This at least was the picture that Hill portrayed to the dismayed Dutch bondholders after his consortium had purchased all the available stock at cents on the dollar in America. What Hill had recognised was the value that was embedded in the existing line and the cash flow that could be generated from land sales – if they could be completed before the charter expired. It was also helpful to Hill that, through his relationship with the receiver, he was aware of, and possibly involved in, the deliberate deflation of reported earnings through the treatment of improvements as an operating expense. The strategy worked and the Dutch investors sold out to Hill at a fraction of both their initial cost and the true worth of the railroad.
Hill quickly raised capital by holding a land sale, and used the funds to complete a link with the Canadian Pacific Railroad, by which a link was established between Winnipeg and the Mississippi. By 1879 the venture’s earnings had tripled and had a capitalisation of $32m ($2.7bn) split equally between stock and bonds. Hill then proceeded to expand the railroad paralleling the Northern Pacific, although the manner in which he did so was very different. Hill was building a railroad on firm foundations and the renamed St Paul, Minneapolis & Manitoba took great care to build an efficient and reliable line premised upon modern engineering techniques. Undoubtedly this would have been scant consolation for the Dutch investors who sold their stock cheaply on the basis of insufficient knowledge, at least some of which was fraudulently misheld. It was certainly no comfort to the Northern Pacific that a new competitor had emerged from the ashes of a previous foe, but carrying little of the sunk costs incurred in its construction.
The Northern Pacific sought to become the northern counterpart to the Union Pacific. Its greatest foe turned out not to be UP, but rather a gentleman by the name of Henry Villard. Villard had arrived from Bavaria in 1853, just before his 20th birthday. He changed his name from Heinrich Hilgard on his arrival and began work as a journalist for a German newspaper. His subsequent occupations included working as a war correspondent and, more significantly, as an associate of Jay Cooke.
In 1871 he returned to Germany, where his knowledge of the US railroads proved a valuable commodity for distraught German holders of American railroad bonds. When he returned once more to the US he did so as their agent, a position which gave him favourable access to European capital for a sustained period. Villard perceived the opportunities associated with the expansion of America and managed to obtain control of the Oregon Steam Navigation Company, the name of which was then changed to incorporate the word ‘Railway’. Villard gave a portion of the stock to influential figures on Wall Street and, helped by some favourable announcements on the company’s prospects, was able to push its share price substantially higher.
Against this higher share price he was able to issue further stock and almost immediately paid higher dividends, thus perpetuating the rise in the share price. The reputation he thus achieved on Wall Street provided him vital financial backing in his next manoeuvres. Villard set out to prevent the Northern Pacific completing its link to the Western Coast either by obstruction, building track (and thus preventing others doing so), or by purchasing the available land upon which links could be built. Having achieved this goal, he then proceeded to negotiate a traffic-sharing agreement with the Northern Pacific.
This agreement was signed by Northern in 1880, but only as a stopgap. The intention was to use the time the agreement afforded to raise funds and remove Villard as a threat by completing the line. Northern Pacific sold $40m in mortgage bonds to Drexel Morgan, a sum ample to allow completion of the main line and hence completely outflank Villard. Villard’s response was to use his reputation on Wall Street and with foreign investors to raise a blind pool of $8m ($650m), which he then used to raise a further $12m ($1bn) and underwrite his plan to gain control of Northern Pacific. He eventually achieved this in 1881, at which point he immediately paid a dividend in excess of 11% to his shareholders. Now in control, he pushed for the rapid completion of the Northern Pacific line. This was achieved in 1883, accompanied by a lavish ceremony which included guests such as President Arthur, General Grant and the captive Red Indian chief, Sitting Bull.
Unfortunately the construction of the various components of the Northern Pacific line had been completed with more regard to speed than to quality or cost-effectiveness. The competition had ostensibly been to achieve the advantage of completing first, from which presumably all other benefits were to flow. The enterprise found itself struggling under the dual burdens of high debt and substandard track. In early 1884 Villard’s holding company, the Oregon and Transcontinental, fell into bankruptcy – bringing the Northern Pacific down with it. This early example of sacrificing all to obtain first-mover advantage brought as its reward the standard outcome for businesses which become over-extended, have poor quality infrastructure and a management which is more concerned with perceptions among speculators than in the fundamental business. The Northern Pacific was to survive these travails for a period but it remained in a precarious financial position and beset by competition from Hill’s railroad, then called the Great Northern, and it too fell into the hands of the receiver.
Union Pacific Railroad
2.8 – Union Pacific: heading west
Source: Commercial and Financial Chronicle. Union Pacific Railroad annual reports.
The backdrop to the analysis of Union Pacific in the Gould years is the Credit Mobilier scandal which engulfed not just the company but also most senior government figures during the construction phase of the railroad. It was estimated that as much as two thirds of the construction costs were siphoned off from the company through the subcontractors. The scandal was public knowledge but proved insufficient to put an end to corruption within the railroad. The report to the House of Representatives,¹⁵ for example, was set up to investigate the 1869 suspension of the company’s ability to sell land as part of the construction of the railroad.
