Sources of Value in the Formation of U

Merger for Monopoly: The Formation of the United Sates Steel Corporation

Merger for Monopoly:

The Formation of the United States Steel Corporation

Preliminary and not for quotation.

Charles Reback

Clemson University

Clemson, SC 29634

July 10, 2005

The author would like to thank Mike Maloney, Skip Sauer, Matt Lindsey and the participants in Clemson’s Doctoral Dissertation Seminar, the participants of the Southern Economics Association annual meeting in November 2001 in Tampa, and the participants of the Southwestern Economics Association Annual Meeting in March 2001 in Fort Worth. All of the errors are those of the author.

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Merger for Monopoly: The Formation of the United Sates Steel Corporation

I.Introduction

In 1901 the United States Steel Corporation (US Steel) became the first billion-dollar corporation in the United States, controlling 60% of the nation’s primary steel capacity. It represented the culmination of the first great merger wave and the height of J. P. Morgan’s influence over the American economy. US Steel was capitalized at $1.4 billion, at a time when the total capitalization of American manufacturing was $9 billion. This $1.4 billion was larger than the national debt and over three times the size of the federal budget.

It has been well established by Parsons and Ray (1973), McCraw and Reinhardt (1989), Mullin, Mullin and Mullin (1995) and others that in the early part of the twentieth century US Steel exerted market power over the steel industry. However, the question remains whether it was formed with the expectation that it would become a monopolist. This is the first paper since Stigler (1968) to specifically address this issue and I find evidence to support the contention that US Steel was formed with the expectation that it would exert pricing power in the steel industry.

Thee are three potential reasons for the formation of US Steel:

• Swindle the public
• Monopoly
• Efficiency

The swindle hypothesis posited that US Steel was formed in order to sell overpriced securities to an unsuspecting public. Contemporary accounts emphasize US Steel’s $1.4 billion capitalization compared with the $700 million capitalization of its component firms. Stigler (1968) reports that A. S. Dewing (1941) made the most influential statement on this hypothesis in the 4th edition of his Financial Policy of Corporations. Dewing compares the merger movement to a “virus,” continuing

…It was the harvest-time of promoters… During 1900 and 1901, the movement continued, but the new promotions were fewer in number, owing to the fact that most of the opportunities for the formation of ‘trusts’ had already been fully exploited by bankers and promoters. Accordingly, the ground was combed over again. The trusts themselves were consolidated. A pyramid was built of pyramids. The United States Steel Corporation, capitalized at over 1300 millions of dollars, was built up out of half a dozen smaller ‘trusts,’ themselves, in several cases, the combination of smaller combinations. By 1902 signs were apparent that many of the trusts had not justified the predictions of their promoters.[1]

This write up from $700 million to $1.4 billion in capitalization was used as a “classic example of watered stock” in finance texts.[2],[3] Under this hypothesis, there was no business or economic reason for the steel firms to consolidate. The sole purpose of the consolidation was to sell overpriced stock to an unsuspecting public.

Stigler (1968) advocated the second hypothesis, monopoly, postulating that US Steel was “…formed for the monopoly power that it achieved.”[4] Under this hypothesis, US Steel became the dominant firm in the American steel industry and was able to increase its profits by reducing output and raising prices. Parsons and Ray (1973) and Mullin, Mullin and Mullin (1995) confirm Stigler’s conclusions that US Steel was a monopolist but shed little light on the reasons behind its formation.

Burton (1985) advocated the efficiency hypothesis in an unpublished dissertation. However, he did not reject the possibility that US Steel was more efficient and a monopoly.

In theory, each of these hypotheses has its own testable implications and can be disproved through an event study. This paper attempts to resolve the issue of why US Steel was formed by examining the stock price reactions of several constituencies to the US Steel consolidation. I conclude that US Steel was formed in order to dominate the primary steel market.

The results invalidate the swindle hypothesis. Most of the wealth increase resulting from the consolidation accrued to the stockholders of the component and competitor steel companies, not to the organizers and promoters of US Steel. My empirical results are consistent with the monopoly hypothesis, although do not allow for a complete rejection of the efficiency hypothesis. The stock prices of the component firms reacted positively to the formation, as did the stock prices of US Steel’s future competitors. These are the results predicted by Stigler’s Dominant Firm model. The securities of the customer firms exhibited no statistically significant reactions.

Also, my findings that there was no insider trading prior to the announcement of the formation of US Steel are consistent with Banerjee and Eckard’s (2001) conclusion that insider trading was no more prevalent during the mergers of the First Great Merger Wave (1897-1903) than it is in the modern era. However, my conclusion that US Steel was formed for market power reasons contradicts their earlier (1998) conclusion that mergers during the First Great Merger Wave were mainly a result of firms’ desires for increases in efficiency. While one this one case study cannot refute their study of a large number of mergers, it does suggest that their results may merit a closer look.

