1959 IRE TRANSACTIONS ON ENGINEERINIG MTANAGEMENTX 1

An Oscilloscopic View of the Electronic Industryby Investment Capital

CASPER M. BOWElItt

AiM genuinely pleased to have been asked to address publicized judgmiienlts of secturit.y aiialysts anid their fore-you on the provocative anid complex subject of how casts for future earnings, which contribute to the everinvestment analysts appraise the securities of the changing price level for corporate securities.

some 4,200 companies which comprise the electronic in- For these reasonis, later in the paper, I will offer todustry. In discussing the methods and tools used in se- electronic coiipany imanagemnenits some reporting proce-curity appraisal, I must present a broad panorama, and, dures wrhich may assist security analysts, stockholders,as an analyst, I must dwell on economics, politics, and, of and in fact, emiployees in evaluatinig a comipany's fiscal-course, managements. But in the final analysis, invest- year performiiance, the coinpaniy's place in the broadeningment conclusions-largely empirical-are constructed on spectrumi of military and commercial markets, and finally,the crosseurrents of human emotions; and, with a deep its sales and earnings forecast for the year ahead.bow to cybernetics, these emotions as yet cannot be fore- As a prologue to my subject, I consider it expedient tocast with any finite accuracy. discuss briefly and comment on:

Considering this, my paper at least will serve these 1) The security analyst's principal corporate measuringuseful purposes. tools, which colnsist of comparative operating ratios,It may help you appraise your present company or e p aperhaps some competitive company making an attrac-tive offer, and judging by the engineering ads in the 2) the methods of applying these yardsticks of coIrpo-Sunday newspapers, many tempting dishes are offered rate and management analysis to specific securityweekly. recommendations; and

It may assist you in sizing up a merger in which your 3) the fact thatcompany may be involved. These corporate marriages of m

convenence-pompte by thenedfopending as they do oIn the analyst's final summariza-conveniene-prompteddbyrthe nete forexpa work- tion of his data, part of which are statistics and parting capital and for the corporate team concept, whi1chcombines the specialized technical skills of several com- empirical, are far from an exact science. Therefore,

. > ~~~~~~finalJudgments are subjected to challenge by con-panies,-will probably occur with greater and greater fre- tmoar analysts.quency. I plan to discuss this point in more detail.And today, with well-intentioned but often not so sound The latter point was nleatly packaged by Edward 11.

investment advice coming from all quarters, it may con- Collins, the profound economic and business writer fortribute some small guidance in designing your investment The New York Times, who commented recently as follows.planning for your future financial independence. "But the mere possession of such an arnmory of sta-To managements attending this meeting, I trust this tistics carries no guaranty that the conclusions drawn

talk may enlighten you on the security analyst's unique therefrom will be valid ones, or that they will coincideproblems and responsibilities to both you and the public with the findings of other economic analysts."which stem from these appraisals. Collins' remarks which, in a sense, evaluate the anialyst'sThe electronic industry, within a relatively few years, evaluating tools, highlight the fact that whereas measur-

has sprouted from a single seed of generally understood ing tools used by other fields of industrial endeavor pro-basic technical terms and product lines into a plant struc- vide the investigator with the mneans to obtain concreteture whose branches in turn are generating seedlings for a and specific conclusions, those available to the corporatevariety of new sciences, new products, and abstruse nomen- security analysts are primarily vanes of direction -clature. And, we analysts, as nonscientists, must collect, nothing more.analyze, translate, and finaally evaluate, with ahigh degree And peering at investmlenlt philosophly thlroughl theof perspicacity, the expanding scientificehorizonand its as- public's eyes, the objectives of the average stockholdersociated technical terms in relation to a corporation's fu- when the chips arc down are capital appreciation andture earnings. And, management is one of the principal dividend income growth. 'these twin targets of capitalsources for this basic information. These functions are growrth and income are acutely sensitive to a spectrumcritical responsibilities. For it is the aggregate of the of forces cutting across the vagaries of economics, weather,

and human emotionls. In- no sense do they lend themselvesat Manmeeting ftrheeIiReE, N:eweYPork, N. Y.; oNevemlb9e5r20, 19g5n8. to any precise mnathenmlatica1l, physical, or chemlicall laws or

t Utilities and Industries Management Corp., New York, N. Y. formulas.

