Engines That Move Markets (2nd Ed) Read online

  There were some who recognised the power of fast information transmission. For example, in 1851 a historian of the English railways commented:

  “For the highest and the lowest this simple power is alike beneficial. It purchases; it sells; it equalizes prices, it destroys monopoly; it places the poorest tradesman on a level with the wealthiest speculator; it renders commerce healthier; and it possesses that which it has been said distinguishes most modern discoveries, it is as free to the peasant as to the prince; as open to the mean as to the mighty; it is controlled and controllable by all.”²³

  Far-sighted words, but ones which clearly were in a minority.

  The European model was slightly different to that of Britain. In Britain, the Regulation Act compelled private operators to do the government’s bidding, but in countries such as Prussia, France and Austria, the telegraph was a state monopoly from the outset. The telegraph was quickly recognised as an important tool in national security. In Britain, for example, it was used to assist rapid deployment of troops during the period of revolutionary fears involving the Chartists. It also became an important tool of commerce. London financial prices were disseminated by telegraph from 1846 onwards. Ownership and control of the telegraph largely coincided with that of the railways; for example, the chairman of the Electric Telegraph Company was also the chairman of the North Staffordshire Railway. Although the public had right of access, there was pressure on government to regulate the telegraph to avoid potential abuses. At first, the regulation took a form similar to that which governed the railways. The Telegraph Act, passed in 1863, gave the Board of Trade some authority over the companies. By 1868, however, there were moves to grant the Post Office a monopoly. These were prompted by public reaction to a proposed price rise by the telegraph companies. This was seen as the companies exercising monopoly power. It threatened (among others) newspapers, which were by this time dependent upon the telegraph for rapid information transfer, a development which made possible the growth in national newspapers.

  The government authorised the Post Office to purchase existing telegraph facilities. The offers were sufficiently generous that the railways did not oppose nationalisation. While the Post Office took over the operation of the telegraph, a third of the telegraph entry points remained in railway stations. The change of control led to a rapid growth in the service, which continued until it was eventually supplanted by the telephone. The expansion of the telegraph in the UK can be seen in figure 3.1. The number of telegrams sent trebled in the ten years from 1870 to 1880 and doubled again in the decade to 1890. As the telephone’s impact began to be felt in the last decade of the century, the growth in traffic began to slow and in the early 1900s slipped into decline.

  3.1 – Number of telegrams sent in Great Britain 1870–1908

  Source: J. Simmons, The Victorian Railway, London: Thames and Hudson, 1991, p.228.

  Western Union and the US market

  In the US, it was private capital that financed the development of telegraph networks. At first this was a direct result of the growth in the railroads, rather than any great faith in the intrinsic merits of the emerging technology. As in Britain, the telegraph was an important tool in the control and management of the expanding rail networks. It was not long before the potential for users to communicate across a vast new country spurred new levels of interest. Competition for market share ensured rapid growth. By the 1850s, a basic telegraphic grid covered the northeast and midwest states. The early years were marked by heavy capital expenditure, fights over patent access and price wars. The financial pressures these produced brought about a ‘pooling’ arrangement, designed to exclude new competition, and a price-setting and volume-allocation cartel involving the six largest telegraph companies. The arrangement, colloquially known as the ‘Treaty of the Six Nations’, covered most of America and set out spheres of influence, terms for mutual assistance and measures to remove new competition.

  The pool proved to be inherently unstable and ungovernable. The pricing war quickly reasserted itself. The war was only resolved when the three largest companies, led by the New York and Mississippi Valley Printing Telegraph Company, merged to become Western Union. Western Union’s emergence as the dominant telegraph company was greatly assisted by the impact of the Civil War. Before the Civil War, the telegraph was still a technology in its infancy. In the 1850s, sending long distance messages by telegraph was expensive and laborious. The electrical signals carried down the telegraph wires grew weaker with distance, requiring a series of relay posts where messages would be recorded by the operator and then re-keyed. From initial transmission to hand delivery of a telegram, it could take a full day for a message to cross the US continent. The main customers tended to be government, businesses and wealthy individuals.

