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A Case for Conglomerates

Stick to your knitting, or expand your core competencies?
Randy Myers, CFO Magazine
March 1, 2001

In a corporate landscape littered with failed mergers and acquisitions, it's getting hard to argue the advantages of operating in diverse lines of business. Even if you pull it off, numerous academic studies conducted over the past decade suggest you'll pay a penalty in the stock market--a so-called diversification discount relative to more highly focused companies. No wonder countless firms have sought to "unlock" the value of important subsidiaries by spinning them off as separately traded entities, leaving both parent and child to operate with a more narrow focus.

Yet diversification continues to exert an alluring appeal. Why? Done well, it can help to smooth financial results for companies in cyclical industries. More broadly, it can allow firms in mature markets to grow their revenues far more rapidly than they could by hewing to their existing lines of business. For companies with excess financial and management capabilities, it may offer the only practical avenue for growth if there are no good opportunities to invest close to home.

And there is some evidence that conglomerates don't necessarily suffer a stock-price discount after all. Larry Shulman, a senior partner in the Chicago office of Boston Consulting Group, has studied the performance of the companies in the Standard & Poor's 500 stock index for the 10 years ended December 31, 1997. When he compared the total shareholder return generated by the diversified companies with that of the more focused companies, he found that, on average, the diversified companies performed in line with the S&P 500, earning 18.6 percent per year versus 17.6 percent for the index.

What's more, Shulman was able to identify a subset of 50 conglomerates--companies with at least four SIC codes--that substantially outperformed the S&P 500 over that 10-year period, with an average annualized return of 27 percent.

How can Shulman's research be at such odds with the academic literature? Most previous inquiries have taken one of two approaches, he explains. One uses price-to-earnings multiples to discern a bias against conglomerates. The other calculates the intrinsic value of a conglomerate's diverse businesses as if they were stand-alone companies, in order to arrive at a figure greater than the conglomerate's market capitalization.

The problem with the former approach, says Shulman, is that investors in the real world buy and sell stocks, not P/E ratios. As for the second approach, he notes that until somebody actually ponies up the cash to buy part of a diversified company, any guess as to what that part is worth is just that--a guess.

Shulman isn't suggesting that conglomerates are ipso facto better investments than focused companies, and therefore embody a better business model. In his 1999 study "Management Lessons of Premium Conglomerates," he also found a subset of 50 conglomerates that consistently underperformed the S&P 500 during the 10-year period in question. Still, his work suggests that companies that automatically shy away from diversification opportunities may be shortchanging themselves and their investors--especially if they are led by executives who are proficient in strategic thinking and capital allocation, and emphasize performance and accountability.

"If, in a nondiversified company, you routinely make decisions to back some product lines and move away from others, to put more capital over here and less over there, and to hold the managers of plants or products to absolutely rigorous performance standards, you have the discipline to run a diversified company," Shulman says flatly. "The single most important factor is being able to make the decision to put more and more capital behind your winners, and basically shut down or get rid of your losers."

THROWING GOOD MONEY AFTER BAD

Raghuram Rajan, the Joseph L. Gidwitz Professor of Finance at the University of Chicago's Graduate School of Business, says Shulman's findings dovetail in many ways with recent academic inquiries concluding that the diversification discount may be much smaller on average--perhaps 5 percent--than the 10 percent to 12 percent that previous studies had suggested. "That said, interest has now shifted to the variations in the discount," Rajan observes. "Why do some diversified firms trade at a huge discount, and others at a huge premium?"

Rajan says his own and others' studies into the phenomenon have backed the notion that poor capital-allocation decisions are a major culprit. "Diversified companies often allocate investment dollars to keep poorly performing divisions alive," he says. "The market would cut them off, but in a diversified firm, good money is thrown after bad."

More specifically, Rajan says, companies whose competing divisions have the greatest diversity of opportunity, in terms of industry growth prospects, tend to do the worst job of allocating resources internally. In other words, a company with one division operating in a high-growth industry and another in a low-growth industry will generally do a worse job of allocating capital than one with two divisions operating in industries with comparable growth prospects.

"Corporations tend to have an in-built sense of intrafirm equity," says Rajan. "They don't let any unit suffer overly relative to others, nor do they let any unit benefit too much relative to the others. If the firm has to tighten its belt because it suffers a big loss of value in one division, that tightening will usually spread throughout the firm, even though for sound economic reasons it should be focused on the division that is doing badly."