v IRE I'RA NSAC(7IION.. ON ENGINEERING MANAGEMENT' March

And now to our tool crib -the iiost frequently used than the present. And, during recession periods, the ratiostools for semiserious company investigation are price eart- decline-but more on this subject later.ings ratios, pre-tax net il-eonc e as a percentage to sales, Pre-tax net income, as a percentage to sales, is a verycurrent ratio which shows the extenit by which current as- important eomparative tool. It represents a company'ssets exceed current debt and book values. None of these net earnings after all of its expenses are paid, but beforeratios or percentages when applied to a single company is Federal income taxes. It permits us, therefore, to measure a

tnecessarily conclusive. Actually, to be effective, they must corporation's efficiency and compare the company's effi-be compared with the identical ratios of other competinig ciency rating with that of competitors.compalnies. In the case of corporate examiniations which In fact, were you to consider changing your position,nmay lead to the supply of new working capital or mergers, you might, as an additional guide but certainly not amaniy otheer initernial operating ratios are employed to assay final one, compare the present and past efficiency ratiosfiscal stability antd managerial efficiency. Rather tlhan dis- of your company with those of the company you plancUss each one--and many are niot germaane to this discus- to join.sion. -I prefer to examine only those of immediate interest. Bear in mind, however, that oftentimes a corporationMy first choice- and for what I consider to be good may have had some unusual or nonrecurring expenses

reason, havinig in mind public responsibility---is that of the durinig the year, or it may employ different accountingprice earnings ratio. I deliberately elect this one because methods for certain of its expenses. This would affect the

the present security price level for a majority of electronic efficieney ratio. A disputative example of the latter iscompaniy shares presents a most provokinig iiivestment that of eontinuous or single product research and de-eonunidrum, yet unresolved. Price earnings ratio is the velopmenit costs, which you are aware, are a heavy drainrelationship between the presenit security price level and on cash and oftentimes nloll-income prodtucing for years,currelnt as wvell as estimated near-term, earinzgs. if at all.

This ratio is an important broad spectrum ratio and Some companies follow the praetice of charging all ofatldways has beeni. Yet, one of yotur industry's corporate these expenses within the year in whieh they occur. Others,presidents, for example, suggests that this yardstick is niot on the advice of their acecountaints, or because of manage-presently applicable in evaluating electronic companies. ment policy or other considerations, may charge onily aHis words were: "I would like to refer again to the use of portion of these expenses withini the year and, in theprice earninigs ratio as a measurement of the souindness of language of the Certified Public Aecountait, they capital-inivestmelnt in electronie companies . .. Many finianeial ize or prorate the balance of these costs over a specifieanalyses from blue-chip investment and brokerage firms period of years. You can appreciate, therefore, that com-

recommenid to their clients to sell or buy electronic stocks panies, heavily involved in research and development ex-

on some arbitrary mathenmatical basis such as a price expenses for their owni conmmercial products anid the

earn-ings ratio. I know one or two electronic stocks that sequential costs for breadboard circuitry, product designare showilng no earninigs and a few that are priced at prototypes, packaging, pr(oductioni, marketing, and sellilngthirty times earniings, which as anl investment-and I do --all prerequisites for introducing new products -can re-

not meani short-termn speculation-are far better than a port substanitially differeint pre-tax net income, depenidinggrefat maniy others whose market price is onlly six, eight onl the accountilg practices employed.or ten times earnings . ." Our inivestigators, in checking final pre-tax niet inlcome.We shall see. Historically, investors pay a given, number therefore, examine a company's various operating expense

of dollars a share of stock for each one dollar of present componienits; make corporate comparisoins; check for uii-

or forecast earnings applicable to these shares. tsually. usual accounting treatmenit for reserves, taxes, research

the emphasis is oIn the future rather thani the present and developmrent charges; anid read carefully the CPA

earninlgs. These present or future figures are the basis certification of the company's quarterly and annual re-

for the price times earniings ratio. If investors believe a ports to stockholders; theni come up with comparativecompany will earn $1.00 a share for a giveni year, they pay pre-tax net.

ratios raniging from as low as $4.00 to as high as $30.00 a Net income or net earniiigs, of course, are those wvhichshare and sometimes even more for these $1.00 earninigs. remain after provisions for payment of federal income

We say, therefore, the present market price of a security taxes. And this remaining sum, divided by the number of

is at four or thirty times earnings. shares of comimon stock outstanding, provides the basis

The price earnlings ratio varies industry by industry, for "'earnings per share"---the variable yardstick for stock

TIhe shares of railroad, public utility, food, drug, and market appraisal.chemical companies, for examlple, all sell at different A company's current ratio, which indicates the relation-price earnings ratios, which also vary under the impact of ship between current assets anld current liabilities-hencechanging economic conditions. During prosperous times, working capital-is, of course, of critical importance,price earnings ratios tend to rise, reflecting investor cx- particularly for those companies heavily inlvolved inlpectations that nlext year's earnlings wvill be still higher governmwent contracts andl wXhichl may depend substanl-

