United States. Congress. Senate. Committee on the.

The Industrial reorganization act. Hearings, Ninety-third Congress, first session [-Ninety-fourth Congress, first session], on S. 1167 (Volume pt. 7) online

. (page 51 of 140)
Online LibraryUnited States. Congress. Senate. Committee on theThe Industrial reorganization act. Hearings, Ninety-third Congress, first session [-Ninety-fourth Congress, first session], on S. 1167 (Volume pt. 7) → online text (page 51 of 140)
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It would seem to me that one interpretation of what's happening
in this industry is that IBM's success is in part based upon their per-
ception that this was a service; more important, a service-based
industry than a technology-based industry; that it's important to
have good hardware; it's even more important to have personnel
needed to show the customer how to effectively use this hardware.
And this is where they spend an amount of funds to develop what
economists call "human capital."

In other words : In the computer industry you could develop physi-
cal capital, and very competent physical capital, but IBINI developed
physical capital as well as human capital; the human capital being
their salesmen and technical staff to service their computers.

This is what has led to their success, as opposed to some of the other
allegations made, and looking across the board here, each firm has
attempted to enter the computer industry where it felt they had a
technological, comparative advantage and simply ignored, relative
to IBM, this other critical aspect of the industry. Do you have any
comment on that naive interpretation ?

Mr. Collins. Yes. My comment would primarily focus on the fact
that, liowever well or less well, these companies understood the indus-
try at the time they were addressing it — they realized that c^st of
entry was so huge that they had to focus on some aspect of the indus-
try 'where they had a technical advantage, where they could sell
equipment outright, where they didn't have to have an army of
salesmen and of systems engineers and of support activities — in order
to initially get into that market that that's the basis for these com-
panies focusing on those individual markets.

IBISI, on the other hand, had huge deferred profitability in its tab-
ulating machine lease base and a "marketing group established such
that it was simply a natural extension of their dominance of that
market that allowed them to absorb those initial front end costs, again
the high cost of entry getting into the market.

The paradox is that if any one of those companies had attempted
to address the general purpose systems market by building that ex-
tremely capable sales, field service, systems support activity, and
shippiiio- that product on a lease basis the losses would have been
so huge that they could never raise that next level of financing that
they needed in order to stay in the industry.

Mr. Granfield. That's because you would perceive they wouldn't
be under a comi-)etitivc rate of return. I don't know that they couldn't
raise the capital. They were not effectively spending that capital as
other alternative investments open to the investing public.

Mr. Collins. Let's take Control Data in the mid-1960's. The para-
dox is that the company was extremely successful in huge number
crunches that thev sold to the scientific market.

If they made the decision that the incremental $100 million worth
of equipment that they were going to ship in that next year was going



5379

to be into tlie general purpose market and they put together that
entire support activity that was required and they shipped that equip-
ment on a lease basis, my example in my statement shows the negative
numbers that would have shown up.

The paradox is that if they would have made that decision they
never would have gotten any more money to be able to pursue that
activity; and indeed, it's questionable whether or not Control Data
would have survived if they did not acquire Commercial Credit at the
time that they did.

Mr. Granfield. You have indicated, and we have heard this in
previous testimony, that IBM only innovates when competitive pres-
sures force them to. Yet it is my understanding that one reason Gen-
eral Electric and RCA dropped out of this industry is the rapid pace
of technological change.

Let me explain my point. It may be a strange one but it says that
if IBM had been allowed to pursue their normal pace of technological
development, and these other firms are now trying to leap frog ahead
in technology, that we would still see RCA and GE in this business.

Mr. Collins. Yes : I agree.

Mr. Granfield What I'm saying is it is the competitive technique
used by IBM's competitors that drove GE and RCA out of business,
not IBM.

Mr. Collins. As a generality I agree. "\^niat we run into is a paradox
of many, many paradoxes of a rental based market.

Yes, to a degree that was true. It was perhaps Burroughs innovating
an increasing market share that led IB]M to announce its System 370,
which then in turn led RCA to drop out of the industry. But that
does not negate the fact that given a less competitive environment in
the industry, that the motivation of the leading rental based company
to innovate will be significantly less.