II.Theory

The formation of US Steel seems to be an ideal candidate for an event study, an examination of the reactions of securities to new information. Given the assumption that markets react rationally and that prices incorporate new information rapidly, then any change in value that cannot be explained by changes in overall market conditions reflects new information. It should be possible to answer the question of why US Steel was formed by examining the stock price reactions of the various US Steel constituencies. I place the firms to be analyzed into four portfolios: components, competitors, non-railroad customers, and railroad customers. The components, as the name implies, are those companies who comprised US Steel. The competitors are companies engaged in primary steel production, not finished goods, which did not become part of US Steel.[5] The non-railroad customers are steel companies that produced finished goods who, likewise, did not become part of US Steel. The railroad customers are a sampling of some of the leading railroads of the day. At the time, railroads were the largest consumers of steel, and steel was a significant portion of their costs.

Under the first hypothesis, the merger will have no impact on any firms that compete with or are customers of the US Steel component firms. With no economic basis for the merger, the component firms’ expected future cash flows do not change. Since there is no change in the economic fundamentals of the component firms, then the economic fundamentals of competitors and customers will not change. With no change in the underlying economic characteristics of any of the firms, there is no new information conveyed and there should be no stock price reaction to the announcement of the consolidation. This hypothesis is almost laughable but should be formally discussed. To think that J.P. Morgan or any other party could offer a security at a price exceeding its value assumes investor irrationality, questions the entire underpinnings of modern financial theory, and invalidates the entire literature of event studies.

If the second hypothesis, monopoly, is correct, then the consolidation will affect other firms. The component firms become part of a dominant firm that can set prices and quantity in order to generate higher profits. As fringe firms, the competitors can free ride on US Steel’s pricing power and earn abnormal profits. In fact, these firms should be more profitable than US Steel, since they do not have to enforce the restrictions on industry output. Therefore, under the second hypothesis both the component firms and the competitor firms will exhibit positive reactions to the announcement of the consolidation, with the competitors having larger positive abnormal returns than the US Steel component firms since the consolidation would benefit the competitive fringe more than the dominant US Steel. Customers of a monopolistic industry will be negatively impacted since their input costs will rise. Therefore, the customers’ stock price will decline.

If the third hypothesis, efficiency, is correct then the announcement of the consolidation should also affect firms other than those directly involved in the merger. The component firms will be part of a more efficient entity, with reduced costs and increased profits. However, the competitor firms will be hurt by having to face a more efficient US Steel. So, under the efficiency hypothesis, the component firms should react positively and the competitor firms should react negatively. The efficiency hypothesis also prescribes a positive reaction by the customer firms. A more efficient US Steel will lower steel prices and its customers will benefit by having lower input prices for their goods. These effects of these three hypotheses are summarized in Table 1.

I should emphasize that the efficiency and monopoly hypotheses are not mutually exclusive. There is no reason that US Steel could not have been formed in order to become a more efficient monopolist.

III.Previous Analyses

Stigler (1968) rejected Dewing’s hypothesis by examining ex post returns on the common stock of US Steel and several other steel firms. He found that US Steel outperformed the other steel firms by a wide margin from 1901-1924. From this he concludes that the organizers of US Steel did not exploit the stockholders, and that US Steel was formed to exploit monopoly powers. Stigler did not explicitly consider the possibility that US Steel was a more efficient firm but was not a monopoly. It would have been more appropriate had Stigler examined the ex ante reactions of the firms in order to judge their expectations of future profits given this change in the market structure of the steel industry. By examining the stock returns over a long period of time, Stigler implicitly addressed the issue of what US Steel became rather than why was it formed.

Parsons and Ray (1975) found that the formation of US Steel created a non-competitive market and allowed the industry to capture monopoly profits. However, unlike Stigler, they explicitly reject the efficiency argument, basing their conclusions on an examination of the structure of the steel market in the years following the consolidation. They find evidence of increases in American steel prices relative to world prices and price discrimination in exports of American steel, and conclude that US Steel had monopolistic power. Again, whether or not these facts were true after the fact, were these conditions expected at the time of the consolidation?

Burton (1985) also examined post-merger performance of the companies and concurred with Stigler that the merger did not exploit the stockholders. However, Burton rejects Stigler’s dominant firm model in the case of US Steel. He concludes that US Steel formed a more efficient firm, but was not necessarily a monopoly. He based this conclusion on his discovery that while stock prices of US Steel components rose, the stock prices of competitors fell. If US Steel had been a monopoly, the competitive fringe firms would be more profitable than US Steel. Burton concluded that the impetus for the consolidation was efficiency, and that US Steel was a more efficient firm. Examining post-merger trends and activities of US Steel and of the steel industry, he found that US Steel was more profitable than its competitors, and in the contractions of 1904, 1908, and 1911, US Steel’s market share declined by less than its competitors. These observations are consistent with efficiency but not with Stigler’s dominant firm model. However, Burton could not completely discount some degree of monopolization. [Why?] Unlike this study Burton found that the stock prices of the competitor firms reacted negatively to the announcement of the consolidation. However, Burton did not perform a traditional event study, but examined the change in stock prices over a multi-year period. Information regarding the effect of US Steel on the structure of the steel market could have been lost amid other economic changes during that period.