1959 Bower: An Oscilloscopic View of the Electronic Industry byJ Ini.)estment Capital P)

tially on progress paymenits for salaries and materials and I have niow reviewed our basic tools. A.nd as you c.another current expenises. AIany electronic managements judge by my interjected remarks, not one is a basis forwere made painifully aware of this ratio, within the past absolute investment conviction. Debatable variables existyear, when the government decided to economize by in each, and final interpretation anid sequential companystretching out completion dates of contracts which slowed appraisal depend, as I remarked at the beginniing of thisup progress payments. This economy wave could again talk, on-i a combination of experience, observationi, anidengulf the Pentoagon under pressure of steeply rising costs deductive reasoning.of defense about which I will remark subsequently. So much for our tools, and now to the subject mnatterOur analysts cannot be satisfied alone with this ratio at hand which is the application of these tools to the

itself because the components of current assets must also eleetronie ilndustry. Your industry, as measured by itsbe diagnostically examined. Oftentimes, inventories in individual company equities, is today an arena of e(quityform of raw material, work in progress, and accounits re- value dispute, the likes of which have not been presentedceivable, particularly those due on governiment contracts, for years. Anid why: for a host of debatable reasons whichcomprise a sizeable portion of current assets. And, if I niowv plain to review.these items are unexpectedly slow in liquidation. the The present price earninlgs ratios of the majority ofcompany might be face to face wvith a shortage in cash to electronie company shares are from twenty to thirty timesmeet payroll aiid current bills outstanding. current or near-term earnings. Yet, the equities of lolng-Book values represent a company's total assets available established companies, with sizeable wvorking capital,

to the commoni stock after provision is made to pay all unbroken dividend records, seasoned managemenits, broaddebt and other prior claims. This figure is important for and established product lines sold to a diversified consumerserious investnment investigation, particularly if a merger market, anid with still further growth, may be bought atis in the makinig. Managements, in considering a consoli- price earniings ratios of fifteen to twenty times earninlgs.dation, must carefully examine each other's net tangible By contrast, a majority of the electronie companies areassets as well las earning power, in determining equitable heavily dependelt for their survival on nilitary contracts,exchange of shares. Of eourse technical skills of staff, the which when completed, are subject to profit renegotiation,most vital asset, unfortunately do not appear in any even though the net profit reported by the contractor afterform in the balance sheet. taxes may be only 4 per cent or 5 per cenit. Only a few

In your industry, mergers occur quite frequently and electronic companies are well-heeled with working capital,there are strong technical, financial, and economic under- and bidding oIn Government contracts withotut even thecurrents, which will accelerate the rate of these corporate assurance of winning one is expensive in engineering hours.combines. This offers a challenge to electronic company Many managements are relatively new anid in manymanagements and investment bankers to arrange cases are dominated by single entreniehed presidents whomergers-soundly conceived and properly financed. Oddly have become paper-richl oVelrlight because the publicenough, the role of the investment banker in last year's seems to believe the shares of these companiies, which inrash of mergers has been quite small. The majority of the past year have risen enormously, are keys to Fortcorporate weddings seemingly have been company inspired Knox.anid company executed. While this practice has proven The techniology of astronauties, astrophysics, inifrared,successful so far, I believe that as existing firms grow maser, Doppler, cryogenics, microwave, troposeatter,larger in terms of systems contracts and technical person- nuclear energy, cosmology, and others, is without doubtnel, the medium-sized firm must also seek to combine, mystifying to the investor and perhaps also to many inwhich makes it practically mandatory for the low firm on the field of electronics. While these are exciting in termsthe totem pole to scurry around for a partner or so. In of potenitial research, development, and perhaps pro-this climate, it would appear that impartial, seasoned duction contracts worthy of measurable profits, in themanagement advice anid financial guidance are absolute process of their completion, are they not likely to imposerequirements which will save more than one company, its finiancial and engineering strains on many an electronicstockholders, and employees from the grief of improper company?matchmaking. I read T'he New York 7'imes business opportunity see-But let us return to book values. Here too, is a problem tion each Sunday and thereby follow the engineering

because electronic companies have little in the way of net activities and contract awards of many electronic com-assets or book value. And again, an electronic executive panies. Firequently, I read of a company obtaining aconsiders book value appraisal another tool of dubious substantial research and development award, anld a weekvalue. He observed, in speaking of book values: "... But or so later, that same company runs a quarter- or a half-not one of those electronic companies lived up to expecta- page ad looking for engineerinlg skills to fulfill each tech-tions, even though each was selected on the basis of the nical level required of the contract. These ads statehighest book valule per share and the lowest price earnings applicants must have a minimum of two to five years ofratio . ."2 prior experienlce in these fields of science, mlany of wvhich are