Mr. Granfield. Just one "final point I would like to bring out.
We have heard a lot about technological innovation.

To economists this has two sides : You must not only innovate but
innovate a product that sells to the consumer at a reasonable price
throujrh a reasonable level of services for that price.

There are times when we innovated too quickly. One example I
would bring out. Xo one would dispute that the latest Polaroid
camera is a technological wonder which may yet undo the great
previous miracle of tlie Polaroid Coi-p. Because from what I under-
stand tliey brought tliat technological innovation onto the market
too rapidly, and they are having tremendous service problems with that
pai'ticulnr camera.

What I'm saying is that many industries are parallel to this. It's
important to time that technological innovation to the point where it
can be adequately, reasonably, and viably serviced, not where they
can perform on 1 day a tremendous technological feat.

Service is tlie name of the game. We can see that happening in the
automobile market. The automobile buying public has decided that
gadgetry — tlie diminishing returns of gadgetry and increasing returns
to reliability — I'm saying that is the critical decision tliat always has
to be made.

The more technologically advanced the field, the more difficult and
complex that decision becomes, so to fault a firm for not beating its



5380

competitor to tlie market witli what looks like a new improved prod-
uct is a yevj difficult question because that product must also perform
reliably.

I can think of no other area than in the computer area where these
become more apparent. I have been with five different universities
where we innovated new systems. I have gotten a peptic ulcer every
time.

I was more than satisfied with my previous service. I know you
ultimately have to innovate, but I felt every time the cost of that
innovation to the use of myself was extremely high.

That's an uncalculated cost in man-hours and time that I put in and
that happens with all end users. Those are the hidden costs of too
rapid an innovation. If you want to comment, please do.

Mr. Collins. Just very briefly. Again, I agree that the service com-
j)onent is extremely important, but does that enter in all areas?

For example, didn't we, for many years, have to use a keypunch
and a verifier for data entry, when finally they were combined into a
buffered keypunch that saved that customer a heck of a lot of money.

Xow that was a technological innovation that I believe did not
come from IBM. I believe there is a pretty good reason why it didn't
come from IBINI, and the whole data entry market is similar to that.

I mentioned before my example of the 6:250-BPI tape drive. You
don't need a high level of service to implement something like that,
but it could save the customer tremendous amounts of money.

Mr. Granfield. Thank you very much.

Senator Hart. Are there any other questions? Thank you very
much for an interesting, as well as informative, discussion.

The Senate has scheduled consideration of a bill that came out of
the Judiciary Committee. There is an amendment which I feel the
bill requires. A notice has just been received that the bill is now open
for amendments.

For this reason I must recess the hearing. Under the Senate order,
debate on amendments is limited to 30 minutes.

Let's be optimistic and recess until noon.

[Whereupon, at 11 : 10 a.m., the subcommittee recessed, to recon-
vene at 12 noon this same day.]

[The following was received for the record :]

MATERIAL RELATING TO THE TESTIMONY OF EUGENE K. COLLINS

Ewhibit 1. — Prepared Statement of Mr. Collins

Prepared Statement of Eugene K. Collins, Director of Research, Evans &

Co., New York, N.Y.

My name is Eugene K. Collins. My business address is 300 Park Avenue,
New York, New York 10022. I am Director of Research and a security analyst
specializing in the computer industry at Evans «& Co., Inc., a New York Stock
Exchange firm that is engaged in investment banking, investment re.search for
financial institutions and brokerage. IMy undergraduate work was done in elec-
trical engineering and economics and I studied investments and finance at the
New York University. Graduate School of Business.

I have been a security analyst at New York Stock Exchange firms since 19fi."»,
initially following technology companies generally and aerospace and office equip-
ment companies specifically. Since 1068, my analysical work has been almost
exclusively in the computer industry, except for a lirief period during 1071-
1972. During that timeframe, I developed and published forecasts of the U.S.