LESS CYCLICAL, MORE COMPETITIVE

Tyco International Ltd., a fast-growing, highly diversified company with $28.9 billion in annual revenues, is an example of a conglomerate that hasn't fallen into the capital-allocation trap. An acquisition binge over the past 10 years has put it into four distinct lines of business where it has managed, in each case, to become either the number-one or number-two player in its market. Where that hasn't been possible, the company has cut its losses and moved on.

As a result, Tyco outperformed the S&P 500 on a total return basis by 65 percent over the 10 years covered by Shulman's study. That was nearly in line with the acknowledged poster company for diversification, Jack Welch's $130 billion General Electric Co., which outpaced the index by 67 percent.

"I would argue that we're not rewarded or penalized for diversity's sake alone, but that we have been rewarded for a diversification strategy that has made our company less cyclical," says Mark Swartz, Tyco's CFO.

Tyco and GE share a number of important traits. Both strive to be the market leader in each of their diverse businesses, both seek to be the low-cost producers in their field, and both look for business opportunities in which the core technology is unlikely to become obsolete overnight. And like other premium conglomerates identified in Shulman's research, including ConAgra, Berkshire Hathaway, and AlliedSignal (now part of Honeywell International Inc., which is in the process of being acquired by GE), both Tyco and GE are unwilling to tolerate business units that perform poorly.

"We focus on each [business] as if it were the only industry in which we compete," says Swartz. "And we expect every one of them to be able to grow year-in and year-out." During the past year and a half, Tyco has shed its ADT Automotive used-car auctions business and its Mueller Co. hydrants and valves business--both deemed too cyclical--as well as its Grinnell's Supply Sales business, whose growth was deemed unacceptably slow.

A similar obsession with performance shows up over and over again at premium conglomerates, as Shulman discovered when he compared the investment practices of top-performing and underperforming conglomerates from 1991 to 1996. Shulman found that both types had about equal proportions of their assets invested in positive-spread and negative-spread businesses at the start of the period. Over the next five years, though, the premium conglomerates used new capital to expand their higher-return businesses, while the underperformers invested more of their capital in businesses that either performed erratically or actually destroyed value.

In fact, the low-performing conglomerates invested three and a half times more capital in negative-spread businesses than in positive- spread businesses, and allocated nearly 75 percent of new capital to businesses that on average were earning just about the cost of that capital.

DIVERSITY WITH FOCUS

Although conglomerates may seem to operate in businesses that have no common thread, Shulman says the successful ones typically focus on no more than two strategic types of businesses. By doing so, managers are able to clarify their management processes, he says, and so improve their odds of success.

GE, for example, may seem at first glance the model of a diversified conglomerate, with operations running the gamut from auto leasing to locomotive manufacturing. But, in reality, most of its business units fall into one of two strategic types. Either they produce capital goods based on long-lived technology and have few worldwide competitors (GE's locomotive, jet engine, nuclear reactor, medical systems, and generator and turbine businesses would fit into this category), or they are engaged in fast-growth service businesses that require big infrastructure investments (such as the company's various leasing businesses).

With four operating groups, Tyco at first blush may not appear to conform to this model. Its telecommunications and electronics group produces electrical connectors, conduits, printed circuit boards, and undersea fiber-optic cable. Its health-care and special-products group makes Curity bandages, patient-monitoring equipment, adhesives, and plastic hangers. The fire and security services group sells security and fire-protection systems and services. And the flow-control group makes pipe, pipe fittings, tubing, flow meters, and other steel equipment for commercial and industrial applications.

But there is more discipline to Tyco's approach than a casual review of its wide-ranging product lines would suggest. Like those at other highly diversified companies, Tyco executives give the managers of their various business units tremendous autonomy. And, Swartz notes, Tyco made a conscious decision not to expand outside its four main business lines over the past decade.

In part, the decision to stay focused on those four business lines is an outgrowth of the tough financial hurdles that Tyco sets for its acquisition candidates. To pass muster, an acquisition must generate returns at least twice as great as those that Tyco could produce by buying back its own stock, and it must be accretive to revenue and earnings in the first quarter of ownership. To get to those kinds of numbers, Swartz says, Tyco must be able to realize cost reductions by integrating its new acquisitions into one of its existing business groups--especially since the company always assumes in its financial models that new acquisitions will not grow their own revenues in the first three years of ownership.


"If we make an acquisition outside the areas in which we already compete, we enjoy no cost-reduction opportunities, or at least no significant ones," says Swartz. Going outside its existing businesses could also necessitate bringing in outside managers who understand the new venture, introducing an additional and unwanted element of risk to the purchase. "Growing through acquisitions is difficult enough" without the extra risk, remarks Swartz.

