Conglomerates. Once known as an easy way to diversify, now cautioned by shady accounting and poor management. What are the pros and cons to look out for? Introduction
Instant DiversificationThe conglomerate structure's primary benefit is the inherent diversification of owning several operating businesses. If one business is underperforming, it shouldn't dramatically impact other divisions or the share price. The benefits of diversification were on show in the latest Wesfarmers financial result. Here is the earnings performance for each division:
Now imagine if each of the divisions were separately listed on the ASX. The volatility in results would likely lead to significant movements in share prices and impact the ability to pay dividends. But by remaining part of a conglomerate, group earnings fell just 3.8 per cent and dividends marginally increased for the year. While ultimately the conglomerate's performance is driven by the underlying businesses, results should be less volatile. Being part of a bigger entity also enables several scale benefits. Moët Hennessy Louis Vuitton, commonly referred to as LVMH, has made a reputation for acquiring underperforming brands or assets and improving their performance by using its vast distribution, marketing and design resources. Dior is a case in point. The fashion house was salvaged from bankruptcy before being transformed into one of LVMH's leading brands. Conglomerates can also leverage their size and balance sheet to take advantage of opportunities. In the aftermath of the global financial crisis, Bank of America struggled to fund mounting legal issues. Berkshire Hathaway provided capital on extremely favourable terms to the bank, with Buffett securing $5 billion in preferred shares, paying a 6 per cent coupon in addition to warrants worth another $5 billion. In 2017, Berkshire sold the warrants for $21 billion, netting a $16 billion profit in addition to the $300 million annual dividends. While it is less of a factor now due to the democratisation of markets, being a part of a large conglomerate makes finance more accessible and usually on more favourable terms. Bigger Is Not Always BetterOften where investors run into trouble with conglomerates is with the numbers. Accounting, by its nature, is open to interpretation, leaving plenty of wiggle room for manipulation in revenue and earnings to meet short-term expectations (or management bonuses) at the expense of long-term results. Investors need to be cognisant of cash flow and not just accounting profits. If it doesn't add up, then further digging is required. General Electric was the world's largest company in 2009. Today it is splitting itself into three in large part to aggressive accounting practices that overstated current earnings at the expense of future performance. One of the numerous strategies involved selling assets to a 'friendly' bank or internal division to create an accounting gain, knowing it could purchase it back at its choosing. Consequentially, investors need to have a high degree of trust in management to manage the business effectively and act with integrity regarding financial reporting. The reporting of each division within a conglomerate is generally quite high-level, and the opportunity to understand each segment is more limited than with a separately listed business. Furthermore, over time conglomerates can develop 'lazy' balance sheets which don't accurately reflect the current business or its assets. For this reason, they typically trade at a 'discount' as market participants find it difficult to determine its intrinsic value. News Corp is a classic example. Once the 61 per cent shareholding in realestate.com.au owner REA Group is removed, the rest of the business trades on just a mid-single-digit earnings multiple. If News Corp wanted to, it could spin off REA, and the market would rerate the remainder of the divisions. However, shrinking to greatness is not a strategy most managers are keen on, leading to trapped shareholder value. The aforementioned benefits of scale and balance sheet can also be negative. Management teams can squander shareholder cash on new acquisitions to boost earnings per share, but this may not be congruent with the firm's strategy or core competencies. A Final WordUltimately, the success or failure of a conglomerate comes down to management. As previously covered in Skin in the Game, the best-managed ones often have a founder at the helm or an executive team with an owner mindset. History is usually a good guide.
Simply remaining a conglomerate for the sake of size is not a strategy. Investors need to be confident that the structure remains the best way to realise shareholder value and that the underlying businesses are performing strongly. While the structure itself remains potentially useful, a conglomerate is no panacea for a diversified portfolio. Investors should be allocating their portfolios across several asset classes and investing strategies.
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