LIC UTILITY BONDS icts Regarding Their Issue and Their Security By Frederick Lownhaupt PUBLIC UTILITY BONDS FACTS REGARDING THEIR ISSUE AND THEIR SECURITY BY FREDERICK LOWNHAUPT Author of “Investment Bonds” BOOKLET NO. 2 OF A SERIES ON BONDS See Page 4 for other title* V. § MOODY’S MAGAZINE NEW YORK, N. Y. Copyright, 1910 BY A. W. Ferrin iu. e , L^54h >jr. t, CONTENTS Franchise an Important Matter Franchise and Monopoly Geographical and Commercial Considerations Physical Valuation of Plant Depreciation Contingencies Good Record of Bonds Capitalization of Utilities . Earnings and Expenses Utilities Well Established . 6 7 9 10 11 12 12 13 14 15 A SERIES OF BOOKLETS Treating The Subject of Bonds in an instructive and popular manner Booklet No. T-Railroad Bonds. Booklet No. 2--Public Utility Bonds. Booklet No. 3--Industrial Bonds. Booklet No. 4 Municipal Bonds. Booklet No. 5--Irrigation Bonds. Booklet No. 6--Timber Bonds. PRICE TEN CENTS EACH MOODY’S MAGAZINE 35 NASSAU STREET NEW YORK, N. Y. PUBLIC UTILITY BONDS T HE group of corporations known as Pub- lic Utility or Public Service corpora- tions is composed of a number of com- panies of varied activities. Principal among them are street railways, gas, electric light, water and telephone companies. In the general acceptance of the term "public utility,” the telephone companies are included, although they are often not regarded as belonging to this class of corporations. Street railways and thdse other electric railways operating between two cities or touching several important towns are known as the tractions, although those lines not entirely located within the boundaries of a city but running from one city to another take on a somewhat special character. In a word, public utility corporations are those which minister to the local necessities of peo- ple, and which have become indispensable through increase of population and demand for conveniences. A distinguishing characteristic is, therefore, suggested in their intimate rela- 5 tion to public welfare. From the nature of the services they perform one banking house has aptly termed them “Public Necessity Corpora- tions.” Franchise an Important Matter. Another characteristic which differentiates 1 them from other corporations is their franchise privilege for operation. In a wide sense steam railroads are franchise corporations, yet their t different position makes it practically possible to ignore that point in considering their bonds. The franchise with public utility corporations is a most essential consideration. Their char- ters are obtained from their respective States and define their rights, duties and privileges. A franchise, that is, a right to serve, is granted them to carry on certain operations within the community they serve. There is absolutely no uniformity in this matter of franchise. Every State has its own laws in regard thereto. In Illinois there is a law that no franchise can be granted for a longer term than twenty years ; while perpetual franchises have been obtained by many companies, it is customary to limit the number of years a franchise may run, its maximum duration varying with different * 6 States and different companies. The granting of a perpetual franchise or even one for a long period of years often becomes a virtual monop- oly for the company. By its franchise the com- pany becomes intrenched upon the principal thoroughfares, works its way into the desir- able localities, and if it renders a service con- sistent with the needs of the community is likely to be granted a renewal of its franchise on favorable terms. Franchise and Monopoly. The exclusive privilege of using streets for railways, for poles and wires for distribution of electricity or for the stringing of telephone wires to all practical purposes is a legal monop- oly. It is being recognized more and more that competition is undesirable in the matter of public utilities. Experience has proven that where franchises have been granted to install a second system, the public and the companies have suffered. New York State has its Public Service Commission. On the question of com- petition its position is that as long as a com- pany is serving the community adequately at a fair rate it will not permit another to come in. I n addition to its length, its scope, the terms 7 and conditions of its renewal, its limitations, if any, etc., the value of a franchise must be con- sidered from the viewpoint of the relation of the company with its public and with the po- litical situation. Close affiliation with politics is undesirable ; and there must be harmonious relations between the company and the people. Although it is practically impossible to revoke a franchise where its terms and conditions are being met, it is possible through taxation, leg- islation of one kind or another in regard to fares, transfers, etc., to strike at a company which has incurred the hostility of the people. A perpetual franchise is, of course, best for an investor in the company’s bonds. Where the limited franchise exists, a sinking fund should take up some of the bonds each year; and as a general principle the issue should mature be- fore the set date of expiration of the franchise. There is a growing sentiment in favor of the limited franchise. Perpetual privileges so largely unrestricted as have been given to cor- porations are becoming fewer and fewer. The whole question of franchise is broad, interest- ing and important and is one on which hinges much of the value of this type of bonds. 8 Geographical and Commercial Considerations. Other factors that make for strength or weakness in these bonds differ with the nature of the company. Considering an electric inter- urban railroad as a utility corporation, there is the importance of the cities which form its termini upon which much dependence is placed for traffic ; also the character of the intermedi- ate towns. Their geographical and commercial importance should be considered. If the line is a connecting link between some large city and its suburbs, it is likely to prosper from the be- ginning. Connecting two smaller towns in the outer country much more uncertainty of its complete success exists. With the purely ur- ban or street railway it is desirable that it be located in a larger city where there is a density of traffic. Some bankers consider a population of 100,000 as a minimum for perfect safety of the securities of such lines. No hard and fast rule can be laid down, however. With either type of road, population served is the deter- mining influence on the character and service and growth of earnings. In the engineering estimates for the building of such lines great l care is exercised to arrive at data that is fully 9 * reliable. Account must be taken of the growth of the city and the crowding from the city into the suburbs. Physical Valuation of Plant. The value of the property of any public ser- vice corporation must be regarded in consider- ing its securities. Before bankers will buy the bonds, an appraisal is made. Expert engineers are sent over the property to examine real es- tate, plant and equipment, to determine what is approximately a replacement value, that is, for what amount the whole outfit could be duplicated. If the bond issue is less than that figure, the bonds are in a strong position, jbut if the issue is in excess it indicates that good- will, franchise rights, etc., have been capital! zed to some extent. The value of these things is., of course, difficult to represent in figures, andl it is the bankers’ judgment that largely decides whether or not a conservative figure has been used. Where a new proposition is under c on- sideration, there is, of course, a good reason Jor demanding that the first cost be considerably more than the bond issue, since there is no in- dex of earning power in addition to actual value, on which to base judgment. 