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 54 of 140)
Font size

exception of the International Data Corp. census, which is an estimate
of the total number of computers installed.

Since IB]M so closely guards its data none of its competitors are
willing to release additional industry information.

We do not know the number of various classes of machines shipped
monthl}^, quarterly, or even annually on a total basis ; nor do we know
by whom.

5396

Of those machines, we do not loiow how many were leased, how many
were outright sales, and how many were third-party leases.

AVe do not know the coirfiguration of any of those computers, hence
we do not know the sales value or the monthly rental which will accrue.

We do not Iniow if the machines shipped were to new usere, whether
they were upgrades resulting in machine retirements, or whether they

"We do not know whether the machine retirements, if any, were fully
depreciated and, if not, whether there are sufficient reserves on the
balance slieet to cover necessary writeoffs.

We do not know if these machines are domestic or foreign installa-
tions, nor do we have any indication of which industries are increasing
or decreasing their installations of machines.

This incredible lack of industry information is one of the major
barriers to entry in the computer industry ; no reputable financial in-
stitution with a fiduciary responsibility, and acting on the prudent
man theory, can support a new venture where there is no market in-
formation available.

I believe that an initial step in improving competition in the com-
puter industiy is the creation of a central reporting organization with
the responsibility of collecting data under strict rules of confidence.

Such an oiganization could be established either as a user group,
which would report the installation of a class of computer, whether it
was purchased or leased, and the industry classification of the user, or
the computer manufacturer Avho shipped the machine could report the
same information to a central reporting organization.

The establishment of such an organization would serve at least four
showed wliich industries were increasing or decreasing installations;
two, industry would have hard data detailing trends either toward out-
right purchases or toward leasing; three, small competitors would be
able to service only that portion of the industry which constitutes their
viable market, outright purchases; and four, a major barrier to entry
would be eliminated because financial institutions would have data
available indicating market size.

Using other trend-line data, growth rates, and other variables, could
be factored into the projections, thereby enabling the lender to deter-
mine the total amount of financing reciuired to build a viable business.

The minimum data required should include machine class, average
monthly rental, sales value, sale or lease, industry classification of user,
domestic or foreign installation, and replacement, retirement, or up-
grade. Data should be reported on a monthly basis.

The relative size and strength of IBiNI compared with the five other
main-frame companies is clearly demonstrated by a comparison of
financial information taken from their respective latest annual reports
and 10-K reports.

In 19T."> IBM generated computer-related revenue of $8.7 billion or 64.7 percent of the total computer-related revenue for all six com- panies of$13.1 billion.

Pretax income from all operations, including noncomputer-related
activities, total $3.7 billion for all six companies. Of this amount, IBM reported$2.0 billion, or just under four times the combined pretax
income of the other five companies.

5397

In 1973 IBM'S research and development expenditures of $730 mil- lion Avas nearly equivalent to the combined pretax income of the other five companies, which totaled$794 million. ^ ^ ,

In 1973 this $730 million of research and development expense represented 25 percent of pretax income and about 8.5 percent of EDP revenues for IBM. , ^ -, ^ ^ ^ c^-ian However, Honeywell's researcli and development expense ot 5?lbU million was 85 percent of pretax income and 13.5 percent of sales. Sperry Rand spent$146 on research and development, or 09 per-
cent of pretax income and 13 percent of EDP sales.

Clearly, IBM's liuoe lesearch and development expenditures come
not as a' result of spending a proportionately liigher percentage of
income or sales on research and development, but because its massive
profit base permits it to do so.

The foi-egoing statistics indicate that IBM is a self-perpetuating
giant with a formidable financial lead over its competitors, and it is
tins strength in sheer dollars which is the crux of the competitive
problem in the industry.

Because IBM has been spending so heavily on research and develop-
ment, based on its financial ability to do so, the company in the very
recent past has gained a technological lead over its competitors.

