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

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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 52 of 140)
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in the general purpose systems market with many ex-IBM personnel in senior
management positions. In 1970, RCA seemed to be fully committed despite many
years of struggling. In its 1970 annual report. RCA stated that its "most signifi-
cant growth area in the seventies is expected to be in information processing."

In Sepember. 1971, RCA announced that it was withdrawing from the gen-
eral purpose computer field. RCA's computer operations were sold to the Unvac
Division of Sperry Rand in December, 1971 ; and the company took a pretax
loss tliat year of $490 million as a result of its venture into computers, the larg-
est single loss in U.S. business history. At the time RCA left the industry, its
computer operations were still showing a loss. RCA had already committed
capital well in excess of the final writeoff of $490 million: and estimated at
the time that it would have to commit an additional $500 million in order to
establish RCA as a viable company in the computer industry.

General Electric's experience was similar; and in 1970 GE sold its computer
systems operations to Honeywell.

Even among IBM's systems competitors that have survived, it is unclear to
what extent they have "successfully" entered the general purpose systems
market :

Ilnneyu'cU Information Systems (HIS), which acquired GE's computer oper-
ations in 1970, is the second largest company in the general purpose systems
market with a 9.4% market share and revenues of $1.2 billion in 1973. IIIS's
pi'etax profit margin was only 5.3% in 1973 after allocation of interest expenses;
and the total Honeywell Corporation realized a return on stockholders' equit.v
of only 10.8% in 1973, excluding an unconsolidated financing subsidiary. Total
consolidated short term debt, long term debt and minority interest was $885
million at year-end 1973 compared to stockholders' equity of $952 million; but
Honeywell Finance, an unconsolidated finance subsidiary, had additional debt
outstanding of $319 million and equity of $66 million at year-end 1973. The early
success of HIS in the computer systems nu^rket was in part due to the fact that
it initially avoided the IBM software compatibility problem by making the H-200
series, introduced in 1964. software compatible with the second generation, IBM
1401 series through a program called the Liberator.



5385

The Univuc Division of Sperry Rand bad only 8.1% of the total domestic in-
stalled base of general purpose systems at year-end 1973, despite the fact that
Univac acquired the RCA installed base in late 1971 ; delivered the tirst com-
mercially built computer system in 1951 ; and bad about 15-20% of the pre-
decessor tabulating machine market in the middle 1950s. Univac first broke even
in fiscal 1900, following a $290 million loss the previous year. Univac's after tax
profit margin in fiscal 1974, which ended March 31, 1974, was approximately 5.8% •
return on stockholders' equity of the ;Sperry Rand Corporation was a respectable
12.1% ; and the company's debt level was not unusually burdensome. On balance,.
Univac's position in the general purpose market is strong relative to competition
(with the exception of IBM), but Univac's total market share does not reflect
the many early advantages that the company held.

JJtirrottghs Corijoration. is the strongest company financially among IBM's gen-
eral purpose computer systems competitors. The company has compiled an excel-
lent record of revenue and jirofit growth over the last decade ; and has been an
important technological innovator in the computer industry. In 1973, Burroughs
recorded a pretax profit margin of 10.2% and a return on stockholders' equity of
13.3% — second only to IBM. Burroughs' success was in part due to the fact that
it addressed the lease-base segment of the general purpose systems market at a
measured pace; while emphasizing segments of the data processing market where
equipment could be sold outright rather than leased, such as business minicom-
puters (Series L), terminal computers (Series TC) and the banking industry
generally. That strategy allowed Burroughs to record a high rate of annual
revenue and profit growth ; which in turn allowed Burroughs to successfully raise
new capital, including ,$110 million in equity capital and $100 million in sub-
ordinated debt in 1970 alone.

NCR's computer systems operations were profitable for the first time in recent
history in 1973. The company entered the computer market in 1953 through the
purchase of Computer Research Corporation. NCR's total pretax profits in 1973
w^ere $141.9 million, following a reported loss of $97.9 million in 1972. NCR's
1973 pretax profit margin was 7.8% and its after tax margin was 3.9%. The
company's return on stockholders' equity in 1973 was 11.7%. NCR had to stay
in the computer systems business because it was obvious that its traditional
product lines — cash registers and accounting machines — would eventually be
on-line to a computer system. At year-end 1973, NCR had 2.7% of tbe domestic
installed base of computer systems.