4 IRE TRANSACTIONS ON ENGINEERING MANAGEMENT Mllarchstill inelloate or unexplored. Tlhlese ads, therefore, must be of Congress demonstrate the highest order of statesman-considered "iengineering talent raids." This poses several ship in meeting these issues."questions. For example, suppose the new contractor can- Comments on this explosive subject of defense expenidi-not obtain his minimunm of eniginieering skills to fulfill the tures vs sound economy continue to flow from the so-basic researlch and developmenlt essential to conitract com- called "well-informed sources." On September 12, onepletion? Or, what happens to the engineering team broken authoritive source says, "Washington attitude on De-up by key mneni weaned away by raidinig companies? These fense spending has taken a sharp turn which may sloware but two; and I am sure you can think of imany others. down military electronic procurement ...."Are these some of the basic reasons for the "inefficienicy" Another says, in reviewing next year's budget, "The

which seems to plague the industry and may also explain outcome will be new delays in getting advanced projectsGeneral E. R. Quesada's recenit remarks that the competi- under way, some reluctance to push R & D projects in1totive drive, anid I (uiote, ". . is now increasingly directed production and faster decision to wash out competingtoward drafting anid peddlinlg of gaudy sales proposals and projects."toward staying alive through getting development con- And one with an ominous note says, "As of now, theretracts for weapons, regardless of their ability or the ability is no intent to cutback existing weapon and developmentof the contractor to deliver what he promises"? projects. But the outlook for many projects-incltudingThe recenit -trend toward joint-ventuie or systemns con- some in electronics-for the future is dim."

cepts, which seemingly has the Departmenit of Defense On September 19, this editorial observation appeared inblessings, may lessen the opportunity for smaller electronic a leading electronic source: I quote: "Pentagon is startingcontractors to obtain their proportionate share of this the most critical appraisal of military production andyear's $40,000,000,000 defense budget. The joint-venture development to be made since the end of the Korean War.concept seemingly relieves the Department of Defense Goal of the Appraisal is Economy. It ties in with prepara-of having to deal with large numbers of prime and subcon- tion of the fiscal 1960 military budget to be submitted totractors, with the attendant headaches of coordinating Congress in January. At Stake is the Future of All MIajortheir activities. Thus, unless one is elected to a team getting Electronic Programs."worthwhile defense contracts, either research and Additional warnings with respect to government con-development or production may be difficult to come by. cern over the Gordian Knot of defense needs vs economyUppermost in the minds of some electronic manage- are found in further remarks of General E. R. Quesada,

ments, too, should be ani awareness that when Congress who observed: "Some present contractors are almost cer-convenes in January, 1959, some of our legislators, who in tain to disappear; others are apt to live in a most pre-the last session expressed their grave concern over the carious existence-others will prosper."mounting costs of defense, may possibly seek means to And on, The New York World-Telegram, and Sun ofcut back or rigidly control research and development ex- November 19, 1938, in a powerful editorial headedpenditures as well as production programs. For example, "Willful Waste and Woeful Want," called attention tothese may be straws in the wind. the forebodings of Rear Admiral John E. Clark, still in

I quote from First National City RanDk Monthly Letter the Navy but currently deputy director of the new Ad-(October, 1958), as follows: vanced Research Projects Agency of the Defense De-"On September 11, when the revised '59 budget esti- partment. Admiral Clark, as quoted by the Telegram, said:

mates were released the Administration revealed that it "The Army, Navy and Air Force are running hog wildwould freeze $1,170,000,000 in defense funds that Congress in their mad interservice rivalry for missiles . . . are wast-had voted above the President's requests. The decision ing personnel and hundreds of millions of dollars . .. willdoes not deny essential needs but courageously backs up lead us to bankruptcy if they continue the scramble forDefense Secretary Neil H. McElroy's contention that: new weapons. And, for good measure, the aircraft com-

'There is a point, however, beyond which gambling panies are major accomplices."huge sums on untried weapons would be foolhardy- The editorial continued: "Admiral Clark spoke at aboutwould, in fact, endanger the economic, and even the mili- the same time Defense Secretary McElroy conceded thattary, security of the country.' in missile development 'proliferation has gone beyondThe bank continues: "The next step the Pentagon wants what is wise.' The Defense Department's fact sheet shows

to take-anl even harder one-is to curtail or eliminate that the three services have in hand or on the way 46duplicate airplane and missile development and produc- different kinds of rockets and missiles. As one example-tion programs which have been tried and found wranting."' surface-to-surface missiles-the Army is listed for eight,

