Conglomerates: Risky Proposition?

By Glenn Curtis AAA

Conglomerates or companies engaged in a variety of industries and businesses have the potential to grow their earnings at a brisk pace. However, budding investors should realize that there are also sizable risks that go along with investing in a conglomerate. Read on to learn the risks involved in investing in these complicated giants.

Acquiring Problems
By having its hands in multiple businesses, a conglomerate may increase its potential to generate income for its shareholders, and in some cases reduce its overall earnings cyclicality. However, sometimes conglomerates become involved in so many businesses - each involving multiple disciplines, making it difficult for management to get its arms around all of the companies it has under its umbrella. (For more insight, see The Ups And Downs Of Investing In Cyclical Stocks.)

It may also be hard for a centralized management team to get a handle on what drives each business in terms of preferred suppliers, operating costs, the dynamics of that industry, and so on. By extension, that can be a problem because in order to maximize growth of the overall conglomerate and ultimately build shareholder value, management must have a good grasp on each segment and the ability to be "hands on".

This is not to say that conglomerates are destined to be failures. To the contrary, there are many conglomerate firms that have fared well throughout the years, such as General Electric Co. (NYSE:GE), which operates in areas including medical devices, industrial generators, engines and solar panels.

However, even respected firms that are known for their due diligence and integration successes have become entrenched in businesses that they couldn't quite integrate successfully. (For related reading, see Introduction To Diversification and The Dangers Of Over-Diversification.)

Staffing Problems
An organization's most precious resource is usually its human capital - the people that make the products, sell the services and ultimately help bring revenue in the door. In fact, that is why companies, more specifically human resources, will do their utmost to make sure that the ranks are always well staffed.

However, with multiple companies and operating segments, staffing at conglomerates isn't so easy. It may become even more difficult if an acquisition-hungry conglomerate develops a reputation for firing swaths of people after closing a deal. In fact, it's not uncommon for some workers to jump ship once they know a conglomerate has its sights on their company.

This issue isn't just related to human resources. Keep in mind that recruiting, hiring and training individuals can cost a great deal in terms of an organization's overall time and its money.

Accounting Issues
Every company has its own way of recognizing revenues and booking expenses. That said, it can be extremely hard to blend those accounting methods together and can make it difficult for Wall Street analysts that follow conglomerate-type companies to understand all of the methods being used.

But even beyond the problems associated with multiple accounting methods is the question of security and oversight. In other words, when an organization has numerous locations throughout the country or throughout the world, it is hard to ensure that the individuals that maintain each segment's books are being honest and are using proper accounting methods.

Even when looking at GE, analysts have often criticized management's ability to clearly state the operating results of the company's myriad of businesses. It simply becomes a time-consuming effort to evaluate each business segment on its own merits, compare it to relevant peers in the industry and determine whether managers are allocating resources in that division in the most optimal way for shareholder growth.

Hard To Be the Best
Being a "jack of all trades" isn't necessarily a bad thing. Again, when an organization has its hands in multiple businesses, it has the potential to reduce the cyclicality of its net earnings.

However, when an organization has several businesses under its belt, it can be hard for management to concentrate on building out one particular business. By extension, this may prevent the company from becoming (or remaining) the best in any one business.

Investors tend to flock to companies that are best in class, not secondary or tertiary players.

Hard to Evaluate
On Wall Street, analysts are trained and charged with following a certain sector or industry. For example, some analysts follow automakers, while others follow steel makers.

Because analysts tend to specialize in such ways, few are permitted to follow conglomerates.

For example, some businesses are valued on a price-to-sales or a price-to-book value basis, such as retailers. Other businesses, such as gaming and entertainment companies use the popular price-to-cash flow metric. But what happens if the conglomerate has many different types of businesses under its umbrella? What's the best method to use for the overall company? And how do you compare its value with that of other conglomerates?

Again, this can be a major stumbling block in terms of garnering Wall Street sponsorship, but on the positive side, the sheer size and deal-making ability of conglomerates usually keeps the investment banks eager to render their services.

True Value May Be Realized by a Breakup
Because it can be hard for a conglomerate to gain analyst sponsorship, and/or to ever have the full value of its assets realized by the investment community, it may have little choice but to split apart, and let each segment trade as a separate entity.

This can be a positive experience for shareholders, but it often takes years for management to appreciate this strategy and fully act it out.

Bottom Line
Conglomerates have the potential to generate large sums of money for their shareholders, but along with that opportunity comes risks that all prospective investors should consider.

For more insight on this subject, see Conglomerates: Cash Cows Or Corporate Chaos?

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