4.14 – General Electric: the early years
Source: General Electric annual reports. CRSP, Center for Research in Security Prices, Graduate School of Business, University of Chicago, 2000. (Used with permission. All rights reserved. www.crsp.uchicago.edu.) Commercial and Financial Chronicle. New York Times.
4.15 – General Electric: endlessly re-inventive
Source: General Electric annual reports. CRSP, Center for Research in Security Prices, Graduate School of Business, University of Chicago, 2000. (Used with permission. All rights reserved. www.crsp.uchicago.edu.) Commercial and Financial Chronicle. New York Times.
The first century
The business of GE steadily expanded beyond incandescent lighting to power generation and many related fields, including the sizeable ownership position in RCA, which took place at the end of World War I. Up to World War II, income grew at around 10–15% a year, after adjusting for inflation and general economic growth. The return on assets and equity fluctuated around the 10% level – a very strong performance, as befitting one of the global leaders in the age of electricity. Moreover, the growth was maintained without putting undue pressure on the balance sheet or the need for meaningful recourse to shareholders.
The post-war period is more difficult to analyse by reference to simple charts of income and returns. Sales and income continued to grow at a strong pace, but they did so against a backdrop of falling returns on assets and equity. The widening gap between returns on equity and assets suggested a growing use of debt finance to assist sales. The difficulty is that the company’s inclusion of its financing activities on the balance sheet meant that manufacturing and financing areas needed to be analysed separately. The detail was not something revealed in the annual financial statements. The global financial crisis of 2007 revealed the dangers of such financial engineering both in terms of balance sheet risk and in obscuring underlying profitability.
Westinghouse Electric
The early years
Westinghouse Electric had been one of the main long-term competitors to the Edison companies (subsequently General Electric). When GE was formed by the merger of Edison and Thomson-Houston, Westinghouse had been a potential alternative partner for Edison General Electric. The competition between the two had taken the form of high-profile battles over the patent position of the incandescent lamp and the best method of power supply. As the electrical supply and lighting market began to take shape, competition over patents was reduced by the formation of patent-pooling arrangements. The development of the business required heavy capital investment to allow the development of the physical supply infrastructure, and given these capital requirements it was important that competition was kept within manageable boundaries. Westinghouse Electric undoubtedly felt threatened by J. P. Morgan’s backing for GE. The Westinghouse financial statements in the early years make repeated reference to the need not to reveal anything to competitors. Given the number of years when figures were not released, and the level of detail when they were, this goal was probably achieved. It makes detailed analysis difficult. We do know that the company encountered financial difficulties of sufficient magnitude to require the injection of outside funds, as a result of which George Westinghouse lost control of the company he had created.
4.16 – Westinghouse: long-term survivor
Source: Westinghouse annual reports. CRSP, Center for Research in Security Prices, Graduate School of Business, University of Chicago, 2000. (Used with permission. All rights reserved. www.crsp.uchicago.edu.) Commercial and Financial Chronicle. New York Times.
In order to sustain its position, the company needed both equity and debt finance. The financial statements show that, even as sales were growing strongly, margins were contracting; operating margins fell and the cost of debt-service rose. Westinghouse followed the orthodoxy of the day with a very high dividend payout, a practice which in retrospect would have been better curtailed to avoid the buildup of debt, although whether this would have been countenanced by the investors of the day is another matter. Another way of viewing this is that to the extent that Westinghouse Electric sought to please investors through an inappropriate dividend payout, it eventually suffered as the financial consequences caused a recapitalisation, dilution and loss of control.
The first century
The short-term difficulties Westinghouse faced as a result of funding infrastructure and international expansion did not overly inhibit the company in the long term. The electrical supply and associated businesses were in long-term secular growth, from which the company was to prosper over an extended period. Out of its interests in electricity came a participation in the radio boom, through sales of radio sets and the creation of the first broadcasting station. The immediate period after the conclusion of World War I was not an easy one, with the company being forced to react to depressed conditions with a series of inventory write-downs. This, though, proved only to be a short-term problem. The boom of the 1920s was only curtailed by the Depression. Even with the devastation wrought by the declines of the early 1930s, the period up to and beyond World War II was one of fairly constant growth in income, fuelled by sales and operating margins which fluctuated around the 10% mark. The problems which were to beset Westinghouse in later years essentially stemmed not so much from a decline in operating margins as a deterioration in the financial position and the buildup of debt.