A number of questions were raised in the report by the government directors of the company. Firstly, they questioned the Wyoming Coal Company. This company had been granted monopoly rights on the mining and supply of coal to Union Pacific by the railroad itself. The ownership largely rested with Union Pacific or its directors, although the exact ownership structure could not be determined. The coal company not only had tributary roads constructed for it at no cost by UP, but also charged rates for its coal which were well above market rates and those of alternative suppliers. If this was not enough, the contract with the coal company provided a guaranteed profit margin. To all intents and purposes the coal contract served to siphon profits out of the railroad and into another entity. For the government this was more than simply a matter of corporate responsibility, since the repayment of the government loan was to take place out of the net profits of the company, profits that would be understated to the extent that the coal costs were inflated. What this showed was that despite the future which surrounded the company, corporate governance was still highly questionable.
Not only was there an issue of corruption for investors, there was also an issue of what actually constituted profits. The company argued that net profits were profits after all interest and debt charges. The government stance was that its funding was senior to other debt and therefore payments on other debt ranking below it should not be subtracted from the earnings figure. The final main issue in the report related to the definition of when the road was completed and hence when payments to the government should begin. The report decided the road was completed.
For a prospective investor these issues would have been vital. If the company could continue to manipulate its profits so blatantly through transfer payments, then clearly the lessons of Credit Mobilier had not been learned. The practice was discriminatory against outside shareholders and the chances of a fair return were correspondingly diminished. Secondly, the whole position of the ranking of claims on the company was in doubt. The only thing outside shareholders could be certain of was that they ranked last.
Not only that, but the released net income figures depended on what view you took of the ranking and the ‘net income’ definition questions where the company was in dispute with the government. Whatever the merits of the argument, the key point was that the definition used by the company represented the best-case outcome.
In 1874 the gross earnings of the company were $10.6m and expenses of $4.7m, giving an earnings figure of $5.9m. Note that this is before any interest charges. A balance sheet is not included in the annual report, but the text discloses a figure of $115m as the book construction cost of the railroad. This was the minimum asset figure the company could have, given that debt payments were capitalised and there had been no write-offs. In practice, the assets would be substantially higher than this figure. The maximum possible return on assets therefore was 5%. The debt seems to have been roughly half the $120m figure. If a reasonable assumption for the interest charge of $3m is made, this gives a return on assets of roughly $2.5%.
Not surprisingly the annual report paints a somewhat different picture. It makes strong representations about future revenue growth and mentions the arrangement with Pacific Mail, although not Gould’s interest in it. It asserts that the value of the land granted to it is equivalent to the majority of its debt. It talks about the mineral reserves within its domain and alludes vaguely to their potential value. Finally, in respect of its obligations to the government, the company argues that the definition of ‘net’ profits will favour it, that in any case there may be no need to make a payment and that the requirement to pay the government tax on land sales is unlikely to be upheld. On the basis of these arguments, the ‘net’ profit figure detailed in the annual report is held to be fair and as a consequence a 6% dividend to shareholders was recommended.
By the end of the 1870s the railroad had changed substantially.¹⁶ Gould remained on the board and had convinced the company to buy out the competitor he had created for that purpose. The purchase of Gould’s interest in the Kansas and Denver Pacific railroads was noted in the accounts as a course that was “decided upon after mature consideration as being for the best interests of the Union Pacific and Kansas Pacific Roads, not only promising a diminished ratio of operating expenditure, but disposing of a vexatious and disturbing nature between the companies.”¹⁷ So far as profits were concerned, gross earnings had risen to $13.2m, representing an annualised growth rate of 4.5%. ‘Net’ earnings had risen to $7.7m or at an annualised growth rate of 5.5%. Note that these increases came from a base of the depressed period in the early part of the 1870s. Slightly more information is forthcoming in the report and it is possible to take the ‘net’ earnings figure of $7.7m and remove interest payments of $4.8m to arrive at a net income figure of $2.9m. On an assets figure of $185m, the return on assets would have been of just over 1.5%, a figure that continued to ignore potential payments on government debt. Nevertheless, the company once more decided to pay dividends of 6%, based on its rosier view of the world. Again, little balance sheet information is available, but interest received totalled $0.4m while interest was roughly $3.5m. It is likely therefore that cash, or cash equivalents, would have been under $5m and interest payable equivalent to almost half the ‘net’ earnings figure released to the financial press.
