Engines That Move Markets (2nd Ed) Page 14

  At least one decision, to abandon radio-related research, was wrong. Nevertheless, Vail’s moves cemented AT&T’s pre-eminent position within the telephone industry. In the early years, Vail’s principal focus was on attaining as close to a monopoly position as possible. His ambitions were not restricted solely to the telephone; in 1909, AT&T acquired 30% of Western Union, much of it from the heirs of Jay Gould, an ownership position that granted AT&T effective control of the company. This had profound implications, at least when combined with AT&T’s refusal to allow competitors access to its long-distance lines. Vail’s argument for combining telegraph and telephone was that the two services were complementary rather than competitors, and that one company which operated both would achieve much increased efficiency. Vail also argued against the common perception that AT&T was a trust, suggesting instead that by their nature telephone services were natural monopolies. In putting the case for the ‘natural’ position of telephone exchanges, Vail explicitly accepted the likelihood or need for some degree of regulation. Despite these arguments public opinion had turned and, fostered by the independents, it became clear that a battle was looming.

  Vail understood the dangers inherent in confronting the government. His strategy was swiftly adjusted to face the new realities. AT&T agreed to relinquish control of Western Union. Under the Kingsbury Agreement, the company also agreed not to purchase any more independent operators without first obtaining permission from the Interstate Commerce Commission. Finally, it agreed to provide access to its long-distance lines to third parties. The future for AT&T no longer therefore included the attainment of a complete monopoly – political realities precluded this – but nevertheless, the strength of the company’s position made that particular goal unnecessary.

  The Bell companies and AT&T

  Early years

  The financial statements from American Bell and subsequently AT&T reflect the nature of the company and in many ways are similar to those of Standard Oil. It was effectively a holding company with revenues that derived from its operating subsidiaries by way of dividends. Indeed, it was the inability to sustain this method of operation under Massachusetts corporate law which prompted the injection of American Bell into its erstwhile New York-based subsidiary in 1900. Examining the accounts of the parent company provides little by way of information on margins earned, since increasingly the revenue took the form of remitted dividends. In the early years the majority of income flowed from the rental of telephone equipment, but from about the turn of the century onwards the proportions changed and growth in income was effectively solely a result of the income from the Bell operating companies. What is more interesting are the balance sheet changes which were directly related to the changing conditions the company was experiencing and which directly contributed to the change of control and management.

  In the period from the company’s inception until the imminent expiry of the original patents, the balance sheet of the company was relatively unchanged. The high margins and increasing revenue were sufficient to fund expansion internally without increasing levels of debt or equity issuance. Although the number of shares outstanding more than doubled between 1880 and the early 1890s, they did so against a background of revenues which increased more than sixfold and net income which more than quadrupled. For the investor this was an entirely satisfactory outcome when added to a total dividend payout which had over the period exceeded the entire paid-in capital. Between 1881 and 1993, American Bell paid out over $25m in dividends against a paid-in capital amount on the balance sheet of $20m. It also retained on its balance sheet reserves of over $20m. For those investors who had been fortunate enough to take the risk of investing funds, the return from dividends alone would have been of the highest order, leaving aside the returns from the appreciation in the share price. It is worth bearing in mind that this is the business which Western Union could have owned for an outlay of $100,000. The benefits of a monopoly position in a growing business could not be more clearly reflected, but if further proof were needed the rapid growth in earnings per share shown in the chart provides it.

  The increased level of competition that eventually ensued was evidenced not so much by the impact on net income growth as by the increasing recourse to external sources for funding. In 1893 the company had been in a position of zero net debt and this was broadly maintained through the early phases of increased competition. Net debt to equity did rise to roughly 30% by 1900 but this was reduced when the company was recapitalised during the switch to AT&T. However, from 1900 onwards, as AT&T embarked upon a more ambitious expansion through build-out and acquisition in an attempt to stifle the competitive threat, the net debt position rose year on year until in 1907 it reached a figure of 75%. That the balance sheet was able to sustain the debt increase was not a pressing problem as much as the deterioration in the returns to shareholders caused by dilution and the buildup in interest cost.

  Despite the fact that the industry remained in a growth phase, earnings per share were falling sharply. The combination of falling earnings per share and recourse to outside capital culminated in a change in both control and management. In 1907 AT&T had to raise over $130m in debt ($7.5bn). This brought the total debt on the balance sheet to $178m ($10bn). The fact that AT&T continued to grow net income and dominate the industry should not detract from what investors would have experienced at the time, namely EPS halving and the share price behaving accordingly.