5381

economy aud formulated overall investment strategy as Associate Director
of Research for the New York institutional research operation of Black & Com-
pany.

My analytical work in the computer industry has focused primarily on IBM
and on young technology companies that might be able to successfully pene-
tx'ate the industry. My interest in young companies in the industry and in IBM
are closely related disciplines since IBM is the computer industry and the
business practices of IBM largely determine the economic structure of the
industry.

I regularly advise companies in the industry on the subject of future financing
plans and I successfully raised initial financing for a company in the industry.
In 196S. I was instrumental in first introducing peripheral subsystems manufac-
turers to Wall Street and to financial institutions as potentially attractive invest-
ments in tlio industry ; and have closely followed the rise and fall of those com-
panies as meaningful competitors in the industry. I am generally regarded as
Wall Street's resident expert on computer peripheral equipment manufacturers.

In my current capacity as a security analyst at Evans & Co., I act as a con-
sultant to i^anks, insurance companies and mutual funds on the subject of invest-
ing in tlie compiiter industry : and I publish extensively on the industry and on
individual companies in the industry. Many of my remarks today will reflect
impressions that I have received through almost daily contact with major finan-
cial institutions over a period of six years.

My statement today will deal with :

(1) Tlie ability to raise capital and the role that capital plays in determining
competition in all U.S. industry ;

(2) The unique importance of capital to the computer industry, because of the
rental-base nature of the general purpose computer systems market ;

(3) IBM's computer systems competitors and the degree to which they have
"successfully"' entered the industry and can provide meaningful competition in
the future ;

(4) The computer peripheral subsystems manufacturers as a case study in
the effectiveness of the capital barrier to block entry into tlie industry : and.

(5) The outlook for even less competition in the computer industry, liecause
of the highly selective nature of investment interest in the industry today.

INTRODUCTION

The computer industry is the fastest growing major industry in this country
and in the world. The industry has already contributed to vast social, economic
and political change in its brief, twenty-year history ; and the next twenty years
promise to be even more dynamic because of quantum leaps in semiconductor
technology', the inci'eased sophistication of the computer user and the marriage
of computer and communications technologies.

The industry combines tlie best of our natural resources : in management and
systems skill, capital aud technology. The future progress of the computer in-
dustry will have a significant impact on all other important industries in this
country, on national defense and on the futin-e productivity of the U.S. economy,
in general. The products and services of the industry will reach more and more
into our daily lives.

Yet, there are very few companies in the computer industry that receive serious
investment consideration today. The answer to the apparent paradox of a grow-
ing and dynamic technology -based industry and the highly selective nature of
current investment interest can be found in the structure of the computer
industry.

There are two major liarriers to entry into the general purpose computer
industry : the "systems lock" and the highly capital intensive nature of the indus-
try. Together they form an absolute barrier to entry that would allow IBM to
control virtually 100% of the general purpose computer market, in my opinion, if
IBM did not operate under self-imposed constraints tliat limit its market share to
00-70'^'^. Basic to establishing and maintaining the two principal barriers to entry
is IBM's policy of marketing a total bundled computer system on a short term,
risk lease basis.

Testimony before this sultcommittee has extensivel.v addres.sed the esoteric
subject of the "systems lock" and IBM's related marketing support activities.-
Simply stated, the high level of end-u.ser systems' support provided by IBM com-
bined with the investment in IBM softwai'e l)y a computer installation discour-
ages users from switching to another systems manufacturer.



5382

The perspective tliat I hope to bring to these hearings is the unique importance
of the financing question to the structure of the computer industry; and some
insight into how the highly capital intensive nature of the industry is created and
maintained to provide an effective barrier to entry.

COMPETITION AND THE ABILITY TO RAISE CAPITAL

The basic thrust of my remarks can be generalized to apply to all highly con-
centrated industries : iu order to have competition within an industry, competitive
entities must have the ability to raise or to internally generate the capital neces-
sary to successfully compete. This consideration is particularly important today
because of the increasing concentration of the control of investment assets
at major financial institutions and because of the shortage of capital that exists
today in this country and will continue to exist for the foreseeable future.