The position on Union Pacific was relatively straightforward. It was a highly capital-intensive company which was not particularly cash-generative. It was burdened by debt that it sought to avoid by stalling in government negotiation. Growth was moderate at best and the company was manipulated by insiders both in terms of corporate transactions and in terms of a higher-than-prudent payout. Basically there was no fundamental reason for the outside investor to take the risk of owning the stock. The lack of fundamental reasons for owning the stock did not stop it from rising fivefold in the latter part of the decade. Whatever the operating history of Gould, his presence and reputation as a stock market operator was sufficient to bring in other investors, thus boosting the share price. The fundamentals re-asserted themselves eventually and the share price began to fall. It fell through the 1880s before almost reaching zero as the difficult economic conditions of the early 1890s forced the company into receivership. The decline in income which precipitated this move was a fall of just over 15% and it would be difficult to attribute the fall of the company to this factor alone. What really underlay the imminent bankruptcy was the structure of the balance sheet. Over an extended period, debt had accumulated and only partially accrued. Some of the debt had been ignored in order to allow dividend payouts which would not otherwise have been justifiable. Eventually, as the debt moved closer to its repayment date, continuance of this practice became impossible. A railroad is a highly capital-intensive industry and if this is combined with high interest payments then it will always be at risk during an economic downturn. Since the history of the company was one of inflated costs and lack of regard for the long term, it was simply a matter of when bankruptcy would occur. This would all have been obvious at the time, but it was not sufficient to deter investors willing to bet on the probabilities of being able to participate in Gould’s machinations.
The damage on the railroad was simply a result of a long history of abuse and mismanagement coming home to roost. That different outcomes might have been feasible was shown when a group of financiers – headed by Edward Harriman and backed by the Standard Oil bank, National City Bank – took control of Union Pacific and refinanced the company. At the same time J. P. Morgan was taking control of the similarly bankrupt Northern Pacific and seeking to merge its interests with the Great Northern Railway of James Hill. For investors, the point of maximum pessimism would have arrived in the middle of the 1890s, when the economic situation was dismal and the companies were only just emerging from bankruptcy. A quick calculation would have shown that with gross revenues in the $35–55m range and an operating margin of 25–35%, at least $10m of cash flow would be available in a worst-case scenario. Unfortunately, the debt of the company required interest payments in excess of $12m and since there was little by way of accumulated profits, insolvency became bankruptcy.¹⁸,¹⁹ The $10m figure was important, though, since it set the benchmark for what the railroad could be worth if its balance sheet was restructured. Investors such as Harriman and J. P. Morgan certainly made these calculations, and although also motivated by desire to reduce competition and raise prices, were able to put together packages which refinanced the companies. The share price chart in figure 2.8 gives an indication of what the equity was worth before the refinancing and how it improved afterwards as economic conditions picked up through the latter part of the decade and into the next century. The chart also shows how, again, the share price was pushed up by the speculation associated with the interest of parties such as Harriman and Morgan.
Control of the transcontinental lines eventually ended up in the hands of individuals who appreciated that a short-term speculative-oriented approach to their operation could not continue. The main reason was that investors had lost such large amounts that they were only willing to supply additional funds when the companies were demonstrably under the control of strong figures such as J. P. Morgan, or successful operators such as James Hill. From the rescue of the Northern Pacific in the early 1880s, through to the following decade, Morgan sought to create an industry framework that would restrain competition and improve profitability. Early attempts at reducing the frequent price wars centred on the two principal protagonists, the New York Central and the Pennsylvania.
Despite some success with the so-called ‘Corsair Compact’ – a price-fixing arrangement agreed in 1885 on Vanderbilt’s yacht, the Corsair – the industry remained characterised by instability. The reason for this was not just the level of overbuilding and the speculative manner in which the ventures had evolved. The business was by its nature one with high capital costs. This meant that cash had to be generated to amortise the existing fixed cost and the debt it entailed.
More than this, the American economy had also witnessed the emergen
ce of a number of industrial powerhouses, some of whom had capitalised on the weakness in the railroad structure and grown into customers that could dictate terms. The two most notable who fell into this category were Rockefeller with Standard Oil and Carnegie with the steel industry. Rockefeller could easily play the competing railroads off against each other and because of the volume of his business was in a position to ensure a skewed pricing structure.
2.9 – What can go wrong does go wrong
Source: New York Times, 20 September 1873.
For the farming industry in America, the position was the exact opposite. The farming industry was extremely fragmented and had negligible negotiating power with the railroads. For most of the 19th century, farmers were obliged to take whatever transportation price was offered to them. For the railroads, the competition issues were not resolved by the ‘Corsair Compact’, and in 1888 Morgan again sought to broker a peace. The outcome of this was the Interstate Commerce Railway Association, which was to set tariffs etc. and to act as the administrative enforcer. This, too, did not last long, as it was unable to enforce discipline among the competing railroads. The only practical way forward proved to be consolidation. This required that no more speculative railroads be built and that the existing network be rationalised. Morgan’s ownership position and his position as representative of many British shareholders in a large number of railroads – which, it should not be forgotten, were the ‘blue chip’ growth equities of the time – made the House of Morgan the central agent in these changes. Until then, British shareholders had largely resisted the overtures of the main protagonists in the railroad scandals. However, the impotence and frustration felt by many overseas investors drove them into the waiting arms of Morgan.
Engines That Move Markets (2nd Ed) Page 9