He Did It!

The Conference Board Review^® Article

He Did It!

100 years ago, J.P. Morgan created the monolith named U.S. Steel. It was supposed to take over the m

By Peter Krass

When the formidable J. Pierpont Morgan beckoned, it was extremely difficult to resist. As Charles M. Schwab, president of the Carnegie Co., considered Morgan's invitation to a clandestine meeting in New York, he felt compelled to attend, against his better judgment. He had already declined one invitation and was extremely uncomfortable about accepting this latest overture, especially since his boss, Andrew Carnegie, was not to know of it. Sensing Schwab's ambivalence, Morgan's suave messenger, John "Bet-a-Million" Gates, known as a dangerous speculator who once bet a million dollars on a single hand of poker and who now held a few key cards in the game of steel, suggested an accidental meeting on neutral ground at the Hotel Bellevue in Philadelphia. The topic for discussion: a steel company on a grander scale than any previous enterprise.

While an oblivious 65-year-old Carnegie, with his trim Santa Claus beard and sparkling blue eyes, went about his business in early January 1901, Schwab finally relented and took the train to Philadelphia. Upon arrival at the Bellevue, Schwab learned that Morgan was ill, and, subsequently, he was instructed to come to New York later in the week for dinner with the banker. Matters were already becoming complicated, but he agreed. After dinner, the two returned to Morgan's lavish mansion at 219 Madison Ave. Upon entering Morgan's mahogany-paneled library, Schwab found himself face-to-face with Morgan's partner Robert Bacon.

The meeting, which set in motion a series of events that would rock American industry, shock the public, and make headlines around the world, lasted until 3 a.m. The conspirators plotted the consolidation of the steel industry, a strategy that hinged on forcing out the undisputed king of steel, Carnegie. Finally, as dawn broke, Morgan, with piercing eyes set behind a bulbous nose, asked Schwab the key question: "Would Carnegie sell?" Schwab did not know, but somehow he would find out.

Timed Takeover

The business environment was ripe for mergers in the 1890s. As John Moody, founder of Moody Investment Services, said in 1915: "Between the years 1890 and 1900, combinations in industry were as thick as leaves in Vallambrosa." After the completion of the transcontinental railroad in 1869, a national market was born, new industries evolved, new companies mushroomed, and it was only a matter of time before consolidation took place, resulting in a merger boom in the 1890s. In a period that became known as the "Era of Finance Capitalism," Morgan played a key role in consolidating the railroad industry and organizing General Electric, a merger that included Thomas Edison's electric companies, among others. Other industries, from chewing gum to barbed wire, followed suit.

Just as rapidly changing technology acts as a catalyst for mergers today, so it did in the 1890s. In the steel industry, advanced blast furnaces and complex, integrated production facilities required huge sums of capital, so firms merged to either acquire the technology or to become big enough to buy it. The mid-1890s depression made the need for stability through consolidation all the more critical, especially in steel, where steel rails were $23 a ton one day and two days later just $15. Then, as the depression waned, another crucial factor came into play-a bull market on Wall Street. (Sound familiar?) Yes, prosperity had returned by 1898, the markets were booming, and even clerks and secretaries were buying stocks. There were great expectations.

The time was ripe for investment bankers to shake the trees. In surveying the steel industry, Morgan discovered a fragmented landscape that still suffered from severe price fluctuations and destructive price wars, and was extremely susceptible to economic downturns. Morgan, who did not agree with Carnegie's dictum of survival of the fittest, sought profits in controlled order. Convinced that stabilized steel prices would yield great profits in both good and bad times, he created three mergers in 1898. First, he organized the Federal Steel Co. by bringing together the Illinois Steel Co., the Lorain Steel Co., the Minnesota Iron Co., and Elgin, Joliet and Eastern Railway. To assist, Morgan recruited Elbert H. Gary, a former county judge from Illinois who looked like a Methodist bishop and who also happened to be general counsel of the Illinois Steel Co. For his efforts, Morgan made Gary president of the new concern. Gary and Morgan then created National Tube and American Bridge, consolidations of 14 and 25 companies, respectively.