My background is financial, not legal, but as a financial analyst many elements
of Chief Justice White's and Judge Hand's definition of a monopoly are exactly
the same as the generally accepted criteria for the ideal equity investment at
most large financial institutions ; a company that has the dominant position in
its industry and the power to exclude competition : and a company that has the
ability to control prices within its industry. I might add one other criterion of
the ideal equity investment : a company that also has the capability to frustrate
any legal challenge to its dominant industry position on antitrust grounds.

The similarity between the definition of a monopoly by Chief Justice White
and Judge Hand and Wall Street's definition of the ideal equity investment
helps explain the now-infamous, "two-tier" equity markets that have developed in
this country over the past few years. Institutional investors have been primarily
interested in accumulating large equity investments in their "favorite fifty"
and have had only passing and lukewarm interest in other equity investments.
I submit that it is no accident that the top five companies on the list of the
fifty institutional favorites, IBM, Exxon, American Telephone, Xerox and
Eastman Kodak are all being challenged on antitru.st grounds by either the
Justice Department, the FTC or by private litigants.

THE UNIQUE IMPORTANCE OF THE FINANCING QUESTION TO THE GENERAL PURPOSE

COMPUTER INDUSTRY

Although the ability to raise capital is an important consideration in deter-
mining real and potential future competition in any industry, it is a uniquely
important factor in the general purpose computer industry. Its unusual importance
to the computer industry relates to IBM's practice of marketing a total bundled
computer system on a rental basis.

Some clarification of the market that is being addressed is necessary. The
general purpose computer systems market refers to systems typically used in a
commercial and in a mixed commercial /scientific data pi-ocessing environment
in manufacturing, retailing, banking, federal and state government, insurance,
etc. It excludes dedicated applications computers such as minicomputers and
microprocessors, not because it would make a meaningful difference in any total
market share calculation, but because the structure of those markets is signifi-
cantly different from a financing point of view. Specifically, minicomputers and
microcomputers are sold outright to end users and to original equipment manu-
facturers (OEMs), while general purpose systems are typically marketed on a
rental or lease basis. My remarks also exclude computer supplies such as computer
tape, disk packs, and punched cards because, in general, supplies also are sold
outright to data processing installations.

The general purpose systems market is by far the largest and most important
segment of the total computer market. The installed base of general purpose sys-
tems accounted for 91.2% ' of the total domestic installed base of computers at
year-end 1973, based on dollar value ; and the total dollar value of installed
computers was $29.9 billion, including dedicated applications computers. Of the
total domestic general purpose systems installed base at year-end 1973, IBM's
market share was 63.8%.

IBM's practice of marketing computer systems on a short term, rental basis
holds tlie key to the high capital barrier to entry into the industry ; and can
best be illustrated by example.

1 Source : All market share and installed base data from International Data Corporation,
Newtonville, Massachusetts.



5383

A typical manufacturing company that produces and marlvets $100 million in
products in a year records sales of $100 million and a pretax profit, If, on the other
hand, that same manufacturing company produces and ships the $100 million in
product on a short term, risk lease basis (the standard in the general purpose
computer industry) a large negative cash flow and a substantial reported loss
is realized under generally accepted accounting practices.

The first year of operation of two identical companies — with one shipping
on an outright sale basis and the other shipping on a rental basis— can be il-
lustrated as follows :

TABLE 11
[In millions of dollars]

Outright Rental

sale base



Shipments (1st year).



100 100.0



65


8.1


25


25.0


10
10


10.0
10.0


45


45.0



Revenues - - 100 12.5

Cost of sales - - 35 4.4

Gross profit-

Expenses:

Marketing -

Research and development..

General and administrative .-

Total -

Net profit (loss) before taxes - 20 —36.

' Example is obviously oversimplified but the numbers are a reasonable approximation of the revenue and cost structure
of the general purpose computer industry. Exact numbers, of course, are not available because they are a closely guarded
secret at most companies in the industry.