Control Data realized early success and profitability as a computer systems
manufacturer capable of delivering very large and competitive price/perform-
ance systems primarily for application in areas where the system was usually
purchased outright, such as in defense, science and education (including a major
portion to U.S. Government applications). Later efforts to broaden the company's
base into the commercial general puriwse systems market led CDC directly into
the "systems lock" barrier and into the capital barrier to entry — as well as into
an aggressive IBM.

The acquisition of Commercial Credit by Control Data in 1908 helped moderate
tlie capital demands related to entering the rental-l)ase market : but tbe transi-
tion has been extremely difficult and probably would have been impossible except
for Commercial Credit. In 1973. Control Data reported revenues from computer
operations of .$948.2 million and pretax profits of .$41.8 million, indicating a pre-
tax profit margin of only 4.4%. CDC's 1973 results benefited from the settle-
ment of an antitrust suit against IBM filed in 1908 and valued at iRlOO mil-
lion. In 1970-1971, CDC's computer operations lost a total of $04.5 million and
they were only marginally profitable in 1972.

Two new domestic companies that attempted to enter the general purpose
computer systems market over the past five years, Memorex Corporation and
Amdahl Corporation, have had problems. Memorex terminated its svstems pro-
gram in 1973 and took a loss of $40 million that year. Amdahl attempted to
raise public financing for the first time in 1973 in order to complete development
and begin initial shipment of its advanced, general purpose computer systems
which were designed to compete in the IBM System/360 and Svsti'm/370 market'
Amdahl has an impressive management team. Gene M. Amdahl, the President
was manager of achitectural planning for the entire IBM Svstem/300 family
of computers and later the Director of Advanced Computer Systems at JB'si
Nevertheless, the company was unsuccessful in its attempt "to raise public
financing and the fate of the company is currently uncertain. The Amdahl case
IS interesting because the company's design incorporates high speed, LSI tech-



5386

nolngv and advanced compnter technology. Japanese interests may now acquire
control of Amdahl because sufficient capital could not be raised in this country.
The financial highlights of IBM's principal general purpose systems competi-
tors are summarized on the following page (Table II). Burroughs and NCR
do not provide profit data for their general purpose systems' product lines and
only Control Data provides a separate balance sheet for its computer operations.

TABLE II.— GENERAL PURPOSE COMPUTER SYSTEMS MANUFACTURERS: 1973 RESULTS
(Dollar amounts in millions]





Revenues


Pretax
income


Net


Cash
flow 1


Retuinon
share-
holders'
equity

(percent)






(Income)


Margin
(percent)


share ^
(percent)


IBM

Honeywell. - -

HIS


$10,993
2,408
1,177
2,641
1,239 .
1,284
948
1,840


$2,947
190
3 62
212

208"

42
142


$1,576

97

3 29

113

71

116

17

72


14.3

4.0
3 2.5 .

4.3

5.8 .

9.0

1.8

3.9


$3, 278
367

262'


19.2
10.8 .

12.1".


63.8


9.4


Sperry Rand «


8."i


Burroughs

Control data « computer operations

NCR

All others, including IBM plug-compatible
peripheral manufacturers with a 4.8


249
104
218


13.3
2.0
11.7


5.2

3.6
2.7

7.2


















Total














100.0



















' Net income plus depreciation.

2 General purpose installed base at year-end 1973; International Data Corp. „ u ■ .» ,,- ,n-,,

' Interest allocation by division is estimated; Basic Analysis of Honeywell, Inc. by Lehman Brothers, Inc., May lb, 1974.

* For the fiscal year ended Mar. 31, 1974.

6 Sperry Rand's business equipment product line, primarily Univac.

6 Excludes Commercial Credit Co.

Source; Company data, primarily 1973 Annual Reports.

The data ^ raises questions about the staying power of some of the remaining
companies in the industry. Burroughs is the only company that realized profit
margins in 1973 that were in excess of the average of all major U.S. corporations
last year (5.9%)," although Univac was just slightly below the average; and all
of IBM's competitors realized a lower return on shareholders' equity in 1973
than the average of all major U.S. companies last year (14.0%). The relative
difference in profitability within the computer industry is even more significant
than the comparisons indicate, since IBM's accounting for profits is in general
more conservative than competition. Also, total corporation data masks the low
level of profitability of computer systems operations in many cases.

