Thursday, March 5, 2009

The Trouble With Conglomerates

If one wants to find the weak spots in companies or industries, there is no better time to identify them than during periods of economic or financial distress. What seemingly worked very well during a time when the economy appeared to be strong and financing was readily available, can often crumble as the stress of the marketplace works its way through the company or industry.

The stress of the current financial and economic crisis is really starting to highlight these weak links. To focus on just one weak link, it seems as if every day another conglomerate gathers headlines about the problems it is having and the difficulties it sees in turning the organization around.

A conglomerate is a company of companies: the companies are generally distinct from one another and are very often in unrelated businesses. The rationale for creating a conglomerate is that those that run the conglomerate can do a more efficient job of allocating capital to where it can be best used than can financial markets.

Many people argue that, in almost every instance they know, this rationale does not prove to be true. There are several arguments for this statement:

• First, since the businesses are unrelated there will be very few, if any, synergies achieved in putting the disparate companies together;

• Second, there is the overhead expense of the corporate holding company that always seems to be rather extensive in order to present the image that the proper oversight is being conducted to ensure that capital is allocated appropriately to the companies that make up the conglomerate;

• Third, sufficient oversight is rarely achieved in the management of large conglomerates because top level of executives can adequately oversee just so much given, the complexities of the organizations that they are ultimately responsible for;

• Fourth, as we have so recently seen, whereas risk management can be difficult enough for just one company to manage, attempting to oversee the risk management within a conglomerate can be impossible.

Yet, this does not stop people from trying to put conglomerates together. Especially in those times that an economy is expanding and there is plenty of financing available, more and more people seem to want to try their hand at assembling new conglomerates. And, many of the efforts seem to succeed…for awhile…or, once in a while for even an extended period of time.

There seem to be several reasons for such success:

• First, companies may be acquired when they are in the stage of their evolution where they do have a competitive advantage that allows them to earn exceptional returns for a time, even though these exceptional returns are not lasting;

• Second, a company may be acquired that requires a turnaround or a re-structuring and a successful execution of such an effort can produce some exceptional returns, again, for only a limited amount of time;

• Third, a conglomerate company that is losing its competitive advantage may successfully switch its business model to that of a very competitive firm and engage in severe cost cutting that allows it to perform very well in the short run;

• Fourth, the conglomerate can just be lucky and hit the right acquisition at the right time when there is a change in tastes, or market needs, or cultural shifts and ride through a wave of good fortune.

These events almost always happen when the economy is expanding and when there is plenty of money available. In such cases, the overall performance of the conglomerate is achieved when one or more of the conglomerates’ companies can carry all its sister companies by the exceptional performance it achieves. If a management is lucky it can have one or more companies carry all of the others for a while and then have another company come forth to carry every one during the next period of time and so on.

There are even cases where the conglomerate finds that its companies are sufficiently mature so that the ability of any of them to achieve competitive advantage is non-existent. In such cases, one needs a “Neutron Jack” Welch to cut the hell out of costs and preserve the integrity of the conglomerate for a while longer. However, pity the person that takes over after “Neutron Jack” leaves.

Even in good times conglomerates are plagued by the need to continue to buy and sell companies in an attempt to keep rates of return for the holding company at a sufficient level. The portfolio of companies is never right and one must continually shed those that are dragging down the total performance of the conglomerate in order to replace them with new acquisitions that might make a contribution…at least for a while…to the performance of the holding company.

Investors, in my view, should always be suspicious of conglomerates. The economics is just not there for exceptional longer run performance. And, this belief applies even to the “good” times.

Now, we have entered “bad” times and the conglomerates appear to be coming apart. The exceptional performers in their portfolios have ceased to perform in an exceptional way anymore. And, we are seeing that the risk management of these organizations has been almost totally inadequate. Furthermore, this is happening to conglomerates that operated in the finance area as well as those conglomerates that focused primarily on manufacturing or retail distribution.

The stresses caused by the financial and economic crisis are revealing the fallacies upon which the conglomerates were constructed. Again, we see that excessive credit expansions can result in organizational structures that appear safe and sound in “good” times but turn out to be extremely fragile in the face of a less than favorable environment. As we are seeing in other areas of the economy, these excesses must be worked out over time before expansion in the economy can take place.

In other words, the managements of these organizations are not focusing on expanding business at this time and will not be in that mode for an extended period of time. These managements are focused elsewhere…as on the value of their portfolio companies…what companies should be kept…and, what companies should be sold…where might they find a buyer for the companies they want to sell…and, what will they do with these companies if they have to kept them. And, an economic recovery plan will not help them to resolve these questions.

1 comment:

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