DEMANDS ON FINANCE

By their very nature, conglomerates and other highly diversified companies can place special demands on CFOs and their finance teams, especially as they try to manage units that may be subject to unrelated economic or business cycles.

"It can be a bit schizophrenic at times," admits Harold Zuber, CFO at Plymouth Meeting, Pennsylvania-based, $1.7 billion Teleflex Inc., one of the premium conglomerates identified by Shulman's study. "On the one hand, you're trying to let your winners run. At the same time, if you have a business in a market that's contracting, you're trying to understand what to do there to fundamentally reduce costs. You can end up wearing two hats on the same day."

Because acquisitions are almost always the fastest route to diversification, finance chiefs who would succeed at diversified enterprises also need to be skilled in the art of identifying acquisition targets and integrating them into existing operations. At Tyco, Swartz's staff handles most of the finance work in-house, partly because information and insights gleaned during the due-diligence process can be helpful during integration. "The most important parts of an acquisition are the due-diligence and integration phases, and that actually cuts across all disciplines in the company, from finance to legal to sales to operations," says Swartz. "One of the keys to our success has been to get all of these disciplines involved from the very beginning."

The tight link between finance and operations at Tyco illustrates the difference between today's successfully diversified companies and those that took shape in the early 1960s and 1970s, when the legendary Harold Geneen cobbled together ITT Corp. In its heyday, ITT operated some 250 enterprises, many of them wholly unrelated, in 60 countries.

"In the 1960s, Geneen and others saw the value of a well-diversified company in an incredibly disciplined and focused financial control function," observes Shulman. "You heard stories of him going into a company with literally hundreds of pages of numbers and grilling somebody about the cost of sales on this product line in that country. If it was up 2 percent, it was time to talk.

"What is perceived as adding value today is having management play an operating and strategic oversight role that involves making choices about where to put capital and where not to put it," says Shulman. "This is what the best diversified companies do today."

Randy Myers is a financial writer based in Dover, Pennsylvania.

DIVERSIFICATION THROUGH EVOLUTION

Most diversified companies get that way through acquisitions. Few have the patience, the breadth of management, or the manufacturing skills to allow them to branch out into businesses where they have no track record. Yet given enough time, companies can diversify organically, as illustrated by the experience of Teleflex Inc., a $1.7 billion conglomerate based in Plymouth Meeting, Pennsylvania.

Teleflex provides goods and services in three distinct business segments. Its commercial group makes marine, auto, and industrial products, including Humminbird fish finders, control systems for cars and boats, electrical instrumentation products, and fluid transfer hose. Its aerospace group makes turbine engine parts, as well as control and cargo systems for airplanes. And its medical-products group makes surgical devices and disposable hospital supplies.

Most of those product lines trace their origins to the company's launch more than 50 years ago as a manufacturer of helical cable for use in the British Royal Air Force's legendary Spitfire aircraft. "Our diversification has been a result of migrating that cable or its concept first to the automotive and then to the marine and other industrial markets," says Teleflex CFO Harold Zuber. "We also migrated up the technology scale from cable, which is mechanical, to electromechanical products, such as onboard cargo systems, to electronic technology. As a result, many of our product lines that seem unrelated really aren't.

"Our coatings line, for example, which gave rise to our turbo-engine business, came from a search for noncorrosive coatings for cable," says Zuber. "And our medical business came through the migration of our technology for producing the inner liner of cable to invasive disposables, such as catheters. It's been a natural evolution, and one of the results is that in 2000 we completed our 26th consecutive year of increased sales."

As the company grew increasingly diversified, Zuber says, management always kept the focus on customers, resulting in a unifying business strategy that centers on solving customer problems with proprietary and often innovative products not easily duplicated by larger competitors.

Despite the "cross-pollination" that takes place across industries and manufacturing skills at Teleflex, Zuber says the company operates on a decentralized basis that allows managers to be nimble, and encourages entrepreneurial thinking. The corporate staff is lean, he says, and covers such activities as finance, human resources, and legal. Within finance, reporting and taxes are corporate functions, but accounting is pushed down into the business units, where it can best support the operating staff.


Like many other "premium conglomerates," Teleflex has a leading market position in the majority of its market niches. "While we don't have a stated policy of being number one in our markets, we understand the attractiveness [of being so]," Zuber notes.

