Engines That Move Markets (2nd Ed)

by Alasdair Nairn

  4.12 – Edison Electric: the light of the world

  Source: Edison Electric Light Company annual reports. Edison Electric Illuminating Company of New York annual reports. Thomas A. Edison Papers, Rutgers, the State University of New Jersey. Thomas A. Edison Papers Microfilm Database, part I (1850–1878), University Publications of America.

  The profit stream recognised by the company included two main components. Firstly there was the issuance of new licences and the net receipts received, normally in the form of stock in the licencee company. Secondly, there were the licence fees paid from the profits of the licencee company. Long-term profits therefore depended upon the underlying success of these operating companies. This in turn depended upon the trade-off between the initial cost of building the infrastructure and the ongoing revenues received from clients. Although the annual reports make glowing references to the increasing list of new operating companies taking licences, there are also references to the litigation from the partially owned Edison Illuminating Company of New York regarding the excessive cost of the Pearl Street Station. In other words, for the investor, detailed analysis of the accounts would have revealed a holding company with two main assets, the patents on electric light and holdings in a number of generating companies. There would have been little evidence of either cash flow or profits. An appropriate share price would have had to be determined by reference to the potential success of the operating companies, most of which were only in their formative years and not yet yielding a meaningful return on a high level of capital expenditure.

  While sketchy in nature, the accounts do reveal enough to show that the company would be susceptible to cash flow problems, irrespective of the ultimate success of its operations. This is ultimately how it turned out. The requirement for additional funding arrived during an economic downturn, when existing investors found themselves short of capital. As a consequence, despite various earlier attempts at consolidation, the company was eventually merged with its competitor, Thomson-Houston, to form General Electric. The prime driving force in this was J. P. Morgan, with the creation of GE being one of his earlier attempts at consolidating an industry.

  Edison Electric Illuminating Company of New York

  So far as the operating arms were concerned, the evolution of the business proceeded along the lines that would be expected of a highly capital-intensive business. That is, sales and net income gradually expanded, raising the returns earned on the asset base, and allowing margins to increase gradually as costs were amortised over a growing revenue stream. Reflecting the stability of income flows, expansion was financed through debt expansion rather than equity. The early years, where cost overruns bedeviled the project, eventually gave way to a more stable operating environment.

  Drexel, Morgan and Company spearheaded Edison’s expansion across Europe and soon most European countries followed the example of London, where Edison’s first ever station had been constructed at Holborn Viaduct. Edison’s success only spurred on his competitors, most notably the Thomson-Houston Company, George Westinghouse and the United States Electric Lighting Company, newly created by merger. The possibility that electric light might prevail against gas, and the profits this would produce, also led to an extended period of litigation over patents.

  In the first instance, Edison had headed off a protracted legal battle in the UK by agreeing to merge his British subsidiary with Swan’s company; in 1883 the Edison and Swan Electric Light Company was formed. However, around the time of the British merger with Swan, Edison was rocked by a decision from the US commissioner of patents which ruled that William Sawyer had precedence over Edison for the electric lamp. This ruling set the stage for a battle that took nearly eight years to reach its conclusion. The Edison Electric Light share price plunged to $130 and the European equivalent found no potential purchasers. In response, and in order to protect their position, the Edison companies were forced to initiate over 200 lawsuits and spend over $2m ($150m today) in defence of their patents. The matter was only resolved in 1892 when the Circuit Court of Appeals upheld the lower court’s 1891 finding in favour of Edison.

  Westinghouse and the AC/DC wars

  The arduous series of legal battles was only part of a wider conflict, though. Edison had championed the DC power supply while many of his competitors had travelled down the AC route. The method of power supply became increasingly important as the success of Edison’s lamp or light bulb increased. The DC power supply was better suited than AC to arc lighting, but the opposite was the case for incandescent lighting. The reason was that the DC power supply was efficient only in densely populated areas. The leakage of current meant that it was incapable of being sent any meaningful distance from the generator. As a consequence, if incandescent lighting was required, there had to be a generator in close proximity. With AC supply, on the other hand, a large central generator could supply fairly distant areas simply by stringing power supply cables. Edison’s vehement opposition to AC power supply rested primarily on safety grounds. It is difficult to know the extent to which his safety concerns reflected a genuine underlying belief. It should be noted that, while Edison publicly decried AC, he privately experimented with it at his research laboratories. It is difficult to believe he did this solely to demonstrate its lack of safety.

  Edison had been aware of the potential of AC for some time and had even paid $5,000 (nearly $400,000) for the option on the rights for a European version to inhibit its competitive advances. The European AC transformer (the ‘ZBD’) had dramatically improved the performance of the plant Edison had installed in Milan. However, when William Stanley, a young inventor, offered Edison the rights to his transformer he refused. Instead, Stanley turned to a delighted George Westinghouse, who was to emerge as Edison’s most enduring competitor. Westinghouse was not new to the lighting business. He had achieved success previously, developing the use of natural gas in Pittsburgh. The company he founded there, the Philadelphia Company, leased gas acreage in western Pennsylvania and by 1887 had 5,000 residential and nearly 500 business customers. Between 1884 and 1885 he applied for 28 gas-related patents, most of them in respect of improving safety. One technique he used was to pipe gas at high pressure through long-distance trunk pipelines and then ‘step down’ the pressure in residential urban areas. This is very similar to the method he employed with AC supply in his electricity business.

