level over recent years only with help from securities gains and other unusual items; (4) it would not be easy to leave the savings and loan business, should this course of action ever be desired, without a large income tax burden of a type not applied to corporations other than savings and loan associations; (5) as explained in last year's annual report, the regulatory structure of the savings and loan business creates a competitive situation in which it is hard to make respectable profits through careful operations; and (6) management has not yet found an acceptable remedy for any of the previously listed bad points, despite years of trying.
Moreover, comparisons of post-1984 financial results for Mutual Savings with results for many other and more typical savings and loan associations in California, continue to leave Mutual Savings looking inferior, to put it mildly. As interest rates went down, these other associations, which have greater financial leverage and operated less fearfully than Mutual Savings during former high-interest periods, came to have loan and investment portfolios which (1) now are worth more on average than book value and (2) now produce a high return on book value of shareholders' equity, after deduction of operating expenses and interest to account holders at present rates. Any Wesco shareholder who thinks Mutual Savings has any expertise in predicting and profiting from interest rate changes can look at the 1985-1986 record and despair.
Despite the fact that some other savings and loan associations did much better after 1984 than Mutual Savings, and are now much better poised to report good figures for 1987, we plan to continue operating only in ways acceptable in our own judgment, anticipating as a consequencewidely fluctuating and sometimes inadequate returns. In the future, however, Mutual Savings will make and purchase more loans. Now that Mutual Savings' old mortgage loans have declined in amount and increased in market value, (the market value increasing being caused both by a decline in generally prevailing interest rates and by a shortening of remaining loan life), new loans will be added as seems wise, with a target that at least 60% of assets be in housing-related loans. New direct loans aggregating $9 million were made in 1986, all adjustable rate mortgages with no cap on future interest rate changes but with an extremely low "spread" for the lender. In recent months, the total of all loans on hand has risen as new loans made exceeded principal payments on old loans.
With assets not employed in direct real-estate lending, Mutual Savings continues not only to make payments to FSLIC far in excess of fair charges for risks imposed on FSLIC but also to employ a large part of total assets in short-term loans to the Federal Home Loan Bank. These practices are pro-social but will continue to reduce profits.
Mutual Savings also continues to support the Federal Home Loan Bank Board in its efforts to change the present rules of the savings and loan business to augment average soundness of FSLIC-insured associations and prevent recunence of widespread insolvencies like those now bedevilling the industry.
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, the company has 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 specially metal products.
Precision Steel's businesses contributed $1,701,000 to "normal" net operating income in 1986, down 15% compared with $2,010,000 in 1985. The decrease in 1986 profit occurred in spite of increased revenues (up 2% to $52,304,000).
Under the skilled 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.
Shortly after Wesco's purchase of Precision Steel, a substantial physical expansion of steel warehousing facilities was authorized, involving a new buildings in Charlotte, North Carolina. The new building and the whole North Carolina operation are now very successful, contributing $10,172,000 to 1986 sales at a profit margin 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 culling to order, and remembrance when supplies 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 available liquid assets.
Wesco-Financial Insurance Company (Wes-FIC)
A new business was added to the Wesco group in 1985, in co-venture with Wesco's 80% owner and ultimate parent corporation, Berkshire Hathaway Inc.
With the enthusiastic approval of all Wesco's directors, including substantial Wesco shareholders in the Peters and Caspers families, without whose approval such action would not have been taken, Wesco in 1985 invested $45 million in cash equivalents in a newly organized, wholly owned, Nebraska-chartered insurance company, WescoFinancial Insurance Company ("Wes-FIC"). Another $36.2 million was invested in January 1986.
