Max Holland

If there’s a category of books that many people find boring, those on the management of manufacturing would rate among the worst, along with guides on better book-keeping.  Burgmaster was an American machine tool manufacturer based in Gardena, a Los Angeles suburb.  The author of its story was Max Holland, a journalist, whose father had worked at Burgmaster for nearly thirty years.  Holland is better known for his books on politics and especially the Kennedy assassination.   His book on Burgmaster, ‘When the Machine Stopped: a Cautionary Tale from Industrial America’, was published by Harvard Business School Press in 1989, and republished in the same year by Beard Books as ‘From Industry to Alchemy:  Burgmaster, a Machine Tool Company’.  Copies are hard to find, possibly as it appears such an uninteresting topic.  Almost forgotten, yet I consider it an important and revealing study, indeed I would argue it should be an essential book for anyone interested in management, business, and the fate of companies.  What follows is its story in four acts.  It is a salutary account, showing the impact of acquisitions, moving production offshore, and leveraged buyouts.  Perhaps it is best described as a morality play, or even a horror story!  This summary of the sorry saga draws extensively on extracts from articles by Max Holland.

Burgmaster was founded in 1944 by a Czech immigrant, Fred Burg.  Over twenty years it became known as an innovative manufacturer of turret-type drilling and milling machines.  In fact, it rapidly became the largest American machine-tool builder in the US West.   Despite successful growth, by the middle of the 1960s it was beginning to face some problems, the result of increasing competition.  One issue was turnover.  While Burgmaster had a modern and well-run factory in Pasadena, trained staff were constantly being poached by other companies, offering them higher wages.  Turnover was annoying, but company was able to replace staff with new apprentices:  they could manage.

The second problem was more serious.  In recent years, the market had begun to change, and instead of fixed equipment, more and more businesses were wanting what were described as tool changing systems, or ‘machining centers’.  These were machines where the cutting was controlled through punched cards, allowing the cutting tools and workpiece to be realigned, several times if necessary, without an operator having to stop the process and manually shift parts for each different operation.  The process was known as NC machining, NC an abbreviation for ‘Numerically Controlled’.  Most manufacturers today would laugh at a system based on running punched tape to align the device, as now sophisticated computer controlled (CNC) systems are used, ones which are both very flexible, and far more easily adjusted, but back in the early 1960s NC machines were starting to have a major impact.

Despite this, Burgmaster was only changing very slowly.  Its ‘turret drills’ were still their major sales item, and the NC systems other manufacturers had begun developing back in the mid-1950s were still not being introduce into its work.  As a result, from being an industry leader Burgmaster was slipping behind.  Rather than trying to gloss over the limitations of their products, which they called ‘Centers’, it was clear they had to adapt to a changing market.  In other words, Burgmaster had to have a tool changer, and time was against them.  While this was becoming pressing, in 1965 the company became the object of a friendly takeover by a conglomerate, the Houdaille Industries group, based in Buffalo, New York.

A year later Houdaille’s CEO, Gerald Saltarelli, asked Alan Folger to replace Tom Norton, who was the then president of Burgmaster.  Folger was told, “Burgmaster is not generating a sufficient return on its assets.” Houdaille was among the most profitable machine-tool builders: the group averaged a 14-16% return on investment, but Burgmaster’s contribution was about 8-10%.   Saltarelli knew Wall Street regarded the profits/equity measure as the best indicator of corporate performance, rather than net income, and it was seen as key to Wall Street’s assessment of Houdaille’s price-to-earnings ratio, a ratio that was the driving factor in Saltarelli’s plans to boost the price of Houdaille stock and acquire more businesses.

A clear plan, but most of Alan Folger’s years of experience in machine tools had been in marketing.  Saltarelli believed Burgmaster’s principal problem was marketing, which was why he wanted to draw on Folger’s marketing expertise, leaving the plant manager to look after production and technical issues.  This was a major change.  In place of a thoroughly integrated operation now the company was divided.  Folger as president was in only nominal control of the entire operation, with someone else responsible to run the entire manufacturing end of the business.  This situation satisfied Folger because it relieved him of immediate responsibility for almost everything but Burgmaster’s numbers.  He was not a ‘people person’.  Holland notes, “To nearly everyone who worked with him he seemed fair but remote, almost to the point of being cold. Employees were paid to do a job, and he expected them to do it without being coddled or praised, although at times criticism was in order”.  While his predecessor toured the shop floor at least daily, Folger “was rarely seen outside the executive offices, and many long-time employees soon dubbed him the “invisible man.”