However, this technology has not immediately benefited the user
by reducing his computer costs, nor has it been available to the com-
petition at the same time at which IB]M had the technology in house.

IBM has withheld that beneficial technology from the marketplace
to protect its rental base until a competitor, whether it be the pe-
ripheral equipment companies with a speedier product, a main-frame
company with virtual memory, or a semiconductor company with ]MOS
memoiy, forced IB]\I to move forward.

This practice has impeded technological progress because none of
IBM's competitors can afford to risk the viability of their comi)any
on an unproven technique. It is only when IB^t bestows its official
blessing via the introductory route \hat competition returns to the
marketplace.

If IBM continues to restrain competition by ^yithholding techno-
logical advances for its own financial benefit it is possible that the
technolog^^ which exists in our other main-frame computer companies,
which is well advanced from that of foreign competitors, will be ex-
ported through foreign investment in those firms.

IBM's research and development activities, while privately financed,
have become a national asset. Although the com]:)any's scientists present
many papers before various professional society meetings, the com-
petitors in the industry do not have the financial wherewithal to pursue
a large number of state-of-the-art research activities.

Any restructuring of IBM should therefore direct itself to giving
the scientific community an opportunity to liave at least limited access
to this vast pool of knowledge.

This would actually be a conservation of assets since those with
limited resources would not continue to seek a nonexistent light at
the end of the tunnel.

The institutional investor has come under attack recently for creating
the so-called two-tier market, meaning the acquisition of stocks of
those companies which have unblemished earnings records.

5398

These stocks are also referred to as "one decision'' stocks, meaning
that a [)ortfolio manager bnys them, pnts them away, and adds to
them in market downturns, but never sells them.

One of the reasons for this philosophy is that these companies
typically have very large capitalizations and can be purchased in
size or in large blocks.

Why the commitment to large capitalization stocks? A portfolio
manager generally is responsible for a sizable pool of money, at least
$100 million at an institution of any size, which he will invest in 20-30 stocks. His minimum position would therefore be$3 to $5 mil- lion, and since it is considered unwise to own a sizable percentage of the market value of a given stock the portfolio manager typically will look only at stocks with total market value in excess of$100
million.

The market capitalizations of a random sample of 20 companies,
both large and small, in the overall technologv area shows only 11 com-
panies with at least a $100 million capitalization. The peripheral equipment companies, however, regardless of earn- ings, all have market capitalization well below the$50 million mini-
mum and only Telex and California Computer are above $20 million. Obviously, one of the best measures of the value of an investment is the pi-ice one pays today for future earnings. The two companies in the peripheral industry with the best records, California Computer and Storage Technology, are selling at five and seven times earnings, respectively, based on last year's earnings. In both cases earnings are expected to increase this year, so the multiple on future earnings is even lower. Both companies are in need of longer term financing to replace their costly short term bank debt, but are unable to go to the equity market because of the low relative prices of their common stocks. Their debt to equity ratios are already top heavy so that the debt route is closed to them also. The third avenue of cash inflow is also unavailable, and this is private placement of some combination of securities with an institutional investor. The offering statement for a private placement generally contains more information about future product plans and strategies than the prospectus covering a public offering. In many cases a 5-year plan is included, estimating contribution to sales and earnings of both existing and planned products. The peripheral equipment companies are unable to present such a long-range plan very convincingly because of IBM's past practices of introducing phantom machines and/or price reductions in the form of long term leases. Furthermore, the peripheral companies have difRculty in establishing the size of their market because of the lack of informa- tion on computer shipments. The institutional investor has a strong fiduciary responsibility be- cause he is investing funds for others. He must operate under the pru- dent man theory, for he is legally liable for the loss of those funds. Based on past experience, prudence dictates that it is unwise to invest in a company which exists only so long as it docs not encroach upon IBM's market share. The institutional investor is unable to invest in the publicly owned common stocks of the peripheral equipment companies because their market values are far too low. 5399 Storao-e Technology lias a market capitalization of less than$30
million and California Computer's market value is just over $21 mil- lion. This compares with$29 billion for IBM, $3.4 billion for Bur- roiio-hs, and almost$2 million for Texas Instruments. The dilemma
which we face is that on a multiple basis, California Computer, at 5
times, and Storaire Technology, at 7 times, are more attractive than
either IBM at IS'^times or Burroughs at 29 times earnings. California
Computer and Storage Technology are also growing faster than IBM
or Burroughs, so if the computer market was truly competitive these
two stocks would be selling at a premium. However, investors assume
that the computer market^is not competitive, and thus, the future of
California Computer and Storage Technology is uncertain.