  However, in times of war, speed of communication takes precedence over cost. Just as the Rothschilds amassed a fortune during the Napoleonic Wars in Europe with their efficient information networks and use of carrier pigeons, so the American Civil War enabled financiers such as J. P. Morgan to make large sums from trading government bonds, thanks to timely information on the war’s progress received via the telegraph.

  The Civil War also stimulated the telegraph business directly. Speed of information was vital to the armed forces, which assumed control of maintaining and extending the telegraph network. Western Union was to inherit more than 14,000 miles of new lines built and paid for by the government. Officially this was simply a return of private property to its owners, but it may have been no coincidence that almost all the wires and poles were returned to Western Union or companies that it absorbed. General Thomas Eckert, the chief of US military telegraphs under Lincoln and later the assistant secretary of war, subsequently took a top management job at Western Union.

  The telegraph companies were already in receipt of large government subsidies by the time the Civil War broke out. The Pacific Telegraph Act of 1860 provided for up to $40,000 ($5m) per annum in subsidies to telegraph companies in return for transmission of federal messages. Just as with the railroads, most of these subsidies ended up in the pockets of the proprietors.

  The combined impact of merger, government subsidies and the Civil War, ensured that Western Union emerged with a dominant, near-monopoly, position. The importance of information transfer and its close relationship to the railroad was obvious to at least one of the railway tycoons; as Vanderbilt switched his interests into the railroads, he made it his purpose to gain control of the company. The symbiotic relationship with the railroads was vital to the success of the telegraph. For a railroad, the tie with a telegraph company provided it with an unlimited free telegraph service through the lines along their track, and reduced prices along other lines. In return for this service, the railroad typically provided transportation and materials for construction, ongoing maintenance and staffed offices in train stations and depots.

  The railroads needed a fast and reliable communication service; Western Union provided this, effectively annexing large parts of the country’s infrastructure as it tied up most of the railroads. Its dominant position made it increasingly difficult for other competitors to encroach, allowing Western Union to grow so large that it became the only real viable partner for railroads. There were more than 100 telegraph companies in the late 1870s, but the vast majority were small ancillaries of railroads. In contrast, by 1878 Western Union had over 7,500 offices, 12,000 employees and nearly 200,000 miles of cable.

  Competitors emerge

  The only competition of any note came from the Atlantic and Pacific Telegraph Company, which had come to arrangements with Union Pacific in 1869 (and later also Central Pacific) in exchange for stock. Despite these contracts, A&P was less than one twentieth the size of the Western Union – and apparently little threat to the industry giant. However, for an ardent speculator such as Jay Gould, nothing was that simple. Gould recognised the strategic importance of the telegraph and took an increasing interest in A&P following his involvement
with Union Pacific.

  With the assistance of Thomas Eckert – whose career aspirations had been disappointed by Vanderbilt’s appointee as president of Western Union, William Orton – Gould attempted to gain control of new technological developments by backing Thomas Edison, an increasingly prolific scientist and sometime Western Union employee. In the convoluted sequence of events that unfolded, there were the by-now-normal ingredients of double-dealing, intrigue, broken contracts and litigation. At root was an attempt by Gould to get control of the technology underpinning the rapid transmission of information. This battle, ironically, took place just before Alexander Graham Bell emerged with the technology that would eventually eclipse the whole telegraph system. Even the greatest speculators of the day completely underestimated the importance of the telephone, instead fighting a battle over a technology which was to soon prove largely redundant.

  The sequence began with Edison resigning from Western Union in 1869 to strike out on his own as an inventor. In August 1870, Edison made significant improvements in the automatic telegraph. This system replaced the Morse methodology by using perforating machines to record messages. These were then fed into a transmitter, sent down the lines, received and printed automatically at the other end.

