Tuesday, February 06, 2007

Conglomerates

The Financial Times had a good article yesterday on the state of the conglomerate and issues that some conglomerates have had in having the market embrace them.

Here is the link.

Less than the sum of its parts? Decline sets in at the conglomerate

By Francesco Guerrera

Published: February 5 2007 02:00 | Last updated: February 5 2007 02:00

The question - shouted across the seventh fairway at Augusta by a golf buddy - almost interrupted Jack Welch's swing ashe teed off from the third hole. "For Chrissakes, Jack, what are you going to do next? Buy McDonald's?"

It was April 1986 and the General Electric chief had just announced the addition of Kidder Peabody, one of Wall Street's most venerable investment banks, to GE's stable of manufacturing businesses.

The $600m (£305m, €463m) deal had come just after the $6.4bn purchase of RCA, the music and television group - an even bigger departure for a company with an industrial heritage dating back to Thomas Edison. Mr Welch's efforts to broaden GE's empire beyond its industrial core were a sign of the times: investors rewarded companies that boosted profit growth by acquiring businesses in a plethora of at best tangentially related sectors.

Today, however, that conglomerate business model, which looked so visionary in the deal fever of the 1980s, appears more and more endangered.

In his memoir, Jack: Straight From the Gut, Mr Welch recalls dismissing the burger chain remark as a light-hearted jibe, but in the ensuing years the joke turned out to be on him. Seven years later, Kidder Peabody was sold off, marking a U-turn in GE's strategy.

For nearly half a century the diversified business group was a cornerstone of American capitalism, but now many are either disappearing or struggling to justify their existence. Their predicament is made all the more serious by the rise of nimbler predators - private-equity groups betting that the old business-guru mantra got it backwards: the parts of a conglomerate are actually worth more than the whole.

Last week Altria put an end to a 20-year marriage of convenience between its tobacco and food businesses by spinning off Kraft from Philip Morris. A day later, American Standard split its $10bn-a-year toilets, brakes and air conditioning business. It will soon be followed by Tyco, which is poised to ask investors to forgive and forget its recent scandals by breaking itself in three.

Other once-mighty groups such as Cendant, the property-to-travel giant, and Viacom, Sumner Redstone's media powerhouse, have already unravelled decades of acquisitions to split into their component parts. Those that remain, like GE and its rival Honeywell, are reshaping their portfolio in an effort to convince sceptical investors of their worth. So far, their calls have gone unheeded, with share prices in both languishing below their historic highs.

"The conglomerates are dead," says Chris Zook, head of the global strategy practice at Bain, the management consultancy. "With some rare exceptions, the conglomerates' business model belongs to the past and is unlikely to reappear."

The struggles of some of the oldest names in US business raise the prospect of a fundamental shift in corporate America's make-up. Supporters of conglomerates argue that their diversified structure has enabled them to safeguard industries, and their millions of employees, that would have struggled on their own.

Leaving such businesses toprivate-equity groups, whose focus is on asset trades and cost-cutting, or turning them into stand-alone operations exposed to the whims of the equity market might lead to further dramatic reductions in the US industrial base.

Lewis Campbell, chief executive of Textron, widely regarded as America's first conglomerate, recalls that when its Cessna aircraft unit was hit by a downturn in 2001-03, the investment needed to turn it around came from other parts of the helicopters-to-lawnmowers group. "Where would Cessna's employment level and profitability be now if we were not a diversified, multi-industry company?" he asks.

To be sure, conglomerates are alive and kicking in Asian economies, from Japan to India, and even in the US not all diversified groups are gasping for air. Companies such as Warren Buffett's Berkshire Hathaway - with interests ranging from car insurance to Fruit of the Loom apparel - and, to a lesser extent, Rupert Murdoch's multi-media News Corporation have reaped rewards from operating across several industries.

But the rare successes highlight the problems of the rapidly shrinking US conglomerate sector. Indeed, the strategy of a renowned investor such as Mr Buffett is remarkably similar to the leaders of the conglomerates of old: buying companies whose diverse dynamics together cushion the whole group from the vagaries of business cycles.

"Conglomerates were the most exciting corporate form to appear in more than a generation," wrote the late Robert Sobel in his 1984 The Rise and Fall of the Conglomerate Kings. "They shook up the business scene as no other phenomenon had since the era of trust creation at the turn of the century."

A bespectacled first world war veteran called Royal Little is credited with starting the trend in 1953 when his Textron, then a maker of rayon, bought a car upholstery supplier. The acquisition helped the company to weather a downturn in textile supplies and the recession of the late 1950s, emboldening Mr Little to go for an even more extravagant move: the purchase of Bell Aerospace, the helicopter manufacturer.

