“the influence of electronics is certain to be felt during the next decade, either directly or indirectly, by virtually every element of our national economy.”
“changes in the requirements in order to have the most advanced possible military force-in-being have brought about a shift in the character of procurement. Electronics is to be increasingly more important in the defense weapons of the future.”
“Many products which are not considered related to electronics today will feel the impact of the science in the future. Some industries may see the whole character of their products change, while others, of course, will be much less affected.”1
In 1957, Litton’s founder felt the winds of change swirling. As top-down institutional procurement departments renewed their investment locus, Charles Thornton’s company was perfectly positioned to benefit.
Working capital close to tripled. Earnings rose nearly 80%. The backlog almost doubled.
This was the year Henry Singleton was promoted to Director of the Electronics Equipments Division at Litton. Did his competence show in the numbers?
Charles “Tex” Thornton’s Operational Highlights:
1957 Sales: $28,130,603
1956 Sales: $14,920,050
1957 Earnings $1,806,492
1956 Earnings $1,019,703
1957 Earnings per share $1.51
1956 Earnings per share $0.97
1957 Net Working Capital $6,731,956
1956 Net Working Capital $2,655,003
1957 Backlog $54,000,000
1956 Backlog $35,000,000
1957 Employees 2,700
1956 Employees 2,000
1957 Shareholders 4,500
1956 Shareholders 3,000
Calibrated Innovation
A point I’ve alluded to before … studying Teledyne and Litton reminds us that innovation, economic profits, and growth are achievable simultaneously.
These case studies challenge the overly simplistic notion of the value-growth investing spectrum wherein there exists the implicit assumption that companies can either prioritize profits today or tomorrow but not both.
“Value” investors might pose such a question:
How is it possible for a company to capture economic profits in technology when there is a diminishing marginal cost of reproduction (cheaper for competitors to imitate you), an incentive to disseminate products as widely as possible (more competitors can imitate through first principles), and constant change (difficult to forecast)?
Well … not all technology exhibits the second tenet of that question, as Charles Thornton showed us in 1957.
Even though products can be broadly applicable to many markets…
“The company’s 1957 catalog of transformer products lists over 75 models new to the company. Most of these new products have application in both military and commercial markets.”2
…monopolies can still exist:
“At mid-year, a new item of equipment of Litton Industries design, for which the company is the principal source, was put into production for still another of the nation’s important guided missiles.”3
In the twenty-first century, a lot of noise is made about raising outside capital, delaying gratification for decades, and the aggressive pursuit of market share at the sacrifice of present profits (for more in the future). Intuitively, if one understands compounding, such a strategy appears rational.
But for anyone with significant skin in the game, such an approach seems ludicrous. Howard Marks citing the story of the 6ft man crossing a river that is 5ft deep on average springs to mind. A tenet of capitalism is ownership. Other People’s Money destroys the crux of what makes capital, as a force for progress, work, if one does not act as though it is their own.
What if there was another way?
I think Singleton and Thornton present an interesting model of profitable innovation. Value investors shun aggressive sales growth without a demonstrable increase in value-per-share for long-term equity holders. And rightly so. Henry and Charles, who were both known to never sell their shares, aggressively reinvested in new products and processes whilst capturing the economic benefits of doing so.
In the early days, both Teledyne and Litton grew sequentially.
“The company’s increased proprietary research and engineering activities, expanded plant capacity and facilities, and the addition of highly-qualified personnel give promise of realization of our growth plans - growth not just for growth’s sake, but the logical sequel to the establishment of a broad and strong company.”4
There seems to be a “logic” of the corporation’s growth: it wasn’t by any means necessary. Instead, areas of research, experimentation, and iteration were selectively chosen. This is distinct from the immediate MVP, move fast and break things, iterate and adapt philosophy that tends to characterize ideas about young technology companies today.
Inside-Out
In 1957, novel color cathodes inside communications systems resulted in various potential applications for display technology and integrated systems:
“A unique color cathode ray tube having outstanding potential in numerous industrial and military applications, the new tube makes possible display of radar information on the radar screen in more than one color, at the election of the operator, giving an added and most important dimension to radar viewing.”5
A very obvious break from the past. Radar displays could present distinct elements or objects in such a way that made them visible to the radar operator that the items on the screen were different, e.g. friendly vessel vs enemy pilot.
Great minds go inside their subject matter. How do qualitative investors go inside the companies they study?
At the heart of innovation and excellence in every walk of life lies human creativity. In the same way that human decisions are the fundamental building blocks of markets, individual humans are the fundamental building blocks of exceptional companies.
