Conglomerate

what is conglomerate diversification

DEFINITION of 'Conglomerate'

A conglomerate is a corporation that is made up of a number of different, seemingly unrelated businesses. In a conglomerate, one company owns a controlling stake in a number of smaller companies, which conduct business separately. Each of a conglomerate's subsidiary businesses runs independently of the other business divisions, but the subsidiaries' management reports to senior management at the parent company.

The largest conglomerates diversify business risk by participating in a number of different markets, although some conglomerates elect to participate in a single industry – for example, mining.

BREAKING DOWN 'Conglomerate'

The basic advantages and disadvantages of conglomerate companies as a structure both have to do with the issue of size.

For the management team of a conglomerate, having a wide array of companies in different industries can be real boon for their bottom line. Poorly performing companies or industries can be offset by other sectors. By participating in a number of unrelated businesses, the parent corporation is able to reduce costs by using fewer resources, and by diversifying business interests, the risks inherent in operating in a single market are mitigated.

In addition, companies owned by conglomerates have access to internal capital markets. enabling more ability to grow as a company. A conglomerate can allocate capital for one of their companies if external capital markets aren’t offering as kind terms the company wants.

However, the size of conglomerates actually hurts the value of their stock, a phenomena called conglomerate discount. The sum of the value of the companies held by a conglomerate tends to be more than the value of the conglomerates stock by anywhere between 13 to 15%. History has shown that conglomerates can become so diversified and complicated that they are too difficult to manage efficiently. Since the height of their popularity in the period between the 1960s and the 1980s, many conglomerates have reduced the number of businesses under their management to a few choice subsidiaries through divestiture and spinoffs.

The combination of a handful of different issues relating to financial transparency and management makes it so conglomerate stock is valued at a discount.

Layers of management add to the overhead of their businesses, and depending on how wide-ranging a conglomerates interests are, management’s attention can be drawn thin. The financial health of a conglomerate is difficult to discern by investors, analysts, and regulators because the numbers are usually announced in a group, making it hard to discern the performance of any individual company held by a conglomerate. For instance, media conglomerate IAC’s (which owns Investopedia) Form 8k from 2014 revealed the earnings, losses, depreciation. and amortization of intangible assets of their different segments, but not from their specific companies. As with most company acquisitions, there is always the risk friction developing because of differences in company

culture, and innovation can stagnate .

Well Known Conglomerates

Warren Buffet’s Berkshire Hathaway, a conglomerate that has successfully managed companies involved in everything from plane manufacturing to real estate, is widely respected. Berkshire Hathaway owns majority stake in over fifty companies. and had minority holdings in companies ranging from Wal-Mart to car manufacturers, yet only has an office of 24 people. Buffet’s approach to management of companies in Berkshire Hathaway’s owns is to manage capital allocation and allow companies near total discretion when it comes to managing the operations of their own business.

Originally founded by Thomas Edison, General Electric has grown to own companies working in energy, real estate, finance, and healthcare, previously owning majority stake in NBC. The company is made up of specific arms that are independent in their operation but are all interlinked. This makes it so research and development on specific technologies can be applied to a broader range of products.

Conglomerates in the 1960s

Conglomerates were popular in the 1960s and initially overvalued by the market. Low interest rates at the time made it so leveraged buyouts were easier for managers of big companies to justify because the money came relatively cheap. As long as company profits were more than the interest needing to be paid on loans, the conglomerate could be ensured an ROI .

Banks and capital markets were willing to lend companies money for these buyouts because they were generally seen as safe investments. All of this optimism kept stock prices high and allowed companies to guarantee loans. The glow wore off of big conglomerates as interest rates were adjusted as a response to steadily rising inflation that ended up peaking in 1980. It became clear that companies weren’t necessarily improving performance after they were purchased, which disproved the popularly held idea that companies would become more efficient after purchase.  In response to falling profits, the majority of conglomerates began divesting from companies they bought. Few companies continued on as anything more than a shell company .

Foreign Conglomerates

Conglomerate companies take on slightly different forms in different countries.

Japan’s form of conglomerate is called the Keiretsu where companies own small shares in one another companies, and centered around a core bank. This business structure is in some ways a defensive one, protecting companies from wild rises and falls in stock market, and hostile takeovers. Mitsubishi is a good example of a company that is engaged in a Keiretsu model.

Korea’s corollary when it comes to conglomerates is called Chaebol. a type of family owned company where the position of president is inherited by family members, who ultimately have more control over the company than shareholders or members of the board. Well known Chaebol companies include Samsung, Hyundai, and LG.

Source: www.investopedia.com

Category: Insurance

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