Companies such as Litton Industries, International Telephone & Telegraph and Gulf + Western followed suit, acquiring many unrelated businesses in a quest to expand earnings and revenues.

The success of the early conglomerates was predicated on the simple tenet that businesses find strength in numbers. This strategy of harvesting synergies between businesses, or simply cross-subsidising weaker operations with revenues generated by the more profitable ones, was warmly received by investors looking for safe, reliable earnings streams. That, in turn, gave conglomerates a powerful weapon: highly-rated stock that could be used to acquire even more companies, further expanding earnings power.

Over the past few decades, this virtuous circle has been progressively undone by profound changes in the US financial and business world.

On the financial front, Wall Street has grown to dislike the "one-stop shop" nature of the conglomerate. As capital markets have become more global and liquid, fund managers believe that they can diversify risk, and gain better returns, by buying shares across several sectors rather than by delegating that choice to a conglomerate's chief executive.

At the same time, academic and empirical evidence began to show that, far from delivering the promised synergies, conglomerates' bias towards ploughing surplus resources back into their weaker businesses led to waste and inefficiency. "Conglomerates that engage in 'winner picking' find it optimal to allocate scarce capital internally to mediocre projects," say Heitor Almeida and Daniel Wolfenzon, two New York University academics, in a recent study.

Indeed, academic studies dispelled the theory that acquisitions and cross-subsidies boost earnings and share prices, calculating that conglomerates are valued at average discounts of 10-12 per cent to the rest of the stock market.

Henry Silverman, who built Cendant through an acquisition spree in the 1990s and then disbanded it in 2005, summed up the conglomerates' plight when he said the company had been a "financial success but a stock market failure".

"This is a classic case of the sum of the parts is worth more than the whole,'' he said in announcing the break-up.

Sluggish share prices have been mirrored by financial performance. Looking at data from the past decade, Bain found that conglomerates have 50 per cent less chance of achieving sustained earnings growth than more focused groups.

Klaus Kleinfeld, chief executive of Siemens, the German conglomerate, rejects this view, arguing that the ability of diversified groups to cross-fertilise ideas, products and talent gives them an inherent advantage over focused companies. "Customers want a stable partner that can offer a variety of services. Customers do rely on us being around for a long time," he says.

If he is right, conglomerates should come back in favour during an economic slowdown, when investors flee to the relative safety of broad-based companies whose earnings are less sensitive to a downturn.

But investment professionals argue that a cyclical return to favour of conglomerates is unlikely because today's financial markets offer investors more sophisticated risk management tools. "Investing in a conglomerate is not the only way to diversify your risk, as it perhaps was 30 years ago," says one. "The financial instruments we have today mean anyone can diversify risk effectively by going on [the broking site] E*Trade."

The space in the business landscape left by the slow unwinding of the conglomerates is likely to be taken over by aggressiveprivate-equity groups. Armed with cash raised from indulgent lenders, the buy-out groups are assembling large collections of varied businesses.

Even Jeffrey Immelt, Mr Welch's successor at the helm of GE, arguably the quintessential modern conglomerate, ack-nowledges private equity's coming of age. "Private-equity funds are the conglomerates of this era," he recently told the FT. "[Trade buyers] have not seized the moment in terms of doing deals they could have done to build their companies for the long term."

It is perhaps ironic that private equity should fatten its portfolios with businesses hived off from old-style conglomerates, such as Cendant's Travelport and GE's speciality materials unit. The crucial difference between the new hoarders of businesses and their predecessors, however, is that the former have it in mind to sell them again within years.

But that comes after private equity applies, and extractsbenefits from, another lesson learnt from the conglomeratesof old: that diffuse businessescan be held together by a common set of managerial skills and processes.

Experts argue the conglomerates that will survive and prosper are the ones that succeed in linking their disparate operations through a common denominator of management and business principles. It is no coincidence that two surviving conglomerates, GE and Washington-based Danaher, have each created management "playbooks" to remind their employees of their shared business goals and values.

"I am not prepared to bury the conglomerate just yet," says Cynthia Montgomery, professor of management at Harvard Business School. "There will alwaysbe a role for them because they bring managerial expertise and discipline."

Perhaps the longer-lasting heirs to the conglomerates will be companies that spread themselves across more than one industry but do not overstretch into wildly different sectors. Bain's Mr Zook points to Apple as a company that branched out of its traditional computer business by harnessing a neighbouring technology with the iPod.

Google is following a similar path, building on its dominance of online search to expand into the global advertising market.

"It is not a matter of being diversified or not, it is the degree of diversification," says Michael Patsalos-Fox, chairman of the Americas region for McKinsey, the management consultancy. "A modest degree of diversification can lead to superior shareholder returns because companies that only do one thing eventually run out of rope."

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