Others quickly followed Morgan's lead-it was the standard follow-the-leader merger pattern that has not dissipated in 100 years. Gates consolidated companies in the finished-steel market to create the American Steel and Wire Co. Two other big players were William and James Moore, who had promoted trusts in the biscuit, match, and chewing-gum industries. Now they consolidated a number of iron and steel concerns to create the American Tin Plate Co., the National Steel Co., the American Steel Hoop Co., and the American Sheet Steel Co. Some of the new consolidations with vertical coordination were less reliant on Carnegie's raw steel, resulting in lost orders for the king. More potent, both Morgan's Federal Steel and Gates' Steel and Wire laid plans to extend into the raw-materials market, directly challenging Carnegie.

Torn between business and his determination to dedicate the remainder of his life to philanthropy, in the late 1890s Carnegie vacillated between wanting to dominate the steel industry and wanting to sell out. Twice he came close to selling, including to the Moore brothers, but both times the buyer's financing was too weak. The only man capable of buying him out, he knew, was Morgan. But now Morgan was laying plans to compete with him. It would not do. In retaliation, Carnegie threatened to enter the finished-products sector, to wipe out Morgan and Gates and the rest of the competition by duplicating their establishments. To attack National Tube with a frontal assault, Carnegie bought 5,000 acres in Conneaut, Ohio, to build a tube mill. To repel American Steel and Wire, he announced plans to build a state-of-the-art rod mill in Pittsburgh. To flank the Morgan-controlled Pennsylvania Railroad, he hired surveyors to determine a route from Pittsburgh to the East Coast, and he ordered a new fleet of ore carriers for the Great Lakes.

Now he had Morgan's attention; the financier despondently declared, "Carnegie is going to demoralize railroads just as he demoralized steel." It was survival of the fittest in its purest form, and a shaken Morgan realized he had few options to thwart Carnegie's might. But then an angel of sorts appeared, in the form of Charles Schwab.

"Steeling" an Industry

On Dec. 12, 1900, two close Carnegie friends hosted a dinner to which Morgan was invited. Schwab was assigned to speak about the glorious future of steel, of a grand integrated company able to compete globally. Although a plain-looking, broad-shouldered, workingman's man, Schwab was an eloquent orator, said to be able to "talk the legs off the proverbial brass pot," and he won an admirer in Morgan. Several weeks later, the covert meeting took place, and it was agreed to see if Carnegie would sell.

But now Schwab was in a tight spot: How should he approach Carnegie without appearing to have been involved in some underhanded, traitorous activity? Schwab knew Louise Carnegie was anxious for her husband to retire, so he turned to her. Louise suggested that Schwab join Andy for a round of golf. It would put the steel titan, who found golf so relaxing and medicinal he called it "Dr. Golf," in a good mood, and losing to Andy would help, too. After the wintry round, while lunching, Schwab recounted his conversations with Morgan. Rather than castigating Schwab, Carnegie said he'd have to think it over and that Schwab should call on him the next morning-perhaps that dinner at which Schwab and Morgan met was not a matter of coincidence.

When Schwab arrived the next morning, Carnegie handed him a sheet of ordinary notepaper; a set of figures amounting to Carnegie's asking price of $480 million was scribbled on it. The only other request: Carnegie wanted his and his family's share to be in 5 percent gold bonds. Schwab took the notepaper to Morgan, who simply said, "I accept this price." The deal was done without lawyers and without a written contract. A few days later, Morgan rode to Carnegie's home to shake on the agreement and declared, "Mr. Carnegie, I want to congratulate you on being the richest man in the world." Once Carnegie was on board, the other targeted companies were quickly brought into the fold.

Whispers of an industrial consolidation on a scale never before imagined hit the newspapers in mid-January 1901. The next month, J.P. Morgan confirmed his intention to unite a number of steel and iron companies, including the powerful Carnegie Co., under one financial corporation. On Feb. 27 that year, The Wall Street Journal correctly disclosed: "A study of the figures indicated that the combination, from the standpoint of Federal Steel and National Tube, had been defensive rather than offensive." While it was defensive, there were other strategic reasons for the merger, reasons that continue to ring through corporate hallways today, regardless of the industry. The creation of U.S. Steel was to achieve greater economies of scale, reduce transportation and resource costs, expand product lines, and improve distribution. Additionally, it would eliminate overcapacity, provide capital to take advantage of changing technology, and allow the United States to compete globally with Britain and Germany.