Over the 10 years ended December 31, 1997, Teleflex outperformed the S&P 500 on a total shareholder return basis by 12 percent, according to Larry Shulman, a senior partner with Boston Consulting Group. Zuber says it's hard to know whether the company's stock would have performed better or worse if the company had been more focused on one particular line of business. --R.M.

DIVERSIFICATION THROUGH EVOLUTION

Most diversified companies get that way through acquisitions. Few have the patience, the breadth of management, or the manufacturing skills to allow them to branch out into businesses where they have no track record. Yet given enough time, companies can diversify organically, as illustrated by the experience of Teleflex Inc., a $1.7 billion conglomerate based in Plymouth Meeting, Pennsylvania.

Teleflex provides goods and services in three distinct business segments. Its commercial group makes marine, auto, and industrial products, including Humminbird fish finders, control systems for cars and boats, electrical instrumentation products, and fluid transfer hose. Its aerospace group makes turbine engine parts, as well as control and cargo systems for airplanes. And its medical-products group makes surgical devices and disposable hospital supplies.

Most of those product lines trace their origins to the company's launch more than 50 years ago as a manufacturer of helical cable for use in the British Royal Air Force's legendary Spitfire aircraft. "Our diversification has been a result of migrating that cable or its concept first to the automotive and then to the marine and other industrial markets," says Teleflex CFO Harold Zuber. "We also migrated up the technology scale from cable, which is mechanical, to electromechanical products, such as onboard cargo systems, to electronic technology. As a result, many of our product lines that seem unrelated really aren't.

"Our coatings line, for example, which gave rise to our turbo-engine business, came from a search for noncorrosive coatings for cable," says Zuber. "And our medical business came through the migration of our technology for producing the inner liner of cable to invasive disposables, such as catheters. It's been a natural evolution, and one of the results is that in 2000 we completed our 26th consecutive year of increased sales."

As the company grew increasingly diversified, Zuber says, management always kept the focus on customers, resulting in a unifying business strategy that centers on solving customer problems with proprietary and often innovative products not easily duplicated by larger competitors.

Despite the "cross-pollination" that takes place across industries and manufacturing skills at Teleflex, Zuber says the company operates on a decentralized basis that allows managers to be nimble, and encourages entrepreneurial thinking. The corporate staff is lean, he says, and covers such activities as finance, human resources, and legal. Within finance, reporting and taxes are corporate functions, but accounting is pushed down into the business units, where it can best support the operating staff.

Like many other "premium conglomerates," Teleflex has a leading market position in the majority of its market niches. "While we don't have a stated policy of being number one in our markets, we understand the attractiveness [of being so]," Zuber notes.

Over the 10 years ended December 31, 1997, Teleflex outperformed the S&P 500 on a total shareholder return basis by 12 percent, according to Larry Shulman, a senior partner with Boston Consulting Group. Zuber says it's hard to know whether the company's stock would have performed better or worse if the company had been more focused on one particular line of business. --R.M.

U.S. Premium Conglomerates, 1988-1997   

Rank*Company'88- '97 10-yr. Relative TSR**No. of 2-digit SIC Codes
1Gillette3.306
2Safeguard Scientific Pfizer3.114
3Pfizer3.094
4Berkshire Hathaway3.0310
5Crompton & Knowles2.474
6Clayton Homes2.344
7Thermo Electron2.126
8Kansas City Southern Inds.2.114
9Lancaster Colony2.054
10Williams2.005
11Premark International1.895
12Volt Info. Sciences1.876
13Leggett & Platt1.794
14Philip Morris1.774
15Procter & Gamble1.765
16Lennar1.754
17General Electric1.6711
18Tyco International1.656
19PepsiCo1.604
20ABM Industries1.575
21Centex1.545
22Sara Lee1.535
23Oneok1.504
24Federal Signal1.505
25Carlisle1.484
26Crane1.478
27Allied Signal1.444
28Monsanto1.415
29Textron1.415
30ConAgra1.417
31Walt Disney1.374
32Equifax1.364
33General Dynamics1.334
34Cincinatti Bell1.325
35Bestfoods1.315
36Honeywell1.314
37Paccar1.294
38Deere1.287
39Briston-Myers Squibb1.264
40Lockheed Martin1.257
41Fleetwood Enterprises1.224
42Royal Dutch Petroleum1.185
43Service Corp. Int'l1.174
44American Home Products1.164
45Alltel1.156
46Enron1.154
47Chevron1.135
48Teleflex1.124
49DuPont1.128
50United Technologies1.114



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