A state-ordered audit of interisland ocean cargo carrier Young Brothers LLC said an emergency 46% rate hike regulators begrudgingly granted last year is now generating profits for the company.

The audit, delivered to the state Public Utilities Commission last week, said Young Brothers as of June 30 has been able to generate a monthly profit of over $2 million primarily due to the rate increase, raising a question of whether rates should be reduced.

“On this basis there is a strong argument to be made that the commission should now consider reducing the ERI (emergency rate increase) to reflect the improvements in the company financial position and to provide some rate relief to customers,” the audit by Nevada-based Munro Tulloch Inc. stated.

Munro Tulloch’s report said customers may have a legitimate grievance about Young Brothers profiting from the emergency rate hike, and noted that the purpose of the temporary increase was “to keep the company afloat, NOT as a mechanism for the company to recoup losses from past management mistakes.”

In July 2020, Young Brothers sought PUC approval for a 47% hike to produce $30.4 million in added revenue so the company could break even financially.

The company said the need was due to interisland business declines triggered by the coronavirus pandemic, and that the only viable alternative to a rate hike was to cease service — a drastic move that would curtail shipping options for customers on bigger neighbor islands while stranding smaller markets such as Lanai and Molokai.

The PUC approved a 46% increase Young Brothers projected would generate an extra $27 million, which the state Consumer Advocate considered excessive.

An audit was part of the conditional approval by the agency, which had criticized Young Brothers for a bad track record of estimating how much revenue it needed in recent past years to achieve positive financial returns allowed under state regulations.

Kris Nakagawa, vice president of external and legal affairs for Young Brothers, said in a statement that the current rate has been a “vital lifeline” that has allowed the company to maintain its 12 weekly sailings between Oahu and the neighbor islands, and that the company wants to keep current rates through the end of 2023 as it continues ongoing cost containment initiatives.

The audit did credit Young Brothers for cooperating and approaching the examination as an opportunity to receive constructive feedback, evaluate existing practices and identify potential improvements — some of which it has committed to carry out.

But the 217-page report also found considerable fault with Young Brothers’ operations, noting that root causes of the company’s financial trouble preceded fallout from COVID-19.

The auditor recommends that the PUC seek a slew of changes for how the carrier does business, and noted that such recommended changes may not be totally embraced by the company.

“While there is a new management team in place at YB, there still appears to be some residual leadership reluctance to make any significant changes,” the report said.

Munro Tulloch added that responses it received from Young Brothers on audit results were not encouraging in some instances.

“It would have been encouraging to see more open acceptance and commitment by the company to adopt and initiate recommendations and changes,” the report said. “Instead our review noted a trend towards less proactive activities such as ‘review’ and ‘consider’ as opposed to ‘implement.’“

Nakagawa said everyone at Young Brothers is embracing and making positive changes to deliver better, more cost-efficient services to customers.

“For example, a new customer portal, a dedicated supply chain manager and a 5-year strategic plan are just a few of the auditor’s suggestions that are already well underway,” Nakagawa said.

One major issue covered in the report focused on how Young Brothers expanded beyond regulated interisland service with unregulated service predominantly moving large containers for a few large international shipping companies, and how it’s hard to determine if costs between the two are fairly distributed.

Young Brothers, the audit said, created a “structural imbalance” in its business with unregulated service representing 65% of cargo volume but only 35% of revenue while regulated service reflects the reverse.

“This effectively has created an inverse relationship where regulated customers would be responsible for financing the downside if unregulated volume drops but the company benefits as volume increases,” the report said. “It is essential that there is now a renewed focus on servicing the core regulated customer base on an economic basis.”

The audit said Young Brothers doesn’t sufficiently calculate costs that are divided between regulated and unregulated business using the same assets, especially labor, and that unregulated business appears to be negatively impacting regulated customers.

“Based on our analysis and observations there is currently an over allocation of costs to the regulated business,” the audit said.

The report said the diversification effort appeared to be a move by company leadership reacting to a negotiated 2015 union contract that pushed labor costs up by more than 10% a year.

Since then, negotiated rate increases approved by the PUC weren’t enough to keep Young Brothers from losing money, and the audit said the company made minimal effort to strategically address operating efficiencies or to contain costs.

Frequent company leadership turnover from 2016 to 2020 may have contributed to the trouble, according to the report, which also said financial infusions from the parent of Young Brothers, Seattle-based Saltchuk Resources Inc., along with limited oversight from Saltchuk and the board of directors at Young Brothers may have contributed to problems not being addressed before the emergency action.

Some positive things about Young Brothers cited in the audit include significantly enhanced board oversight, little evidence of excessive staffing levels or elevated executive compensation, and no indication of any unsubstantiated financial transactions with Saltchuk.

The audit also identified several areas where Young Brothers might be able to cut costs by $3.4 million to $7.1 million while maintaining service, including overtime labor that can include regular overtime, double time, double overtime and triple time.

Munro Tulloch recommends that Young Brothers implement an “integrated package” of 15 actions in agreement with the PUC if the emergency rate increase is to remain in place without a reduction.

Such actions include having an independent oversight observer appointed by the PUC within three months, a commitment to deliver at least $3.4 million in annual cost reductions by December 2022, no rate increase requests for at least two years, and delivering a five-year strategic plan that incorporates audit recommendations by December.

The recommendations also include collecting and sharing more granular cost data that more clearly shows cost allocations between regulated and unregulated business.

“We must stress that these recommendations have been developed as an integrated package to promote long term stability, not as individual items to accept or reject,” the audit said. “These recommendations present the new YB leadership team with key elements of a roadmap to help them take advantage of this unique opportunity to navigate the company to calmer waters.”