If the competitive question is not resolved quicldy the viability of
these companies is not assured because of their inability to finance
internallv-generated, long-term growth.

It is to management's credit that these companies have performed
so well in the face of unfair and uncommon competition. As an insti-
tutional investor I would like to own California Computer and Stor-
age Technology because I have been given every reason to have faith
in management.

Fiduciary responsibility and prudence prevent me from doing so
because the risks from outside, uncontrolled forces are too great.

]\Iy universe of acceptable investments has thus been curtailed; con-
versely, the risk of foreign investment in these companies, and con-
sequent export of their technology, has increased markedly.

The management instinct is to survive, and if the only avenue for
survival is control from outside the United States then that is the
avenue which will ultimately be followed.

The next part of my statement concerns what I consider to be the
heart of IBM — its component division.

By way of background : In 1912, in a small house in Palo Alto,
Calif., Lee do Forest and his associates started the electronic revolu-
tion by perfecting the vacuum tube as a sound amplifier and genera-
tor of electromagnetic waves.

In the 1950's, or 40 years after its invention, IB:M used vacuum
tubes to build its first computer, the 701. It was introduced in 1953.

The next major technological event occurred on December 23, 1947,
at Bell Telephone Laboratories. Three distinguished scientists who
later won the iS^obel Prize for their invention demonstrated the first
successful transistor. The inventore were Dr. John Barclcen, Dr. Wal-
ter Brattain and Dr. "William Shockley, and it is the latter who is the
father of the commercial semiconductor industi-v.

The original Shockley Transistor Coi-p., backed by Beckman Instru-
ments in 1955, is the direct antecedent of nearly 25 companies in the
San Francisco Bay Area.

Shockley Transistor never became the successful commercial ven-
ture which its founder envisioned, and was sold by Beckman to Cle-
vite, who sold it to I.T. & T., who was unable to sell it and finally shut
it down in 1968.

The eight young scientists who left Shockley and founded ^Fair-
child were responsible over the years from 1959 to let's say 1970 for
forming approximately 20 odd companies during that period of time.

They were able to gain financial backing from a variety of sources.

5400

They had no difficulty in doing so. The semiconductor industi-y is
now, and was during that time, a very responsible viable industry
growing on a strong technological base.

The transistor was still the dominant device type being built in the
early 1960'S, although technology was progressing to the point where
processes for other types of semiconductors were nearly perfected.
This is the primary reason for the number of spinoffs which occurred
during this period.

The most successful spinout from Fairchild is Intel, an aci'onym
for Integrated Electronics. Two of the original eight Fairchild
founders left Fairchild to pursue the MOS semiconductor memory
market, which they believed could shortly become price competitive
with ferrite memory cores.