  The development work was funded by a company, the Automatic Telegraph Company, set up in November 1870 for the purpose by George Harrington, a former secretary to the US Treasury. Edison soon exasperated his financiers by spending over $30,000 ($2.5m) developing the system, five times the original projection. After disagreements over the speed of development, Edison walked out, only to return two years later after spending the intervening period upgrading the stock ticker machine for a company controlled by Western Union. Edison then combined working directly for Western Union and upgrading the ‘automatic’ for his previous company.

  The new, improved automatic was sufficiently successful to worry Western Union. As the telegraph lines ran parallel to the railroads, information transfer had become a vital part of a railroad’s commercial viability. They were thus an integral and expanding part of Western Union’s success. In 1873, during Edison’s tenure with Western Union, he developed the Quadruplex. This device allowed two streams of information to flow in both directions along the telegraphic cable and made a huge difference to the cost of laying telegraphic lines. Edison estimated the cost saving to Western Union would be of the order of $450,000 and demanded a better contract from William Orton, the company president. Orton believed Edison was effectively tied to Western Union with no alternatives, and therefore pitched his financial offer substantially below the package Edison requested.

  Edison responded by falling into the arms of Jay Gould. This was engineered through the offices of General Thomas Eckert, the general superintendent of Western Union’s eastern division. Eckert had expected to become president of Western Union, but his ambitions had been thwarted by the Vanderbilt’s installation of Orton. With his path at Western Union barred, Eckert defected to head Gould’s company, the Atlantic and Pacific Telegraph Company. Western Union was stung into immediate action by this betrayal. They tried to re-enter negotiations with Edison, but to no avail. In December 1874, the Atlantic and Pacific Telegraph Company purchased the Automatic Telegraph Company, bringing with it the rights to the automatic. Since Edison had never entered into any formal agreements regarding the Quadruplex with Western Union, Gould now ostensibly had the potent mixture of the automatic and the Quadruplex. When combined with his telegraph network, it seemed that Gould could easily mount a serious challenge to Western Union’s supremacy in the information transfer business.

  In 1875, Gould set about using A&P as a vehicle to threaten Western Union’s dominance. Ever the mercenary, Edison fell out with Eckert and defected from the A&P camp, but the battle continued against Western Union and its owners, the Vanderbilts. For three years, Gould conducted a price war against Western Union, including threats to expand the A&P network, further encroaching on Western Union’s domain. This attack was bolstered by undermining the Vanderbilts’ other interests.

  The death of Cornelius Vanderbilt in 1877, combined with the concerted attack on the Vanderbilts’ railroad interests, forced William Vanderbilt to bring the war to a conclusion. In 1878 Western Union bought A&P. However, the success of this raid only served to whet Gould’s appetite. Within a year, and using effectively the same set of tactics, he launched another price war, this time through a company called American Union. The result was even more successful; on this occasion Gould emerged with 90,000 shares of Western Union and a seat on the board of directors. Extensive stock watering and an $80m recapitalisation accompanied the 1881 merger.

  Gould’s attacks on Western Union resulted in his acquiring a position of influence within the company. It is not surprising, then, that Western Union soon found itself under attack from other rivals. The principal attacker was the Baltimore and Ohio Telegraph Company, which pressed a price war until it too was eventually acquired by Western Union in 1887. Even in 1880 Western Union accounted for 80% of America’s telegraph traffic, but with the absorption of B&O, Western Union effectively was the telegraph industry. The boardroom reflected the company’s power and influence, with nominee directors of Gould and Vanderbilt, representatives from Union Pacific and Central Pacific, Thomas Eckert and, last but not least, the financier J. P. Morgan. Western Union dominated its industry in a way that no railroad had been able to do. It was against arguably the most powerful corporation in America that the telephone was to emerge to do battle.

  3.2 – Number of messages sent by Western Union in America

  Source: NBER Macro History Database. US Department of Commerce, Historical Statistics of the United States, Colonial Times to 1970, Bureau of the Census, 1975.