  From 1907, AT&T redoubled its efforts to reduce the impact of competition. In the main this focused on acquisition by squeezing competitors both operationally and financially. The quest for monopoly extended to obtaining control of Western Union to broaden the services offered by AT&T and increase the utilisation of its lines. Although income growth was coming at the expense of margin deterioration, AT&T eventually came into conflict with the authorities over its degree of control over the industry. As a consequence, Western Union was disposed of at a loss less than five years later. AT&T also removed the barrier to interconnecting the independents. For the investor these were profound changes. The fall in profitability could perhaps be explained by a marketplace that was in the flux of a consolidation phase. With the removal of all remaining barriers to entry, AT&T was in the position of having to show more regard to service and pricing. Although it still enjoyed a dominant position in the industry, it no longer had the ability to make profits at the same rate as before. On the other hand, it did successfully avoid the complete breakup of the company which would surely have followed had it pursued its previous strategic goals. Whether this benefited the investor is an open question, given the experience of the breakup of the Standard Oil Trust.

  Longer term

  A long-term analysis of American Bell (subsequently AT&T) falls into three distinct phases. In the first phase, American Bell enjoyed the protection of the Bell and other patents. In the second phase, the industry was in a state of flux, as new independent companies competed with the Bell companies and franchisees. In the third phase, a degree of market stability finally prevailed. The difference between these phases is fairly starkly illustrated in the table below. The rate of top-line revenue growth slowed from its early rapid pace, an average compounded growth rate of 16% over the 15-year period from 1880 to 1895. In the second phase, growth remained brisk at 14%, but profit margins fell from over 40% to 30%. The return on assets declined consistently. The gap between operating and net income margin increased, as first debt to fund expansion and later federal taxes took an increasing chunk of net income. The high returns earned during phase one undoubtedly drew in new competitors and incentivised them to challenge the Bell patents. For early investors in the American Bell Telephone Company, the rewards were exceptional and were reflected in a rising share price and a dividend payout policy which on average distributed two thirds of the company’s net income in annual dividends. The new competitive environment that followed saw a stabilisation of margins and a reduction of balance sheet pressure as predatory expansi
on reduced and the company established a working relationship with the authorities. Long-term investors were rewarded by share price gains and a dividend stream which produced a fivefold increase in total returns during the first 20 years of the company and a further doubling in the 20 years that followed.

  Real figures deflated by the Consumer Price Index.

  Source: Historical Statistics of the United States, US Department of Commerce, 1975.

  3.7 (a) – Bell: The early years

  Source: US Department of Commerce, Historical Statistics of the United States, Colonial Times to 1970, Bureau of the Census, 1975. Commercial and Financial Chronicle. AT&T annual reports. AT&T historical stock prices. 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.)

  3.7 (b) – Bell: the long-term picture

  Source: US Department of Commerce, Historical Statistics of the United States, Colonial Times to 1970, Bureau of the Census, 1975. Commercial and Financial Chronicle. AT&T annual reports. AT&T historical stock prices. 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.)

  Conclusions

  The invention of the telephone owed much to Alexander Graham Bell’s experience in acoustics. Bell’s research work was conducted mainly from personal interest and for a long while was merely a sideline to his focus on improving telegraph technology. At the time, the popular view was that the lucrative returns were to be earned through speeding up telegraph messaging. Western Union, the industry giant, employed a staff of the most eminent scientists of the day to protect its position from attack. It had witnessed at firsthand the potential for damage if competitor companies obtained the patent on technological improvements. With scientists such as Thomas Edison, Elisha Gray and Amos Dolbear on its books, it successfully produced the Quadruplex and many other improvements.

  For Bell, competing against such a formidable array of talent and finance was an uphill struggle. He had little hope of forging ahead of them with the telegraph. Western Union had seemingly every right to feel confident. It had control of the technology. It had control of the cable network, and it also had the finances. In a climate where investors’ confidence had been knocked by the crash of 1873, this latter point was particularly important.

  Indeed, the financial strength of Western Union could – and should – have ultimately saved the company by protecting its leading market position. In an environment where funds were in limited supply and investors were sceptical, Bell and his backers ran desperately short of capital and were forced to offer the telephone patents to Western Union, the well-financed giant of the day. However, Western Union was unable to see the potential for the telephone, remaining convinced that the telegraph was still the future. It therefore turned down Bell’s offer. Events were not long in informing them of the error of this decision, but despite frantic efforts to recover, the company could not gain a lead on Bell and his established patents.

  For Bell, the refusal of Western Union to buy his patents marked the birth of American Bell, the Bell operating companies and eventually AT&T. The major milestone in this regard was the decision against Western Union and Elisha Gray, which confirmed Bell’s primacy and the strength of his patent rights. From this point forward, the fortunes of the two companies would march in opposite directions. The message was not lost on the stock market. As soon as the potential of the telephone became clear, the fortunes of those who depended on telegraph revenues went into relative decline. The only action that could have saved Western Union would have been to move swiftly and aggressively to adopt the telephone technology, but this action was barred by the court decision and the subsequent agreement which gave the Bell companies patent protection. From that point on, Western Union was doomed to become a stock market loser.