The new subsidiary, Wes-FIC, has reinsured, through another Berkshire Hathaway insurance company subsidiary as intermediary-without-profit, 2% of the entire book of insurance business of the long-established Fireman's Fund Corp. (listed on the NYSE). Wes-FIC thereby assumed the benefits and burdens of Fireman's Fund's prices, costs and losses under a contract covering all insurance premiums earned by Fireman's Fund during a four-year period commencing September 1, 1985. The arrangement puts Wes-FIC in almost exactly the position it would have been in if it, instead of Fireman's fund, had directly written 2% of the business. Differences in results should occur only from the investment side or insurance, as Wes-FIC, instead of Fireman's Fund, invests funds from "float" generated. Wes-FIC's share of premiums earned in 1986 exceeded $67 million.
Wes-FIC's separate financial statements, covering the brief period of its existence, September 1, 1985, to December 31, 1986, are included on page 30 of this Annual Report, and show that Wes-FIC's net income for 1986 was $6,967,000 versus a small deficit ($359,000} for its first 4 months of operation in 1985. The 1986 net income figure included securities gains, net of income taxes, of $352,000.
It is in the nature of even the finest casualty insurance businesses that in keeping their accounts they must estimate and deduct all future costs and losses from premiums already earned. Uncertainties inherent in this undertaking make financial statements more mere "best honest guesses" than is typically the case with accounts of noninsurance-writing corporations. And the reinsurance portion or the casualty insurance business, because it contains one or more extra links in the loss-reporting chain, usually creates more accounting uncertainty than the non-reinsurance portion. Wesco shareholders should remain aware, not only of the inherent imperfections of Wes-FIC's accounting, but also of the inherent cyclicality of its business.
However, Wesco hopes for: (1) a reasonable return on its investment over the four years of the Fireman's Fund reinsurance contract, and (2) possible future reinsurance contracts with other insurers.
We very much like our association with Fireman's Fund, a real class operation, and with Jack Byrne, its CEO, who displayed great integrity, intelligence and vigor in returning GEICO Corporation to glory before he took his recent position.
All Other "Normal" Net Operating Income
All other "normal" net operating income, net of interest paid and general corporate expenses, decreased to $1,459,000 in 1986 from $3,354,000 in 1985. Sources were (1) rents ($2,229,000 gross, excluding rent from Mutual Savings) from Wesco's Pasadena office building block (predominanlly 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. The great decrease in interest and dividends received in this "other income" category was caused by the transfer of assets to Wes-FIC, where income is now classified as insurance Income.
Net Gains on Sales of Securities
Wesco's aggregate net gains on sales of securities, combined, after income taxes, decreased to $4,590,000 in 1986 from $41,523,000 in 1985.
Bowery Savings Bank
In 1985 Wesco, in another co-venture wilh its parent corporation, approved by Wesco's directors in the same manner as the Wes-FIC co-venture, joined a group which invested $100,000,000 cash in a newly organized, New York-chartered savings bank. The new bank !hen look over !he name, assets and liabilities of the insolvent Bowery Savings Bank in the city of New York. The takeover received (1) much needed assistance from FDIC, the federal agency, akin to FSLIC, which insures deposits in banks, and (2) the blessing of New York bank regulators. Wesco invested $9,000,000, other Berkshire Hathaway subsidiaries invested $12,384,000, and other unrelated investors invested the balance of the $100,000,000.
The terms of the FDIC assistance, which include income-assistance payments over many years to the newly organized bank, are extremely complex but can be fairly summarized as far from adequate to assure that the investors will make a profit. This is as it should be when $100 million buys a highly-leveraged residual equity position in a $5 billion bank, albeit one with many sick assets.
Any minority-position investment with such extreme financial leverage (in effect buying with a 2% down payment), involving a troubled company in a demanding environment, can fairly be called a venture-capital type investment for Wesco. In our judgment. the prospect for gain justified the risk of loss.
This investment continues to be carried at cost in Wesco's accompanying financial statements. and we continue in guarded optimism regarding our position.
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 slow pace of acquisition of additional businesses because few are found available, despite constant search, at prices deemed rational from the standpoint of Wesco shareholders.