  Westinghouse had taken control of the United States Electric Company in the mid-1880s and was already a serious competitor to Edison. Moreover, Westinghouse had championed the cause of the use of AC for the distribution of electricity. Westinghouse’s ultimate leadership in the AC field was a consequence of the work of an individual rejected by Edison as being overly theoretical and impractical. Nikola Tesla, a Croatian who had transferred to New York from Edison’s Budapest facility, had his financial demands rebuffed by Edison in much the same manner that Edison himself had experienced from various financiers and employers. Tesla left to join Westinghouse and developed one of the milestone discoveries in the history of electricity – the rotating magnetic field. From this it was possible to develop the AC motor, transformer and dynamo. This represented a completely new stage in electricity’s development. However, this development almost caused the bankruptcy of the Westinghouse Electric Company. Although the Tesla induction motor was to become of vital importance to the subsequent success of Westinghouse, the extended and costly development period added so much to the increasing capital costs that in 1893 the company was near to financial collapse.

  Westinghouse had acquired a patent for the incandescent carbon lamp developed by William Sawyer and Albon Man, and entered into cross-licensing agreements with Thomson-Houston on AC transformer patents to avoid a potential litigation minefield. With the addition of the transformer, he became a powerful competitor to Edison. By late 1886 Edison’s sales agents were writing to him, complaining about the successful encroachment of Westinghouse.

  Edison fought a rearguard action and respo
nded in his traditional manner. In public he launched an offensive against AC supply in general and Westinghouse in particular. In private he gradually increased research efforts on both DC and AC. Despite advances in DC technology, he was unable to match Westinghouse, and Edison’s sales agents began to desert him. Some even portrayed Edison as behind the times and a ‘fossil’. The public debate then took a more pointed turn. A New York engineer by the name of Harold Brown wrote to Edison and enlisted his aid in a crusade against the dangers of AC.

  The scientific part of this crusade took the form of using high-voltage current to electrocute large numbers of small furry animals. The dangers of AC thus demonstrated, Brown wrote to leading figures in all the major towns in the US citing the dangers of AC and the number of accidental deaths already recorded. Westinghouse countered that by the time the current reached the consumer, the voltage was only 50 volts and safe. Brown’s campaign backfired: in 1889, New York opted to enact the death penalty via the use of electricity. Brown had demonstrated the ability of high-voltage currents to kill more than small furry animals by extending the tests to include a 1,200-pound horse. Thus convinced, the state bought three Westinghouse AC dynamos from Brown, together with an electrical cap and shoes for the sum of $8,000 (or over $500,000 in today’s dollars). There followed a morbid competition to name the new form of death. Various entries included ‘dynamort’ and ‘electricide’; Edison suggested ‘Westinghouse’!

  4.13 – Electricity has multiple uses: a therapeutic punishment!

  Source: New York Times, 27 December 1878.

  It was to be some time before AC became the accepted power supply method. Scientists such as Lord Kelvin recanted and admitted that without Westinghouse’s development of the AC power supply, the level of development in electricity could not have happened with any rapidity.

  The industry consolidates

  Despite the publicity battle and Edison’s opposition, the advantages of the AC method were such that utilities showed an increasing interest in AC over DC. Westinghouse was not the only competitor who saw the advantages of AC supply. Thomson-Houston had also done extensive research and development work on the system. Indeed, Elihu Thomson had concentrated much of his efforts on ensuring that issues of safety were incorporated as a key element. Thomson-Houston stayed out of the public debate, however. Partly this was because, although its systems had been designed with safety in mind, many of its utility customers had not installed these safety features as part of an effort to reduce costs. Pressure on Edison to change his stance on AC also came from companies that had licensed Edison’s technology and were under competitive attack from Westinghouse and others using AC.

  At the same time as the pressure was mounting regarding the type of power supply, pressure was also mounting on the structure of Edison’s businesses. Edison’s investors had become increasingly uneasy over their lack of control over the profitability of their investments and the obvious lack of centralised direction of the different Edison concerns. These concerns included the Electric Light Company, which controlled the patents, the Lamp Company, which manufactured the incandescent lamps, and the Machine Company, which produced electric motors for both the railway and lighting concerns. This structure made centralised negotiation impossible and the lack of both financial and managerial efficiency was obvious. As a consequence, a protracted series of negotiations took place, ending with the consolidation of these businesses and the formation of the Edison General Electric Company.

  The consolidation took place against the backdrop of the legal case regarding the Sawyer patent. Edison’s conviction that he would prevail made him push for the consolidation to take place quickly. Since a successful outcome of the patent case would push up the share price of the Electric Light Company (in which Edison was a small shareholder) versus the manufacturing companies (where he held a majority stake) it was important that it take place quickly so that Edison could maximise his personal shareholding in the consolidated company. In April 1889 the company was formed and Edison ended up owning 17% of the outstanding shares, as compared with the 10% owned by the Vanderbilts through Western Union. The main shareholder of note for the future, though, was J. P. Morgan.