The difference in realized revenues between the manufacturing company that
sells outright and a company that ships its product on a lease or rental basis is
straight forward. Typical computer industry leases pay out over 48 months (the
sale price is about 48 times monthly rental). Consequently, in the first twelve
mouths of installation, computer equipment generates 25 percent of the full
purchase price or $25 million in my example. During the first full year, assum-
ing a uniform monthly shipment level, the actual revenues booked are only one
half of that amount or $12.5 million.

Most expense items, however, remain the same, independent of whetlier the
equipment is shipped on an outright sale or on a rental basis. The only exception
is manufacturing costs, which are capitalized and depreciated over the esti-
mated future life of the equipment, typically four to six years. The expense items
that remain the same (marketing, research and development and administrative
costs) are a large portion of the total expen.se in the computer industry.

Con.sequently, the manufacturing company is forced to ship its product entirely
on a rental basis records a first year operating loss of $30.9 million on shipments
of $100 million — in contrast to a profit of $20 million for the typical manufac-
turing company. If no new products were shipped on a rental basis in the second
year and expenses were reduced accordingly, revenues of $25 million would be
recorded for the rental4)ased manufacturer and a profit would be realized. But,
that would be a company in liquidation. If. on the other hand, the management
of the company addressing a rental market was attempting to build a viable
company over the long term (the usual definition of successful entry into an
industry) .shipments could not be reduced to zero in the second year but would, in
fact, have to be increased on a year-to-year basis.

Increased shipments on a rental basis, in turn, result in an even larger reported
loss in the second year and increa.sing losses for some time. Eventually, the losses
peak and begin to decline gradually until, finally, a breakeven level is reached.
Black ink arrives for the first time when sliipments are high enough to realize
competitive economies of scale in manufacturing, software development and
product development such that the gross profit contribution from the rental base
exceeds the high fixed cost of marketing, systems support, field service, research
and administration.



5384

The foregoing illustrates one of the many contradictions of a rental-base busi-
ness : the higher the incremental shipments in any year (the more successful
the company is in shipping product that year) the greater the reported loss in
that year.

The problem from a financing point of view is enormous. An investor is being
asked to commit capital to a business that may now show a profit for perhaps as
long as 10 years ; and will only show a profit at that time if management does
not make any important mistakes along the way ; if the economy does not slump
into a recession at the wrong time ; if the dominant company in the industry
does not become sufficiently concerned to focus its competitive strengths on the
new company, which could result in premature product obsolescence; and if
sutticient capital can be raised along the way to keep the company alive long
enough.

The capital that must be raised is also equity and equity related, risk capital
since straight debt will not be made available to a company realizing a negative
cash flow and operating at a loss. Consequently, most of the companies that have
attempted to enter the general purpose computer market have l)een involved in
otlier businesses that could help support some of the initial capital demands,
sucli as General Electric, Philco, Bendix, NCR, Burroughs, Sperry Rand, RCA
and Honeywell.

Not all general purpose computer equipment is shipped on a rental basis. As a
result of tlie 1956 Consent Decree. IBM is required to sell equipment to inter-
ested customers ; and IBM's pricing is structured such that some portion of ship-
ments are sold outright. But that portion is relatively small and the imposed
standard in the industry remains the short term, operating lease. Conseqiient-
ly. the fact that some customers purchase equipment outright only slightly re-
duces the total capital commitment necessary to successfully enter the industry.
Prior to 1956, IB:m would only rent computers and tabulating equipment to
customers.

THE EXPERIENCE OF IBM'S SYSTEMS COMPETITORS

The history of the general purpose computer industry clearly establishes
that reaching the critical mass level necessary for "successful entry" takes a
long, long time and huge amounts of capital.

RCA provides a good example, since it attempted to compete directly with IBM



Online LibraryUnited States. Congress. Senate. Committee on theThe Industrial reorganization act. Hearings, Ninety-third Congress, first session [-Ninety-fourth Congress, first session], on S. 1167 (Volume pt. 7) → online text (page 51 of 140)