U.S. Steel's size, Schwab and the others so emphatically claimed, would allow the company to pursue distant international markets-globalization, a popular catchword 100 years later and a prominent force in today's merger mania.

Critics screamed "MONOPOLY!"-one looking to dominate not just steel but the construction of bridges, ships, railroad cars and rails, wire, nails, and a host of other products. Fueled by speculation in the media, the Lilliputian public feared the behemoth might deliberately cause financial panics and engage in price-gouging.

The public had reason to fear its size. Consider that at the time of U.S. Steel's inauguration on April 1, 1901, its capital amounted to 7 percent of the nation's GNP (today that translates to an astounding $650 billion). In addition, the company employed in its 170 subsidiaries more people than were living in Maryland or Nebraska at the time. It owned or controlled about 150 steel plants producing more steel than all of Great Britain or Germany, 115 steamships on the Great Lakes, six sizable railroad lines and several smaller ones, 80 percent of the quality iron ore found at the head of Lake Superior, over 75,000 acres of coal land, 18,309 coke-ovens, and 98,000 acres of leased natural-gas lands, among other tangible assets. In one fell swoop, Morgan had captured two-thirds of the steel market, and Schwab was confident the company would soon own 75 percent of the total market-a prophecy that would prove difficult to fulfill.

An editorial in the April 1901 Cosmopolitan made a more objective appraisal of what U.S. Steel meant to the world: "[T]he entire aspect of the business and political world will be changed. . . . It is a revolution so radical in its sweep, so wide in the area affected, that in comparison the most important movements of history become insignificant. . . . Because this new organism is in the direction of perfected economies, there will be no return to the old system."

Metal Madness

The capital of the new company was set at $1.1 billion in common and preferred stock and $304 million in bonds, bringing the grand total to over $1.4 billion-the first billion-dollar company. The billion-dollar question: Would the formation of U.S. Steel become the greatest bloodless revolution from which mankind would benefit, or would it be remembered as the greatest fleecing of stockholders? Analysts and stockholders who felt like they were sold out made accusations of overcapitalization and a watered stock. Such accusations were not new-high expectations for future growth during the bull market of 1898 to 1900 had led to the overcapitalization of many companies. Rising markets throughout history have resulted in wild premiums, be it with steel or e-commerce. Indeed, in 1911 the Bureau of Corporations set U.S. Steel's 1901 tangible assets at $682,053,385, which, assuming the agency was reasonably accurate, left more than $700 million chalked up to intangibles.

When trading commenced in April, preferred shares opened at $84, common at $39. Morgan had hired market riggers to boost U.S. Steel's price, and, within a month, preferred stock was trading at $101 and common at $55, giving Morgan and his banking syndicate a chance to reap quick profits. But in 1902, the common high was just under $47. By 1903 the 4 percent dividends were being cut, then eliminated, and in 1904 the common stock crashed below $10. The company's market share of iron and steel fared no better. In 1901 the company controlled about 66 percent of all iron and steel output; in 1906 the share declined to 58 percent, and in 1910 it was down to 54 percent. By 1920, U.S. Steel's market share was half of what it was in 1901 and in the 1930s, just one-third. The company never came close to achieving Schwab's dream of 75 percent market share.

So what went wrong? Certainly, the end of the railroad boom contributed to U.S. Steel's troubles, but other markets for steel-such as automobiles, boats, airplanes, and skyscrapers-opened in the early 20th century. Also, management had worked at achieving economies of scale. Certain divisions of the constituent steel companies were merged, as were certain sales departments to set output and prices and avoid cross-selling. All international business was combined in one office based in London. Patents and secret processes became available to all, and R&D costs were shared. A premium was put on intellectual capital and information sharing, and Schwab called the company a "clearing house for information." Stenographers were present at meetings, and minutes were disseminated throughout the organization. A network of telegraph lines connected every operation.

Although Schwab, Gary, and Morgan talked a good game and great effort went into post-merger integration, the rewards expected from these economies of scale were never realized. To begin with, the organization was just too unwieldy, and there were cultural conflicts, allowing other steel companies to eat into its market share. The biggest issue, however, was the premiums paid for the constituent companies and the resulting overcapitalization that, from day one, made it impossible for U.S. Steel to give its shareholders a decent return. The inability to realize cost efficiencies and cultural conflict doomed the company-causes for failure that still haunt CEOs 100 years later.

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