Even when Charles is explaining a step-change in Litton’s product offering, look at what he says produced that:
“In our inertial guidance activity, the feasibility of utilizing two-degrees-of-freedom gyros in inertial guidance systems was positively demonstrated by the company this year. For some years Litton Industries scientists have pioneered this revolutionary concept. Proof of its feasibility now makes possible inertial guidance systems more accurate, lighter in weight, and cheaper in cost than other inertial systems previously developed in the industry.”6
People are essential to not only pioneering new products but also enabling the market adoption of new products via effective sales organizations. Investors are often enamoured by new products or services and unintentionally disregard what is more difficult to see. It’s human nature. Peter Thiel felt that the centrality of the sales function to a technology company’s success was often overlooked or underestimated by markets and investors.7 Thiel’s contrarian supposition fits with the emphases of Litton’s early annual reports:
“During the year, a new and expanded organization for the sale of the company’s precision components was established. More than 20% of our component sales came from products which were new this year.”8
That was 1957. Look at the Triad acquisition announcement in 1956:
“The addition of Triad’s outstanding and nationally known line of electronic transformers, wave filters, and other magnetic component products, represented throughout the country by 387 jobbers, distributors, and representatives - one of the most extensive sales organizations in our industry - will make a major contribution to our progress in the future.”9
Bottom-Up Analyst of Top-Down Decisions?
“Changes in the requirements in order to have the most advanced possible military force-in-being have brought about a shift in the character of procurement. Electronics is to be increasingly more important in the defense weapons of the future.”10
At the end of the 1950s, as Thornton alluded to, the U.S. Department of Defense redirected its spending. Initially, there was investment in the Air Force before funding trickled down to other areas of the military. A primary focus was electronics.
The cynic might say that government spending sounds a lot like macroeconomics - why would a bottom-up analyst be interested in markets governed by exogenous economic forces outside of the investor’s control?
Granted such funding is interrelated to government fiscal and monetary policy.
“The Secretary of the Air Force has recently indicated that by 1960 Air Force purchases of advanced electronic equipment and systems will have increased to approximately $1.3 billion a year as compared to 1956 purchases which totalled $756 million.”11
That is just under double in four years. Using the Rule of 72 implies (roughly) a 20% CAGR in institutional investment into military systems in the late 1950s. Not as high as one might expect given the extraordinary performance of Litton in 1957 which saw its earnings per share increase by 59.34%.
So we have the government spending more on electronics. What else contributed to Litton’s exceptional business performance?
The pattern of Henry Singleton’s early acquisitions at Teledyne revealed the extent to which holistic technological systems can be redefined and improved by replacing the underlying electronic components. That’s what your author terms combinatorial fructification.
Are some levels of technology more impactful than others?
Brian Arthur argues that technology has a recursive structure.12 At each level of the technology, you see a combination of other technologies below and above it. It’s a little abstract so let’s use an example to clear this up.
Charles Thornton gives us a perfect one here:
“Included in missile procurement will be navigation, guidance, computing and control, instrumentation, and other equipment of the types developed and produced by Litton Industries.”13
On the surface, we see missiles. Underneath, families of different technologies co-exist and interrelate like telemetry, transducers, and potentiometers to name just three.
The point is not that each technology is identical or even its relationship to other technologies is identical at every level but that its structural form is self-similar from the inside out.
It seems logical to conclude that new, improved technology at the most fundamental level of broader integrated systems would result in the largest second-order improvements in the broader, holistic technological systems.
Petered Plans?
Singleton’s preference for flexible strategies and his distaste for plans is well known.
There is a clear distinction between Singleton’s philosophy (expressed in the 1980s) and Litton’s actions in the 1950s. Take a look at this from Litton’s 1957 Litton Report:
“The progress of an electronics company must be measured by its capability to envision future markets and opportunities, realistically plan and implement those plans, and accomplish the longer range objective of being a strong company recognised as a leader in a major industry - an industrial citizen that adds strength to national defense and to our national economy.”14
Singleton and Thornton practiced opposite strategies. One could look at the long-term performance of Litton vs Teledyne and conclude flexibility is the “best” approach. But concluding that one is better than the other with no context is futile.
Notice that Singleton made his comment in the 1980s whereas Charles Thornton was writing in the late 1950s.
If we rely upon the memory of George Roberts then we may believe that Henry also kept things flexible in the early acquisitive 1960s. That message rings loud and clear in George’s memoir Distant Force.
Don’t forget, though, that George Roberts joined Teledyne in 1966, with the acquisition of Vasco Metals (oops…spoiler!). How can someone remember what a company was like before they joined?
Who Cares?
There is a similarity in formatting that both Teledyne and Litton use. Both report four key operational metrics in graphical form. Perhaps this was the corporate flair of the day … equivalent to overpriced repurchases of stock in the 21st century.
Forgive my facetiousness.