These changes did not address either the staff turnover or the machine competition issues.  Houdaille had invested in Burgmaster.  When Folger arrived, it boasted one of the most modern factories in the industry.   Of Burgmaster’s 40 or so machine tools, Houdaille had financed the purchase of 21, which meant the bulk of productive equipment was less than five years old, but there were few NC versions.  Realising action was needed, Houdaille decided Burgmaster couldn’t wait at least two years that it would take to build their own tool changer from scratch.   Instead, Burgmaster would continue to research and develop its own line of tool changers as rapidly as possible, but while it tried to catch-up, it would sell, for the first time, another manufacturer’s machining center. “We wanted to get into machining centers and believed that the fastest way was to acquire [another’s] center,” Folger recalled.

Their choice was the Hughes Aircraft Company’s MT-3, considered the “Cadillac of machining centers”.  Burgmaster knew about the MT-3,  Back in 1959, Hughes had approached Burgmaster to see whether it was interested in manufacturing the MT-3, but Burgmaster, swamped with orders for their turret drills, had declined.  Hughes made a deal with a German builder for overseas production.  Many problems had arisen, and production was far from successful, but despite limited success, Hughes was not actively trying to unload the MT-3.  Folger was enthusiastic about the idea.  Any entry in the machining-center market was better than none.

There were some  internal concerns.  Most staff agreed the MT-3 was impressive, but a few Burgmaster engineers thought Hughes, through inexperience, had sought to have the machine over-designed.  Saltarelli was aware of the criticism levelled by Burgmaster employees and took them seriously.  Some objections were easily overcome.  For example, it would be easy enough to improve the controls for the machine in place of the awkward setup Hughes had used.   Although only a relative handful of the machines had been sold, this was put down to Hughes’s marketing inexperience.  What persuaded Saltarelli to go ahead was another part of the deal: namely, Hughes’s right to the MT-3 technology giving it patent protection.   As part of the sale, Hughes agreed to indemnify Houdaille against patent-infringement claims.  In August 1969, Houdaille paid $4 m for the rights to “manufacture” the MT-3, six unsold machines, and all of Hughes’s associated patent rights. It also hired some Hughes engineers and repairmen.  However, Houdaille decided to continue with the production taking place in Germany.  With both inflation and interest rates at post-war highs, it seemed sensible to keep the German manufacturer responsible for making the machines at an agreed price.

A mere three months later Burgmaster received disturbing news.  A Wisconsin federal judge had reached a verdict in two patent suits over the technology.  If Burgmaster went ahead and used the technology Hughes had used, they would almost certainly be facing a lawsuit.  At the best, the court process would delay Burgmaster’s renamed MT-3 for years.  On the other hand, if Burgmaster desisted from using the technology, it could take years to complete a new design without any patent issues.  Either way, it could ill afford the loss of time.

That problem marks the end of the first act in this saga.  In January 1970, at the end of Folger’s first year as president, it was clear a recession in the machine-tool industry was going to continue. New orders dropped, with a predicted a 15% decline in sales for the year. That could mean layoffs, up to half of Burgmaster’s 400 work force.  The recession on top of the MT-3 problems led Saltarelli to lose enthusiasm for machine-tool industry.  As he did so, Computer NC systems appeared, and it was clear CNC was going to replace NC systems.  Houdaille, despite its considerable investment and early lead, quickly lost the technological edge to much larger companies like General Electric.

Once problems arose, more fateful decisions were made.  Saltarelli wanted to shift production of Burgmaster’s small tools from Gardena, California, to McMinnville, Tennessee.  In 1967, the approach was justified on the economics.  Burgmaster was operating at capacity, yet it could not fill all its orders; in addition, its bench and table models were being manufactured by high-paid workers, whose skills could be used more profitably in reducing the backlog of NC machines.  Transferring production to Houdaille’s Powermatic machine division in Tennessee, with lower wages, no union, and its own foundry, seemed obvious.  Within two years, it was obvious Saltarelli had made a costly mistake.  Powermatic became a union shop, and the wage advantage was substantially reduced.  At the same time, the expensive precision machines required highly trained machinists.  The staff in Tennessee weren’t good enough.