Since capital is a major barrier to entry into the computer industry, the ability
to internally generate cash to meet future capital requirements is an important
measure of the ability of any company to compete effectively in the future. IBM's
cash flow in 1973 at $3.3 billion seems overpowering relative to its nearest com-
petitor, Honeywell, Inc., with cash flow in 1973 of only $367 million. Further, IBM
held cash and equivalents at year-end 1973 of $3.3 billion, excluding $496 million
in securities held for repayment of long-term debt. In contrast, a number of
IBM's general purpose systems competitors are bixrdeued by relatively high debt

levels. . , .

The ability of IBM's competitors to raise outside capital is equally unin-
spiring for many of the reasons that have already been mentioned : profit mar-
gins and return on stockholders' equity below the average of all major U.S. corpo-
rations in 1973, despite more liberal accounting than IBM ; high debt levels ; and
low market shares. Also, excluding Burroughs, price-earnings ratios are relatively

3 Some additional companies could be included in the general purpose computer industry
such as Xerox Data Systems (formerly Scientific Data Systems), the Business Machines
Division of the Singer Company and Digital Equipment Corporation, the leading producer
of minicomputers. However, including those companies would unnecessarily complicate the
data while adding little to any understanding of the industry because their market share
is too small Singer and Digital Equipment both have less than 1% of the domestic installed
base of general purpose computers ; and Xerox Data Systems' market share was only 1.4%
at year-end 1973. „ . , . . ■,. <• cj^ i i p

* Data compiled by Investors Management Sciences, Inc., a subsidiary of Standard &
Poor's Corporation.



5387

low, ranging from a high of 10 times for Honeywell and Sperry Rand down to 6
times for Control Data, based on 6/30/74 common stock prices and earnings for
the twelve months ended 3/31/74 ; and, again excluding Burroughs, the ratio of
common stock price to hook value at 6/30/74 indicates that any new common
stock offerings could dilute current stockholders' equity at a number of com-
panies in the industry .°

The future availability of external fumncing must also be viewed in the con-
text of the history of the industry. Through the decade of the 1960s, the mystique
of the computer and the hypnotic influence of possibly approaching IBM's profit-
ability attracted considerable external capital into the industry. The myth that
many companies would be able to achieve rapid growth and high profitability in
the computer systems market has been shattered by the reality of the economics
of the industry.

All of the previous financial considerations indicate that the industry could—
and perhaps will — become even more highly concentrated than it is today, if
capital remains a major barrier to entry. Burroughs Corporation is the only
exception among IBM's competitors, because of the high level of profitability and
of investor recognition that the company has achieved, despite the fact that many
analysts suspect that the company's computer systems product line is well below
the corporate average in profitability.

Some reasons for Burroughs success have already been discussed, but one
factor deserves repetition : Burroughs has been very successful at avoiding too
heavy a commitment to shipments of systems on a rental basis by concentrating
on products and market areas where equipment can be sold outright. If Bur-
roughs' policy of managing the sales/lease mix in favor of outright sales can be
maintained, it can probably continue to gradually increase market share. How-
ever, if it attempts to accelerate its market penetration by dramatically increas-
ing lease shipments, current earnings will decline and the company's ability to
finance growth will suffer.

A CASE STUDY IN THE DYNAMICS OF THE CAPITAL BARRIER : THE INDEPENDENT
COMPUTER PERIPHERAL EQUIPMENT MANUFACTURERS

The history of the independent peripheral equipment manufacturers' attempt
to penetrate the general purpose market in the late 1960s further illustrates the
extent to which capital acts as an effective barrier to entry into the industry
and the dynamics of the interaction.

Prior to the introduction of third generation computer systems in 1964-1966,
independent peripheral equipment manufacturers primarily supplied peripheral
such as printei-s, digital tape drives and disk drives to computer systems manu-
facturers on an original equipment basis. Those manufacturers, in turn, incor-
porated the peripherals into their systems to be marketed to computer installa-
tions in competition with IBM systems.