Litton presented the following:
Sales
Earnings
Stockholders’ Equity
Gross Assets
Whereas Singleton presented these stats, in 1963:
Sales
Net Earnings
Working Capital
Shareholders’ Equity
The order of the presentation and specific items are similar but also slightly different. What could you infer about the reason behind that?
In contrast, a point of commonality is that both Litton and Teledyne displayed their key operating statistics from the inception of the company to the present day. Which companies in today’s market do that?
On Laboratories: Geographical Dancing
“In cooperation with the Air Force Office of Scientific Research, the company has developed a unique research facility for the study of physical phenomena in an environment which simulates the conditions of ultra-high altitudes - altitudes currently far beyond the access of manned aircraft.”15
Whereas earlier we focussed on the intangible asset of high-quality people, here we see differentiation in Litton’s tangible assets.
“The Laboratory will facilitate research activity in the development of equipment that will operate in outer space. It is the only such laboratory existent in the free world.”16
“We attach significant importance to the extensive fund of basic scientific knowledge which the company has and will acquire in the operation of this facility. The culmination of over three years of effort, the continued success of the laboratory is destined to further enhance the company’s reputation in this new field.”17
Notice again the importance of reputation.
Buffett prioritizes his reputation above almost everything. This is evident in his behavior. It’s a key theme in his investment style too, after his philosophical transition away from Ben Graham.
Litton’s focus on reputation was visible in a quote we discussed earlier too:
“The progress of an electronics company must be measured by its capability to envision future markets and opportunities, realistically plan and implement those plans, and accomplish the longer range objective of being a strong company recognised as a leader in a major industry - an industrial citizen that adds strength to national defense and to our national economy.”18
An idea from David Senra that I picked up by listening to Episode #110 of Founders is that founders are teachers. They teach their philosophy.
Again, we see Litton reiterating its plans for plant facilities and emphasising how this will benefit the company:
“Construction was begun on the first building of a new three-unit plant in Salt Lake City and plans are also being finalized for building a major addition to the new plant in San Carlos, California, for the Electron Tube Division. The capacity of this projected plant will be double the capacity of the division’s new plant completed and occupied in the fall of 1956.”19
The theme of combinatorial fructification can also be applied to physical locations and assets. By substituting and combining facilities that originated from different companies, the conglomeration is more productive, efficient, and valuable than the sum of the parts in isolation.
Teledyne used the strategy of combinatorial fructification in its early days. Did Henry learn that at Litton?
“Utrad, with a product line of pulse transformers complementary to that of Triad, also serves as an eastern manufacturing and distribution facility for certain of Triad’s product items.”
Here is the 1+1=3 effect. Though a theme of Teledyne was decentralization with empowered leaders at each level of the company, in the early days of Litton and Teledyne, centralization played an important role:
“The manufacture of our precision potentiometer line was centralized in one location in the East, and was expanded during the year. In the face of highly competitive market, continued highest quality production resulted in sales of this line being almost triple last year.”
Subsidiaries:
Here is a list of every wholly-owned Litton Industries companies in 1957 (I wish Teledyne did this):
Litton Industries of California
Litton Industries of Maryland, Inc.
Triad Transformer Corporation
U.S. Engineering Co., Inc.
USECO, Incorporated
Utrad Corporation
The Automatic Seriograph Corporation
Majority Owned
West Coast Electronics Co. (99% of common & 85% of the preferred stock).
Earlier we touched on the emphasis Thornton placed on the sales organization of Triad in his announcement to shareholders.
It’s interesting to note a point of departure in the way Singleton and Thornton introduced their significant acquisitions. Litton describes what Triad excelled in at the time, and why it led the market:
“One of the nation’s leading producers of electronic transformers reactors, toroid coils, electronic wave filters and related products in wide use today in such advanced electronic equipment as guided missiles, commercial airline weather detection radar, communications systems, military fire control equipment, electronic computers, high fidelity sound systems, and precision electronic instruments. Triad also is one of the industry’s foremost firms in the design and manufacture of miniature and sub-miniature transformers for use with transistors.”20
Contrast that with Singleton’s description of how UED came into being and why it was at the forefront of a given market. As discussed in the Teledyne Inc. Annual Report 1964 write-up, Singleton was an assiduous history student. That’s clear to see in his introduction of UED in 1964:
“In 1956 UED made the first application of solid state circuitry to airborne telemetry in the Sergeant missile program, and since that time has been a leader in advancing the technology of airborne telemetry.”21
Of course, Singleton didn’t always present acquisitions like this. So the critique that your author is cherry-picking examples to justify his argument may well be valid.
