Engines That Move Markets (2nd Ed)
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The difficulty for the investor in such a scenario is in obtaining sufficient information on cash flow to anticipate any liquidity crisis. It is not, for example, always possible to be certain that the indebtedness reported at the holding company level is truly reflective of the capital position of the company. In theory the consolidated accounts should aggregate such figures, but where there has been a series of acquisitions, and where financial controls are suspect or less than rigorous, there is always the possibility of a lack of accurate reporting or non-conformity in accounting treatment of different items.
The 1909 financial statements for the components of General Motors were published, albeit in an aggregated form. The liability side of the balance sheet gave no information about the debt of subsidiaries, giving only figures for the capital stock and amounts payable. Investors had to make an assumption that the surplus (or profit and loss) accounted for the difference between the liabilities shown and the total assets.
The Financial Chronicle, for example, took the net worth figure for Buick released by GM as indicating that the surplus (or profit and loss) was roughly $9m, which when added to the payables and capital stock pretty much equalled the total assets figure.
Yet as the 1910 figures were to show, this was an erroneous assumption, as by that point Buick was carrying debt approaching $8m. GM’s 1909 annual report also showed net income of $8.6m and a profit margin over 30%. The figure would therefore have looked internally consistent, as there was no reason to anticipate rising debt levels against such a buoyant and profitable backdrop.
6.14 – General Motors: the early years
Source: General Motors 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.
The reality was that the organisation had been run without any meaningful central control over costs or operations. Acquisitions such as the Heany Lamp Company were made without any apparent awareness of mounting cash flow problems. Heany Lamp was purchased for 8,290 shares of GM preferred stock and 74,775 of common stock, which was more than the consideration paid for Buick and Cadillac combined. The net result on this occasion was that GM had to be rescued from the waiting receivers with an injection of $15m.
6.15 – General Motors: the long-term picture
Source: General Motors 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.
The cost to GM of the rescue was an underwriting fee of $2.25m together with a distribution of stock at par to the underwriters comprising $4.169m of preferred and $2m in common. Shareholders in GM experienced earnings dilution through debt cost and repayments, as well as the additional stock. The change in management associated with refinancing also proved costly, when the lenders took executive control until the repayment of the loan due in 1915. Profits fell sharply when Buick unwisely decided to drop production of its small car, the Model 10, which accounted for half its profits. As consequence of both the financing and the model changes, profits plummeted.
Durant’s second term in office was to end in much the same way as his first. The company reembarked upon the acquisition trail. The net outcome was similar to the 1910 experience. Poor management structure and information systems overlaid on a poor acquisition policy came home to roost when the post-war boom conditions reversed into a downturn. This time investors should have had an inkling of what was coming.
The return on assets had been declining ever since Durant returned to the company. Net income did rise, but only in response to buoyant market conditions and at the expense of substantial equity issuance and dilution. When the downturn came, GM was caught with inflated inventories and the unavoidable losses that accompany such a position. When Du Pont stepped in to underwrite his overgeared stock position, Durant was replaced by Alfred Sloan. GM then set off down a different path from where it eventually challenged and overtook Ford as the industry leader.
For the investor, the lessons were relatively clear. A visionary is not necessarily, or even likely, to be able to manage the vision he creates. Durant’s personal financial affairs were as unstructured as the company he led. After one example of the Durant management style, the second period should not have come as much of a surprise, particularly when declining margins and stock dilution were obvious, though not all brokers at the time showed much awareness of the real position.
The Studebaker story
With the form of power established, the question became which of the manufacturers of gasoline-powered automobiles would succeed. For the investor there was a long list to choose from, including companies that were deliberate stock market scams; genuinely hopeful but inept operations; and a range of companies with different skills relevant to automobile production. In the latter group were companies with operations adapted to counter the growing threat of the new form of transportation. Bicycle manufacturers formed one large grouping, while another emerged from the producers of horse-drawn carriages. The most notable company in this second category was Studebaker. Unlike Ford and General Motors, which had emerged from an engineering background, Studebaker was one of the world’s largest producers of horse-drawn carriages and wagons. As such it had a well-developed national distribution network – but, with the advent of the horseless carriage, a network that would soon potentially be redundant. The company reacted to this threat and became one of the very first mainstream ‘traditional’ technology companies to make the transition to the new technology.