In the late 1960s, independent manufacturers began to address the end-user
market directly, with particular emphasis on the IB]M rental-base of peripherals
attached to the IB^l System/360 family. The development of the end-user market
for peripheral equipment was the result of a number of factors :

(1) The potential market was large, particularly among IBM systems users,
because standard peripherals and interfaces were used over virtually the entire
IBM System/360 family ;

(2) The economies of scale of product development and maufacturing were
not significant barriers to entry ;

(3) Technological progress in peripherals had been slow — perhaps because
IBM never had to compete on a peripheral subsystem level (all previous end-user
competition within the industry had been on a total bundled computer system
level) ;

(4) Profit margins were excellent, based on manufacturing costs and pro-
jected marketing and field service expenses ;

(5) Peripherals were an increasingly large portion of the dollar value of a
total computer system (in 1960 peripherals were about 20% of the total dollar
value of a system and the central processing unit was 80% ; by 1970 the split
was about 50-50 ; and by 1980 peripheral subsystems are expected to represent
about 80% of the total value of a system) ;



s The ratio of common stock price at 6/30/74 to year-end 1973 book value ranged from
a premium of 2?,% for Sperry Rand to a discount of 57% for Control Data, except that
Burroughs was at a premium'of 293% and IBM was at a premium of 210%.



5388

(6) One of the two major barriers to entry into the general purpose computer
industry, software compatability with IBM, was avoided by making the inde-
pendent peripherals fully compatible with IBM software and systems, such that
the peripherals were "transparent" to the mainframe — they looked exactly like
IBM peripherals to the central processing unit ; and, finally,

(7) The other major barrier to entry — capital — was reduced significantly, in
part by investment enthusiasm for young technology companies in the late
1960s but more importantly by the fact that an independent i>eripheral equip-
ment manufacturer could address one market (e.g. the digital tape drive market)
and was not forced to develop an entire computer systems family, including
central processing units, an operating system, applications software and all
of the related peripheral subsystems — as a prerequisite to entry.

The initial entry into the IBM end-user market of companies with capabilities
in compatible peripherals was hardly noticed. In 1966, DuPont requested bids
for digital tape drives to replace the drives on its IBM computer system ; and.
The Telex Corporation, a tape drive manufacturer, won the contract. Through
1967-1969, production was increased, a marketing/field service organization
was built, end-user credibility was established and attractive financing packages
were negotiated to sell equipment outright to third-party leasing companies. The
ability of Telex to minimize the capital burden of building a rental-base by
selling equipment outright to third-party leasing companies reflected confidence
in the attractive economies of the plug-comDatible market.

By 1970, the success of Telex and the availability of initial capital had at-
tracted a number of independent competitors into the industry including Mem-
orex, California Computer Products, Ampex, Potter Instruments, Storage
Technology, Information Storage Systems and Marshall Industries. The domestic
recession of 1969-1970 also gave the IBM plug-compatible manufacturers a
considerable boost, since data processing installations were looking to cut costs
and replacing higher-priced IBM peripherals with less expensive and, in most
cases, superior products, was a logical choice. Finally, the General Accounting
Ofiiee released a study that found that federal agencies could save taxpayers
.'?200 million by using independent peripherals.

During 1970, shipments of independent peripheral subsystems manufacturers
increased sharply. Telex alone shipped about $80 million in equipment and was
budgeting shipment levels for 1971 that were approaching the levels of some
of the surviving systems manufacturers that had been attempting to pene-
trate IBM's market for a considerably longer period of time. — Plug-compatible
manufacturers were achieving what IBM's systems competition had failed to
do — they were providing some real competition.

Then, after careful study, IBM began to react or overreact — depending upon
one's perspective — to competition on a peripherals subsystem level. In September,
1970, IBM introduced a "new" disk drive subsystem, the IBM 231 OA. which was
actually a repackaged IBM 2314 subsystem, the most popular product being mar-
keted by independent competitors at the time. The IBM 2319A was introduced
at a significantly lower price than the functionally equivalent IBM 2314. In
December, 1970, IBM introduced the IBM 2319B, which extended the price cut
to disk subsystems used on all System/360 and System/370 family computers,
and reduced prices further by eliminating extra use charges. At the time, rBM's
share of the 2314 type disk subsystems market attached to IBM computer sys-
tems was 94%.