Or, Congressman Byrrnes of Wisconsin had this to the Navy for four, and the Air Force for seven."say on the matter of the rising costs of goversnment: The lVForld-Telegram and Sun conltinued: "Admiral

"...this fiscal situation is beyond the point w~here it can Clark's major complaint was that each service undertakesbe brushed off lightly. It is time, if this economy of ours, research and development on many separate types of newrif our whole political system is to sulrvive, that members weapons-hoping that one will work out. Given today's

1959 Bower: An Oscilloscopic View of the Electronic Industry by Investment Capital 5

costs, the Admiral critically noted, 'we can no longer This retrospection is not intended as a criticism-rather,afford the luxury of multiple approaches.' " it is submitted to emphasize the dangers inherent inThe newspaper concluded the editorial with its personal many young companies, and managements relatively

morale boost, probably having in mind other military inexperienced to the complexities of sudden corporateleaders who were dispatched to Gethsemane by daring to bigness. This ineptitude in fiscal management is notspeak out against profligateness. necessarily a disease limited to the newer electronic com-Each of the foregoing topics, and others I have not panies. One of the longer established companies with many

mentioned, is a detectable, feedback, hot-spot area of fine divisions, acquired rapidly in the past several years,possible corporate and industry financial trouble. Yet reported 1957 earnings of over $8,300,000 or $3.03 perfacing us here is the anomaly of investors willing to pay, share on its common stock. Yet, by June, 1958, or sixand obviously paying, higher and higher prices for esti- months later, its earnings shrunk to an almost vanishingmated future electronic earnings-which may not develop point of $180,000 or $0.16 per share.to the extent now enthusiastically believed-than they These are but two; there were many others. Of course,are for the surer future earnings of a broad range of estab- there are substantially more doing an excellent job forsished industrial companies less burdened with govern- the Department of Defense, their employees, and theirment interference or dependence and where corporate stockholders. Concerning the latter, I must point out thatefficiency policies, measured by earnings and dividend historically, the shares of young growth companies sell atpayout, are in the hands of seasoned professional man- price earnings ratios which bear little or no relationshipagement. to actual or near-term earnings-a reflection of the pub-The obvious question is: What is the basis for this lic's willingness to bet on the future in any form. Sooner

irrelevancy? Is the public paying these premium prices or later, however, the public's appetite or enthusiasm isbecause beguiled by the aura of mystery of new sciences watered down by earnings results which do not measureand terminology, they are abandoning basic and estab- up to anticipated totals. Or the period of actual earningslished investment principles? is deferred from year to year by unexpected "nonre-

Or, are these pristine sciences actually opening the curring" expenses or other unforeseen events. And manydoor for substantial near and longer-term earnings which temporary investors fatigue quite easily if the marketmay minimize any threats from the eco-political factors price for these chosen shares fails to maintain the speedybriefly touched on? ascent which prompted their purchases in the first place.

Or, stimulated by imaginative newspaper and maga- Seasoned investors, on the other hand, usually shyzine feature articles and electronic managemeent state- away from many "growth" company equities until man-ments of unlimited business horizons, are security analysts agement has demonstrated its capabilities to cope withthemselves becoming infected with a virus of electronic the stresses of sudden prosperity and adversity. Undereuphoria, thereby tossing caution and historic rules of the weight of these depressing forces, "growth shares"evaluation to the winds? Let me explain this last point. tend to drift downward and begin to establish price earn-Some officials of electronic companies in public state- ings ratio patterns more in keeping with the business

ments have obviously been too optimistic about their characteristics of the industry. For example, finance com-present or anticipated government business which may pany shares may sell at ten to twelve times earnings;consist largely of low profit margin research and develop- chemicals, twenty-five times; rails, ten times; utilities,ment contracts with only modest production. fifteen times; steels, ten to twelve times, etc. Each industryTwo examples come to mind; one electronic company ratio reflects years of investor experiences with the earnings

executive, in February, 1957, said that his company which sensitivity of individual industries to periods of good andhad sales of $29,400,000 for its 1956 fiscal period would bad business.chalk up $40,000,000 for the 1957 fiscal year. He also Not to be overlooked either as potent factors in alteringanticipated company sales would climb to $100,000,000 the historic pattern of price earnings ratios are the impactby 1960. Here is how this company actually performed. of technological, style, or evolutionary strides within eachFor 1957, sales were $38.000,000 vs $40,000,000 forecast; industry which may strike powerful blows at its survivaland for 1958, sales rose only slightly to $39,800,000, far or boost its growth enormously. We certainly do not lackshort of the annual increment previously anticipated. This for case histories. The railroads have lost passenger busi-executive also presaged that his company's 1957 earnings ness to the air lines and turnpikes, less than carload lotper share would probably exceed the $1.36 reported in freight to trucks, and now small but significant amounts1956 and that an annual increase could be expected for to the air lines. And railroad shares were once consideredseveral years. Actual earnings for 1957 were $0.16 per blue-chip investments. The movie shares used to enjoyshare vs the better than $1.36 predicted; and for fiscal high regard and along camwe television with the result1958, the company lost approximately $946,000. Now, and that theater attendance dropped from an annual ninetyonly after major managerial shifts, the company is back million to forty to forty-five million. Fabric firms are stillon the profits road again. suffering from the lonzg-wvearing life of man-made fabrics