The Studebaker family were skilled metal workers who emigrated to America from the Ruhr Valley in Germany during the early 1700s. The initial years were difficult as the family struggled to sustain an existence, most commonly through blacksmithing and wagon-making. Their fortunes improved when one member of the family returned from the Californian goldfields with a fortune of $8,000 ($1m), accumulated not from the original intention of gold prospecting but the more mundane but lucrative venture of building wheelbarrows. This capital was used to put the family business of wagon-making on a more sound financial footing, just in time for a rapid expansion in business occasioned by the Civil War. This expansion in turn allowed the newly constituted Studebaker Brothers Manufacturing Company to supply the increasing trade westward as the continent expanded. It also enabled the company to increase its distribution outside of Indiana – and, just as importantly, retain the US Army as a valued customer.
In 1870 sales exceeded $500,000 in value ($37m) and continued to grow until the depression of 1873. The company was in a strong financial condition and able to weather the storm, though production had to be halved and dividends passed. As a survivor it benefited when conditions improved and growth was strong, occasionally helped by further military orders such as that which accompanied the Spanish American War. By the turn of the century, sales were nearly $4m in value ($300m). In addition to the traditional wagon business, the company had been experimenting with the new form of horseless carriage. This was underwritten by a contract with one of the members of the subsequently infamous Lead Cab Trust, with Studebaker building the bodies for electric cabs. The knowledge gained from this venture was put to work in the production of a Studebaker electric vehicle named the ‘Electric Runaround’, released in 1902. These vehicles, though, remained a tiny part of the overall business.
Within Studebaker, the view was growing that gasoline-powered vehicles were the future, not electric, and the company tied in with the Garford Motor Company – which had supplied the chassis for Studebaker’s electric cars – to produce a Studebaker-Garford gasoline vehicle. Success was almost immediate, and by 1907 orders reached nearly $8m ($460m). Eventually Studebaker gained control of Garford in an effort to improve expansion plans. Its major acquisition, though, came with the purchase of t
he Everett-Metzger-Flanders Company (E-M-F). E-M-F had begun a relationship with Studebaker as a partner whose national distribution channels would allow sales of E-M-F’s mid-priced automobile. The joint venture was successful in the sense that both the E-M-F and Garford vehicles registered rapid increases in sales volume, but the relationship was never an easy one. E-M-F increasingly viewed Studebaker as a partner intent on gaining control – with some justification. By December 1910, Studebaker had acquired control of E-M-F and formed the Studebaker Corporation. The new company was incorporated in New Jersey in February 1911, and with the aid of Goldman Sachs and Lehman it sold $13.5m (over $700m) of convertible stock and $30m ($1.5bn) of common stock.
Growth accelerated with the focus on automobiles, although the historic business also prospered as the company received the largest ever munitions order from Britain when World War I broke out. This included 3,000 horse-drawn wagons, 20,000 sets of six-horse artillery harnesses and 60,000 artillery saddles, with a delivery period of just 16 weeks! Over time, though, it was the automotive business which was to sustain Studebaker, making it one of the very few businesses entrenched in the traditional methods of transportation that successfully made the transition to the new technology.
Studebaker was primarily a manufacturer of automobiles at the more expensive end of the spectrum and as such excluded from the booming growth most evident with the success of the Model T. The company sought to enter this market in 1927 with its own small vehicle, the ‘Erskine’, named after Albert Erskine, the company president. However, this offering was uncompetitive and was discontinued after three years. The company was protected from the failure of this vehicle by the success of its other automobiles and remained ostensibly healthy and profitable.
The Wall Street Crash of 1929, though, exposed management and operational problems within Studebaker. The company had weathered many downturns in the past and perhaps this gave an undue level of confidence to existing management. Equally, relatively optimistic reports from dealers undoubtedly contributed to Erskine’s maintainance of high dividend payments. Further aggravating the loss of cash associated with dividends was a subsequent attempt to enter the low-cost vehicle sector, which met with even less success than the previous foray. This behaviour was almost the exact opposite of the reaction of the Studebaker brothers to the 1873 depression, when dividends had been passed and production cut to conserve capital. With the financial situation becoming critical, the company sought an exit route through a merger with the White Motor Company – only to see this blocked by White’s shareholders. As a consequence, Studebaker was placed in the hands of the receivers in early 1933, with Erskine committing suicide some months later. Eventually, through the efforts of the receivers, Studebaker emerged from receivership and regained profitable production. Moreover, for a short while it actually managed to carve out a market share in the low-cost sector of the market with the introduction of the model ‘Champion’. The company continued through World War II, although as its finances again deteriorated it merged with Packard before closing its US operations in late 1963.