IB:M's price reductions on disk drive subsystems were followed in May, 1971
by the introduction of the Fixed Term Plan (FTP), a new lease plan that
provided rental reductions for IBM customers that signed one and two year
leases with penalty clauses for cancellaton and which also eliminated extra
use charges. FTP represented another substantial price cut by IBM and was
only applicable to those products where IB]M was experiencing competition from
plug-compatible manufacturers : disk drive subsystems, tape drive subsystems
and printer subsystems. IBM also reduced its purchase prices of those products
at the same time. Tv\-o months later, IBM raised prices on central processing
units and memories by an amount that offset the price decreases repre.sented by
FTP. according to IB:\rs estimates.

At the time, IBM was also beginning to experience competition from inde-
pendent memory subsystems manufacturers that were offering add-on memory
for System/360 and System/370 computers at attractive prices. After studying
the situation in detail. IBM introduced its new System 370/1.^8 and 370/168
computers with semiconductor memory at lower prices than the cost savings
seemed to justify and with higher central processing unit prices.



5389

The losses experienced by IBM's peripheral subsystems competitors in 1971-
1973 " were staggering relative to the size of those companies. Some of the losses
could l)e directly related to IBM's price reductions ; some were the result of
manufacturing problems and other difficulties unrelated to, but certainly com-
pounded by, IBM's actions ; while some of the reported losses were due to the
inability of those companies to favorably complete linancing arrangements that
would have eased the capital burden.

Memorex Corporation, a highly successful and profitable manufacturer of
computer tape and disk packs for many years prior to its entry into the IBM
end-user disk subsystems market, reported a pretax loss of $24.9 million in 1971,
a profit of $1.9 million before taxes in 1972, and a loss of $119.1 on revenues of
$176.9 million in 1073, including writeoffs from its discontinued computer sys-
tems program and from previously deferred expenses.

The Telex Corporation reported a loss of $18.0 million for the fiscal year
ended March 31, 1973 on Telex Computer Products' revenues of $43.3 million and
shipments of $98.1 million. In fiscal 1974, Telex's computer operations lost $35.4
million on shipments of $62.7 million. The fiscal 1974 loss effectivelj' wiped out
all of Telex's stockholders' equity.

California Computer Products, Inc., the leading producer of computer graphic
systems, was less heavily committed to the end-user, plug-compatible disk driA^e
market in 1970, when IBM started to react. Nevertheless, the company sustained
a loss of $12.9 million in its fiscal 1972 year and was only marginally profitable
in its fiscal 1973 year ended June 30, 1973. after more than 10 years of profitable
operations as a specialized peripheral subsystems manufacturer.

Despite the sharp financial setback of the peripheral subsystems manufacturers
throughout the 1971-1973 period, some companies, through superior product
lines, strong management or simply luck, were not forced to drastically cut back
product development and end-user marketing programs and were continuing to
enjoy strong customer response for their products. Also, some peripheral com«
panics were continuing to expand rapidly in product areas where the penetration
of IBM's market was too small to invite a competitive reaction, such as in data
entry and remote batch terminals. But there was one major missing ingredient:
NEW CAPITAL was no longer available. IBM's actions served notice to Wall
Street that competition on a peripheral subsystem level had little chance of suc-
cess — and Wall Street listened. IBM's promise of doom had the effect of a self-
fulfilling prophecy.

Telex was able to complete a $27.5 million subordinated debenture financing
with warrants in 1971 ; but the company has been unable to tap the long term
capital markets since that time. Memorex managed to complete the private financ-
ing of a leasing subsidiary in the amount of $142 million in 1970, but has been
unable to i*aise additional long term capital since that time. California Computer
Products was able to raise $10 million through a convertible debenture financing
in .January, 1972, and also has been unable to raise permanent capital since that
time.

Short-term funds were provided to peripheral subsystems manufacturers by
commercial banks, since bank lines can be collateralized by inventories, receiv-
ables and rental equipment ; and since, in many cases, it was necessary for indi-
vidual banks to advance additional funds and to restructure repayment schedules



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 52 of 140)