Engines That Move Markets (2nd Ed)

by Alasdair Nairn

  Source: Horseless Age, 7 October 1903.

  The eventual settlement came in 1903 and involved the creation of an association that would hold the patents (the Association of Licensed Automobile Manufacturers, or ALAM) and receive a licence fee of 1.25% of the vehicle’s purchase cost. The royalties would be paid in the ratio of 40% to the Electric Vehicle Company, 20% to Selden and 40% to ALAM for the promotion of the industry generally. For the participants, the negotiation avoided the chance of any decision being rendered against them, while at the same time ALAM was viewed as a body which could stabilise the industry. Not all manufacturers joined ALAM, however. The most notable absentee was the new firm headed by Henry Ford, which was initially denied admittance on the grounds of not having a commercial working vehicle.

  ALAM had written into its articles of agreement the ability for its board to decide on the admittance or otherwise of any producer. In effect ALAM was out to control entry to the industry. Ford subsequently refused to join ALAM and responded to the public threats of ALAM against unlicensed producers by circulating a note arguing that the Selden patent would not be sustained in the courts. Eventually, as sales of the Model A increased, the Association brought a lawsuit against one of Ford’s distributors. Fortunately for Ford he was to be assisted in his battle by a wealthy and well-respected merchant of the time, John Wanamaker. Wanamaker added backing to Ford’s resistance to ALAM and offered an indemnity against their lawsuit to any Ford purchasers of a Ford automobile. The battle against ALAM captured the public imagination, sitting as it did in the middle of the reaction against monopoly businesses such as Standard Oil. In 1904, though, Ford still had to capture the public mind, and his attempt on the land-speed record across the frozen Lake St. Clair was timed to take place four days before the automobile show at Madison Square Garden.

  This was a show from which ALAM had sought to bar Ford entry, and it was only through the influence of Wanamaker that he was able to exhibit. Ford had to fight the battle with ALAM on number of fronts. Firstly, there was the ongoing battle for public opinion as a backdrop to the continuing litigation. Ford attempted to demonstrate the lack of precedence embodied in the Selden patent by building an automobile based on knowledge publicly available prior to Selden’s work and simultaneously challenging Selden’s patent holders to produce a working model based on the patents. Secondly, there was the battle for market share fought both in the public mind and in the production and research departments.

  The battle for market share did not advance substantially with the Model A. While the Model A was a success, the display of European vehicles at Madison Square Garden illustrated the technological lead still held by European producers and convinced Ford of the need to move the technology of the car forward, with the twin goals of achieving technological equality and lower-cost production. Equally, Ford had to counteract the propaganda of ALAM and its warnings of potential liability incurred through distributing or purchasing an automobile from a non-ALAM member. The propaganda issue had been dealt from the very early days with a typically head-on approach. In equally large print, Ford offered guarantees against ALAM to any distributor, importer agent, or user of a Ford vehicle (see figure 6.11).

  On the matter of models, more than marketing was required: a meaningful technological shift was necessary. This was what Ford achieved with the Model T. In 1908, when the Model T was unveiled, total US auto production stood at roughly 65,000 vehicles. In 1907, Ford’s production was just over 8,000 vehicles, and during the transition period with the introduction of the new model, the figure fell by about 25%. Subsequently the success of the Model T and the construction of the Highland Park facilities saw production double in 1909 and rise by another 50% in 1910. Startling as these figures were, they were only in line with the overall growth in production in America. The real explosive growth was still to come.

  6.12 – The impact of the Model T: volume production and the cost curve as a barrier to entry

  Source: P. V. D. Stern, Tin Lizzie, New York: Simon and Schuster, 1955.

  Meanwhile the battle with ALAM continued. Ford received a setback in 1909 when the Federal Court Southern District of New York upheld ALAM’s claim against him. Immediately, the majority of the producers who had refused to join until now switched camps and signed up. This increased ALAM members’ share of total production from slightly under half to nearly 85%. Ford considered joining but in the end did not because of ALAM’s refusal to pay his legal fees, estimated at somewhere in the range of $200,000 (well over $10m). However, in January 1911, the Circuit Court of Appeals upheld the Selden patent but specified its limitation to those vehicles which utilised the Brayton two-stroke cycle. Since most cars used the Otto four-stroke cycle, the patent was rendered essentially worthless. Ford emerged from this battle not only victorious in the matter of the patent, but with vehicles grabbing market share and with a public persona of the ‘David’ who had triumphed against the ‘Goliath’ of the Association.

  For the industry there was a new reality to be grappled with. No longer was the structure going to be that of a large number of small producers. Ford had been first to produce a low-cost commercially viable and reliable vehicle. The success of this vehicle had been self-reinforcing. As production rose sharply, unit costs fell and the cost of production could be amortised against an ever-increasing volume, allowing prices to continue to fall and increasing the pressure on competitors. The latter part of the decade had seen increasing numbers of manufacturers fall by the wayside and the trend was set to continue. As far as the main protagonists were concerned, the financial market troubles of 1907 helped to push both the Electric Vehicle Company and Pope Manufacturing into receivership.