Saltarelli had to turn the company around.  In June 1970, after lengthy negotiations, he agreed to sell some of Houdaille’s technological production to a Japanese company, the Yamazaki Machinery Works in Nagoya.  Others had made similar agreements, given Japanese builders wanted to produce technologically advanced American machines. Equally important, Japan was gradually becoming integrated into the world economy.  Rising exports persuaded the Japanese government to relax its stiff controls on capital in the late 1960s.  Scores of joint ventures followed, in manufacturing machine tools, automobiles and semiconductors.  Unlike earlier arrangements, where US companies set up wholly owned subsidiaries or dealer networks abroad, these arrangements were more like partnerships, in large part because the Japanese government, even as it liberalized controls over foreign capital and investment, had no intention of handing over a basic industry to American builders.  Through the Ministry of International Trade & Industry (MITI), it insisted on foreign-equity controls that virtually prohibited wholly owned US subsidiaries.  Houdaille, like many other builders, shared its most advanced technology in return for access to Japan’s market. But Japanese builders would soon prove to be more than keen to learn and did not intend to remain junior partners.

Holland’s story now moves into Act 3.  In the winter of 1978, Houdaille common stock was selling for around $ 14.50 a share, well below the conglomerate’s book value. A depressed stock price was a familiar problem for Houdaille and many other industrial conglomerates in the stagflation-prone 1970s.  The conglomerate’s long-time CEO, Jerry Saltarelli, wanted to retire, but speculators noticed that Houdaille was simultaneously debt-free and cash-rich, making it a likely takeover candidate.  An unfriendly takeover worried Saltarelli; Houdaille would lose its independence, and he’d lose much of what he hoped to get in share options.

Then along came a saviour (yes, a classic tragedy element in Act 3!).  Just when there seemed to be no good solution, Houdaille’s financial advisers passed along a message from a then-obscure trio of bankers named Jerome Kohlberg, Henry Kravis and George Roberts. Kohlberg, Kravis, Roberts & Co. suggested that Houdaille could have its cake and eat it too. Saltarelli could liquidate his stake in Houdaille and keep it intact for his chosen successor, with an opportunity to reap large profits in just a few years. All Houdaille had to do was undergo a leveraged buyout.  The deal?  Briefly, a small group of investors, primarily KKR and some Houdaille managers, would buy Houdaille’s public shares, borrowing the cash from institutional investors, which would lend the money based on Houdaille’s assets.

Where was the money coming from?  KKR could offer an inflated $40 per share for Houdaille stock, leverage the company to the hilt and then cash in four or five years down the line, while using the US government tax provisions for the redepreciation of capital assets and interest write-offs.  In effect, Houdaille would have to pay little, if any, corporate income tax for the life of the buyout, increasing net corporate income.  This would immediately provide an extra 30-40 percent in cash, enabling Houdaille to service its massive debt.  KKR did acknowledge managing for cash flow, rather than quarterly profits, might not be easy. But other smaller companies had proved that it could be done.  In May 1979, Houdaille became the first large industrial corporation to undergo a leveraged buyout.

Houdaille recognised it was a gamble when it agreed to the leveraged buyout in 1979. A bad year or two could suck the conglomerate into a whirlpool of debt, without equity to fall back on.  Just such a ‘bad year’ came with the 1981-82 recession.  If that wasn’t enough, Houdaille was also facing fierce competition in machine tools – from the Japanese !!  Two years after the buyout, Houdaille was caught in a triple bind of debt, recession and competition.

The final act was quick and nasty.  The Houdaille buyout had become a ‘dog’.  After failed  attempts to find a buyer for its machine-tool group, Houdaille announced a ‘business restructuring program’ in late 1985, and seven divisions were split off from the conglomerate, including its entire machine-tool group.  The Burgmaster plant in Gardena, California, closed its doors for the last time on September 19, 1986. Contents of the plant were sold at auction.  Houdaille passed into oblivion as an industrial manufacturer, a salutary example of a world where debt was more profitable than equity, speculation more lucrative than traditional sales.

Do management students read When the Machine Stopped?  I doubt it.  Harvard Business School uses two case studies on machine tool industry:  one concerned with how to draw up a cash flow budget, the other with choosing between paying dividends or repurchasing shares.  Meanwhile, the wheel of change has come full circle.  In the US today, politicians and business leaders are arguing to reduce the dependence on foreign manufacturing and foreign products and are trying to rebuild onshore capability.  They want to see the country have its own massive semi-conductor pre-fabrication plants.  They want to stop relying on US cars being manufactured in Mexico, China or South Korea.  Perhaps they might seek to build up a machine tool industry.  I wonder if there is anyone left from Burgmaster to help them?