Mullin, Mullin and Mullin (1995) examined stock price reactions to the US Steel dissolution suit, which was active from 1911-1920. In some ways, their paper is the mirror image of this one. In United States v. U.S. Steel, the federal government sued US Steel for being a monopoly in violation of antitrust laws. They examine stock price reactions of various constituencies, and based on those constituencies’ reactions to the progress and setbacks of the suit, conclude that US Steel was a monopoly, and that if US Steel had been dissolved, steel prices would have declined and output increased. Had US Steel simply been a more efficient competitor then a dissolution of this more-efficient firm would have led to higher prices and lower output. Uniquely, their analysis utilizes the stock price reactions of railroads, which were major consumers of steel, and for whom steel costs were a significant cost component. At the time of the suit, the railroads operated under a regulated rate regime and could not pass increased costs onto customers. The railroads reacted positively to progress in the suit and negatively to setbacks in the suit.

IV.Background and the Merger

At the turn of the century, the steel industry could be categorized into two broad groups. Some firms (“primary goods producers”) produced primary products such as steel bars and pig iron. The most important of these firms were Carnegie Steel, Federal Steel, National Steel, and Republic Steel and Iron. Other firms (“finished goods producers”) purchased these primary goods in order to produce finished products such as plate, wire nails, tubes, rails, hoops, etc. Many of these finished goods producers were the result of horizontal mergers beginning in the later 1890’s resulting in monopolies in their narrow niches.[6] While most firms specialized in one of these areas, some firms spanned both the primary and finished goods markets. In the summer of 1900, a slump in profits caused the finished goods firms to consider vertically integrating backwards; and the primary goods firms, most notably Carnegie, began to consider vertically integrating forward [Connaught Mill]. J.P. Morgan, who controlled some of the finished goods firms, along with Federal Steel, the second largest primary steel manufacturer, was not happy about this alteration in the balance of power. Morgan did not believe in unbridled competition, preferring cartel or monopoly behavior with him at the center.

In 1898, J. P. Morgan and Elbert Gary formed Federal Steel, which by 1900 was the second largest steel company in the United States, behind only Carnegie Steel. Carnegie Steel began to integrate vertically and Andrew Carnegie’s plans included competing with National Tube, another Morgan company. Despising competition, Morgan berated Carnegie “as someone who would ‘demoralize’ the industry with price cuts rather than do the smart, gentlemanly thing: join a cartel.”[7]

On December 12, 1900 Morgan attended a dinner at Manhattan’s University Club honoring Charles Schwab, Andrew Carnegie’s chief lieutenant, who was also the principal speaker.[8] Schwab presented a vision of a steel industry dominated by a vertically integrated firm that would effectively eliminate competition. Supposedly, Morgan was completely enthralled, so much so that he forgot to light his cigar.[9] Schwab may have been speaking on behalf of Carnegie, but to this day it is uncertain whether he was operating with Carnegie or behind his back.

Morgan and Schwab immediately began working on the consolidation that would become US Steel. The combination included Carnegie Steel and the Morgan controlled firms of Federal Steel and National Tube, along with National Steel, American Steel and Wire, American Sheet Steel, American Hoop Steel, American Tinplate, and American Bridge Company. See table 2 for listing and description of these firms. On February 1, 1901 rumors of a gigantic combination in the steel industry began appearing in newspapers, and by April 4, 1901 the combination was essentially complete. Most of the firms were acquired in stock swaps with US Steel, although Carnegie, who would have no management role in the new firm, exchanged his holdings in Carnegie Steel for $300 million in US Steel bonds. [Expand this discussion for publication]

V.Data and Analytical Procedures

The age of the event and the lack of regulation in the economy and securities markets present some interesting challenges to the modern researcher. Disclosure and insider trading rules were nonexistent. Disclosure was neither full nor immediate. This creates a potential problem in conducting an event study, since there may not be a clearly defined announcement date. Furthermore, announcements were confounded by rumors and possibly by deliberate misinformation. In the case of US Steel, although rumors of a “gigantic” combination in the steel industry first appeared in newspapers on February 1, 1901, it was not until the end of that month that the general public knew the form of the merger, the companies involved, the exchange ratios, and whether any premium over market would in fact be paid.