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Why are conglomerates underperforming?

07/14/2022 | 11:05am EDT

Formerly all-purpose machines, big groups are joining the graveyard of conglomerates, where their past gigantism is honored. Recently, it is Siemens, then Toshiba and finally General Electric that have or will pass the sword to the left. Are these groups, whose activities range from technology to energy, health and aeronautics, doomed to split up? Why are conglomerates underperforming?

What are the reasons for the willingness of large groups to split up?

The separation of a conglomerate into several entities allows the holding discount to be eliminated. This discount corresponds to the difference in valuation between the holding company of several entities and the one that would be obtained by adding the valuation of each company independently.

This separation therefore leads to a better valuation of each entity, with a better visibility for investors. Let's take the example of a conglomerate made up of a technology company valued at 25 times its profits (because it is the most profitable), a healthcare company valued at 20 times its profits (more profitable), and a company in the health sector valued valued at 20 times its profits (more capital-intensive, with lower margins) and an energy company valued at 15 times its profits (ultra-capital-intensive, with low profitability). If we apply an average of the valuations of the three entities, plus a holding company discount of around 20% to more than 30%, we obtain an unreadable mix of valuations that strongly penalizes the most profitable businesses. Separating the entities therefore allows to "liberate" the most profitable business(es), boosting their valuation and visibility for investors.

The simplification of a conglomerate structure makes it possible to improve the operational performance of a group, by directing the capital more easily towards the most profitable sectors, without them being handicapped by less profitable and more capital-intensive businesses, thus requiring a lot of resources. It is therefore in the interest of the holding company to detach its most profitable activities, such as a technological business, to make acquisitions and investments with a higher ROI, and thus remain competitive on the most strategic activity.

By extension, in addition to encouraging investment in the most profitable activities and improving their profitability, a segregation also makes it possible to improve the performance of less profitable activities which, once separated, can call on the capital markets. These businesses will therefore no longer suffer from the most profitable activities monopolizing the majority of the holding company's capital.

What are the obstacles to the aggregation/disaggregation of a conglomerate?

In countries where corporate management is strongly influenced by state decisions and recommendations, such as Japan, restructuring is not easy to implement. These countries are the places where it is most difficult to do activism. It can therefore be tricky to try to shake things up, especially if they have been in place for years. The example of Toshiba is a perfect illustration, since the restructuring file has been on file for a long time. The same goes for Panasonic, Sony and Kirin.

Groups wishing to restructure go through long phases of aggregation or disaggregation, where consumers, shareholders, directors, employees and politicians must be convinced. To integrate a company into a conglomerate, it is necessary to succeed in explaining the creation of synergies and cost reductions without this new company encroaching on existing entities, and without sucking up capital. When it comes to breaking up a company, it is necessary to convince people of the benefit of separation, when the multitude of activities becomes unreadable, and the profitable activities are weighed down by mediocre neighbors.

Some examples of demergers and conglomerates

Siemens is an example of a successful forced demerger. The German industrialist separated its medical (Siemens Healthineers), energy (Siemens Energy) and renewable energy (Siemens Gamesa) businesses, of which it still owns 75%, 40% and 67% respectively. The three companies, now listed independently, offer better visibility with separate balance sheets, and can call on the markets if necessary. Unfortunately, these restructurings have cost over 11,000 people their jobs.

General Electric is the latest illustration of the necessary break-up of a massive conglomerate. The American company makes everything from aircraft engines to insurance, health care, household appliances, car parts, gas turbines GE has announced its split into three entities in November 2021 under the leadership of Larry Culp, after narrowly avoiding bankruptcy. Typically, such large and diverse groups are guilty of disastrous management, leading to internal conflicts between companies, and accounting manipulations to allocate resources. At GE, the number of frauds was abnormally high before Larry Culp came to clean up the mess. By trying to do everything, some large groups end up doing nothing well.

Conversely, some (rare) groups, ultra diversified, show sound and rational management. The best example is Berkshire Hathaway, decentralized to the extreme but no less successful. But not all are lucky enough to have been founded and managed by a genius. Another example is Danaher, which has not hesitated to spin off (Fortive and then Vontier), even if the company has refocused a lot on the medical field.

Usually, for a conglomerate to function optimally by creating synergies between entities, it is better for it to focus on a particular sector, unless it is managed with a master's hand. LVMH is an obvious example of a perfectly synergistic conglomerate, with all its brands operating in the luxury sector (clothing, cosmetics, leather goods, etc.). However, there are counter-examples.

Sprawling, but perfectly managed, structure of LVMH (Source: LVMH universal registration document 2021)

There are generally two reasons why conglomerates restructure or split up:

1-An activist investor enters the capital and presses to separate the group from its less profitable, less valued activities. The bad ones are detached via spin-offs, during which they are loaded with debt in order to be able to pay tax-free dividends to the head holding company. This holding company uses this new flow of money to buy back its shares or to invest in the juiciest businesses.

2- Evidence of wrongdoing or a fraud is revealed in the workings of a conglomerate. A new management is put in place to clean up, which leads to a restructuring.

© MarketScreener.com 2022
Stocks mentioned in the article
ChangeLast1st jan.
BERKSHIRE HATHAWAY INC. -0.83% 420667.5 Delayed Quote.-8.29%
DANAHER CORPORATION 1.16% 282.29 Delayed Quote.-15.18%
ELECTRICITÉ DE FRANCE -0.25% 11.925 Real-time Quote.21.04%
FORTIVE CORPORATION -0.59% 61.9 Delayed Quote.-18.38%
GENERAL ELECTRIC COMPANY -0.15% 67.44 Delayed Quote.-32.68%
KIRIN HOLDINGS COMPANY, LIMITED -0.60% 2251.5 Delayed Quote.22.63%
LVMH MOËT HENNESSY LOUIS VUITTON SE -1.47% 637.3 Real-time Quote.-11.03%
PANASONIC CORPORATION 1.58% 1063.5 Delayed Quote.-17.23%
SIEMENS AG -1.96% 104.24 Delayed Quote.-30.36%
SIEMENS ENERGY AG -5.62% 11.51 Delayed Quote.-45.78%
SIEMENS GAMESA RENEWABLE ENERGY, S.A. -0.28% 17.92 Delayed Quote.-14.71%
SIEMENS HEALTHINEERS AG -1.94% 45.55 Delayed Quote.-29.43%
SONY GROUP CORPORATION 0.14% 9763 Delayed Quote.-32.65%
TOSHIBA CORPORATION 0.02% 5070 Delayed Quote.7.17%
VONTIER CORPORATION 0.72% 18.15 Delayed Quote.-41.36%