Cloud over conglomerates

The conglomerate avatar of General Electric died last week at age 129. No tears were shed for what was once a global symbol of American business power. Instead, investors cheered the formal splitting of GE into three public companies. It’s easy to see why: The conglomerate’s revenue for 2020 was $79.62 billion, a far cry from the $180 billion-plus revenue it booked in 2008. It was also knocked off the Dow Jones Industrial Average in 2018 after being part of the blue-chip index since 1896.     

GE Chief Executive Larry Culp’s strategy is in stark contrast to the path pursued in the 1980s and 1990s under Jack Welch, who expanded the company and turned it into an industrial behemoth. The diversifications into multiple businesses (nuclear power, locomotives, lightbulbs, television and even ice cream) were then considered to be an effective way to mitigate risk; the argument being when one industry was in a downturn, another might be thriving. If that strategy has reached its expiry date, the reason is obvious: GE, like many other conglomerates, is no longer able to prove that it is worth more than the sum of its parts.  

GE, of course, is not the only company to turn away from a conglomerate structure in recent days. In fact, last week saw two others — Johnson and Johnson and Toshiba — announcing their decision to break up. They joined the long list of other conglomerates such as United Technologies, DowDuPont, Honeywell, ThyssenKrupp, ABB and Siemens. Activists have now stepped up their demand to break up Royal Dutch Shell into two, reigniting the debate on whether the old-fashioned conglomerate model should be buried.
 

Many analysts, however, say conglomerates may be regarded as dinosaurs in the developed world, but in emerging markets such as India, they will continue to remain relevant. That’s because there are too many dwarf companies that fail to make much of an impact because of scalability issues. Also, diversified business groups still have the advantage of low-cost capital, as money earned from performing businesses can be invested in new businesses, which have the potential to become hugely profitable over the long term.

But this traditional view is changing fast as the markets are showing their love for standalone and single industry-focused players. In comparison, many conglomerates in India no longer hold an advantage in total shareholder returns over pure-plays and have begun to underperform in revenue growth and margin improvement. A Bain and Company study on conglomerates in India and Southeast Asia cites this as a major concern. As their performance suffers, there will be calls from sceptical investors to break them up. This is what happened in the West. “If it starts happening in India and Southeast Asia, a doom loop will be set in motion: Conglomerates will be less able to attract talent, money and opportunities, further hurting their performance,” the study says.

There is indeed a growing realisation that more focused companies perform better, and therefore they will be more productive and in a better position to make efficient capital allocation decisions, if separated from the conglomerate structure.

Though the aggregate financial ratios of some of the conglomerates still look respectable, that’s primarily because one company usually makes up for all the other underperforming businesses in the group. For example, Tata Consultancy Services accounts for 67 per cent of the combined market capitalisation of all listed Tata group companies and over 90 per cent of the group holding company Tata Sons’ dividend income. TCS has virtually funded the group’s growth for over a decade now. Similarly, Aditya Birla group’s financial ratios would look less impressive if Ultratech Cement and its parent Grasim Industries are excluded. There are many more examples.

Tata Sons Chairman N Chandrasekaran articulated the conglomerate dilemma quite well in an interview with The Economic Times a couple of years ago. He said that the Tata group needed to reduce its complexity and he would rather see the Tatas as a group focused on five, six or seven broad businesses, and not as a conglomerate of 110 or 120 companies.

A related problem in conglomerates is a complex web of crossholdings of shares among subsidiary and associate companies. Usually, the most profitable company supports weaker firms of the group, leading to misallocation of capital. Conglomerates continue to justify them as necessary to maintain business relationships — whatever that means — but an increasing number of sophisticated investors treat them as a recipe for low returns on equity and poor corporate governance. 

Also, most conglomerates in India were created under the licence-quota raj before and after independence. In that sense, most of them can be termed accidental conglomerates as no strategic thinking went behind such a structure; it was mostly about using political connection to get into totally unrelated businesses. That’s the reason why many like the Mafatlals, Khaitans, Thapars, Modis, Sarabhais and the Ruias could not cope with the rapid change in the external environment and became irrelevant.

Of course, some like the Ambanis and the Adanis are still the monarchs of all they survey. But that’s another story.