Conclusions
The battle for the supply of lighting was one fought over decades rather than years. The gas companies had been able to negotiate monopoly rights for geographic areas because of the high capital commitment required to set up the necessary distribution infrastructure. Once the costs of this infrastructure had been amortised, these exclusivity rights allowed the companies to become very profitable. Most gas companies acted predictably, maintaining high prices protected by their contractual rights. Such a pricing strategy meant gas lighting was typically restricted to communal areas funded by municipalities or large commercial premises. Only very wealthy households could afford gas lighting, leaving the way open for kerosene to capture the household mass market.
The profits earned by gas companies provided the incentive for the development of electric light. The economics of electric light were similar to gaslight. High initial capital expenditure was required, with meaningful returns on capital only arriving once the infrastructure was fully in place and the market expanded. What electricity therefore required if it was to supplant the gaslight was a technological edge at a competitive price.
Arc lighting failed to provide the technological edge and was consequently unable to displace the existing providers. This is not to say that the threat it provided was not taken seriously – both by the financial sector and the companies themselves. The financial sector reacted by marking down the share prices of the gas companies and raising capital for the new entrants. In both cases it did so in an indiscriminate manner. For investors in the gas companies, at least, there was the possibility of a recovery in the share price, and indeed in the medium term this is what happened when it became clear that arc lighting was not going to be able to sustain a commercial threat.
For investors in the arc lighting companies, the outcome was less palatable. Driven by an increasing level of available liquidity associated with economic recovery and growth, investors had committed sizeable funds to the newly launched companies. Most companies associated with the so-called ‘Brush Bubble’ used up the capital they had raised by building infrastructure, only to find that the product did not satisfy consumer needs and hence was not commercial. As a consequence, most ended up in the hands of liquidators. A few companies, particularly those involved in the creation of electrical generators, were to survive as the equipment they produced proved important for a different form of electric light, the viability of which was ultimately sustained. The main point, though, was that capital was willing to flow to the new ‘hot’ area well before viability had been established. This process was either assisted or st
imulated by the support of the financial press and the promoters of the new companies.
The Brush companies’ activities represented basic business strategy – a strategy repeated in most industries where infrastructure development was a pre-condition for increasing the number of end users. For example, the radio industry built broadcasting stations to help the sale of radio sets. More recent examples include the efforts by microprocessor manufacturers to encourage new software applications – ones which continually increase demand for higher-margin and higher-specification computer chips. While the commercial reasons for such actions are valid, there are also reasons related to the financial markets. Companies are typically quick to take advantage of periods of optimism and the attendant opportunities to raise capital. That applied in the case of the Brush companies, and it still applies in relation to newer companies. To the extent that investors are willing to invest on the basis of a concept and unproven commercial viability, there will invariably be those who will willingly accommodate the desire for indiscriminate investment.
The irony was that when Edison began to make progress with the incandescent lamp, the press – supported by the scientific community – proved to be substantially more sceptical. Edison knew the importance of propaganda and worked extremely hard to maintain a confident public façade, even when progress lagged expectation. This was vital, since without such a façade it is unlikely that the available financial backers, chastened by the demise of arc lighting, would have provided sufficient capital to bring the technology to a commercial footing. Even with Edison’s track record, there were numerous periods when further capital was nearly not forthcoming.
Eventually, problems with the incandescent lamp were overcome and electric lighting was ready to move to the next stage – supply of the service – an area where Edison was less well suited. His scientific ego made him slow to recognise the reality that part of his system was inferior. This was one factor in the eventual transformation of Edison General Electric into General Electric and his loss of control and influence. However, the main driving force was that the industry was not highly profitable and the providers of capital required sufficient consolidation to take place to put it on a firmer financial footing. When economic conditions tightened and capital availability declined in the early 1890s, the consolidation phase took place. Over successive years thereafter, profitability began to improve, but it was still a long time before returns were earned that would justify the level of capital which had been committed to the incandescent lamp, let alone its arc predecessor.