6 IRE TRANSACTIONS ON ENGINEERING MANAGEMENT March

and the style informality of sweaters and skirts against the pany can possibly have. We have seen company afteronce rigid formality of women anid girls waearing onlly company grow to a certain point and then stagger anddresses to business and school. fall back . ." Now compare this with the observation ofFor the electronic industry, it is still too early to say another electronic company presidenit: "Besides assumino

whether its price earnings ratio wvill settle down to fifteen, the responsibility of president and general manager, Itweenty, twenty-five, or thirty times. Were the Government personallv direct the company's over-all engineering pro-to decide to establish a type of surtax on defense produc- gram. We expect that some day one of our own engineerstion in order to help pay for mounting defense appropria- will naturally develop into this position."tions, or conceive other types of profit restrictions designed Here are two views, as irreconcilable as the naorthespecially for defenise contractors, a sharp decline would and south poles, and yet we analysts are face to faceoccur in this pattern of price earnings ratios. Another pos- wvith it in trying to determine which in your industrysible price-depressing factor would be that of governmenit is the sounder investment view. I leave the matter of"economy scares" accompanied bv contract stretch-outs, management evaluation now and turn to the next topicslowed down progress payments, and research and develop- which, I believe, contributes substantially to the public'sment (R & D) profit limitations, and still others which current enthusiasm for electronic shares. This is the tick-legislators can conceive if it becomes politically popular lish subject of R & D.to tax defense industries in face of mounting tax burdens. I have noted in the past year or so that many electronic

If investors come to believe these forces will hanig over companies have been calling attention to the amoun:tthe electronic industry like Damocles' sword, it would be of their Pt & D expenditures in relation to sales. This isconceivable, and in fact, most likely that electronic shares borrowinig a leaf from the book of the highly successfulwould sell at perhaps fifteen to twventy times present or pharmaceuticals, drugs, and chemical companies whichnear-term earnings-a considerable drop from present over the course of many years have spent vast sums ofinflated investor regard. We analysts, as you can see, their ow-n funds for research. In fact, about $0.08 out oftherefore, must separate the wheat from the chaff and our eveery chiemical sales dollar is reinvested in research. Bu-tevaluating tools are, without question, extremely useful here is where the comparison ends. These companies sellyardsticks, despite the implications to the conitrary. But domestically to a broad market of 175,000,000 people. notevery competent analyst will quickly agree that they are including foreign consumption; wthereas in the instance ofnot final measurements. They might be considered barom- electronic companies, the Government is the largest singleeters of management performance, which leads to the politically fickle customer, taking some 55 per cent of alldelicate subject of management and its evaluation. electronic production.A corporation legally is a paper entity. But its life, its R & D expenditures seemingly point to many new pro-

growth, its strength, its diseases, and even its death are ducts and in time lots of profits. But many people arethe images and actions of men-an appraisal often over- uniawvare of the trials and tribulations of research thelooked. Thus, the luster of its health or the depth of its real costs, the failures, the time consumed between thesicknless depends on the men or women who control and breadboard, the prototype, and the production model, anldoperate this paper entity. To investment analysts, man- finallv the acid test of marketing. Very few people areagement appraisal is by far one of the most important aware of these problems, indeed, because failures are skele-yardsticks, and under ordinary conditions is difficult to tonls in a closet and managements are not too keen tomeasure. Top electronic executives represent a phalanx reveal these factors to their stockholders.of new forces in management. Many are scientists and MNlanagement views differ widely on methods to evaluateskilled enginieers and temperamental a characteristic of the efficiency and productivity of their R & D progranms.the profession. But few possess the balanced managerial Last year, for example, the Massachusetts Institute oftraining necessary to cope tactfully with the singular Techniology conducted a survey to ascertain how con-organizational and personnel problems inherent in elec- companies, seriously concerned with their R & D ex-tronic companies. Thus electronic management appraisal penditures, evaluated these efforts. Some twenty-nineseemingly calls for a set of additional measurement stand- companiies replied to MIT's questionnaire, and the re-ards. This viewpoint finds support in the contradiction of sults, while not necessarily all inclusive, were quite re-the analyst's management evaluation tools by two lead- vealing. For example, nineteen companies related R & Ding electronic executives. to sales volume or revenues; twenty-eight, to the timue