  At the time of the Electric Vehicle Company’s receivership, the balance sheet assets were accounted at $14m ($800m). Of this figure, some $12,000 was in cash, with the main asset the Selden patent at $11.5m ($660m).⁵⁶ By the end of the decade the concern had emerged out of receivership with a capitalisation of $2m as the Columbia Motor Car Company. It was to prove no more remunerative to investors than its predecessor, though did it become part of US Motors as part of the trend within the market to form ever larger groupings of manufacturers. US Motors was to lose out to General Motors, the other great auto congolomerate being created at the time.

  Ford Motor Company

  Analysing the Ford Motor Company is relatively straightforward. The achievement of being the first to produce a high-quality, low-cost vehicle put Ford Motor Company almost overnight in a virtually unassailable position. This was a genuine first-mover advantage. Being first to the market allowed a large increase in sales, which helped lower unit costs, which in turn allowed prices to continue to fall and increased the competitive pressure on other participants. The cost advantage created an insurmountable barrier so long as the technology embodied in the vehicle was not overtaken.

  6.13 – Ford Motor Company (1903–1919)

  Source: Ford 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.) New York Times. Commercial and Financial Chronicle.

  As can be seen in the accompanying charts, despite continuous price reductions, the company’s return on assets continued to exceed 60% up to 1914, with stable margins causing both sales and net income to grow at an annual compound rate in excess of 65% in the same period. As a consequence of the underlying profitability, Ford was able to self-fund its expansion without recourse to additional equity or debt capital. Eventually the returns being earned by Ford had to fall, as the business was simply too lucrative and the technological lead too narrow.

  By the mid-1920s there were other major producers which had become more efficient in their methods and were more than able to challenge Ford. Inevitably the overwhelming success of the Model T carried with it the danger of Ford becoming a one-product company. The irony was that few outside investors succeeded in sharing in the exception
al returns that Ford’s success achieved. Both Malcomson and the Dodge brothers sold their shares back to Ford after falling out with him.

  Malcomson was paid $175,000 for his shares in 1906. When Henry Ford eventually lost the court case that followed his falling out with the Dodge brothers in 1914, he was forced to pay $19.3m (nearly £900m) in dividends. He also had to negotiate the purchase of the 10% interest the brothers held in the company for $25m ($1.1bn). For the purposes of the settlement, the value of the company in 1919 was determined by the Internal Revenue Service to be $250m ($11bn). For the original investors, this meant that a $100 investment in 1903 had become worth $355,000.

  Undoubtedly, had the company been a listed stock, the total return from the shares would have been substantially higher than the 50%+ that the shares returned in the form of retained profits and dividends. Unfortunately for aspirant investors, the initial $28,000 in capital raised at the inception of the company did not require to be augmented over the period. The very success of the company precluded the opportunity for equity investors to participate.

  So far as Ford was concerned, the production of the Model T pushed the company from strength to strength. The financial crisis of 1907 had impacted a couple of the early backers, allowing Ford to buy back shares at the same price that had been paid to Malcomson. The shareholder structure was to remain unchanged for nearly ten years until Ford’s final break with the Dodge brothers. The brothers had been instrumental in the creation and delivery of the Model T, but by 1914 had decided to resign from their board positions with Ford to create their own eponymous automobile and associated company. The Dodge Brothers believed it could produce a better automobile than the Model T, which had seen little by way of technological improvement since its introduction. In this it was to be proven correct.

  The court case that followed the brothers’ departure stemmed from Ford’s decision to build a giant new production facility and restrict dividend payments to maintain the company’s financial strength. At least this was Ford’s contention. The Dodge brothers saw it as a manoeuvre to cut off the funds they needed to help the development of their new business. The courts eventually decided in the Dodge brothers’ favour and the Ford Motor Company was required to pay out $19.3m in dividends (nearly £900m). Ford subsequently negotiated the purchase of the Dodge brothers’ 10% interest in the company for $25m ($1.1bn) and at the same time bought out the other original investors, leaving the Ford family in sole control and without the necessity of external reporting to shareholders.

  So far as the Dodge brothers were concerned, they were able to go and build an automobile superior to the Model T, as they had predicted, although they were not to see the realisation of its full value, as both brothers died in 1920. The company they created was eventually sold in 1926 by their widows to the investment bank Dillon Read for $146m ($3.5bn), before being sold to Chrysler for $170m ($4bn) of stock a year later.

  Durant joins the fray

  In the same year that Ford introduced the Model T, William Durant began the process of trying to consolidate the automobile industry by acquisition. His goal was the creation of a concern with a portfolio of models to shield it from changing tastes and with the necessary size to internalise the production of components and reduce reliance on suppliers. The trend towards the creation of trusts – and the example of Standard Oil in maintaining prices and margins – would have played a role in underpinning the argument for the amalgamation of the major producers of the time. Durant turned a degree of independent wealth into a substantially larger fortune by building the Durant-Dort Carriage Company in Michigan, one of the largest carriage producers in the region. His knowledge of the carriage industry convinced him of the future of the automobile, and when the Buick Motor Car Company required capital to stay in existence Durant was on hand to take control.