  Ultimately Western Union’s success depended upon two things: the outcome of a series of lawsuits regarding the ownership of the patents on improvements to the telegraph, and a dominant position in the physical ownership of the network. These two aspects were linked, in the sense that without the Western Union patents, ownership of the cables was of little value. There was also some luck. Western Union’s industry dominance had made it careless about protecting its rights, and it was only Edison’s deteriorating relationship with the management of Gould’s company that enabled it to maintain its stranglehold. The fallout allowed Orton to reach an agreement with Edison, resulting in all suits being dropped and Edison receiving a series of payments.

  There were clear lessons in the story of the Quadruplex. First, it was vital to establish clear legal title on inventions. Second, that legal title had to be protected, not used as collateral to fund other experiments or business ventures. Learning these lessons proved an expensive exercise. Fatally for Western Union, the company did not see the technology shift that would make its patents obsolete. At the time, the potential challenge from the telephone must have seemed remote to a company which had achieved a dominant position in its own new form of information transfer. Not only did it dominate its industry, it also had on its books the most eminent and successful scientists of the age. Western Union’s internal records show that it saw the telephone as only a peripheral threat. It also assumed that should such a threat emerge, the company’s scientific resources and its financial strength would give it the strength to resist. Since the company was in perhaps its most prosperous phase, with strong revenue and profits growth, such a view was not unreasonable. But as history was to prove, it was completely misplaced.

  Western Union

  Western Union’s dominance of the telegraph market is readily apparent from its financial statements. In the early years of the 1860s, operating margins rested in the 35–40% range, while sales grew at an average annual compound rate of 10%. Sales were sensitive to underlying economic conditions, though demand was relatively inelastic. Growth slowed rather than declined significantly when times were tough. During the economic turn-down and stock market crash in the later 1860s, Jay Cooke and many financial companies – a
s well as a number of railroads, including Northern Pacific – went under. Western Union remained profitable at both an operating and net income level. Net profits fell by around 10%.

  The strongest period of growth in profitability for Western Union was seen as the US economy emerged from the problems of the early 1870s and telegraph traffic soared. The irony was that the increased traffic came just at the time that a competitor was being formed which would eventually overtake and dwarf the company’s business. Margins had started to fall even before the emergence of the telephone. Sales increases required lower prices and cost pressures proved difficult to control. Unit volume growth also slowed, and as a consequence the net income of the company stopped growing in any meaningful manner. Industrial unrest at the company also played a part. With demands for higher compensation intensifying in a period when profitability was declining, it is not surprising that management resisted these demands strongly.

  3.3 – Western Union: 30 years of dominance

  Source: Western Union annual reports. Commercial and Financial Chronicle. 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.)

  The balance sheet of the company had been subjected to the malign influence of Jay Gould. The impact of new stock issuance and the subsequent recapitalisation in 1881 can clearly be seen in the decline in return on equity and return on assets over the period. The balance sheet before the recapitalisation showed little debt and there was no real business need for new equity to be issued. If earnings per share had been one of the metrics of the time, the impact of share issuance would have been much more obvious. A rough estimate suggests that earnings per share barely increased at all in the 50 years to the mid-1860s. Having said this, the main criterion for most investors was the dividend paid – and, aside from a drop during the depression of 1873, investors were rewarded with a sharply rising dividend stream. This continued until the mid-1880s, when the telephone’s inroads into the telegraph’s domination of high-speed communication became increasingly clear. The telegraph effectively became a niche player rather than the mainstream carrier. This did not mean that the business suddenly became unprofitable. Even during the rapid growth in the telephone market, Western Union continued to earn a reasonable return on its assets. The problem was that the cost of adding to capacity could not be justified by the incremental increase in earnings. The business was experiencing falling profitability but had little potential to restore growth. From the mid-1880s onwards, the investor could only invest on the basis of future dividend flow, which in turn was constrained by earnings.