10 Because of the peculiar nature of much of the property of electric light, gas and water power plants, in that it consists of wire, pipe and more or less machinery, some investors hesitate to take bonds of such companies. Such ^ people do not regard transmission wire and ap- paratus as an excellent basis of security. Depreciation. i The value of the physical property is not the *>nly measure of worth of such securities, be- cause eventually earnings is the criterion. A plant in a desirable locality, if properly man- aged, should produce good returns; and it is not at all unlikely that foreclosure on such a plant would bring a price greater than the so- called replacement value. A complete analysis of a public utility concern involves a thorough investigation of its physical condition, financial operation and political associations. A con- sideration of the first touches on the matter of depreciation. What may be said of industrial corporations applies here also ; and that is that no rule can be laid down. It is, however, con- sidered good practice to allow somewhere near ten per cent, of gross earnings for this item, at * least for street railways. A gas, telephone or 11 lighting plant may not require this amount in every instance, although it is well to use it. The deterioration of plant and equipment is rapid. Only by a liberal allowance for its up- keep can a true statement of its condition be gained and efficiency maintained. Contingencies. One of the elements of risk in purchasing bonds of a street railway in a small community is the danger of accidents. One accident of serious proportions with its resulting damage suits, were they successful, might impair its financial position and cause much difficulty in meeting its obligations. Good Record of Bonds. The record of public utility bonds as a class is not marred by any great amount of default or difficulty of any kind. These companies have shown an excellent record during periods of general business depression, having passed through the trying times unaffected to any- thing like the degree that steam railroads have been. These bonds, therefore, enjoy a certain advantage. The record of earnings of public service cor- porations during periods of business depres- 12 sion tend toward stability even to a greater ex- tent than is the case with railroads. Where steam railroads have suffered a reduction of earnings from ten to twenty-five per cent., the earnings of these public utility corporations have shown but a moderate decline. This sta- 4 bility no doubt lies in the fact that the need of their services is imperative in a large sense. They supply things which the public cannot * very well dispense with. Their operation is a public necessity and the nature of their busi- ness is such as to make them largely inde- pendent of the periodic fluctuations in general business and industrial conditions. Capitalization of Utilities. The bonds of a street railway ought to be a security of high value providing the company is not over-capitalized. Where this evil of over-capitalization exists it is one which has grown largely out of the consolidations effect- ed in large cities where a number of indepen- dent lines were joined and welded into one sys- tem. The bonds ought to be a good invest- ment where the company has a satisfactory franchise, one that is not hedged about by too many restrictions, does not expire too early l and is not onerous. Furthermore, such securi- ties ought to be desirable where the company serves a comparatively large community. Sta- tistics prove that the securities of street rail- ways operating in cities of fair size are becom- ing better each year with the development of these cities. New York City lines have been a notable exception to this statement, but their difficulties have been attributable to what has already been mentioned, a burden of tremendous capitalization, a large part of it unwarranted. The earning power of such companies is an established fact where the proper conditions exist. It has passed much beyond the experi- mental stage. There is every indication of a steady growth of population in important cen- ters. The trend of traffic is toward the cities, and where interurban lines connect cities, that condition is all the more pronounced. Earnings and Expenses. The statistics also show that the ratio of in- crease of earnings of these companies is even faster than that of the population. The ratio of operating expenses to the gross income varies altogether with conditions. All avail- able data points to the fact that street railways 14 in cities of from 100,000 to $00,000 require about 55 per cent, of gross earnings while a greater population means an increase of these expenses. This is due to the fact that up to a certain density passenger traffic of this charac- ter may be handled expeditiously ; beyond that it becomes a hindrance and is more difficult to move. Cities of 25,000 or under in population show operating expenses of about 70 per cent., 25,000 to 100,000, 60 per cent. Utilities Well Established. Considering gas, electric, water and water- power companies, it is obvious that each has important economic functions in a community. The electric light and power industry is grow- ing by leaps and bounds. Electricity is rapidly becoming the prevailing illuminant and is as rapidly being installed for power purposes* Where it is generated by large water power, as at Niagara Falls, it is usually much more economical than steam power. In twenty-five years the lighting and power industry has ad- vanced so greatly that it is now on a permanent and stable basis. Although gas has been sup- planted as an illuminant in no small measure, it now has a new use compensating for the 15 loss. The adoption of gas as fuel for cooking has become widespread. In view of this in- creasing use it is more of a necessity than ever. The demand is constant and ordinarily in- creases with the increase in population. In moderate-sized towns, the debt of such a com- pany should bear a proper relation to the cost of the plant. It is economical and of instant use. Its con- venience has commended it so that enormous numbers of gas-using appliances are constant- ly being installed. The gas industry is nearly a century old, and for all the competition of electricity, is an industry whose bonds when well selected are of great stability. The tele- phone business, although of a different charac- ter, has now entered the final stage of its ca- reer, the stage of investment. Financially con- sidered, the earlier phases of this business were the experimental and speculative state, and the construction stage where as now the telephone business is on an investment basis. A recent issue of American Telegraph and Telephone bonds which so rapidly found pur- chasers here and abroad bears witness to this fact. 16 I . \ * I i