Intel was founded in 1968 with backing from Arthur Rock, the
original backer of Max Palevsky of Scientific Data Systems. Five
years later in 1973, Intel had sales of $67 million and had successfully perfected the processing techniques necessaiy to make high-density MOS chips at low cost. The semiconductor industry debacle of 1970 dried up the stream of venture capital which had supported the startups, and there have not been any new companies formed in the past 3 years. Texas Instruments has spawned only a few new companies, the largest of which is Mostek. On the other hand, IBM Components Di- vision has spawned only two companies : Cogar, which went bankrupt about 2 years later; and Advanced Memory Systems, which is cur- rently ha\'ing rather severe problems. A third spinout. Semiconductor Electronic Memories, has yet to develop significant revenues. There is a schematic diagram in my prepared statement which shows the genealog}' of the industry since its inception in 1947. So, only three groups have left the IBM Components Division to strike out on their own, and none of them have been successful. The reason, as the following discussion will show, is that IBM's semi- conductor expertise lagged the industry until quite recently. Texas Instruments Avas one of the 12 original licensees of Bell Tele- phone Laboratories in 1952 and was in high volume production of germanium transistors in the mid-1950's. In 1954, TT announced the first silicon transistor which was available for certain military pro- grams in 1956. In 1958 at Texas Instruments, Jack Kilby invented the integrated circuit, and the first were commercially available in 1964. IBM'S first computer, the 701, used vacuum tubes, and that machine was produced until 1959. The 1401 was introduced in 1959 and used germanium transistors, although silicon transistors, which are faster, had l>een available since 1956. It is difficult to pinpoint the exact time when TB]\r decided to go into the comnonents business, but in 1954 research and develo]unent expen- ditures leaped 7 to 8 percent of sales from 3 percent the previous year. Since the computer had been introduced in 1953. nnd IBM was already i-)lanninff its next machine, the 1401, we can only assume, that man- agement set up an R. & D. facility in 1954 to mirsue the still relatively new transistor technology which was already in volume production on the outside. 5401 Altliougli silicon transistors were available IBM elected to remain with the germanium transistors which it was then producing in-house. li^M's largest outside suppliers were TI and Fairchild, but they were used as second sources to till gaps in IBM's internal supply lines. By 1960-61. IBM was in the early design stages of its 360 computer. The heart of this machine was the components. In spite of the fact that the integrated circuit had been invented at least 4 years earlier, and could easily have been in volume production at IBM and TI and probably Fairchild in 1963, IB^NI made the decision to use a hybrid circuit which it called solid logic technolog;\' — SLT- SLT was an early form of transistor-transistor-logic — TTI./ — and was ultimately extremely easy to produce. IBM's organization charts show just how critical these components were. The components divi- sion operated semiautonomously until 1963, when the entire division was suddenly pulled under the jurisdiction of Vincent Learson, where it remained until the end of 1966. IB^NI stayed with tlie SLT technology until the introduction of the 3T0"s in 1970, although the independent semiconductor companies had by then introduced many faster and denser devices. Was IBINI cautious or was it deliberately bringing the heart of its machines in-house ? Wc think the evidence shows that the latter answer is correct. If IBINI was being cautious it could have selected several of the semiconductor houses which were proliferating in the early 1960's as suppliers, thereby guaranteeing itself at least one second source. When IBM introduced the first 370 macliine in 1970, the circuitry used was another in-house design called monolithic systems technology. However, in 1965 Texas Instruments had introduced the most-success- ful logic family in the industry, TTL. And, by the time the 370 was introduced, large scale integration was readily available. The history of the devices used by IBM in the 370's is revealing. In June 1970 the 155 and the 165 were announced with core memory. In ]Marcli 1971 the 135 and 145 were announced with bipolar mem- ory, but in July 1971 the 195 was introduced wdth the older technology which was core. In August 1972 IB^I announced new versions of the 155 and 165 — (which had used core memory — the upgraded 158 and 168, which used INIOS memory. The last two of the 370 machines to be introduced, the 125 in October 1972 and the 115 in June 1973. both use MOS memory. Again, one might ask if IBM were merely being cautious, and the answer has to be negative. In 1970 when the first 370 was announced using core memoiy, sev- eral suppliers were already building MOS memories. In August 1972 IBM announced the upgraded versions of the 155 and 165, which were called the 158 and 168, using MOS memories. Meanwhile, the early purchases of the 155 and 165 with core mem- ories — and there are an estimated 2,000 installations of these machines with monthly rentals of$50,000 to $100,000— were offered the oppor- tunitv to upgrade their new but obsolete machines at a cost of about$300,000.

