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Conglomerates – Corporate Dinosaur: On Their Way to Extinction?
Introduction: The reason for diversification
Every company reaches a stage in its lifetime when management is in a dilemma whether to diversify or launch new products in the existing range in order to survive on the market. It’s almost inevitable: to drive growth when a company reaches a certain size and maturity, executives will be tempted to diversify. Companies implement diversification strategies to improve or increase the strategic competitiveness of the entire organization. If they are successful, the value of the company increases. Value can be created through related or unrelated diversification if the strategies allow the company’s combination of operations to increase revenues and/or reduce costs when implementing appropriate business-level strategies.
Companies can also implement a diversification strategy to gain market power over their competitors. Firms can pursue diversification strategies that are either value neutral or result in the firm being devalued. They may try to diversify in order to neutralize the market power of competitors or reduce managerial hiring risk or increase managerial compensation because of the positive relationships between diversification, firm size, and compensation.
Although a few talented people have proven capable of managing diverse business portfolios over time, today most executives and boards of directors understand how difficult it is to add value to companies that are not related to each other in any way. As a result, unlikely pairings have largely disappeared. In the United States of America, for example, by the end of 2010, there were only 22 conglomerate rights. Since then, 3 have announced that they too will part ways.
The argument that diversification benefits shareholders by reducing volatility has never been convincing. The rise of low-cost mutual funds emphasized this point as it made it easier for even small investors to diversify. At the aggregate level, conglomerates have underperformed more focused companies in the real economy (growth and return on capital) and the stock market. From 2002 to 2010, for example, conglomerate revenues grew 6.3 percent annually; those of focused companies grew by 9.2 percent. Even adjusted for differences in size, focused firms grew faster. They also increased their returns on equity by three percentage points, while conglomerate ROCs fell by one percentage point. Finally, average total shareholder returns (TRS) were 7.5 percent for conglomerates and 11.8 percent for focused firms.
What matters in a diversification strategy is whether managers have the skills to add value to companies in unrelated industries—by allocating capital to competing investments, managing their portfolios, or cutting costs. Over the past 20 years, TRS with good and bad results among the 22 conglomerates remaining in 2010 clearly differed on precisely these points. Although the number of companies is too small for statistical analysis, three characteristics that are generally seen for good results are:
1. Disciplined (and sometimes contraindicated) investors –
High-performing conglomerates are constantly rebalancing their portfolios by buying companies they believe are undervalued in the market – and whose performance they can improve.
2. Aggressive capital managers –
Many large companies base their company’s capital allocation for a given year on their previous year’s allocation or on the cash flow they generate. High-performing conglomerates, in contrast, aggressively manage the allocation of capital among units at the firm level. Any cash in excess of what is needed for business needs is transferred to the parent company, which decides how to allocate it to existing and new business or investment opportunities, based on their potential for growth and return on invested capital.
3. Strict ‘lean’ corporate centers –
High-performing conglomerates operate much like better private equity firms: with a lean corporate center that limits its involvement in managing business units to selecting leaders, allocating capital, vetting strategy, setting performance goals, and monitoring performance. Equally important, these companies do not create extensive company-wide processes or large shared service centers.
The future of conglomerates: growth versus risk reduction:
The economic situation in developing markets is specific enough to make us cautious in applying the insights gathered from American companies. The conglomerate structure will face tests in the near future, the level of which will vary from country to country and industry to industry.
In emerging markets, large conglomerates have economic benefits that do not exist in the developed world. These countries have yet to build their infrastructure – such projects usually require large amounts of capital that smaller companies cannot raise. Companies also often need government approval to buy land and build factories, as well as government guarantees that there will be sufficient infrastructure to get products to and from the factories and enough electricity to operate them. Large conglomerates usually have the resources and relationships necessary to navigate the maze of government regulations and ensure relatively smooth operations. Finally, in many emerging markets, large conglomerates are more attractive to potential managers because they offer greater career development opportunities.
Infrastructure and other capital-intensive businesses are likely to be parts of large conglomerates as long as access to capital and linkages are important. In contrast, firms – including export-oriented ones such as those in IT services and pharmaceuticals – that rely less on access to capital and connections are more focused on large conglomerates than on a fraction of them. The rise of IT services and pharmaceuticals in India and Internet companies in China show that the advantage of large conglomerates in accessing managerial talent has already declined. As emerging markets open up to more foreign investors, the advantage these companies have in accessing capital will also diminish. This will leave access to government as their last remaining strength, further limiting their options to industries where its influence remains important. While that time may be decades away, the sheer size and diversification of conglomerates will eventually become obstacles rather than assets.
As business dynamics become more and more complicated, equally effective management of these conglomerates becomes a problem.
Taking the example of one of the major engineering and construction conglomerates, L&T. Looking at the company’s performance, the stock price has fallen close to 25% over the past two years to date. If that was an exception, let’s look at another powerful company, Adani Enterprises. The company’s share has fallen close to 75% in the past two years.
ITC, in contrast, has shown excellent performance over the past two years, with its share price up close to 65%. This seems to contradict our discussion. But if we take a closer look, the company made close to 65% of its cigarette business.
So, what can be the possible solutions for this can be –
1. Consolidation –
Earlier during the Raja license, there were restrictions on companies not to expand their capacity beyond a set point. Therefore, they could not expand their business. And so in some cases companies used excess cash, and in other cases they diversified by seeking higher returns on excess cash than they could earn from bank interest. In some cases, the results were compared to the income they would have received from banks’ interest, while in many cases they destroyed the value of their core business.
Now with the license heaven is dismantled so there is no need to have multiple companies. In fact, consolidation has taken place in various industries like Cement where the major players are like Ultratech, where the parent company has increased its capacity by investing heavily, taking over businesses, etc.
2. Dismissal –
Another type of structure that can work here is divestment, i.e. the sale of an existing side business to raise funds to focus on their core business. This can be very helpful, especially in cases where ancillary businesses have underperformed and as a result the entire company has suffered and their stock prices have been undervalued. It can also be very helpful if the company had plans but didn’t have enough funds to expand. For example, IBM decided to sell its PC business to focus on IT solutions and services.
3. Establishment of separate companies –
Another way to deal with such a situation is to separate the companies and run them as if they were separate companies so that each company focuses on its own business without the influence of other sister companies. By doing so, management and the company as a whole can be held accountable for their actions. For example, TATA Group has been following this model for a long time. Each of their companies operates independently as a separate company.
Many companies in the past had the dream of becoming a conglomerate to showcase their skills and talents in managing various businesses. But looking at the current scenario, the concept of “conglomerate” becomes a thing of the past, i.e. a corporate dinosaur on the way to extinction. This is mainly due to the changing dynamics of the business world where competition has led companies to think less about profitability and more about sustainability. Further, earlier general business management skills and having a core competency in finance, human resources and other general functions have been sufficient for the long-term viability of many businesses. But the current complexity in business, superior skill sets in support functions will not enable any company to achieve sustained performance across multiple businesses in the long run. Therefore, a focused infrastructure and team are the keys to success for any business in today’s dynamic and rapidly changing business environment. Therefore, companies are forced to rethink their strategies set for growth from diversified to more focused businesses.
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