The early years in the automotive business for Studebaker had been almost an unqualified success. The company made use of its sales and distribution network, at the same time building on its existing skill base to become a top producer of automobiles. The problems came with the increasing pressure for volume production, which Studebaker could only achieve through entry into the low-cost vehicle market. Repeated attempts to achieve this met with failure and were exacerbated by poor financial decisions, ultimately leading the company into receivership. Although Studebaker emerged from the hands of the receivers, the fundamental problem remained an unsuccessful entry into the volume segment of the market.
Studebaker
Among the producers of horse-drawn carriages to enter the automobile industry, the most notable and successful example was Studebaker, which was one of the world’s largest producers of horse-drawn carriages and wagons (at the turn of the century, Studebaker’s sales were nearly $4m in value). It had a well-developed distribution network and proved to be one of the few ‘traditional’ technology companies to make a transition to the new technology.
Studebaker took control of two automobile companies, first Garford and then, in 1910, the Everett-Metzger-Flanders Company (E-M-F). The new company that this created, renamed the Studebaker Corporation, incorporated in February 1911 and raised some $43m of convertible stock and common stock from a public share issue. For the investor, Studebaker would have been one company worthy of serious investigation when the newly constituted Studebaker Corporation came to the market for funds in 1911. A number of factors would have put them in favour.
Firstly, Studebaker had an unrivalled historic operating track record, with sales increasing consistently over a 40-year period. The only blemishes to this record occurred during the difficult economic periods of 1873, 1893 and 1907, when conditions were such that many other companies fell into liquidation. During those periods the company retrenched operations, and in 1873 and 1893 passed its dividend. As soon as fortunes improved, the dividend was reinstated.
Secondly, although the family retained a strong influence, the management team spotted the opportunity to enter the new market and competently managed the transition to horseless carriages. Thirdly, the growth path of the new industry and the potential rewards for success had been clearly illustrated by the growth in sales generally, and the success of Ford in particular. Finally, the company was supported in its efforts by two powerful financial institutions: Lehman Brothers and Goldman Sachs.
From a negligible market position in 1905, Studebaker had gradually increased its market share of the automobile business, and with the acquisition of E-M-F – which was funded by the creation of the new company in 1911 – was set to become one of the major industry players. New facilities allowed the company to produce almost as many gasoline automobiles in 1911 as it had in its entire history up to that point. The new Studebaker Corporation made an impressive debut. Sales by volume tripled; in value they doubled.
6.16 – Studebaker: struggling to make it
Source: Studebaker 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.
Although the average price received was falling, such was the production growth that profitability was rising, as evidenced by a climbing return on assets. Since the company was virtually debt-free, the return on equity was a fairly similar figure. The period up to the entry of America into World War I would have looked good by most criteria. Yet the company was in fact entering a period of decline that was to lead to receivership and eventual disappearance. The initial success masked the fact that it was falling behind its major competitors. In 1911 Studebaker’s profits were roughly half those of General Motors, yet by 1916 GM was three and a half times the size and by 1919 six times. The same was evident for Ford.
The root cause of lagging growth was Studebaker’s lack of exposure to the low-priced automobile, which was by far the fastest growing segment of the market. This did not make the company a bad investment, simply one which would not fully participate in the growth of the industry. The danger points proved to be a threat to the niche markets that Studebaker offered and a failed attempt to enter the low-cost market. The company sought to enter this market in 1927 with its own small vehicle, the ‘Erskine’. However, the offering was uncompetitive and was discontinued after three years.
The company remained ostensibly healthy and profitable. The Crash of 1929, though, exposed management and operational problems. The company had weathered many downturns in the past and perhaps this gave undue confidence to existing management. Optimistic reports from dealers undoubtedly contributed to the maintainance of high dividend payments. A second attempt to enter the low-cost vehicle sector met with even less success than the previous foray. Through a
combination of an abortive attempt to penetrate the low-cost segment, the purchase of a luxury producer and a series of financial and management errors during the Depression, Studebaker could not meet its obligations and fell in to the hands of the receivers. Shortly after this Erskine committed suicide.
For the investor, the demise of Studebaker would only have become apparent with the abortive foray into the mass market. Up until that point the profitability of the existing business would have appeared reasonable, though against a backdrop of no sales growth. The company clearly had to make some form of move and as such was sitting at a crossroads, with success or failure resting on a single new model range.
Eventually, the company emerged from receivership and resumed profitable production. For a short while, it managed to carve out a share of the low-cost sector of the market with its ‘Champion’ model. Later, after World War II, its finances again deteriorated, and it merged with Packard before closing US operations in late 1963.
The evolution of the automobile industry in America