There are many modern parallels to this. A recent one at the time of the first edition of this book lay in the level of funds committed to mobile telephony, particularly for the purchase of government licences. Any technological advance which requires huge capital expenditure always runs a real risk of disappointing returns in the early years, even if it is ultimately successful. Where companies have overextended themselves to fund such expenditure, then typically during the first period of general economic difficulty they find themselves at the mercy of capital markets. These markets do not show mercy and the rationalisation process which takes place does so at valuations which reflect the balance of power rather than future long-term prospects. The biggest and most successful lighting companies all experienced a change of control when cash flow became an issue. Investors who successfully avoided the arc lighting bubble, sold gas lighting and bought incandescent lighting, even if they managed to make all these correct technological choices, would still have had to be careful about the price at which they made their purchases and the stability of the financial structure of the company in question. In other words, picking the technology was only one part of the equation. It certainly assisted in identifying the losers, the ‘old’ technology companies, but selecting the winners required the patience to wait until the industry had matured sufficiently to evolve into an appropriate operating structure. Effectively this meant waiting for a recession to cause the shake-out.
* * *
29 C. Cerf and N. S. Navasky, The Experts Speak: The Definitive Compendium of Authoritative Misinformation, New York: Villard, 1998, p.225.
30 Ibid.
31 For an account of the development of the electrical industry, see: The Electricity Council, Electrical Supply in the United Kingdom: A chronology – from the beginnings of the industry to 31 December 1985, London: The Council, 1987.
32 R. Conot, Thomas A. Edison: A Streak of Luck, New York: Da Capo Press, 1979, p.123.
33 Ibid., p.124.
34 P. G. Hubert, Men of Achievement – Inventors, New York: Charles Scribner’s Sons, 1893, p.223.
35 R. Conot, Thomas A. Edison: A Streak of Luck, New York: Da Capo Press, 1979, p.125.
36 Ibid., p.129.
37 Ibid., p.130.
38 Ibid., p.138.
39 Ibid.
40 Ibid.
41 Ibid., p.167.
chapter 5
Digging Deep
The search for oil
“Drill for oil? You mean drill into the ground and try to find oil? You’re crazy.”⁴²
Drillers whom Edwin L. Drake tried to enlist to drill for oil in 1859
Edwin Drake’s discovery
The search for alternative methods of lighting to candles and gas encompassed a number of sciences. On the one hand there was the development of the incandescent lamp and electrical power supply; on the other, there were more mundane efforts to expand existing methods. While electric light would eventually take over the illumination market, by necessity it had to begin at the upper end of the market with large-scale lighting before it could move down to meet the needs of the household market. In the intervening period, before the full impact of electric lighting was known, others continued to explore the potential to improve existing technology. This rested in the chemistry of hydrocarbons and in particular the product known as kerosene.
The development of kerosene in the 1850s had allowed camphene and whale oil to be replaced as illuminants. In the early stages the spread of kerosene was inhibited by the lack of a high-quality lamp and by the scarcity of the raw materials for producing kerosene. The first obstacle was overcome relatively quickly with the use of lamps from Vienna, which utilised a glass chimney to reduce the emission of smoke and fumes. The second obstacle was ultimately down to cost; it was relatively expensive to obtain coal oil and refine it into kerosene. It was in finding cheaper alternatives to the use of coal oil that the entrepreneurs of the 1850s foresaw great profits. Widespread use of kerosene lamps required an abundant supply of kerosene, and demand for illumination was self-evident – the missing link was the supply of the raw material. As the combustible properties of rock oil were well known, could rock oil be used as a source for kerosene? If so, could be it be found and recovered in sufficient quantities to make it a viable proposition? The search was soon on.
In 1854, a group of investors headed by George Bissell, a New York lawyer, and James Townsend, president of a Connecticut bank, commissioned a report on the potential lubricating and illuminating properties of rock oil. The group commissioned Professor Benjamin Silliman, an eminent chemist from Yale University, to conduct the tests. Initial indications were encouraging. When Professor Silliman presented the group with a bill for $586 (nearly $80,000), however, it was much higher than the group had expected, and they baulked at paying it. It was only Silliman’s refusal to hand over the completed report and his threatened disappearance on a long trip that forced the investor group to make the payment. The report was worth the money. Silliman confirmed that rock oil was a hydrocarbon that could be heated and distilled into fractions, one of which was a high-quality illuminant. The report, and Silliman’s subsequent personal investment, enabled the group to raise capital and form a company, the Pennsylvania Rock Oil Company. The company’s objective was to find rock oil in sufficient quantities to produce kerosene and thereby capture a share of the lighting market from camphene and coal-oil-based kerosene.
Engines That Move Markets (2nd Ed) Page 19