  The outcome of the court battle went in favour of Edison. Westinghouse, who had purchased Sawyer’s patents, had managed to have the suit held in Pennsylvania, his home territory, while Edison had as a witness the late William Sawyer’s brother, himself seriously ill and having his medical expenses paid by Edison. Accounts of the case suggest it could have gone either way. Although independently developed the lamp could have been seen as a derivative of Sawyer’s work. At the same time, Sawyer had been found to be less than truthful as to the origins of some of his work. The verdict, recorded in October 1889, followed the expert evidence of the time and went in favour of Edison. While this verdict established Edison as the inventor of the incandescent lamp, it did little to assist his position against Westinghouse. The pressure exerted on Edison, most tellingly from the Association of Edison Illuminating Companies, eventually forced a rethink and design work on an AC system began in earnest. During 1890 and 1891, conditions worsened. Edison became increasingly short of funds. The consolidation of the electrical companies had increased his capital at the expense of his income and caused him liquidity problems. He resolved some of these by quietly disposing of some of his stock.

  The growth in the Edison General Electric Company had dramatically increased the need for working capital beyond what the existing capitalisation of the company was able to sustain. Finally, the summer of 1890 was also the time when Barings Brothers collapsed (for the first time), sending shock waves through the financial community and increasing the cost of capital for anyone who needed it. The result of all these forces was the move to consolidate in the industry and in 1892 Edison General Electric merged with the Thomson-Houston Company to form General Electric.

  This merger solved both the AC question and financial issues. Discussions about the merger, however, took place without the knowledge of Edison and some accounts suggest he demanded that his name be removed from the new company. The new company was capitalised at $50m (or nearly $4bn in current terms) with Thomson-Houston management gaining the upper hand as a consequence of their greater past profitability.

  This left two major companies in the field in the US, Westinghouse and General Electric. In the UK the General Electric Company (GEC) had been formed and in Germany the antecedent of Siemens (Siemens & Halske). This structure was to continue for some time and the incumbent companies were able to gradually increase their profitability as their markets grew and the range of applications for electricity expanded. What was important for these companies was not simply their technological expertise but access to capital to allow them to roll out the necessary infrastructure to support their product. Moreover, during the 1890s, when economic conditions tightened, the companies with access to capital were in an immensely strong position as competitors, whatever their skills, found themselves unable to develop their businesses. At the time the support of one of the major banking houses, with J. P. Morgan pre-eminent among them, was vital for a business which had a tendency to consume capital and run short of cash.

  General Electric

  The early years

  General Electric was formed under the financial aegis of J. P. Morgan from the merger of the Edison General Electric and Thomson-Houston companies. To a degree this is reflected in the initial financial reports formed from the pooling of the two companies. As has already been seen from the reports of Edison General Electric, the balance sheet assets contained substantial prior cost which had been capitalised rather than being treated as ongoing costs and expensed through the income statement. This treatment is reasonable in the sense that some value should be attached to the asset being created, but it does carry dangers if the accumulated costs which are treated as representing that value fall short of what the asset ultimately realises.

  The newly formed GE found it necessa
ry to take a substantial write-down shortly after it was formed on these assets to better reflect the true underlying value. In the 1894 accounts, therefore, a $14m loss was recorded in the income statement due to the write-down in assets following the merger. The underlying trading position, though, was one of a small net operating profit. The lack of retained profits meant that the $14m was shown as an asset which was gradually reduced by ongoing trading profits until such time as it had been removed and the profit-and-loss account could be moved to the liability side of the balance sheet to become part of shareholders’ funds. Treating the write-down in this manner allowed the company to avoid reducing shareholders’ funds until such time as sufficient retained profits had been accumulated.

  In 1899, GE switched the profit-and-loss account to the liability side of the balance sheet and made a reduction in shareholders’ funds sufficient to leave the profit-and-loss account in a marginally positive position. Looking at this in another way, the profits recorded by the prior company were effectively only paper profits. In its new form GE required a number of years to unwind this position and as a consequence it was only at the turn of the century that the balance sheet was in a sufficiently strong position to reinstate the payment of dividends on an ongoing basis. For the investor in the early years, a lot depended upon the confidence one held in management’s ability to maintain the underlying business in a profitable position while strengthening the balance sheet. By 1900 this had occurred and the true growth of the business began to show through, with the returns on assets and equity on a rising trend. This rising trend, though, was only sustained in the early years and as competition increased both earnings and the return on assets declined. During the early period GE entered patent-pooling arrangements with Westinghouse on the electrical generation and transmission side of its business. The initial jousting between Westinghouse and Edison over the incandescent lamp and AC versus DC supply had given way to a more pragmatic approach, once it had been recognised that competition was leading to financial difficulties. The patent pools were also to feature in the absorption of the activities of American Marconi by the newly created RCA in association with GE and Westinghouse. For the investor, the agreements between GE and its principal competitors undoubtedly assisted profitability and returns since they acted not only to restrain competition between the participants but also as a barrier to entry for new entrants.