Onle key official of an electronlic company, inl placing anld cost of the technical solution; seventeen, to the effecthimself in the role of a securities analyst of electronic on sav-ings inmaterials, labor and other costs; and thirteencompanies, commented on mzanagemuent s importanlce as related it to the effect on profits. Conlsidering this surveyfollows: "Evren more hazardous as anl investment is a wvas conducted by a competent inastitute, it certainlly dloescompany whose success is dependent upon, or wrhich reveal that mlanagements disagree wTidely on methods tois dominated by one or two or three individuals. The evaluate the increasing sums w-hich must be spent an:-indispensable man is the greatest w^eakness that a com- nuallIy onl this vital activity. These different management

19,59 Bower: An Oscilloscopic View of the Electronic Industry by Investment Capital 7

approaches to R & D studies should also serve as a warn- With respect to past R & D expenditures and forwarding buzzer that unless definitive controls of some sort are budget planning, rather than suggest procedures for dis-exercised, R & D could readily affect a company's earn- closure, I offer instead for management consideration ainlgs adversely and even its financial stability. number of specific questions. If these are answered withA recent example involving a publicly-owned electronic frankness to the degree permitted by competition and

company will suffice to drive this point home. I quote Government security regulations, they would contributefrom a semi-annual report just released. "The first half substantially to a thorough investment appraisal.losses of $85,000 compared to earnings of $222,389 for the Here they are, as applied to Government R & D.same period of 1957 were attributed to " 'writing off in- What percentage of the past year's R & D expenditurescreased engineering costs due to a build-up in research was for Government account? What percentage was com-a-nd development.'" pany financed? What are these percentages for the currentFrom the various points referred to, electronic R & D year's budgeted expenditures?

expenditures, both Government paid-for and company- What percentage of government contracts is cost plussponsored, obviously should become a high priority in fixed fee (cpff)? What percentage is fixed price? What aremianiagement consideration and investment appraisal. the percentage fees for each category?

I have now concluded a diagnostic appraisal of your Do any contracts contain incentive fees coupled withinduLstry as developed by one investment analyst. Criti- penalties? This is important for companies engaged almostcism is a cheap commodity particularly for the bleacher exclusively with government. For example, one companyexpert who does not have to solve these problems dav in recently obtained a $23,000,000 cpff contract which pro-and day out. As a doctor once remarked in speaking of vides for fees ranging from 5 per cent-7 per cent of esti-physical pain, you cannot understand it unless you have mated cost. Target cost has been set at $22,000,000 andexperienced it. But we analysts too have our problems, as I target fee at 6 per cent-or $1,300,000. Therefore, ap-haye frequently remarked. Our objectives and responsi- proximately $0.20 of each dollar of actual cost belowbilities are to advise our clients as realistically as possible target will be added to the fee. But $0.20 could be sub-as to the future earnings of companies. Thus, gentlemen, stracted from the $1,300,000 fee for each dollar by whichto achieve this target for our mutual good, we must enlist the target cost is exceeded. Maximum and minimumyour support and cooperation. And to this end, I am limits have been set at $1,500,000-$1,100,000-or aoutlining several areas of corporate operational data difference in net earnings before taxes of $400,000 through-which, if described by management along the suggested out the life of the contracts, which was inot revealed. As islines, may create light where darkness now exists. apparent, it is mandatory also to know the target date for

Mly first suggestion deals with a glossary of technical contract completion.terms. Every industry, as it develops and grows, creates Do the R & D contracts provide for any production?its- own personalized dictionary which in due time be- If so, what is the estimated volume?comies a workable vocabulary to stockholders and even Do any of these R & D contracts niow in progress havethe public. But scarcely aliy industry can hold a candle to foreseeable commercial use or application? If so, whatelectronics for the constant outpouring of complex and does your marketing research department if you have one,mystifying language. Even electronic text book publishiers estimate these to be in terms of sales.find it difficult to keep pace to avoid technological obso- Questions I pose to explore and evaluate commerciallescence in this grand sweep of kaleidoscopic advances. R & D expenditures would be these:How then can the investment analyst, lacking basic Are R & D expenditures budgeted and tied, as a per-