The rebuttal is that both UED and Triad were important acquisitions made four years after Singleton and Thornton founded their electronic conglomerates. Both were large and important to the company’s operations at the time. In Singleton’s earliest annual reports, he introduced key acquisitions that moved the needle in a similar way to Thornton. Simple. Straight to the point. Focussed on current operations.
But as both companies grew and made selective acquisitions their presentations to shareholders seemed to diverge.
Jim Nisbet’s 12th Question:
12. How is depreciation counted and is it a significant % of profit?22
Litton detailed their use of the Straight Line and Declining Balance methods in the notes of their 1957 Annual Report. (Such disclosure by a defense company in the mid-twentieth century was rare).
The straight-line method is recognized by most investors. This is simply taking the difference between the purchase price of an asset and its estimated terminal value over a certain number of years and decreasing the carrying value of the asset on the balance sheet by an equal amount each year.
The declining balance method front loads the decrease in an asset's carrying value. Think linear vs exponential decay. It also reduces the entire value of the asset down to zero whereas the straight-line method reduces the carrying value of the asset to a defined terminal value.
With the high rate of asset obsolescence in technology, it is logical to use the declining balance method to calculate depreciation. But without knowing companies use(d) that method for certain, it would be very dangerous to assume so.
In 1957, Litton’s depreciation charge was $694,000 against an operating profit of $3,530,739 and long-term assets (less accumulated D&A) of $5,338,231.
Therefore, Jim Nisbet looking at this company would focus on the 19.66% of operating profit charged as depreciation.
In isolation, that statistic means little. What is the ratio of declining balance to straight-line depreciation? I don’t know.
How does it compare to industry peers? This is where things get tricky.
Let’s look at Teledyne’s first public annual report.
In 1961, the total value at cost of Teledyne’s long-term assets was $1,049,586. They were carried at a net value of $649,766.
You need to remove the construction in progress figure of 65,332 because how can you depreciate physical assets that don’t exist (talk about intangible…
maybe they should be amortized ;)).
Assuming the leasehold improvements have taken place on finance leases, whereby the assets accrue to the lessee at the end of the contract, then we have a total cost of assets to be depreciated of 984,254 vs net long-term assets of 584,434.
That gives what appears to be a depreciation charge of 399,820 in 1961 alone. That figure over the 984,254 assets implies a 40.62% depreciation rate (if the straight-line method is used) which suggests an estimated life of ~2.5 years. Wow.
Teledyne’s EBIT was $144,795 in 1961! A depreciation charge of $399,820 over $144,795, i.e. depreciating more than double operating profit. Not quite.
Teledyne acquired assets from companies that had accumulated depreciation from years before 1961 so what looks like a double-operating-profit depreciation charge doesn’t measure depreciation charged in 1961 alone but many years beforehand too.
Teledyne did not reveal in its notes which depreciation method it used.
You could try to figure out depreciation from first principles. This might work by looking at the change in accumulated depreciation over several years.
However, you run into difficulties because of the additional acquisitions that occur year after year at Teledyne. More accumulated depreciation, less clarity on the annual depreciation charge.
The lesson then is that sleuthing beyond corporate reports, at least in the 1950s and 1960s, was critical to understanding financial statements. With this particular example of depreciation methods, it is much simpler for investors today because companies (in developed markets) are legally required to share their depreciation and amortization methods in the prelude to the financial statement’s notes.
The great thing about studying Singleton closely is that he said so little but produced so much. This is true of not only his bold statements to the press but also the brevity of his company’s financial reporting.
Dear Intelligent Investor, thank you for reading.
All emphasis added is my own.
If you enjoyed this week’s article, I’d appreciate you sharing it.
3 Things I’ve Enjoyed this Week:
Charles Thornton, Litton Industries, Annual Report 1957. pp. 4-5.
Litton (1957), pg. 20.
Litton (1957), pg. 18.
Litton (1957), pg. 2.
Litton (1957), pg. 8.
Litton (1957), pg. 16.
Peter Thiel with Blake Masters, Zero to One (2014), pg. 21, and pp. 126-130.
Litton (1957), pg. 20.
Charles Thornton, Litton Industries, Annual Report 1956, pg. 6.
Litton (1957), pg. 4.
Litton (1957), pg. 4.
Brian Arthur, The Nature Technology: What It Is and How It Evolves (2009), pp. 37-43.
Litton (1957), pg. 4.
Litton (1957), pg. 5.
Litton (1957), pg. 12.
Litton (1957), pg. 13.
Litton (1957), pg. 12.
Litton (1957), pg. 5.
Litton (1957), pg. 10.
Litton (1956), pg. 8.
Henry Singleton, Teledyne Inc. Annual Report 1964, pg. 12.
James Nisbet, The Entrepreneur (1976), pg. 148-149.
This is excellent! Out of curiosity where did you track down the report?