The history of the semiconductor industry introductions and IBM's
usage of electronic circuitry is shown in my prepared statement.

5402

ISTow that IBM has MOS technology perfected it is apparently gain-
ing a technological lead over the semiconductor industry for the first
time.

We know from papers delivered to professional meetings that IBINI
has the capability of buildmg a single 4- K — K is the engineering term
for thousand — MOS device, and that it lias had some limited success
with a 32-K MOS device on a single chip.

The other computer companies will not have this capability for a
significant period of time because their suppliers, the semiconductor
companies, must make a profit on the components which they produce,
and they caimot produce these chips profitably for some time.

In the semiconductor process the most critical factor in profitability
is yields, the number of good chips from a wafer, and the most critical
factor in good yields is good chip design.

At the present time the semiconductor industry is struggling to pro-
duce 4-K MOS parts in quantity, but it is unable to do so because of
very low yields, which in turn make the parts too expensive to be cost
competitive.

IBM does not have the same cost requirements as do the semicon-
ductor companies because its profits are derived at the system level
and the components do not necessarily have to be profitable items when
they are first used.

On the other hand the semiconductor companies cannot afford to
sell chips to the computer main-frame companies at a loss, even though
these chips might make their products more cost effective.

Quoting IBM— exhibit No. 115, page 43, from the IBM-Telex trial :

* * * The memory technology, phase 21, absorbs about 50 percent of each new
build cost, while the MST-2 lo^c cost accounts for another 25 percent. Both
technologies are cost sensitive to quantity variations and yield percentages. The
performances of East Fishkill, Burlington, and Endicott CPM are, therefore, as
vital to the financial success of the M135 as the effectiveness of Kingston in pro-
viding the power and the assembly and test functions. * * *

If, as IBM seems to suggest, 75 percent of new build cost is accounted
for by components, then the other computer main-framers are indeed
at a great disadvantage, but the reasons are far more complex than
just the cost of components.

IBINI is quite probably the most profitable semiconductor manufac-
turer, on an unallocated cost basis, because it does not produce a broad
line of circuits ; only those which it uses in its own products. Volume
is the key to profits in the components business, and IBJM clearly has
the longest production runs of any of the houses. What other house
can run the same product with no iterations 7 days a week for 2 or 3
years ?

IBM's research and development activities in the components are
also extremely effective because it can allocate all of its expenditures
to the improvement of technology for computing uses.

In 1973 IBINI S]:)ent $730 million on research and development. If 10 percent Avas spent in the components area, then$73 million was spent
on improving components for computer usage.

On the other hand the semiconductor inclustry spent a total of $150 million on research and development in its four major markets: Gov- ernment, consumer, industrial, and computers. If those dollars were al- located equally this would mean that 25 percent of the$150 million was

5403

spent on computing uses, or about $38 million, approximately half the amount spent by IBjNI. We suspect that IBM spent more than$73 million on components
since we have shown how critical they are to the computer business, and
I think that the figure was closer to $100 million, or three times the amount spent by the other semiconductor manufacturers for improv- ing computer products. These figures become even more distorted when one considers that the$38 million spent by the semiconductor industry for computing use
minicomputer manufacturers, and at least 100 other computer-related
customers.

IBM has a great advantage because when it begins the design process
on a new computer family, all of its needs are available in-house —
especially the components.

Perhaps more important than anything else is the absolute secrecy
which is maintained internally, because no outsiders need to be
involved.

As the above discussion shows, IBM is moving from a follower to a
leader in semiconductor technology, and the pace appears to be acceler-
ating so that IBM will clearly be at the forefront in semiconductors