enigineering knowledge, truly comprehend or properly centage, to past year's sales and present year's sales fore-evaluate the significance of these developments if the cast, or are they single product allocations?terms are obscure and management makes little or no What fiscal or management reporting procedures areeffort to clarify these subjects. No doubt, it is difficult to employed to assay the productivity of your R & Dferret out mental word pictures or other common denomi- groups?nators of understanding for many of the newer scientific What interim controls, if any, are established to regu-niomenclature and yet, in my judgment, a determined late actual expended project engineering hours, targeteffort should and must be made. This would be of in- progress, and allocated funds to the initial target hours,calctulable value to research analysts and investors alike. rate of progress and futnds allotted for each project?And to those who argue it cannot be done, or who have WVhat new products have been brought to the market

not vet considered this bridge of mutual understanding, within the past or present year attributable to R & DI respectfully call your attention to the fine effort of outlays?Fairchild Camera and Instrument Corporation, which in WVhat amounlt of sailes volumze has been developed byits 1957 annual report to stockiholders, included a glossary- these newx products?of technical terms in simnple lay language to describe the And finally, have yourI R & D efforts directed at cuttingcomnpany's products andl fields of endeavor, production costs for your existing product linle-as for

8 IRE TRANSACTIONS ON ENGINEERING MANAGEMIENT March

example, simplified operational controls, miniaturization produetion. and sales of products without adequate knowl-of components, and improved internal and external de- edge as to whether the sales price, predicated on pro-sign and packaging-permitted you to maintain or even duction costs and necessary profit margins, could orincrease your share of the market by list price adjustment would sell sufficient volume to justify the initial andwithout profit margin pelnalty? continuing investment in the product. And with myriadWere managements to provide answers to these probes, new components and products presumably competitive

the analyst would then be fortified with a clearer knowl- with existing lines emerging from the many hundreds ofedge of the productivity of these critical R & D expendi- electronic companies annually, knowledge of a company'stures. A limited number of companies have already taken marketing policies ranks high in investigatory procedures.steps in this particular direction by distinguishing between Marketing and technical research go hand in hand.the government- and company-spolnsored research ex- MIanagement policies dealing with these two functionalpenditures. Just recently for example, Varian Associates operations should be presented to stockholders and po-said; "It had spent approximately $1,000,000 for com- tential investors in the clearest fashion possible. Supportpany sponsored research and development in the 1958 for mutual collaboration between company managementsfiscal year. This was about 6 to 6.25 per cent of Varian sales." and security analysts comes from a prominent electronicResearch and engineering outlays not sponsored by Varian executive who said, in speaking of the analysts functions,were approximately $4,000,000-$4,500,000. and I quote: "Security analysts must be company ana-

Marketing research, without which a company's for- lysts. They must search out the answer to such questionsward sales planning would be severely handicapped, is as: What is the market potential for the company's newanother relatively lnew corporate activity and significant products? What is the nature and quality of the com-area of investigation for the investment analyst, particu- pany's research effort? And where wvill it lead them?"larly for electronic companies. It should be ascertained We analysts do not shirk from the task of the searchingwhether the subject company maintains its own market- out processes suggested to us by this executive. But man-ing research staff, employs independent firms, utilizes a agements must also cooperate.combinationi of both or, as many companies do, relies on The answers to these and other questions posed herethe advice of its sales staff or field representatives. should bring reason out of uncertainty, and if this isMany firms have beeni knoown to plunge into R & D, achieved, then this paper has been of mutual beniefit.

Research and Development Cost Estimation*VERNON L. LAMBERTt AND HUBERT F. SACKETTt

Summary-Four companies engaged in research and develop- INTRODUCTIONment were interviewed relative to their method of cost prediction.Company A, engaged in military equipment development, uses a r[ HIS report records the research which has beencomplex operating organization to make estimates. Company B, l conducted in conjunction with the Research inengaged in commercial development, uses a summary unit cost, Business course offered by Xavier University. Fol-i.e., number or predicted man years multiplied by a given number lowing the recommendations of the Department of Busi-of dollars. Company C, commercial research and development, esti- l mmendations ofte.earmnoB usimates on the basis of individual projects but holds department ness Administration, the tOpiC chosen is one which is ofmanagers accountable only for total department costs. Company interest to the company employing the writers. BothD, government research and development, uses the future operating writers are engineers employed by the Crosley Divisionstructure as does Company A, but seems to use a less complex Of the AVCO Mvanufacturing Corporation. The topic isstructure. A further investigation into the use of Summary unit one which was suggested by the Director of Product De-

costs isrecommended. ~~~~~velopfihen-t Engineering at Crosley.

* Mauscipteceved y te PEM, oveber , 158.One of the greatest uncertainties facing a company en-t Crosley Div., AVCO MIanufacturing Corp., Cincinnati., Ohio. gaged in engineering research and development iS the