  3.8 – No doubt about the winners: total returns to shareholders in American Bell/AT&T and Western Union

  Source: Commercial and Financial Chronicle – annual financial review. AT&T historical stock prices.

  The early history of the telephone was all about barriers to entry. Up to 1893, Bell’s companies relied on the protection afforded by Bell’s patents. The exceptionally lucrative nature of the business attracted many new entrants and forced the Bell companies to use litigation aggressively to defend their position. In this they were largely successful. Although Bell did try to prepare for the period of when its patents expired, the early years made the company complacent and arrogant towards both competitors and customers. When the patents expired, the Bell companies’ initial defence rested on other patents they had acquired. However, these were less firmly founded. Public and legislative opinion had meanwhile begun to swing against the company, which was now perceived as one of the ‘trusts’. The independents soon established a foothold, and eventually a meaningful market share, but were always hampered by AT&T’s control of the long-distance lines.

  As far as AT&T was concerned, the costs of doing business had risen significantly. As price and service moved on to a more competitive footing, profit margins began to fall. Although growth was reasonable, it could no longer be funded internally. The returns to shareholders fell accordingly. Eventually this resulted in a change in effective ownership and a new management structure. The first order of the day was to reduce competition, the second to reduce costs. Both were aggressively embarked upon with some success, but the former exercise soon brought AT&T into conflict with the authorities who, spurred on by public opprobrium for America’s new combines, had become increasingly interventionist. The key decision for AT&T was whether or not to continue with a course of action that would inevitably bring conflict with the authorities. The company preferred the route of compromise that would at least protect its dominant position within the industry. A solution was reached. It was to set the conditions for the company for the next 60 years. In this sense, the management was extremely forward-thinking.

  Whether this was to the greatest benefit of shareholders or the economy is another question. The later history of the telephone was all about maintaining the core business of the corporation and avoiding charges of anti-competitive practices. This created a risk-averse attitude to the technologies and opportunities which were to come out of the technological advances which accompanied development and expansion of the telephone network. AT&T was ideally positioned to become a major participant in the growth of radio and broadcasting, but it was effectively restrained by fear of the potential accusations of monopoly practices.

  This is not to say, in either the early years or subsequently, that the telephone was not adopted for uses other than simple conversations. It did not take long for it to be utilised for direct marketing, a fairly obvious application since the early households with telephones were, by definition, wealthy households. Equally it was also seen as a medium for broadcasting: a subscriber base was built with music being played down the line on a pay-per-listen arrangement.

  The telephone: direct marketing and pay-per-listen

  Direct marketing

  It was not long before the telephone was seen as a medium which could be put to other commercial uses. In the early years it was only businesses and the more affluent households that could afford the installation of a telephone. For the retailer, the household with a telephone had therefore almost pre-selected itself as a marketing target. The article from which the following extract is taken was written by a retailer explaining the use of the telephone in generating interest in purchases from the affluent part of his community:

  “Not so long ago we arranged to have a representative of a high-class manufacturer of suits and waists visit our store for a short period. We asked him to bring a line of first-class goods, which even the swell trade could not find occasion to find fault with. When he arrived we telephoned every woman in town whose trade we had trouble winning for their best apparel. Th
ey listened to our argument, and in nearly every case promised us over the telephone to look over our samples…Women enjoy seeing nice things, and after we had notified them they seemed willing enough to pay our store a visit… The result of our efforts was to sell more to the bon-ton trade than we had ever been able to at any past time… Sending clerks or errand boys does not result in so much effective returns.”

  – Western Electrician, 12 September 1903

  The response

  Retailers might have been enthused by the cost advantages and targeting afforded by the use of the telephone, but households did not necessarily feel the same degree of warmth towards the practice.

  “ ‘My telephone is far more of a nuisance to me than it is a convenience,’ said a housekeeper yesterday, ‘and I think I will have it removed, if I am called up as much in the future as I have been during the past week by theater agents, and business firms, who abuse the telephone privilege, using it as a means of advertising. My hands were busy moulding bread yesterday morning, when I heard the bell ring, and upon responding was told by a woman just gone into business in a main street building, that she had a fine line of curtains… Shortly afterwards an employee of another firm making extracts solicited patronage in the same way… Last week a number of my friends and I heard of a Shakespearian actor who was to fill a long engagement here, and we were asked by a theater attaché to please get our seats early, as there would undoubtedly by a rush for tickets. These are samples of a telephone annoyance that I would like to be freed from.’ ”