  After initial success in resuscitating Buick, Durant began negotiations to create the largest company in the industry. In 1907, agreement seemed close in efforts to combine four of the largest producers: Buick, Maxwell-Briscoe, Reo and Ford. Henry Ford required $3m ($170m) cash for the sale, and while Durant’s group could raise this figure it was unable to meet the demand for equal treatment which immediately followed from Ransom E. Olds of Reo. This led to the deal collapsing and Durant moving on to incorporate the General Motors Company in 1908. With GM incorporated, Durant initiated a buying spree, purchasing Cadillac, Oldsmobile and Oakland (subsequently Pontiac).

  The acquisitions were financed with securities and debt and typically with little regard to profitability. (This judgement is perhaps rendered with the benefit of hindsight; it would be fairer to say that analysing future profitability at such an early stage in the development of the industry was a hazardous task.) Some commentators of the period, looking back, have suggested that the amalgamations were typically the result of a shortage of capital, since buoyant demand meant most manufacturers could sell their product relatively easily. The shortage-of-capital thesis does not appear to be borne out given the amount of capital raised in the early years and the proliferation of automobile companies. (This is not to say that for individual companies at particular times shortage of capital was not the critical issue, as it undoubtedly was in the case of US Motors.)

  Within a relatively short space of time, General Motors found the financial pressures intense – such that by 1910 its very survival depended upon new funding from a financial consortium. The severity of the position at General Motors required a cash injection of $15m (over $800m), but as was the case with other troubled recipients of capital, such as GE or AT&T, the situation allowed the financial consortium to effectively dictate its own terms. These terms included the removal of Durant and the reorganisation of the company under Charles Nash, previously the head of Buick, and his replacement at Buick by Walter Chrysler.

  Durant responded by teaming up with a Swiss emigrant racing driver named Louis Chevrolet, a former employee of Buick, to produce a new car to challenge the increasingly dominant Model T. Using the limited success of the new car, Durant was able to enlist the support of the Du Pont family and from 1913 onwards began his campaign to return to General Motors. Durant made an offer to trade Chevrolet stock for that of GM, which investors rapidly accepted despite the differential in size between the two companies. In combination with the Du Pont family, which sought to invest its booming war-time profits in General Motors, by 1915 Durant was able to regain control of General Motors with Pierre du Pont as his chairman.

  Some of the senior management were to leave the company, most notably Henry Leland, who had replaced Ford and built up the successful Cadillac operation. Leland left in 1917 and ended up creating the Lincoln Motor Company to work on aircraft engines, converting to the production of luxury automobiles at the conclusion of World War I. A downturn in the market in 1920 caught the company short of cash and allowed Henry Ford to purchase the concern for $8m (over $200m). A similar fate was to befall General Motors. Durant had continued with his policy of acquisition, adding numerous component manufacturers such as Delco and the Hyatt Roller Bearing Company run by Alfred Sloan. Many other acquisitions followed, a number of which – such as the Guardian Frigerator Company (later Fridgidaire) – bore no relation to the automobile. Durant argued otherwise, on the basis that both the refrigerator and the automobile were simply boxes containing a motor.⁵⁷

  Eventually these actions, born of the optimism of the time, caught up with both Durant and General Motors. Not only had Durant made GM an acquisitive vehicle, he had also taken a speculative approach to his own finances through his stock market activities and his personal exposure to GM stock. On top of this, the growth in the automobile industry had led to a lax approach to inventory control and cash management. When economic conditions worsened and the stock market fell, with GM stock dropping by 70%, Durant found both his personal wealth and the company he managed at risk. In order to avoid the panic that might have followed the personal bankruptcy of Durant, a sum sufficient to cover h
is debts of $30m ($475m) was advanced by a combination of the Du Ponts and the Morgan banking dynasty in return for his 2.5 million shares in GM. In addition, the presidency of GM passed to Pierre du Pont (as a figurehead) but in an operational sense to Alfred Sloan. Durant’s triumphant return to the company had therefore lasted barely five years before, in 1920, he was again removed.

  By this time Walter Chrysler had left the company to join the ailing Willys-Overland Company, which like its peers had been badly hit by the depression of 1920–21. Through his efforts at this company he had been invited to take over the running of the struggling Maxwell Motor Car Company, which had been part of an abortive attempt by one of Durant’s former partners to build another automobile conglomerate, the US Motor Company. It had been founded in 1910 and acquired many struggling manufacturers, such as the Columbia Motor Company, that had begun with Pope, moved into the Electric Vehicle Company and ended up with the US Motor Company. After reorganising the concern and producing successful new models, the company eventually took his name: becoming the Chrysler Company.

  General Motors

  History records that twice in its early years General Motors would have gone into liquidation had it not been bailed out by injections of capital. On both occasions the root causes were the same: an acquisition policy that paid little regard to capital structure and the strategic rationale of the purchase prior to the transaction – and even less to the integration after its conclusion. Durant’s rule seems to have been to purchase anything available in a potentially related business with whatever funds were on hand at the time. Shareholder value was not high on his list of priorities.