As indicated in Note 3 to the accompanying financial statements, the aggregate market value of Wesco's marketable equity securities was higher than their aggregate carrying value at December 31, 1986 by about $13 million, up modesty from about $5 million one year earlier. The consolidated aggregate market value of all marketable securities, including bonds and other fixed-income securities, exceeded aggregate carrying value by about $23 million. As earlier noted, about $17 million of this unrealized appreciation lies within the savings and loan subsidiary.
Wesco's Pasadena real estate, a full block (containing (1) about 125,000 first class net rentable square feet including Mutual Savings' space, in a modern office building. plus (2) an additional net rentable 34,000 square feet of economically marginal space in old buildings requiring expensive improvement), has a market value substantially in excess of carrying value, demonstrated by (1) mortgage debt ($4,940,000 at 9.25% fixed) against this real estate now exceeding its depreciated carrying value ($3,091,000) in Wesco's balance sheet at December 31, 1986, and (2) substantial current net cash flow (about $1 million per year) to Wesco after debt service on the mortgage. The modern office building is 96% rented, despite a glut of vacant office space in Pasadena. We charge just-below-standard rents and run the building as a sort of first-class club for tenants we admire. With these practices, a prime location and superior parking facilities, we anticipate future increases in cash flow, but at no better rate than the rate of inflation.
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 morn business extensions. The extension activity, however, requires patience, as suitable opportunities are not always present.
As indicated in Schedule 1 accompanying Wesco's financial statements, investments, both those in the savings and loan and reinsurance subsidiaries and those held temporarily elsewhere pending sale to fund business extension, tend to be concentrated in very few places. Through this practice of concentration of investments, 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 19%, in 1984-86, was dependent to a very large extent on securities gains, irregular by nature. This recent ratio is almost certain to continue to decline, probably sharply, as it did in 1986. Neither possible future acquisititions of other businesses nor possible future securities gains appear likely to help much in the short term. The business acquisition game continues to be crowded with optimistic players who usually force prices for low-leverage acquirers like Wesco to levels where return-on-investment prospects are modest. And future securities gains are likely to prove harder to come by for very simple reasons. Because securities generally traded lower several years ago than they do now, relative to the intrinsic values of the businesses represented by the securities, creating more obviously sound investments then than now, and because prospects for above-average returns tend to go down as assets managed go up, it is now, early in 1987, even easier than it was early in 1986, to predict Iess desireable future results. It is also easy for any sophisticated Wesco shareholder, reviewing either (i) this virtual reprint of last year's letter or (ii) Wesco's marketable securities disclosed heirin, to diagnose correctly the decision makers are now even more dry of good ideas than they were last year.
The considerable, and higher than normal, liquidity of Wesco's consolidated financial position as this is written does not result from our forecast that business conditions are about to worsen, or that interest rates are about to rise, or that common stock prices are about to fall. Wesco's condition results, instead, from our simply not finding opportunities for more aggressive use of capital with which we are comfortable.
Wesco continues to try more to profit from always remembering the obvious than from grasping the esoteric (including much modem "strategic planning" and "portfolio theory"). Such an approach, while it has worked fairly well on average in the past and will probably work fairly well over the long-term future, is bound to encounter periods of dullness and disadvantage as it limits action. Moreover, the approach is being applied to no great base position. Wesco is sort of scrambling through the years without owning a single business, even a small one, with enough commercial advantage in place to pretty well assure high future returns on its capital. In contrast, Berkshire Hathaway, Wesco's parent corporation, owns a fair number of such high-return businesses.
On January 22, 1987, Wesco increased its regular quarterly dividend from 16.5 cents per share to 17.5 cents per share, payable March 12, 1987, to shareholders of record as of the close of business on February 20, 1987.
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 audiled financ;al statements bearing extensive footnotes. As usual, your careful attention is sought with respect to these items.
Charles T. Munger
Chairman of the Board
February 13, 1987
